Libertarian Monetary Policy, Part I

Once I started writing this, I realized that it was too long for a single post. So here is part 1, with part 2 to follow in a day or two. I don’t yet know if I’ll need a part 3.

Libertarians want government to do less. Many seem to criticize every change in monetary policy as just another instance of the Fed interfering with the functioning of the economy. Finance and economics blogs have a lot of self-labeled libertarian commenters calling for the abolition of the Fed. Some would replace it with privately issued competitive moneys, others want to return to the gold standard. I believe the former is highly unlikely to come about for several good reasons, and the inherent flaws of the latter were largely responsible for the Great Depression. So for this post, at least, I’m going to take as given the continuance of our current fiat money regime with a central bank that can create or destroy bank reserves at will.

In today’s system, every time the federal government buys or sells anything, it affects bank reserves, because the Fed is the government’s bank. When the government buys something, even something routine like the labor services of government employees, it typically pays with a check drawn on the Treasury’s account at the Fed. When the check is deposited, the depositor’s bank forwards the check to the Fed in return for a credit to the bank’s reserve account at the Fed. Payments made to the government, like taxes, have the opposite effect, as your check to the government results in the Fed debiting your bank’s reserve account. Since every financial transaction involving the government on either end changes the supply of bank reserves, you could think of every such transaction as a mini-monetary policy.

In fact, these routine transactions are sterilized (offset) by the Fed buying or selling short-term Treasury securities, or by short term loans called repos (repurchase agreements) and reverse repos. The Fed intervenes this way in the overnight money markets just about every business day. If it didn’t, the fluctuations in bank reserves due to federal transactions would make short term interest rates bounce around much more than they already do. But notice that the decision to smooth them out is itself a policy decision. Unlike the gold standard days, there’s nothing automatic about it. The idea that there is some kind of “non-interventionist” monetary policy out there that could and should be implemented is wrong.

If “non-intervention” is not the right guide to monetary policy, than what is? Stop for a minute and think about the institution of money itself. Money is one of the greatest inventions of all time, right up there with fire and the wheel. Selling products and services for money is far more efficient than arranging long chains of barter trades. And being able to express values in a common unit is also of great importance. How can anyone make intelligent decisions about resource allocations without being able to numerically compare the alternatives? Indeed, it is hard to imagine how any society could advance much beyond the aboriginal without something serving as a medium of exchange and unit of account.

So the first rule of monetary policy is: Don’t screw it up so badly that money can no longer function as the medium of exchange and unit of account. You might think this is so obvious that it goes without saying, but these historical examples of hyperinflations will disabuse you of that. In many of these instances, the value of money kept changing so fast that it became worthless as a unit of account, and so much of it was needed for even ordinary transactions (trade you a wheelbarrow of currency for that loaf of bread, sir?) that the medium of exchange function was destroyed as well.

To motivate the second rule, consider what happens if the demand for oil increases but the supply of oil does not. Absent any interference from the authorities, the price of oil will rise until it reaches a level at which the quantities supplied and demanded are the same. The same is true for all traded goods and services. When supplies and demands change, the individual prices change to balance supplies and demands.

Well, not quite all. There is one thing we all trade whose price can’t easily adjust because it is the unit of account. That is money itself. The monetary value of a dollar is, by definition, one dollar. There’s no way to change that. But the real value of a dollar is what you can get in exchange for it. Suppose all money prices suddenly doubled. Then the real value of a dollar is cut in half. If prices change by X percent, the value of a dollar is its old value divided by (1 + X/100).

The important point is that, since money is the unit of account, the only way to change it’s value is to change the general level of prices. In the real world, however, that is always disruptive. Prices don’t all change at the same rate and in exact proportion to each other. So you’re going to end up changing the relative prices of some things, and there will be shortages and surpluses in various markets while things adjust to the new overall price level. Financial assets and liabilities are denominated in dollars, so if you’re increasing the price level, debtors will be repaying creditors with dollars that are worth less than the ones they borrowed. If you’re decreasing the price level, you make it harder for borrowers to repay the loans they took out, and some may be ruined. Declining price levels usually come about after long recessions.

Because changing the value of money is so disruptive, the second rule of monetary policy is that shifts in money demand should be accommodated by equal shifts in money supply. Actually, this rule may need a bit of modification as we go along, but for now it’s OK.

That’s all for part 1. Part 2 should be posted in a day or two.


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