You are on page 1of 8

Journal of Economic Behavior & Organization 80 (2011) 331338

Contents lists available at ScienceDirect

Journal of Economic Behavior & Organization


journal homepage: www.elsevier.com/locate/jebo

Do we need a distinct monetary constitution?


Steven Horwitz
Department of Economics, Hepburn Hall, St. Lawrence University, Canton, NY 13617, United States

a r t i c l e

i n f o

a b s t r a c t
Elements of the Chicago and Virginia traditions of political economy have rejected both competitive money production and moneys politicization via post-constitutional bargaining, opting instead for constitutionalization. This paper argues that competitive money production is not subject to the pro-cyclicality that concerns constitutional political economy. It also meets the standard of predictability that motivates constitutional perspectives, although at the level of individual prices rather than the price level. An effective monetary constitution is implicit in any constitution that protects rights to property, contract, and exchange and sets limits on the democratic process. 2011 Elsevier B.V. All rights reserved.

Article history: Received 6 March 2011 Received in revised form 28 June 2011 Accepted 13 July 2011 Available online 23 July 2011 Prepared for the Fund for the Study of Spontaneous Orders Lifetime Achievement Award Conference in honor of James M. Buchanan, Fairfax, VA, United States, September 2010 JEL classication: E58 N2 Keywords: Constitutional political economy Monetary regimes Free banking ination

1. Introduction If nothing else, one clear lesson from the Great Recession we are currently recovering from is that political control of money can do grave damage, even though it is taken for granted by the political class and the intellectuals. Leaving the quantity of money to the incentive structure produced by modern American political institutions is a recipe for disaster, as political actors are almost always willing to take the short-run illusion of economic well-being that ination creates and pass the costs on to the future, whether those cost bearers are the citizenry or political actors, including their future selves. The value of money is too important of an input into a functional market economy to leave to what James Buchanan has termed the post-constitutional bargaining among political actors and interest groups. If we are to avoid a repeat of the mess we are in now, we should be looking for ways to ensure that moneys value is not subject to those institutional incentives. In his response to the nancial crisis and Great Recession, Buchanan (2010) argues that money should be constitutionalized. Buchanan argues that neither what he terms monetary anarchy nor politicization are effective alternatives for ensuring the requisite stability in moneys value. He argues that the typical Hobbesian exercise in which we explore the argument for a constitution rarely, if ever, includes money as one of the goods that belongs at the constitutional level. He

Tel.: +1 315 229 5731; fax: +1 315 229 5819. E-mail address: shorwitz@stlawu.edu 0167-2681/$ see front matter 2011 Elsevier B.V. All rights reserved. doi:10.1016/j.jebo.2011.07.010

332

S. Horwitz / Journal of Economic Behavior & Organization 80 (2011) 331338

further argues that the ways in which money is different justify its inclusion at the constitutional level in contrast to most of the other goods that markets produce. In language borrowed from Ludwig Lachmann, I have argued this view of money sees it as an institution external to the unfolding of the market process, much like, Buchanan argues, the denitions of weights and measures (Horwitz, 1998). This places it in the category of being subject to constitutionalization. What I want to argue in this essay is that the desire to make moneys value not subject to politicization is quite correct, but that doing so does not require that we remove the production of money from the post-constitutional level. If the right general constitutional protections for private property, contracts, and the rule of law are in place, as well as the appropriate prohibitions on politicization, there is no need for a specic or distinct constitutionalization of money. If those protections are in place, the production of money is not anarchical in the sense of lacking rules, structure, and predictability. By contrast, it is only under the institutional regime of competitive production of money, redeemable in some commodity, that the goals of a specic constitutionalization of money production can be realized. Historically, full competition in money production has been rejected by the Chicago-Virginia Constitutional Political Economy perspective from Simons (1936) to Brennan and Buchanan (1981). The language they use in rejecting competitive money production is strikingly similar: such a system would be pro-cyclical by over-producing money in good times and under-producing it during downturns. Since that time, advances in the theory of free banking associated with the work of Lawrence H. White (1984a) and George Selgin (1988), have offered compelling arguments for the ability of such a system to maintain monetary equilibrium and avoid the very cycles the critics of laissez-faire in money have suggested they will amplify. As a result, we do not need a specic monetary constitution, nor a monetary component to constitutions in general, to achieve the goals that Buchanan and others rightly seek. The general features of a good constitution will produce good money. To be clear, when I say that the constitutionalization of money is unnecessary, what I am arguing is that there is no need for a constitution to specify a positive role for government with respect to money. A constitution might expressly prohibit the state from playing such a role, much as the First Amendment to the US Constitution does with respect to speech. This sort of constitutionalization would be consistent with the argument that I will make below. Thus, when I refer to constitutionalization in what follows, I am focused on the idea that a constitution needs to specify a positive role for government in the creation of a sound money system beyond what it does in providing protection for private property and contracts in general. Buchanan argues for such a positive role and I hope to show that such a role is not necessary to achieve his ends. 2. The critique of monetary anarchy By referring to the market production of money as monetary anarchy, Buchanan attempts to set up a parallel between the world of the generalized Hobbesian jungle in the absence of constitutional constraints and that of money when left purely to the forces of self-interest. And if by monetary anarchy he means a world that lacks any sort of protection for private property and contracts, we should not expect the emergence of a functional money. But if monetary anarchy simply means that government does nothing to produce or restrict the production of money, then chaos need not result, anymore than chaos in the shoe industry has not resulted from the Constitution being silent on the rules for the production of shoes. The question is whether monetary anarchy means something different, such as money specically being absent at the constitutional level. If that is the case then it is worth asking whether money is sufciently different to be singled out as a good that requires constitutionalization. Whether private production of money is inherently unreliable is the question at issue, not an assumption we should simply accept. Part of the case for moneys difference is that money of stable value is an essential institutional condition required for exchange, credit, and other kinds of contracts to function as well as they can. Buchanan considers it a framework good in the way that the administration of justice is often claimed to be. One implication of these arguments is that we cannot expect markets themselves to produce a good money, as it money is required for markets to operate in the rst place. The circularity of the argument seems to require some sort of bootstrapping in order for markets to produce good money. Distrust of the ability of self-interested private actors to produce a reliable money in the absence of some sort of specic constitutional rule is probably as old as money itself. There are numerous economists who were quite concerned with the politicization of money but who also were highly distrustful of completely unconstrained markets. It is out of this tradition that Buchanans work on money emerges. To illustrate this argument, I want to briey summarize the ideas of three authors who make similar arguments, even if two of them might reject being categorized with Buchanan in this fashion. The rst of the three is clearly representative of the Chicago roots of Buchanans constitutional monetary theory: Henry Simonss (1936) Rules versus Authorities in Monetary Policy and its proposal for a form of 100% reserve banking. Like some before him and many since, Simons saw the root of the problem of the banking systems collapse in the early 1930s as being caused by what he believed was the inherently pro-cyclical nature of fractional reserve banking. The intermediation of short-term obligations in the form of demand deposits into longer-term assets such as commercial loans through fractional reserves made the banking system vulnerable to shifts in the relative demand for base money versus bank liabilities. Once a downturn began, the fall in condence would lead to demands for redemption, forcing banks to call in loans, setting off a multiplied decline in aggregate demand. Each individual attempts to increase turn bank money into base money, but that is not possible, he argued, for the system as a whole. During a boom, the same processes would work in reverse, inappropriately expanding the money supply as condence soared and the demand for base money relative to deposits fell. The solution for

S. Horwitz / Journal of Economic Behavior & Organization 80 (2011) 331338

333

Simons was to wall off deposit banking from lending by holding deposits to a strict 100% reserve requirement that would eliminate the pro-cyclicality of the banking system. Laissez-faire in banking could not be trusted to generate stable money. Friedman (1967) noted that Simonss views here are a result of his understanding of the forces at work in the early 1930s. Simons uncritically accepted the Feds own rationale for what happened during that period, and thus believed that the Federal Reserve System was unable to stem the decline in the money supply that deepened the depression. Friedman argued that if Simons had known what we know now (thanks to Friedman and Schwartzs own work), he would have understood that the Fed was capable of stopping the drop in the money supply, but misunderstood the situation and did not use the tools at its disposal. Writing in 1967, Friedman ended up rejecting Simonss 100% reserve proposal, but only on the grounds that the monetary system is sufciently stable under central banking if the central bank performs its job. Like Simons, Friedman (implicitly anyway) rejected genuine laissez-faire in banking as a feasible option, preferring instead a monetary growth rule, perhaps set at the constitutional level.1 The second is an author who dissociated himself from Buchanans work but whose actual monetary economics reects a similar concern over the alternatives of monetary anarchy and politicization, namely Murray Rothbard. Rothbard (1962, 1994) argued for not just 100% reserves, but a 100% reserve gold standard. All deposits and paper money (if the latter were even possible in such a system) would be required to be backed 100% by gold coins. Without going too far into the details, Rothbards argument against monetary anarchy was different from Simons. Like Simons, he agreed the temptation for banks to move from being warehouses to intermediating short-term liabilities into long-term assets via fractional reserves was simply too great for them to resist. Unlike Simons, who focused on instability, Rothbard believed that fractional reserve banking was a form of fraud, as, in his view, the bank could not possibly keep all the promises it was making if they were all redeemed at once. As such, engaging in it should be illegal. Rothbard denied that making fractional reserve illegal requires a specic constitutionalization of money, but to the extent that the contractual arrangements that underlie fractional reserve banking are consistent with generalized protection for property and voluntary exchange, it is not clear how one could prohibit it without somehow singling it out.2 As some later defenders of Rothbards views seem to have conceded, if actors are fully informed about the nature of the contract, it is not clear that it could be prohibited. Thus, Rothbards own view might be seen a form of constitutionalization as he is declaring somewhat a priori that such contracts are not acceptable, even if voluntarily agreed to by the participants. Money, it would seem, requires a distinct treatment in the eyes of the law in that this is one kind of voluntary contract that we should prohibit. Rothbard and those who agree with him might argue that their proposal does not require empowering the government, but they must answer the question of how the prohibition on fractional reserve contracts will be specied and enforced. Even if one wishes to claim this is not constitutionalization and that the contracts could be prohibited privately, it still seems to parallel the Simons-Buchanan view that neither monetary anarchy nor explicit politicization is acceptable. Also consistent with the Chicago view is that Rothbard believed fractional reserve banking was inherently inationary and it therefore should be prohibited. Finally, a new book by Kotlikoff (2010) argues for a system of what he calls Limited Purpose Banking, under which banks would have to separate their loan business from their deposit business, with the latter required to be back by 100% reserves. Kotlikoffs argument derives more from a concern about the inherent risks involved with the leverage produced by fractional reserves and less from worries about the value of money in and of itself. Writing in the aftermath of the housing bubble and collapse, he sees the risk preferences of bankers as threatening the stability of the nancial system, and the macroeconomy along with it. Consistent with both Simons and Rothbard, Kotlikoff is highly critical of what he calls unregulated banking (i.e., fractional reserve intertemporal intermediation), but he is also more generally critical of laissez-faire in the broader sense as he has no problem both prohibiting mutually agreed upon fractional reserve contracts as well as invoking a regulatory agency to ensure the transparency of his preferred system. What this whole tradition of skepticism toward monetary anarchy shares is the belief that voluntary exchange and contract (with Rothbard as a grey case duly noted), even with constitutional protections for property and contract in place, are insufcient to produce a money of sufcient stability and reliability such that post-constitutional market processes can proceed as well as possible. The clearest statement of this claim is in Brennan and Buchanan (1981, pp. 1718): There seems to be nothing in the competitive-market structure to keep the supply of money in the economy from being expanded too rapidly in fair weather and contracted too sharply in foul weather. Because of the peculiarities of money, the competitive market will fail. A government role in dening and/or regulating the value of the monetary unit seems to follow from the demonstration.

1 At one point, Friedman explicitly endorsed Simons plan. Later in life, Friedman was, of course, associated with a constitutionalized money growth rule, which provides an alternative to Simonss 100% reserve regime as a way to avoid the problems of fractional reserves under central banking. It is also interesting that Friedman assumed, at least in 1967, the benevolence and competence of the Fed as the basis for his criticism of Simons. The later Friedman was more skeptical of the Feds benevolence thanks to developments in public choice theory. The Austrian critique of central planning provides reasons to question its competence even if one assumes its benevolence. 2 [I]mposing a 100% reserve requirement [is] not an arbitrary administrative at of the government, but. . .part of the general legal defense of property against fraud (Rothbard, 1962: 709). As his careful wording there suggests, it requires a particular ethical-legal theory to explain how one is going to single out these particular voluntary contracts to be prohibited especially when one, like Rothbard, believes the production and enforcement of the law is best left to markets as well.

334

S. Horwitz / Journal of Economic Behavior & Organization 80 (2011) 331338

They later return to this argument in the concluding section of the essay by reiterating that they nd the argument persuasive, but wish to observe that even with its imperfections, a competitive monetary system might well be preferred to an unrestrained government monopoly. They later argue that a third option, namely the sort of governmental denition of the value of the monetary unit discussed in the quote above, would be superior to either. The Simons-Buchanan approach has rightly called our attention to the fact that excesses and deciencies in the money supply are problems that a constitutional political economy must take seriously. Modern public choice has given us numerous reasons to suspect that unrestrained democracies will produce both decit spending and ination. Before responding to the critique of competitive money offered above, further exploration of the costs of ination from a constitutional political economy perspective can reinforce the importance of getting money right. 3. In defense of monetary anarchy The problems with the arguments against the competitive production of money are both theoretical and historical. In this section, I address the claim that a generally accepted medium of exchange must be provided externally and the view that competitive money production is prone to pro-cyclicality. The claim that markets cannot evolve with a suitable money provided externally is rebutted by Mengers (1892) theory of the origin of money, an explanation of moneys emergence that does not require intentional institutional design by anyone. Starting in a world of barter, traders recognize that they are more likely to be successful in achieving the necessary double coincidence of wants if they hold stocks of goods that others are likely to nd valuable, a property Menger refers to as salability. As traders perferentially accept in payment the goods that they judge the most salable, they trigger a social discovery process that eventually converges on a generally accepted medium of exchange. Those who make better guesses at which goods are most saleable will be better able to execute mutually benecial exchanges and will increase their wealth the most. The key to Mengers story is that others observe this success and imitate the use of those goods as media of exchange, even if they do not completely understand why they work. As a small number of goods gets used in this way, they will increase in value as they are now desired both for their use and exchange value. Eventually, this process will converge upon one or two goods that become generally accepted mediums of exchange, or money. Mengers story relies upon the existence of other stable institutions in order for money to emerge. He takes for granted that individuals have clearly dened and reasonably secure rights to their property as well as the legal right to exchange that property. All of these rights are presumably effectively enforced. For Mengers spontaneous order story to work, other institutions have to be in place to some degree or another. In the absence of such institutions, whether literally constitutional or just a widely accepted and respected social norm, the exchange and imitation processes at the heart of the evolution of money will be weakened as actors cannot have sufcient condence that they will be able to keep the rewards associated with improved learning. The sketch above largely conforms to the available historical evidence. Stable and reliable moneys can be selected by market processes framed by institutions that protect property, even as the emergence of those moneys created new practices that required marginal changes in the legal order. The numerous examples of so-called free banking systems throughout the history of the capitalist west (see Schuler, 1988 and Dowd, 1992) further suggest that unhampered markets are capable of producing full-edged systems of monetary institutions that can avoid the volatility in the quantity of money that produces the sorts of booms and busts that have characterized recent times and that have concerned constitutional political economists since Simons.3 Theory and history indicate is that monetary systems are capable of evolving their own rules and regulatory practices in the absence of specic governmental interventions. Selgin and White (1994) offer an overview of the literature as well as an extended conjectural history that explains how.4 If we agree that state involvement is not necessary to produce a generally accepted medium of exchange, as in Menger, then the rst step of the process is complete. For simplicity, we shall assume that gold is the choice emerging out of this process, though it is not the only possibility. A next key step is the development of coinage, the history of which also demonstrates that unhampered market processes can produce high-quality coins (Selgin, 2008). With the desire to protect their monetary gold, actors will look for storage services, most likely in the form of a goldsmith or someone else used to handling and protecting gold. Goldsmiths will (and did) charge storage fees for these services. We can further imagine a claim being issued for the stored gold coins. When owners of the gold needed it for transaction purposes, they would have to make a trip to the goldsmith and withdraw some of what they had stored. The inconvenience of this practice, especially if payment was to be made to another of the goldsmiths customers, soon led to the use of the claims as substitutes for the gold, particularly when the claims were issued in various denominations. Soon the bank realizes it can attract more gold by offering another kind of contract to customers in addition to bailments. They offered a debt claim to the value of the coins deposited, redeemable on demand to the possessor, that offered an interest payment rather than charging a storage fee. Competition with other goldsmiths pushed them to offer interest payments on

3 On the ability of a Mengerian convergence process to select commodities that will have the relatively stable and reliable purchasing power that a good money needs, see White (2002). On the historical superiority of gold and silver standards in meeting this criterion, see Rolnick and Weber (1997). 4 Brennan and Buchanan (1981) note this conjectural history but do not recognize the stability properties of the system in terms of maintaining monetary equilibrium.

S. Horwitz / Journal of Economic Behavior & Organization 80 (2011) 331338

335

these new debt claims. This arrangement enabled the banks to take the loan from the customer and lend that out at interest to borrowers. As long as the rate they paid for deposits was less than what they charged on loans (adjusting for risk), banks proted. These last few steps are the invention of fractional reserve banking and the emergence of banks as true nancial intermediaries. It also makes clear that the nature of the contract between the bank and its depositors is a loan to the bank rather than a bailment. As Selgin and White argue, this sort of banking system has important stability properties. Rather than monetary anarchy producing chaos, the result is a self-regulated order that ensures the monetary stability necessary for a functioning market economy. Specically, their work shows how any attempt by such banks to expand the supply of money beyond the publics demand to hold that money at the current price level will initiate self-correcting processes. Such excesses will cause those who do not wish to hold the money to either spend it, leading to redemption through the banking system, or redeem it directly at the issuing bank. In either case, the excess money creation leads to a prot-reducing loss of reserves that can ultimately threaten the banks liquidity and solvency. Seeing this signal, banks are led to restrict the volume of their loans to restore their liquidity and correct the excess money supply. Even during times of growth, free banks are not led to excessive credit expansion as producing more of their liabilities than their customers wish to hold will initiate a costly increase in their liquidity risk. The concern with pro-cyclicality that motivated Simons is more valid for a system that relied on something like the Real Bills Doctrine, which would lead to banks to inappropriately increase their lending because rms brought real bills in as collateral assets. Ironically, it was the Feds commitment to the Real Bills Doctrine that many see as responsible for the failures in the early 1930s that motivated Simonss concern with fractional reserve banking (Timberlake, 2005). Conversely, banks that under-produce money relative to demand will see their excess reserves grow, which involves an opportunity cost in terms of foregone interest on loans they could be making. This prot-reducing increase in excess reserves serves as a signal that they should be creating more money given the level of demand and the current price level. During a period of economic contraction, free banks can respond to falling velocity by creating additional liabilities by reducing their desired reserve ratios and costlessly swapping deposits for banknotes if their customers wish, all of which will maintain what Hayek (1967) called the effective quantity of money in circulation (or in quantity theoretic terms: a stable MV) and avoid a multiplied drain on the banking system.5 A free banking system will ensure that money is not a source of disturbances in the market processes through which exchange takes place and economic order is produced. Historically, economists argued that money should behave like a transparent veil over the top of the underlying fundamentals of the marketplace, simply facilitating the exchanges that comprise the catallaxy. Like the oil that lubricates an engine, money does not propel the system, but instead makes it possible for the systems own propulsion system to work properly. By maintaining monetary equilibrium, a free banking system will ensure that prices reect underlying variables and that market rates of interest will reect the underlying time preferences of savers and lenders.6 Such a system will thereby prevent the waves of expansion and contraction that the SimonsBuchanan view has seen as triggering the pro-cyclicality of an unconstrained fractional reserve system. As long as the state continues to be constitutionally constrained from interfering with property and contracts generally, there is no need for a constitution to speak specically to money. The historical record is littered with attempts by governments to manipulate the monetary system for the self-interest of various political actors and their supporters. As Buchanan (2010) argues, this sort of politicization of money, often the result of excessive budget decits that are themselves the product of unconstrained political self-interest, has been the prime source of macroeconomic instability, both historical and recent. Political intervention has been a much larger source of chaos than banking systems largely free of such intervention. The history of the US nancial system, and the numerous panics and crises it has faced, is abundant evidence of the chaos that post-constitutional politics can cause when allowed to determine the nature of the monetary system. From the 19th century panics that led to the creation of the Fed, to the boom of the 20s and the bust of the 30s, through the ination of the 70s and early 80 and then the boom and bust of the last decade, central banking and the variety of government regulations that preceded it, and continue to be present today, have been at the bottom of those episodes. Putting constitutional limits on central banking is not necessarily the best we can do, however, once we recognize the option of privatizing money. 4. Price stability, predictability, and the productivity norm In a freely competitive monetary system, the prot incentives and knowledge signals of the price system will lead banks to produce a quantity of money that enables prices to do as best as they can in accurately reecting underlying fundamentals. The question is whether such a system will produce the stability and predictability that is the goal of much constitutional political economy discussion of money. Money in its role as a unit of account is often compared to weights and measures (Buchanan, 1962). Because weights and measures are used for comparative purposes, their users need condence that the scale or ruler they are using is accurate both longitudinally and cross-sectionally. The user of a ruler, for example, needs to be sure that both the ruler and the very denition of an inch or a foot do not change through time as he uses the ruler. What the ruler measures as six inches

5 Selgin (1988) offers the most detailed and technical treatment of what he terms the principle of adverse clearings that maintains monetary equilibrium in the face of changes in velocity. 6 On this point, see Horwitz (2000).

336

S. Horwitz / Journal of Economic Behavior & Organization 80 (2011) 331338

today must be equal to what it measures as six inches tomorrow or a year from now. In addition, rulers used by different people at one point in time must also be stable and consistent. If I measure a length of pipe at three feet and someone else uses a different ruler measuring a length of pipe that will t it and that should also be three feet long, we must both believe that our rulers are measuring three feet the same way. Without such assurances, weights and measures are much less useful, just as money that constantly changes in value is similarly less useful for the assessment of comparative value that is at the heart of economic calculation. The lesson drawn from this analogy is that there is a necessary constitutional role in assuring that the value of the monetary unit will have the requisite stability. This could consist of dening the dollar in terms of a weight in gold, or it could be something like Buchanan (1962) brick standard, or even the so-called Black-Fama-Hall system of Greeneld and Yeager (1983). Of course once dened, all agree that it is preferred that rms and markets be the ones actually producing the instruments people use. Those who see a constitutional role for dening weights and measures and money generally have no problem with the market producing scales, rulers, and checking account balances. The question is whether such a denition is needed to provide the stability that is the ultimate goal. The defense of monetary anarchy in the prior section indicates that it might not be necessary. From the perspective of free banking theory, the key to stability is that market-produced moneys are redeemable in whatever outside money that emerges out of the (ongoing) Mengerian process of evolution. The ease with which any institution will persist and thrive depends upon the degree to which it has emerged out of the actual practices of those who use it. Misess (1980) regression theorem was a response to the argument that the value of money could not be determined using marginal utility theory, because the value of the marginal unit to its demander depended on money already having a determinate value. The regression theorem broke that circularity by arguing that commodity moneys anticipated exchange value as a money linked up with its non-money value as a commodity. Once a commodity becomes money, its anticipated exchange value evolves with its experienced value as inuenced by variations in supply and demand, beginning with its exchange value as a commodity. One implication of Misess theorem is that nothing can become a generally accepted medium of exchange without some sort of unbroken line back to a commodity with a non-monetary value. Even the at US dollar can be traced back to gold via its redeemability in years past. In other words, it is only the actions of actual traders engaged in the Mengerian evolutionary process who can determine whether something will be used as money. Imposing a money disconnected from actual exchange behavior will be doomed to fail as it will not have emerged from a process through which its users have indicated a willingness to accept it in exchange (Selgin, 1994). This insight indicates the problems with attempts to dene monetary standards by imagining what a perfectly stable system might look like. The BFH system and the brick standard are both are subject to this critique. The BFH system imagines a unit of account that will be highly stable in value but that is distinct from the medium of exchange. Although this cleavage is conceivable in theory, it tends to fail in practice for reasons articulated in Whites (1984b) response to Greeneld and Yeager: we have strong reasons to think that units of account and mediums of exchange tend to co-evolve based on the trading practices of market participants. They emerge together in Mengers theory because traders simultaneously are discovering both a medium of exchange and a basis for the comparison of value. Neither one exists in a meaningful sense until they both begin to emerge in the same process. Given how far back this connection runs and how deep it is, it is difcult to imagine that imposing a unit of account that is distinct from the medium of exchange will be successful, especially when alternative means of achieving the same end are more likely to work. The brick standard, by contrast, does not cleave the unit of account from the medium of exchange in the same way as Buchanan allows for the media of exchange to be redeemed for bricks. The problem with this proposal is developing a plausible explanation for how bricks came to be used in both capacities. Both theory and history suggest that Mengerian processes will converge upon commodities that both have high subjective value to traders and important properties, including the right degree of scarcity, that enable them to serve as media of exchange. Subjective value is necessary but not sufcient for a commodity to be a useful money. Buchanans desire to solve the problem of predictability leads him to propose a standard that could only come about through exogenous imposition by the state rather than emerging out of actual trading. The latter, as both Menger and Mises demonstrate, is the only way that a sound money can be produced. A free banking system, where bank produced moneys are redeemable in some commodity, will prevent money-side swings in the price level and moneys value. By providing a release valve for excess money creation through the redemption process, free banking cuts the ination process short before it can have any real effects. It also quickly raises the cost to banks of engaging in deation as well. As argued earlier, such a system will minimize deviations from monetary equilibrium, preventing the deviations from the natural rate of interest that concerned pre-Keynesian monetary theorists in the Wicksellian tradition. Although the sort of system I have outlined will minimize money-induced movements in the price level, it will allow for the price level to change in response to changes in total factor productivity. More specically, the price level as a whole will move inversely to changes in productivity, such that a growing economy will lead to a slow, steady fall in the overall level of prices.7 If prices are supposed to reect underlying scarcities, then allowing them to move in response to changes in productivity would seem to be the appropriate policy. Increases in total factor productivity are the equivalent of goods

7 The full case for this view is made in Selgin (1997) where he also connects these arguments to a number of 20th century monetary theorists, many of them pre-Keynesian.

S. Horwitz / Journal of Economic Behavior & Organization 80 (2011) 331338

337

getting less relatively scarce, hence the relevant output prices should fall. Decreases in productivity, perhaps due to war or a natural disaster, reect increased scarcity and prices should move to make that knowledge available to others. Rather than attempting to keep the price level constant and therefore predictable, the so-called productivity norm argues that the predictability of relative prices being indicators of relative scarcity is a more important form of predictability. Part of this argument is that any attempt to stabilize the price level in the face of downward pressure on prices from productivity gains would require increases in the money supply that would themselves disrupt the price systems communicative abilities. Those injections of money, and the inevitable relative price effects they would produce as we noted earlier, would move prices away from their natural values, which in turn induces resource misallocation. Although a stable overall price level enhances predictability at the macro level, achieving that goal in a growing economy requires disruptions in some number of the millions of prices that comprise that price level. Those disruptions cause the sorts of problems discussed earlier and reduce predictability at the microeconomic level. Price level stability can only achieve a crude notion of predictability based on the analytical aggregate construct of the price level, while reducing predictability in the individual markets that comprise it.8 Just because something is predictable does not mean, of course, that it is desirable. We might wish that the price level were predictable for the same reason we want the weather to be predictable: it enables us to be prepared. However, no matter how accurate the forecast is, enough snow can still impose serious coordination costs even on cities used to snow. Predictability is but one means to the further end of social coordination, and events that are predictable at the macro level might still be disruptive at the micro level. To nish the analogy: we might prefer a world in which weather forecasters are always a bit off about snowfall predictions, but where none of the storms are big enough to matter, to one in which they are always accurate about frequent blizzards. I would suggest the former is something like the world of the productivity norm, where the price level cannot be assumed to be stable, yet its divergences from stability are not problematic, while the latter is the world of price level stability where we always know what the price level is going to do, but that the policy of injecting money to offset productivity gains is still disruptive. 5. Conclusion: an implicit monetary constitution The politicization of the money supply has caused a great deal of social havoc in the last century, with the boom of the last decade that preceded the bust and the policy response to the bust, being just the latest example. In his call for the constitutionalization of money, Buchanan correctly perceives the need to take away the printing press from Leviathan. Rejecting the feasibility of monetary anarchy, he sees, consistent with decades of his work, the solution as nding a way to constitutionalize money to take it out of the realm of post-constitutional bargaining. Sealing off money from both the usual forces of the market and the grasping hands of politicians has been part of the Chicago-Virginia tradition since the 1930s, as well as appearing elsewhere in debates over monetary policy. The goal of removing decisions about the production of money from the realm of political self-interest is the right one, but it is not clear that monetary anarchy fails that test in the way Buchanan thinks. I have tried to make the case that by his own criteria, a free banking system performs at least as well, if not better, than would various proposals to use a constitutional rule to lock-in either 100% reserves or price level stability. Much as Friedman (1967) argued that Simonss call for 100% reserves was the result of his skepticism about the stability of fractional reserves under central banking due to his interpretation of the Feds role in the early 1930s, so one might argue that the rejection of competitive money production by Brennan and Buchanan (1981) is a reection of the state of theoretical and historical knowledge about such systems at the time they wrote. Friedman argues that had Simons lived to see the later work on the Great Depression, he would have realized that his rejection of fractional reserves was not necessary to avoid a repeat. I would argue that there is an analogy in the development of scholarship on free banking in the 30 years since Monopoly in Money and Ination. That more recent work is, in my view, sufciently persuasive to reject Brennan and Buchanans skepticism toward competitive money production. A freely competitive banking system with bankissued money redeemable in an actual money commodity, resting on the more general constitutional protections for private property, contract, and exchange, will keep money out of the political arena, ensure that relative prices consistently reect underlying variables of tastes, technology, and resources, and provide the predictability necessary for economic calculation and long-term planning by households and rms. Generating those results requires, as Brennan and Buchanan (1981, p. 65) note, that we engage the constitutional question and recognize that an unrestrained political monopoly over money is the source of much trouble. It need not, however, mean that explicit constitutional treatment of money is the best solution. Constitutional political economy is correctly concerned with erecting constraints on the self-interest of political actors to prevent them from encroaching on the framework institutions necessary to a functioning economy and human freedom more generally. They are further correct to consider money one of those key framework institutions in the sense that without a sound monetary system, the spread of the division of labor, exchange, and social cooperation will be weakened. Money

8 My use of crude predictability is intentionally meant to recall the idea of crude coordination of the wage level associated with Hutt (1979). He argued that using ination to reduce the overall level of nominal wages as a way of driving down unemployment could only achieve the crude coordination of aggregates while damaging the more delicate coordination of the various individual wage rates that needed to be adjusted to get labor markets back to reecting the underlying variables of demand and supply.

338

S. Horwitz / Journal of Economic Behavior & Organization 80 (2011) 331338

does need to be isolated from post-constitutional bargaining, and in that sense needs to be thought of at the constitutional level. However, rather than seeing the solution as explicitly including money at the constitutional level, we can consider the alternative of an implicit monetary constitution. If constitutional protections for property, contract, and exchange are capable of generating a sound and non-politicized monetary system, then cannot we argue that any constitution that provides said protections also implicitly contains a monetary constitution? If free banking theory is correct in explaining the process by which such a system will emerge and in judging its welfare properties, as I believe it is, then I think the answer is yes. There is no need for a distinct monetary constitution when the right constitutional rules so ably identied by the constitutional political economy literature are already in place. Money can remain in the private sector rather than beingmoved constitutionally to the public sector. Acknowledgement The author thanks an anonymous referee for his very detailed and most helpful comments on an earlier draft. References
Brennan, H.G., Buchanan, J.M., 1981. Monopoly in Money and Ination Hobart Paper #88. Institute for Economic Affairs, London. Buchanan, J.M., 1962. Predictability: the criterion of monetary constitutions. In: Yeager, L.B. (Ed.), In Search of a Monetary Constitution. Harvard University Press, Cambridge. Buchanan, J.M., 2010. The constitutionalization of money. Cato Journal 30, 251258. Dowd, K. (Ed.), 1992. The Experience of Free Banking. Routledge, London. Friedman, M., 1967. The Monetary Theory and Policy of Henry Simons. The Journal of Law and Economics 10 (October), 113. Greeneld, R.L., Yeager, L.B., 1983. A Laissez-Faire Approach to Monetary Stability. Journal of Money, Credit, and Banking 15, 302315. Hayek, F.A., 1967. Prices and Production Second revised Edition. Augustus M. Kelley, New York. Horwitz, S.G., 1998. Hierarchical metaphors in austrian institutionalism: a friendly subjectivist caveat. In: Koppl, R., Mongiovi, G. (Eds.), Methodological Issues in the Subjectivist Paradigm: Essays in Memory of Ludwig Lachmann. Routledge, New York. Horwitz, S.G., 2000. Microfoundations and Macroeconomics: An Austrian Perspective. Routledge, New York. Hutt, W.H., 1979. The Keynesian Episode. Liberty Press, Indianapolis. Kotlikoff, L.J., 2010. Jimmy Stewart is Dead: Ending the Worlds Ongoing Financial Plague with Limited Purpose Banking. Wiley, Hoboken. Menger, C., 1892. On the Origin of Money. Economic Journal 2, 239255. Mises, L., 1980. The Theory of Money and Credit. Liberty Press, Indianapolis, Ind. Rolnick, A.J., Weber, W.E., 1997. Money, ination, and output under at and commodity standards. Journal of Political Economy 105, 13081321. Rothbard, M.N., 1962. Man, Economy and State. Nash Publishing, Los Angeles. Rothbard, M.N., 1994. The Case Against the Fed. Ludwig von Mises Institute, Auburn, AL. Schuler, K. 1988. Free Banking: A Bibliographic Essay, Humane Studies Review 6,1, Fall. Selgin, G.A., 1988. The Theory of Free Banking: Money Supply Under Competitive Note Issue. Rowman and Littleeld, Totowa, NJ. Selgin, G.A., 1994. On ensuring the acceptability of a new at money. Journal of Money, Credit, and Banking 26, 808826. Selgin, G.A., 1997. Less than Zero The Case for a Falling Price Level in a Growing Economy Hobart Paper #132. Institute for Economic Affairs, London. Selgin, G.A., 2008. Good Money: Birmingham Button Makers, the Royal Mint, and the Beginnings of Modern Coinage 17751821. University of Michigan Press, Ann Arbor. Selgin, G.A., White, L.H., 1994. How would the invisible hand handle money? Journal of Economic Literature 32, 17181749. Simons, H., 1936. Rules versus authorities in monetary policy. Journal of Political Economy 44 (February), 130. Timberlake, R.H., 2005. Gold Standards and the Real Bills Doctrine in U.S. Monetary Policy. Econ Journal Watch 2, 196233. White, L.H., 1984a. Free Banking in Britain. Cambridge University Press, Cambridge. White, L.H., 1984b. Competitive Payments Systems and the Unit of Account reprinted in Competition and Currency: Essays on Free Banking and Money. NYU Press, New York, 1989. White, L.H., 2002. Does a Superior Monetary Standard Spontaneously Emerge? Journal des Economistes et des Etudes Humaines 12, 269281.

You might also like