Wednesday, December 22, 2010

Thought Experiment

One of our three commentators has asked me to engage in the following thought experiment.

A section of the country secedes, apparently peacefully and I am placed in charge of determining how the new country will pay for things.

The task is to address these questions (or if you think they are the wrong questions explain why);

What will be your currency? How will it be created? Will it have an exchange rate fixed to a commodity (gold?) or be free floating? What will you do with your new citizens "old" US$ ? How will you control inflation?

My responses:

First, the country doesn't pay for anything. And I don't mean this in a semantic sense - I mean that I (as Treasury secretary) would push for anarcho-capitalism and the dismantling of any national state. (This is why libertarians can't get into politics - the first thing we want to do is eliminate the state!) But, since that is probably a cop-out, I'll move forward with the questions.

There wouldn't be an official currency, and the state would not then be able to be the currency monopolist. Banking, including note issuance, would be entirely free. The empirical experience here is Scotland in the 18th century. I imagine that people would develop some matrix of exchange rates among the various currencies, much like exists today among national currencies. The currency, then, would be created by individual banks in a competitive market.

The commodity backing is an interesting question. Scottish banks has a gold backing, but they only held a 2% reserve. The only modern free banking experiment was Hong Kong (ended pretty much in the 1930s, but officially in 1965), but those banks were required to hold 100% foreign currency reserves. So it's not quite the same free banking situation as Scotland. That said, I don't see why the choice of commodity backing shouldn't also be competitive. Gold is obviously a good choice, but any precious metal would do, really. Some banks might try to back their currency fully with the lending on real assets. The problem with the latter is portability (I can't withdraw Jim's land, for example). So I think it would end up being some sort of portable, storable, commodity. Could be gold, silver, platinum.... And, the rate of redemption (one note = 0.01 oz of gold or something) would also be set by the individual banks.

There would be no, repeat no, central banking authority.

Old $ US would still be useful as long as the remaining U.S. had open trade with our new little operation. The rate of exchange to the new currencies issued by banks would, again, be set by the market. Some citizens might even want to be like Panama, and trade only in $US. Again, if the former U.S. maintained open trade with our new operation, people could work in the old US and get paid in $US. Ain't no thang.

Finally, the inflation question. Price inflation is a result of monetary inflation, so the root question is, how would you control money supply. This was the original concern with regard to free banking - that a bank could make money by overissuing its own currency. I won't present the whole refutation here (one can consult Vera Smith, or George Selgin, or Larry White on this issue). But the crux is the clearing process. If one bank overissues relative to its asset backing, as other banks clear more of the notes and the commodity (e.g. gold) is transferred from one bank's reserves to the other's, the overissuing bank will find its reserves becoming depleted. The value of the currency will decrease, as will trust in the bank's ability to refund commodity for currency. People will avoid using the bank's currency and it will lose market share and profit. So general money supply increases will be curtailed.

Note that there will remain one important source of price inflation, and that is an increase in the supply of the commodity that backs the currency. If a new gold mine, for example, is discovered, the value of current gold holdings must decrease if demand stays the same. This inflation can create problems, of course. This was the root cause of the Amsterdam tulip bubble (see Doug French's book at the Mises Institute on this issue.)

I'm sure there'll be questions, but that's my story.


  1. Alright! Lets start with some questions.

    I did specify peaceful secession but are you going to have an army/civil defense force and other pubic employees? If so how will you "fund" it/them? Will there be taxes? What will taxes be payable in.

    All your public institutions will need real resources, will you produce them all in your country? Can you produce them all in your country? ( I'm giving you Tx, La, Ar, Al, Ms,Fl,Ga, NC,SC,Tn, Ky for the sake of argument)

    How will items be priced in your country.? If I'm from the old country and wish to purchase something you produce, how will I know how much it is?

    Your multiple competing currencies is fine for local transactions I think but if you plan to be an international trader I think you will need a national currency. I know as an Austrian economics school Treasury Sec, you will believe in your country being like Germany and China, producing a lot more real goods than your citizens can consume, no profligacy allowed. You will even sell to other govts right?

    Now, your citizens that wish to continue using US$ will only be able to acquire them by selling something TO the US. Yes a certain amount will be circulating but they will go away, in addition, none of your citizens will be able to have dollar denominated accounts in your banking system so only US currency will circulate. No checks or debit card $ transactions. Your banks will never be able to issue loans in $US to your citizens.
    If I work for one of your corporations, what will I be paid in?

    If I'm a citizen of your country though, I'm going to want to know, what will I get for my dollars. I have a 401 k with 1 million of them, what do I get from you? I dont think you can just let a market decide these things, here's why. Everything people have the day prior to the start of the new country is priced in dollars, thats how they know how much its worth. The next day they are still going to need to know a nominal price in some numeraire. You will have to set a numeraire. This isnt 18th century Scotland anymore. All your banks will be part of a global banking system, you will have to make a few decisions BY FIAT. Some authority will have to make some rules about how things will, at least for starters,be priced in your markets. New currencies can emerge after that but there is no way on day one that you can do what you are talking about. I;m afraid it would be utter chaos and you would have no standing in international markets.

    Will there be deposit insurance? Why the heck should I deposit in ANY of your banks if I dont know I'm going to get it back if the bank is fraudulent?

    These are just a few off the top of my head

  2. No public institutions, and public officials receive no remuneration. Yes, that means we all need real jobs. The key is to eliminate the state. If people want to erect local governments, that's their business. No national defense. You want a town militia, that's your business.

    No trade restrictions. You're free to trade with whomever, live wherever, you want. Other countries might limit you, but this nation, whatever you want to call it, will have no national government, and therefore no trade restrictions. Small, local governments might try to restrict trade and peoples' movements, though. Again, their business. This is one area where a national government might have some raison d'etre, but I'm not convinced. I must think it through carefully.

    With competitive currencies, items will be priced according to one or many currencies. Arbitrage will minimize deviations. This is the famous "purchasing power parity."

    Citizens of American junior (I just decided that now) are free to produce or consume according to their own desires. Again, they can trade with whatever entities they desire. See "no trade restrictions" above.

    Why wouldn't US currency be available? Surely not on demand always (although this is possible) but I can go to a bank and order a variety of foreign currencies for delivery in about one week. Why wouldn't it be the same in AJ? No bank can manufacture new US dollars, but there's no reason they can't try to buy some.

    Of course there will be a transition period. We might need to barter for a while, even. There is no "clean break" so you are right in that a provisional government may be necessary for a while. We might need to just use metallic money until some banks start running up their owning currencies.

    There would be no state deposit insurance. If there was a need, then some private entity would sell it. Some people may not deposit in banks. But note that deposits existed far longer than deposit insurance did. The difference is that people did their due diligence to determine the health of the bank prior to depositing.

    Note also there wouldn't be a state lender of last resort.

    You may want to read Walter Block or the Journal of Libertarian Studies for some more in-depth analysis of many of these issues.

  3. I'm liking AJ already. When can I move? Since I live in TX, I'm probably already there. Just waiting for the secession to happen.

    You say no public institutions, but you may want a court system to enforce contracts. Also, since property rights are clearly defined and robustly defended, you might need courts to adjudicate personal property disagreements.

    Also, what do we do with criminals? - I'm thinking property crimes here. The court system would determine their guilt, but who carries out the sentence? I say no prisons, as this is a huge waste of resources. Criminals must make the victim whole, doing whatever that entails.

  4. So while this AJ might be an extreme improvement in theory, in practice, how many people will be willing to give up all that you seem to be insisting that they give up? No public protection system? Everyone just buys a gun and defends their own property? Certainly you admit that even in this population of libertarians (it would be in the millions) there would be crimes of passion, property crimes. How are they enforced or punished?

    This...."No bank can manufacture new US dollars, but there's no reason they can't try to buy some."... buy it with what? What will the bank be able to offer for payment? Banks need capital, that capital has a value. For your country the value will be in dollars at first. What will it be denominated in after transition. I think you are downplaying the importance of some numeraire. You seem to want to have multiple numeraires, generated by each bank related to the profitablity of each banks activities. How can each banks profit be judged? There MUST be some independent fixed reference point, and it seems that YOU (the state) must determine it. How do you know if someone is making money if you dont know what the money is??

    Now, Ive also made it unrealistically easy to start AJ. In reality you would have a military, you would be leery of the USA. Kentucky and Ohio would be an international border.

    I'm pretty sure your AJ would be mostly like everyone else. A state determined money, an Army (hopefully not as large as USA) and public employees. Hopefully you would make your banking system more sane.

    Your idea might work in a community like Iceland, where you are relatively isolated and small but this new AJ will want to be a world economic player. They will insist/depend on people traveling there. How will you assure visitors they will be protected? Tell them to bring a gun?

    You probably anticipated this, but my hope in this thought experiment was to show that when a state or even a bank or business issues a currency that currency is spent into existence out of thin air. The production that those who use the currency are willing to do in the name of that currency becomes the "value" of that currency. Not some conversion rate to gold. When that currency is spent into existence a "deficit" is created and a price is determined by how much of that currency people are willing to spend on a particular item. A deficit will continue unless the same amount of currency is removed by taxation. So any currency left over (measured in the deficit) is equal to the amount of "savings" of that currency.

    As nice as it may be, I really dont think your idea is workable in a world where everyone else is doing it the old way.

  5. I had a long reply to both Brad and Greg. Then the Blogger website screwed up and lost it. So, I'm not responding because I'm pouting. Will get back to yous tomorrow.

  6. Don't you know to reply in Word, then cut and paste. Newbie!

  7. Usually I do. Got out of hand.

  8. Texas is AJ?

    Well considering they are a net receiver of funds from the US Govt, I kind of doubt it. Their banking system was completely bailed out by the rest of the country 20 yrs ago. If we had treated Texas the way Texans want to treat California, they'd have been sold back to Mexico. I wonder how Texas would fare if everyone upstream from them was an enemy?

  9. Now I feel I must add that just because "state" determines something as money, does not mean that the state will spend all it wants. AJ can exercise all kinds of fiscal rules upon its state to keep spending where it feels it should be directed.

    I really dont see any way you can get around declaring something as a national currency and initially giving it some nominal value. With millions of citizens, holding wealth from a foreign currency they will need some notion of how much they have to start out with. Some of your citizens will own no gold but have a million dollars worth of US bonds others will have a couple pounds of gold as their entire savings.

    I think you would want people to view this new AJ as an improvement over the old USA but if you cant give them some sort of sense of relative wealth from the start, that will be very difficult.

    I think my larger point can be made maybe by looking at individual banks. As the issuers of their own currencies, each bank will be running deficits unless no one is holding their currency. How large can each banks deficit get ? Will each banks "deficit" be advertised for the citizens to know? How long before the banks would start explaining "Look these deficits simply mean that people are wanting to hold our currency, these deficits are a reflection of demand FOR our notes"

  10. Still waiting for your thoughts on public institutions ~ court system.

    BTW: I met a new couple at our church. She is a finance prof at University of Incarnate Word here in San Antonio. He's a marketing prof. In case you're ever looking to escape the frozen tundra and settle in a much warmer climate.

    Merry Christmas!

  11. Brad,

    Let me respond to that one now. I think Greg's main issue is currency, so I'll get to that later, because I think the response needs to be fairly careful.

    A method of adjudicating disputes is clearly necessary. What we're talking about is who finances and administers it. In other words, is it tax based, or fee based? And where do the judges and lawyers come from?

    The difference between fees and taxes is that fees are voluntary, and taxes are not. I think most citizens want to have court systems, so it seems to me not too difficult to have a local court in every community. Does there need to be a federal court? I don't see any need, since there's no formal country. So each county (for example) has a court. No big whoop.

    What about those who won't pay the fee? Then no court access for you - unless you pay a big fee when you need to use it (so either pay smaller annual dues, or pay a big one-time fee). What about the people who can't afford even the small annual fee? Well, we can have a work-based fee coverage (hey, you're the new bailiff!), or higher fees to cover any shortfall and free access for the (very) poor, whatever. Some courts might act as charities in such circumstances. You will get free-riding; I see no way around that.

    Prisons similarly could be privately owned and operated. You want the court to be able to put people in jail? Fine - you gotta pay for that.

    I can see this spawning a new industry - incarceration insurance. You're the victim of a robbery, but can't afford to put the scumbag in jail? Incarceration insurance is here to help! Court cost insurance too, why not?

    In the end, I don't think most people would opt out of the court system, but the key here is that there is no coercive taxation.

    BTW: I did apply to West Texas A&M, but I didn't end up with an on-campus interview. I'm quite happy where I am, but me and the wife love TX, so it's probably a close second.

    Merry Christmas! And Merry Christmas to all three of our readers!

  12. Jeff

    That link to Steve Waldmans piece I left for you a few days ago? I really think you would enjoy reading a lot of the talk in the discussion section.
    Mish Shedlock actually leaves a comment but of particular interest is the discussion between the author SRW and a commenter Winterspeak. I really think you would like it. Its a long discussion thread but I think it is worth the time.

    Merry Christmas

  13. Greg,

    Thanks. I may actually be at a point now where I can go read some stuff.

  14. Since you will no longer be responding to the other thread I want to pose ONE set of questions to you here.

    You made the statement that govt debt is crowding out private investment as if it werent even questionable. So where is your evidence of such? Are interest rates going up for private loans seekers? I see interest rates as lower than during the Bush Boom years so the cost of borrowing is not a factor. Now obviously investment does not need to be done via private borrowing channels but if the channel is simply spending down some pool of savings and re allocating it to a new venture, how can that be affected by govt debt levels? People are free to spend their savings on whatever they want regardless of the level of govt debt levels. There is no evidence of crowding out because there isnt a fixed amount of loanable funds.

    Certainly there must be evidence of crowding out. It cant just be claimed and simply cite low investment + high govt debt as evidence. Its already been shown that the drop in GDP in late 2007 was the cause of the increased debt to GDP ratio.