The Next Generation of Austrian Economics: Essays in Honor of Joseph T. Salerno

Scholars* of the Austrian tradition are particularly known for their important work in the field of monetary economics. They analyze the dynamics of fiat money and its impact on the real economy. However, empirical attempts to support the theoretical claims are relatively rare. In this chapter, I sketch an empirical strategy to test whether a change in the monetary regime has significantly impacted the accumulation of public debt and government deficits in the United States. Government deficits appear to be significantly lower under the gold standard regime and significantly higher under a regime of fiat money after controlling for other explaining factors such as, for instance military expenses or interest charges.

This chapter is structured as follows. Section 2 gives an overview about the nature of money to understand the dynamics of fiat money. Section 3 outlines why the introduction of a fiat money regime potentially increases the accumulation of public debt. Section 4 outlines the econometric model to account for the effects of different monetary regimes on public debt. Furthermore, potential lines of research are provided to improve the explanatory power and robustness of the model. Section 5 concludes.

Monetary Mechanisms and Monetary Policy

As Mises repeatedly stresses, money is the fruit of indirect exchange (Mises 1980, p. 45). Thus, the emergence of money is spontaneous and becomes necessary as the division of labor increases and wants become more refined (Mises 1980, p. 5). Individuals only choose to have recourse to indirect exchange when the goods they can acquire are more marketable than those which they surrender.

As a result, the most marketable commodities will become common media of exchange and their position is strengthened as their relative marketability increases in comparison to other commodities (Mises 1980, p. 6). The main function of money according to Mises is its universal employment as a general medium of exchange (Mises 1980, p. 7).

Hülsmann (2008) introduces a further distinction between natural and forced monies. Natural money corresponds to money that arose through voluntary actions of individuals which circulates until it is displaced by an external pressure. Alterations to the former type of natural money are defined as forced money. In this case, money no longer complies with individual preferences, but is the result of a welfare reducing imposition. As a consequence, forced monies are per definitionem less socially beneficial than natural monies, as they only exist due to the violations of individual rights. Based on this distinction, it is possible to introduce a further division between credit money and paper money. As Hülsmann (2008) points out, the value of credit money (a claim to money in the future) is based on the trust that the respective sum of money is eventually refunded in the future.

Paper money or fiat money owes its existence to legal privileges. Hülsmann (2008) emphasizes that paper money has never spontaneously emerged as a result of the voluntary actions of individuals. Legal tender laws impose the use of a lower quality paper money at the expense of the natural money. The bad money, i.e., the overvalued paper money, drives the good money, i.e., the undervalued natural money out of the market as their legal equivalence is only due to imposed laws and do not reflect the economic reality. This process is known as Gresham’s law, named after Thomas Gresham (Hülsmann 2008, p. 127). Naturally, this leads to inflation of the overvalued money, “because this money is produced and held in greater quantities than would be the case in the absence of the price control” (Hülsmann 2008, p. 127). The natural limit in money production is distorted as the full consequences are not borne by the money producer. Legally established values are not altered and constraining competitive processes are suspended under legal tender laws. Moreover, Cantillon effects, named after the French economist Richard Cantillon1 enforce the enrichment of money producers under the regime of legal tender. As Hülsmann (2008, p. 44) points out, there can be no simultaneous increase of all prices as newly created money enters the market. The first users of the new money have the privilege to use it on goods priced according to the quantity of money that existed before the increase in the money supply. However, the newly acquired purchasing power does not remain unnoticed and spreads out through the economy. Prices eventually adjust upward due to the increased demand of the initial users. The last receivers have not benefited from the new money. To the contrary, they suffer a deteriorated quality of the money and higher price levels.

As Hülsmann (2008, p. 89) argues, debasement was traditionally the way to inflate the money supply. The nominal value of a coin was modified not reflecting the metal content any longer or the content of metal was reduced without an according change in the nominal value. However, debasement reached a whole new level with the emergence of fractional-reserve banking, i.e., the issuance of coins or bank notes which are not fully covered by the available reserves. This significantly reduced the cost of money production. According to Hülsmann (2008, p. 93), there are three main reasons that led to this phenomenon.

In the first place, the warehousing institutions, the original function of banks to the late 1700s, have been perverted. Second, credit banking has been perverted as banks use deposits for loans. Lastly, it was a natural response to the threat of government expropriation. As banks feared that their holdings would be eventually confiscated, they preferred to lend out the funds. However, as individuals eventually find out about the debased monies, it is necessary to guarantee a continual demand through legal tender laws. This privilege is the ultimate explanatory link for all other monetary advantages.

In addition to the outlined factors, the twentieth century witnessed the development of maturity mismatching in the banking sector (Bagus and Howden, 2009), i.e., borrow short and lend long. Nowadays, this is considered as one of the main functions of banks. For instance, Freixas and Rochet (2008) point out that “modern banks can be seen as transforming securities with short maturities, offered to depositors, into securities with long maturities, which borrowers desire.” Necessarily, this implies a certain “risk” for banks if the credits are not covered by corresponding savings of depositors. If depositors require their funds, banks can have recourse to derivatives (such as swaps or futures) or engage into interbank lending to limit this “liquidity risk.” However, this type of risk management is very costly. In a competitive environment where the success of a bank’s business is based on its ability to gain confidence of depositors, the constant mismatching of maturities must be relatively limited. Depositors are not likely to give their money to banks that accumulate negative working capital and struggle to refinance their debt.

To recapitulate, money evolved spontaneously in the market. Historically, gold and silver were chosen as the common medium of exchange for their practical purposes. For reasons of convenience, warehouses arose to store these metals and certificates were issued. As a consequence, certificates were traded in everyday business and rarely redeemed into gold. Unfortunately, this created a temptation to engage into fractional-reserve banking and to issue certificates in excess of the actual gold reserves. At some point, governments entered into the game and monopolized the minting of coins and established legal tenders laws. Under the classical gold standard from 1815–1914, a fractional gold standard was institutionalized and guaranteed by the respective states. As already outlined above, fractional-reserve banking diminishes the cost of money production and increases the profitability of banks. As a consequence, there is a tendency to threaten the financial stability of banks as the continual issuance of credits in excess of savings is eventually discovered by depositors and creditors. Bank runs and the liquidation of assets are naturally the cause as people lose confidence.

The drawbacks of this business model must be resolved by some external institution that guarantees the liquidity of banks. This is the role of central banks (Bagus 2012). Central banks are lenders of last resort for commercial banks. Banks can now refinance their debt through short-term credits and liquidity problems can be limited as the production of money is coordinated by the central bank. However, under the gold standard, even coordinated money expansion was limited by the fear of redemption in a crisis. By the 1970s the burden of the gold standard was removed and the doors were further opened for the lucrative business of money creation.

Monetary Policy Since the 1970s in the United States

The abolition of the gold standard on August 15, 1971, led to the establishment of a regime of paper monies for most of the national currencies. Before this date all national currencies were linked to the gold standard via the US dollar. As the US decided to go off gold altogether, the fractional-reserve gold certificates basically became paper money (Hülsmann 2008, p. 223). The new fiat money standard magnified moral hazard at a large scale. Fiat money allows producers of money to “create ex nihilo virtually any amount of money” (Hülsmann 2006, p. 10). The growth of the money supply increased significantly after the decision to go off the gold window. The M3 monetary aggregate grew by 12.42 percent in 1972 in the US, although the average growth rate was about 6.76 percent in the decade before.

Under the regime of William McChesney Martin from 1951 to 1970, monetary policy was relatively conservative. Growth rates of the CPI were below three percent during the early 1960s (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 23). As Martin points out in testimony to the Joint Economic Committee: “the Fed has a responsibility to use the powers it possesses over economic events to dampen excesses in economic activity by keeping the use of credit in line with resources available for production of goods and services.2 In 1964, Martin expressed his concerns about increasing inflation as federal spending increased a lot during the second half of the 1960s. Bremner (2004, p. 191) cites a quote by Martin which summarizes his worries: “I think we’re heading toward an inflationary mess that we won’t be able to pull ourselves out of.” Martin expressed in his last press conference that he had “feelings of failure for not having controlled inflation” (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 26). By 1970, Martin was replaced by Arthur F. Burns. He commenced a period of high inflation and very low real interest rates, a byproduct of loose money now simplified by the full fiat money standard. However, even before the suspension of payment by the Fed in 1971, the federal funds rate was already lowered from 8.02 percent during the first quarter in 1970 to 4.12 percent by the fourth quarter of the same year (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 26). What are the implications of low or even negative real interest rates? They reduce the incentives for people to save money and at the same time the cost of debt is significantly reduced. Even though federal funds rates were eventually raised during the following years, they never kept up with the running inflation rates and real interest would only be over 2 percent in the second quarter of 1976 (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 26). Thus, during his tenure until 1978, real interest rates were only above 2 percent for three quarters. The Per Jacobsson Lecture on “The Anguish of Central Banking” (Burns 1979) summarizes his views on monetary policy and central banking relatively well. Basically, the upward pressures on prices by interest groups are the real reason for the inflationary policy by the Fed. According to him, the Fed does not have enough power to effectively fight against inflation “as it is illusory to expect central banks to put an end to the inflation that now afflicts the industrial democracies” (Burns 1979, p. 21). After a short intermezzo by Miller whose tenure ended into an emergency sale of US gold and borrowings from the International Monetary Fund (IMF) (Dowd and Hutchinson 2010, p. 251), President Carter moved Miller to the Treasury department and appointed Paul Volcker as the chairman of the Fed.

As a consequence, the federal funds rates increased significantly from 2 percent to 12 percent (Dowd and Hutchinson 2010, p. 251) and real interest rates remained high during the 1980s. Just as Burns, he was also invited to give the Per Jacobsson Lecture, but concluded that inflation had been defeated under his regime. However, as the problem of inflation was apparently controlled, another chairman, Alan Greenspan was appointed. He supported the deregulation of the banking sector under Reagan (Dowd and Hutchinson 2010, p. 252). Greenspan emphasized that inflation must be kept low during his confirmation hearings (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 32), however it took only a few months until this plan was scrapped. Greenspan responded to the stock market crash of October 1987 by cutting interest rates and by declaring that the Fed is disposed to provide “liquidity” in such a case (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 32). Later, interest rates were kept low, even as inflation reached 6 percent during 1989–1990. The policy of low interest rates continued until 1994, where the Federal funds yield reached the lowest levels since the 1960s. As a reaction to this inflation scare, interest rates doubled, although Greenspan was reluctant to take this action initially.3 However, this led to big losses for many entities that were betting on low interest rates. Most notoriously California’s Orange County defaulted on its debt by speculating with derivatives on low interest rates (Dowd and Hutchinson 2010, p. 53).

By February 1995, Greenspan announced that his policy of increasing rates is over.4 Effectively, the money supply growth was 2.6 percent higher than nominal GDP during this tenure. The failure of Long-Term Capital Management in 1998 (Lowenstein 2001) illustrated perfectly the approach which was taken by the Fed by now. Not only was a bailout organized, but under Greenspan interest rates were subsequently cut three times to calm down financial markets. This low-interest policy basically allowed the financial sector to maintain more activity of unsustainable trading activities. Ultimately, this policy fueled the dotcom bubble during which stocks were even more overevaluated than during 1929 (Garrison and Callahan 2003). As a consequence, interest rate raises followed in the year 1999 and 2000 which eventually triggered the bust of the stock market. However, already by 2001, the federal funds rate was lowered again to fight the ongoing recession. Together with the occurrence of the 9/11 terrorist attacks and fiscal policy under the newly elected President Bush, interest rates attained the lowest level since 1961 by the year 2002. From 2002 to his retirement in January 2006, Greenspan kept interest low below 3 percent. This period also witnessed the housing bubble and the closely tied structured finance crisis. The burst of this bubble finally led to the current financial crisis. The following “non-moderate” recession is accompanied by nominal interest rates which are currently approaching zero, while real interest rates are simply negative. The development of the federal funds rate can be depicted as follows in figure 1.

To summarize, ever since the fight on inflation of the early 1980s under Volcker, interest rates have been declining. The most substantial reductions happened in the post-era of the dotcom bubble and as a response to the terrorist attacks of 2001. Likewise, federal funds rate have been lowered to an all-time low to fight the current recession. Monetary policy of the last thirty years substantially reduced the cost of debt and consequently eased the issuance of debt securities in the financial market.

Fiat Money and Public Debt

Fiat money and legal privileges reduce the natural barriers to the creation of credits. Debts are an easy way to increase the expenses of governments. Furthermore, debts are by far more popular than the alternative, i.e., taxes. However, governments are special debtors as they can have recourse to means of financial repression: “Financial repression occurs when governments implement policies to channel to themselves funds that in a deregulated market environment would go elsewhere” Reinhart, Kirkegaard, and Sbrancia (2011).

There are several measures that increase artificially the demand of sovereign bonds, however the main measure of financial repression is to keep nominal interest rates low through loose monetary policy. It reduces the interest expenses for governments and high inflation reduces the cost of debt at the expense of the creditors. Similarly, traditional investors are more likely to put their money into government bonds as savings accounts are not profitable enough. In the case of negative real interest rates, as witnessed 1945–1980 and since 2007 (Reinhart, Kirkegaard, and Sbrancia 2011), it even becomes a supplementary tax in addition to the redistributive consequences of inflation. Figure 2 shows the evolution of government debt during the phase of positive real interest rates and a sharp increase since 2007 when real interest rates were negative again.

Empirical Implications

Building upon the theoretical arguments of this paper, it is manifest to test whether public debt and government deficits have, ceteris paribus, significantly increased under a full fiat money standard.

Yoon (2012) shows, using a new recursive method for unit root testing, that the U.S. public debt–GDP ratio was explosive in nature during the sample period. This is an interesting result as a standard unit root test such as an augmented Dickey-Fuller test shows that this series contains an unit root and is therefore stationary (Bohn 2008). As a result, there is no concluding evidence about the properties of public debt in the United States during this period.

Figure 4 suggest that wars played a major role for the accumulation of debt. As Figure 3, Yoon (2012) points out “The War of Independence, Spanish–American War, the Civil War, World War I, and World War II — explain the high debt–GDP ratio in 1791 and the sharp increases in 1812–16, 1861–66, 1916–19, and 1941–46.” By way of contrast, the debt–GDP ratio has generally declined during peacetime periods, with the exception of the Great Depression/New Deal era (1929–39), the 1980s, and the post-1921 period.” Furthermore, the author interprets the exceptional period from the 1980s onwards as a result of the Cold War and the “post-2001 war on terror.”

There might be a potential endogeneity bias for the decision to adopt (or leave) the gold standard or a fiat money standard, which could likely lead to spurious results for our analysis. Basically, this would mean that some underlying factor accounted for both the choice of the monetary regime and the differences in the level of public debt. For example, war times and a suspended gold standard have been highly correlated in history for obvious reasons. However, as Bernanke (2004, p. 16) outlines, those decisions are highly influenced by internal and external political factors so that it is very unlikely to be an issue for our analysis.

Empirical Strategy

One potential empirical strategy has been outlined in Gabriel (2014). As outlined above, there is conflicting evidence about the stationarity of public debt. To overcome this problem, I analyze GDP deficits as the dependent variable for the sample period from 1800 to 2012 (Bohn 2008). In this paper, I use a VAR(2) model which controls for several factors such as military spending to capture the war periods or interest charges to capture the cost of debt.5 The model allows us to make interesting forecasts of how the dependent variable should have evolved during the period of the full fiat money standard (1971 to the present) after controlling for the outlined variables. Figure 4 summarizes the findings of Gabriel (2014).

The red line describes actual data on GDP deficits for the specified period. As described before, the VAR(2) model is applied to the dataset from 1800–1970 to generate a forecast of the how the values should have evolved based on the specified framework. This is the blue line. Finally, the green area corresponds to the confidence interval for the forecast of the VAR(2) model. This graph shows that actual deficits are in general higher (except for the year 2000) than they should be. Thus, the interpretation of this period by Yoon (2012) as a result of the Cold war is not supported by this analysis. The noteworthy GDP deficit figures must be explained otherwise. The theoretical arguments in this chapter make a case that the dynamics of fiat money are a plausible explanation for this observation.

Conclusion

Austrian scholars in monetary economics are not tired of pointing out the dynamics of fiat money and their impact on the economy. This chapter attempted to complement their theoretical arguments by providing a short historical overview of monetary policy in the United States. A preliminary empirical assessment provides evidence that the switch to the current monetary regime possibly explains higher GDP deficits after controlling for other factors such as military expenses or interest charges. A more detailed analysis on this issue is left for future research.

References

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Bagus, Philipp, and David Howden. 2009. “The Legitimacy of Loan Maturity Mismatching: A Risky, but not Fraudulent, Undertaking.” Journal of Business Ethics 90(3): 399–406.

Bernanke, Ben S. 2004. Essays on the Great Depression. Princeton, N.J.: Princeton University Press.

Bohn, H. 2008. The Sustainability of Fiscal Policy in the United States. Cambridge, Mass.: MIT Press.

Bremner, M. R. P. 2004. Chairman of the Fed: William McChesney Martin Jr., and the Creation of the Modern American Financial System. New Haven, Conn.: Yale University Press.

Burns, Arthur F. 1979. “The Anguish of Central Banking.” In The 1979 Per Jacobsson Lecture. Sava Centar. Complex, Belgrade, Yugoslavia, on September 30.

Dowd, Kevin, and Martin Hutchinson. 2010. Alchemists of Loss: How modern finance and government intervention crashed the financial system. New York: Wiley.

Fernandez-Villaverde, J. H., P. A. Guerran-Quintana, and J. Rubio-Ramirez. 2010. “Reading the Recent Monetary History of the U.S., 1959–2007.” Working Paper 15929, National Bureau of Economic Research.

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Gabriel, Amadeus. 2014. Public Debt and Fiat Money: An Empirical Assessment. Working Paper. Department of Finance and Economics, La Rochelle Business School.

Garrison, Roger, and Gene Callahan. 2003. “Does the Austrian Business Cycle Theory help explain the Dot-Com Boom and Bust?” Quarterly Journal of Austrian Economics 6: 67–98.

Hülsmann, Jörg Guido. 2006. “The political economy of moral hazard.” Politická ekonomie 2006(1): 35–47.

——. 2008. The Ethics of Money Production. Ala.: Mises Institute.

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Mises, Ludwig v. 1980. The Theory of Money and Credit. Indianapolis: Liberty Press.

Reinhart, C. M., J. F. Kirkegaard, and M. B. Sbrancia (2011): “Financial Repression Redux.” Finance & Development 48.

Reinhart, C. M., and K. Rogoff. 2011. This Time Is Different: Eight Centuries of Financial Folly. Princeton, N.J.: Princeton University Press.

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Yoon, G. 2012. “War and peace: Explosive US public debt, 1791–2009.” Economics Letters 115(1): 1–3.

• *Amadeus Gabriel is assistant professor in the Department of Finance and Economics at the La Rochelle Business School, France. I was a summer fellow at the Ludwig von Mises Institute as an undergraduate student in 2006, and later as a graduate student in 2011.
• 1See Richard Cantillon, La nature du commerce en général (Paris: Institute national d’études démographiques, 1997).
• 2Martin’s testimony to the Joint Economic Committee, February 5, 1957. Cited by (Bremner 2004, p. 123).
• 3Board of Governors FOMC Transcripts, February 3–4, 1994, p. 55.
• 4Testimony to the House Banking Committee, February 22, 1995).
• 5Refer to Gabriel (2014) for the details of the model, where several tests, such as e.g., autocorrelation in error terms, to account for a potential downward bias are provided.