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    Default Brittany Cobb - Green or Gold: Monetary Policy and Rule of Law



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    BRITTANY COBB

    Development and Events Manager


    Brittany joined Atlas Network in 2014. Originally from Manhattan, she received her MA in International Political Economy and Development from Fordham University and her BA in Economics from Grove City College. Brittany has worked in policy research for the Reason Foundation and also for the Startup Cities Institute at Universidad Francisco Marroquin. She also participated in the Liberty@Work program by the Charles Koch Institute. Over summers and semesters, Brittany lived in Panama, Guatemala, China, and England, and she continues to travel regularly. Brittany is based in New York City. https://www.atlasnetwork.org/about/people/brittany-cobb






    http://www2.gcc.edu/dept/econ/ASSC/P...tarypolicy.pdf


    authors notes and citation at source
    hyperlinks, emphasis, and [brackets] hereafter mine



    Green or Gold: Monetary Policy and Rule of Law
    Brittany Cobb


    A system of capitalism presumes sound money,
    not fiat money manipulated by a central bank.
    Capitalism cherishes voluntary contracts
    and interest rates that are determined by savings,
    not credit creation by a central bank,


    says Ron Paul.

    The medium of exchange significantly affects the workings of the economy. Implementing poor monetary policy has the potential to disintegrate an economy.

    Establishing sound money opens the opportunity for the economy to flourish. Money is central to exchange; as thus it is crucial to understand how different monetary systems uphold or destroy private property rights. This paper examines the links between monetary systems and the rule of law in three environments: with commodity money, in a dollarized economy and under a fiat currency. Commodity money best upholds citizens’ rights to their private property, while fiat money poorly secures freedom. The rule of law is defined as upholding the principle that ―to be just among equals, everyone should be ruled as well as rule‖ (Aristotle, 1885, Book III, 16). Rule of law is the principle that governmental powers are limited to only exercise authority according to the power provided by written laws that are adopted according to established procedure. Aristotle continues, The rule of law is preferable to that of any individual. On the same principle, even if it is better for certain individuals to govern, they should be made only guardians and ministers of the law. … to give authority to any one man when all are equal is unjust. … He who bids the law rule, may be deemed to bid God and Reason alone rule, but he who bids man rule adds an element of the beast; for desire is a wild beast and passion perverts the minds of rulers, even when they are the best of men. The law is reason unaffected by desire (Aristotle, 1885, III.16). Frédéric Bastiat expounds upon this concept in The Law, writing, ―Do not the legislators and their appointed agents also belong to the human race? Or do they believe that they themselves are made of a finer clay than the rest of mankind?‖ (1850/1998, p 63) Sustaining the rule of law requires the restriction of government power according to established laws. When government policies are in accord with the rule of law, assuming a righteous law, then the citizens’ rights are upheld. The arbitrariness of despots is put under check. This paper narrows the over-arching concept of the rule of law by focusing on private property rights. The monetary system of an economy shares significantly links with the degree of private property granted in the economy. The comparison of monetary systems is done under the framework of how well each upholds property rights. Sound money is defined as a hard currency, meaning that it is backed by a commodity. In this case, the currency serves as a store of value. The purchasing power of the monetary unit cannot fluctuate with the whims of the ruling powers. According to Ludwig von Mises, sound money means the gold standard (1953, p. 438). Commodity Money The best monetary system for securing property rights is a commodity money system. Using commodities as currency prevents the government from unlawful creation of money and eliminates the possibility of despotic inflation.

    Individuals have clear property rights over the commodities that they own, and any confiscation of those commodities is clearly stealing. The history of commodity money goes back to the earliest societies. Primitive societies exchange through barter. Under a barter system, if there is no coincidence of wants, the two parties cannot trade. For example, a cow farmer will often not be able to trade away a whole cow or bottle of milk for the goods he desires. These goods are poor mediums of exchange; a cow is indivisible, and milk is high perishable. Due to the difficulties of bartering, eventually individuals begin to engage in indirect exchange. Mises writes, ―Indirect exchange becomes more necessary as division of labour increases and wants become more refined‖ (1953, p 31). The dairy farmer will trade the goods he produces for other goods which are more easily traded. Then he will trade these intermediary goods for the goods that he wishes to obtain. This is the origin of the medium of exchange. At first, multiple goods that are fairly divisible, transportable and durable arise as mediums of exchange. With time, the number of mediums tends to reduce until it becomes general practice to only accept one or two mediums. Throughout history, the preferred mediums of exchange have been precious metals. Silver and gold possess the necessary qualities to function well as a medium.

    Carl Menger describes this phenomenon: The reason why the precious metals have become the generally current medium of exchange … is because their saleableness is far and away superior to that of all other commodities, and at the same time because they are found to be specially qualified for the concomitant and subsidiary functions of money (1982, p 250).

    The gold standard, silver standard and other metal standards function similarly. In the context of this paper, arguments regarding the gold standard apply to all metal standards. The gold standard is essentially a private monetary system. Friedrich Hayek writes, ―If we ever again are going to have a decent money, it will not come from government: it will be issued by private enterprise" (2008). Government intervention is unnecessary and in fact harmful for money to come into being and become the accepted medium of exchange. The market decides what precious metal to use, and all exchange it freely. There is no need for a central bank or for legal tender laws. Individuals can choose to accept the dominant currency, gold, in return for their goods and services, or they can reject it. But they often have no need to reject it, because of its inherent value. Mises writes, ―Thus the sound-money principle has two aspects. It is affirmative in approving the market's choice of a commonly-used medium of exchange. It is negative in obstructing the government's propensity to meddle with the currency system‖ (1953, p 414). The major benefit from a gold standard is that the government is removed from the monetary system. For the gold standard to function properly in a society, there are some assumptions that must be met.

    The governing officials must be willing to abide by the budgetary constraint enforced by having a commodity currency; the ruling powers must not engage in corrupt activity, such as debasing the currency or revoking redemption claims. Likewise, counterfeiters must not debase the currency. The public must accept the chosen medium of exchange and not desire to replace the commodity with another monetary system. If all of these assumptions hold, then all of the following advantages will necessarily occur.

    Money is the life-blood of an economy (Sennholz, 1975, p 168). As such, it is best left to the market. The advantages to a private monetary system are numerous. First, it requires the government to curb their spending to be at or under the tax revenue. Under a gold standard, the government can only legally spend money after it has been collected, enforcing fiscal responsibility.

    Hans Sennholz writes,

    The gold standard forces governments to balance their budgets‖ (1955, p 296).

    Without the power to inflate, the government must restrict its expenditures. With limited budgets, less money is wasted. Secondly, the gold standard prevents artificial booms in the economy which inevitably turn to bust.

    Sennholz continues,
    The gold standard forces governments to … refrain from policies of credit expansion which create booms and unavoidably lead to periods of depression‖ (1955, p 296).

    The boom and bust cycle significantly harms entrepreneurs; so its elimination is beneficial for business. Also, its elimination eradicates the inevitable busts and depressions that cause unemployment, bankruptcy and business losses. Next, a central bank need not exist under a gold standard. Many of the policies of the United States Federal Reserve are common to all central banks: they interfere with the natural workings of the economy and thus hinder economic growth. One of the Federal Reserve stated policies is to stabilize prices (p 15). When the economy suffers from short term price shocks, the Fed seeks to offset those changes. These offsetting policies often reduce stability and bring about unintended consequences. Without a central bank, the economy is free to fluctuate according to the market, without harmful interventions. The Cato Institute discovers that "A gold standard does not guarantee perfect steadiness in the growth of the money supply, but historical comparison shows that it has provided more moderate and steadier money growth in practice than the present-day alternative‖ (White, 5 2008, p 7). The economy does not need perfect steadiness of the money supply, but it does need restriction of erratic monetary policies. The underlying benefit of sound money is that it protects private property rights. Unsound money is often linked with inflation and an expansion of the quantity of money. In a study of a large sample of countries over many decades, Federal Reserve Bank economists found that money growth and inflation are higher under fiat standards than under gold and silver standards (White, 2008). Because inflation is a decrease of the purchasing power of money, essentially it is theft. When the purchasing power of money is diminished, the value of the money is reduced, which is the same effect when a thief enters and steals a wad of cash. Sound money avoids these problems. Some argue that the gold standard also suffers from detrimental inflation. The rationale behind this proposition is that increases in the stock of gold surely have the same inflationary effects as increases in the stock of money. However, the evidence proves otherwise. The largest supply shock of gold occurred during the California Gold Rush in the middle of the nineteenth century. The newly mined gold caused an inflation of the price level, as expected. Yet the degree of the inflation is far lower than many predict. During the most inflationary time, the general price index rose 12.4 percent over the spread of eight years. The compound annual price inflation rate over those eight years was slightly less than 1.5 percent (White, 2008). Thus the possible inflation with a gold standard is insignificant enough that it is not a threat to the economy. Finally, economic growth flourishes best with a sound money system. Unsound money threatens and endangers the economy. Unsound money also jeopardizes liberty because the citizens’ property rights are insecure. According to Sennholz, The return to sound money policies is of utmost importance. Without sound money there can be no economic recovery, no prosperity, no economic cooperation, no international division of labor, no unification. Sound money is the cornerstone of individual liberty (Sennholz, 1955, p 296). For freedom, unity, prosperity and economic development, an economy needs sound money. Of the monetary systems, the gold standard best upholds the rule of law and best protects private property rights. There are many theories of banking under the gold standard, the strictest of which is Murray Rothbard’s 100 percent reserve banking. Typically, when banks lend money, they lend more money than they actually hold in reserve. Banks do this by issuing two or more claims to the same bullion of gold. When everyone rushes to the bank to withdraw their deposits at the same time, the banks suffer from bank runs. This system is called fractional-reserve banking. It is inflationary because it creates credit. Rothbard’s system of 100 percent reserve restricts banks to lending out only the amount of money that they hold in their vaults. Regardless of how much money individuals deposit in the bank, the total quantity of money never changes when banks retain 100 percent in reserves. While the form of money changes, the quantity remains the same (Rothbard, 2008, p 95). Thus, under this most extreme version of banking under a gold standard, banks can issue credit and extend loans without causing harmful inflation. In summary, under the gold standard, the free market controls the monetary system; governments demonstrate fiscal responsibility; the power to cause artificial booms and 7 busts is eliminated; there is no central bank; the rule of law is sustained as private property rights triumph; the currency is protected from government-induced inflation; and the economy has the freedom to flourish. Finally, a 100 percent reserve banking system can be implemented and enforced, extending credit to entrepreneurs without first creating it. Mises writes, ―It is impossible to grasp the meaning of the idea of sound money if one does not realize that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part of governments‖ (1953, p 414). Sound money protects individuals from unjust rulers by upholding the rule of law. Dollarized Economy Dollarization is a middle ground monetary policy. In a dollarized economy, there is more rule of law than in an economy with fiat money, yet less rule of law than is found under a gold standard. Dollarization is the process by which a country adopts a foreign currency as its own. The adopted currency need not be the United States dollar. Any currency is acceptable. Many currencies, including the Euro, New Zealand dollar and Australian dollar have been adopted in the process of dollarization. Dollarization takes many forms. The official form occurs when the new currency is adopted as legal tender, either exclusively or predominantly.

    Partial dollarization happens in situations where the local currency remains legal tender, but the foreign currency is used legally in transactions. Partial dollarization increasingly affects a wide set of countries (Gulde et al, 2004, p 1). Governments choose to dollarize for a variety of reasons. Ecuador was in the middle of a banking and economic crisis in 2000, facing a crippled economy, a poor currency with high inflation, citizens without trust in their government, high levels of unemployment, a low GDP and a low income per capita. Dollarization helped to reverse a number of these problems.

    In contrast, El Salvador chose official dollarization for the purpose of enhancing the set of economic stability structural reforms already implemented. The ultimate objective was to attract foreign investors (Quispe-Agnoli & Whisler, 2006, p 55). El Salvador was not on the brink of collapse; dollarization is not merely a process reserved as a last resort. It provides a number of unique advantages. As in the case of the gold standard, a dollarized economy also relies upon some fundamental assumptions. The necessary preconditions for full and official dollarization are that the government surrenders the right to issue currency; the people recognize and accept the new currency as legal tender; the government owns sufficient stock of the currency to adequately give it in return for the former currency; and the government follows the proper procedures to make the transition. When a government dollarizes, it relinquishes many broad powers. First, it loses the ability to manage monetary and exchange rate policy.

    Secondly, it eliminates the possibility of printing fiat money. Next, it surrenders the capability to guarantee the liquidity of bank deposits. Finally, it can no longer default on the real value of nominal commitment (Hausmann and Powell, 1999, p 6-7). The loss of these four categories of abilities significantly restricts illegitimate power of the government and the central bank. The process of dollarization requires many steps. The country’s central bank must set an exchange rate at which their former currency can be traded for the new money.



    Rather than picking a specific exchange rate, the legislation would establish an official date for dollarization and mandate that starting then, each unit of local currency will be exchanged for the amount of dollars that resulted from application of the formula: Exchange rate at which conversion will take place = stock of international reserves/(Money base + interest-bearing securities denominated in domestic currency) (Gruben, Wynne, & Zarazaga, 2003, p 248). In addition to exchanging the currency, many scholars argue that the country must concurrently adopt fiscally responsible practices (Gruben et al., 2003, p 245). Once the dollarization is officially implemented, the government cannot print money to get itself out of debt. Thus, it must adopt fiscally responsible policies or collapse. Fiscal reforms reduce the likelihood of defaulting on debt and of running out of money in the middle of projects or programs. The Cato Handbook for Policymakers supports this point by publishing the following advice: ―Dollarization alone cannot solve a country’s economic problems, but for countries with poor monetary policies, dollarization would end currency risk, reduce interest rates, and help stimulate investment and growth.‖ (Vásquez, 2009, p 643) Dollarization brings about many advantages. The most notable advantage is that the currency is now accepted with increased confidence.
    Last edited by presence; 03-25-2016 at 03:24 PM.

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