(Originally appeared on June 19, 2013.)

Kurt’s recent post on NGDP targeting just happens to come right on time to introduce one I’d been contemplating concerning the connection between such targeting and free banking. While many readers may suppose the two things to represent alternative, if not antagonistic, approaches to monetary reform, I have always regarded them as complementary. Yet I also agree with Kurt in regarding NGDP targeting as “a form of central economic planning.”

Am I contradicting myself? Much as I’d like to compare myself to Walt Whitman, I don’t think so. Instead, I think that it is those who would insist on the incompatibility of free banking and NGDP targeting whose reasoning is faulty. They fall victim, I believe, to a category error, namely, that of conflating banking regimes with base money regimes.

A free banking system is, as the name suggests, a particular banking regime. A fiat money so managed, by a discretionary central authority or otherwise, as to achieve a specific NGDP target, is a particular monetary base regime. The former entails freeing banks from all manner of special regulations and guarantees, as distinct from their obligation to honor contracts voluntarily entered into with their customers or other banks. To set banks free is therefore not to commit them to any particular base regime. On the contrary, it leaves entirely to them and their clients decisions regarding which base money (or monies) to receive and to offer in exchange for deposit credits or notes; and those decisions will tend, overwhelmingly, to be dictated by custom.

Is the prevailing base medium–the medium in which final payments are made–gold, or silver? Then the usual if not universal practice will be for banks, given the opportunity to do so, to receive and pay gold or silver. Is the prevailing medium some kind of fiat money? Then the banks will go on dealing in fiat money. Schemes such as Hayek’s, in Denationalisation of Money, in which competing private “banks” introduce base monies of their own design, fiat or otherwise, though they provide for interesting thought experiments, are entirely at odds with the part that competitive banks play, or have ever played, in real world monetary systems. In the real world, such banks, unlike central banks, take the base regime as given. Their task is, not to encourage their clients to try some new base money of their own devising, but to get as much of an established base money directed their way as they are able to put to profitable use.

In short, free up the banks all you like; today, in the U.S., they will continue to receive and pay fiat Federal Reserve dollars, so long as no steps are taken to actually demonetize such dollars. Banks might, of course, also offer notes and deposits denominated in other less popular but still well-established currencies; and a few might even offer gold accounts and notes. But such non-dollar bank monies will be but tiny sideshows compared to the main act. And it will be a rare bank indeed that dares to enter the base-money-creation business, the rest remaining content to leave that business to central banks.

It follows that, because it leaves the base regime largely unaltered, a move from regulated to free banking today would not serve to eradicate inflation or otherwise guarantee monetary stability. Such a move would have led to improved stability a century or more ago, because it would have entailed depriving central banks of their role as currency suppliers: so long as gold and silver were economies’ final settlement mediums, to deprive central banks of their paper currency monopolies was equivalent to reducing if not eliminating altogether any tendency for other banks to treat central bank paper (or other central bank liabilities) as a reserve medium, and hence as what might be termed “pseudo” base money. The strict dichotomy of bank- and base-regime that applies today did not, in other words, pertain to specie-based monetary systems. Today, however, the strict dichotomy is quite valid; and this means that freedom of banking alone will no longer suffice to make our (or any) monetary system sound.

Something else is needed, then. And that something must of course consist of a reform of the base regime itself. Broadly two alternatives exist for such reform. These are: (1) the restoration of a base medium consisting of some form of specie, or perhaps of some other commodity; and (2) reform of the existing fiat regime. Both options have advantages and disadvantages. A major advantage of the second is that it is likely to be less disruptive. This advantage isn’t itself decisive. But it does supply one important reason for not simply dismissing out-of-hand proposals for imposing strict rules upon fiat-money issuing authorities, including rules that call for targeting NGDP. Where people have become long accustomed to using fiat money, the scarcity of which necessarily depends on some sort of “central planning,” to suggest a better central plan, instead of merely insisting that people “ought” to use gold (or forcing them to use it when doing so may seriously disrupt their plans), doesn’t make one a pinko–not, at least, so long as one also insists that there be no barriers in the way of people switching to gold voluntarily. It’s easy enough to say, in hindsight at least, that Imperial Russian authorities screwed-up when they decided on a railroad gauge broader than that used elsewhere in Europe. But it doesn’t follow that ripping up the old tracks post-haste, or just neglecting them, is a good idea. With base monies likewise, there is such a thing as sunk costs.

That banking reform and base-regime reform are two very different things does not mean that they cannot be complementary. On the contrary, they can be very complementary indeed; and I have long been convinced that this is particularly the case with regard to free banking and NGDP targeting. The complementarity here arises from the fact that free banking makes for an especially stable relationship between the stock of base money on the one hand and the level of spending (or NGDP) on the other.

How does free banking help? It does so, first, by allowing for a completely market-determined bank reserve ratio and, second, by allowing commercial banks to issue their own currency to take the place of publicly-held central bank notes. To the extent that commercial banks are able to “capture’ the market for paper currency, the public’s preferred “currency ratio” (that is, it’s preferred mix of currency to bank deposit balances) ceases to influence the money multiplier, that is, the relationship between the stock of base money (B) and that of broad money (M). In the limit the multiplier, instead of having its usual, textbook formula of [(1 + c)/(r + c)], where r is the system reserve ratio and c is the currency ratio, becomes simply 1/​r, making M = B(1/r); while the quantity of bank reserves, R, becomes equal to the stock of base money. The reserve ratio, in turn, will rise in proportion (though not necessarily in strict proportion) to the volume of gross bank clearings, that is, of payments, which will themselves depend on the velocity of money. As total payments increase, so does the demand for bank reserves. It follows that, for any given B (or, equivalently, any given nominal quantity of bank reserves) there will be a unique volume of payments consistent with equilibrium in the reserve market. Changes in V will tend, therefore, to give rise to such changes in r as will keep MV relatively stable.

This is, admittedly, a crude argument. (It is a little less crude as presented in The Theory of Free Banking and in this Economic Journal article, but not much.) For starters, it does not allow for changes in the ratio of income to total (income and non-income) payments; it does not allow for any influence on interest rates on the demand for bank reserves*; it does not allow for economies of reserve demand connected to changes in the composition of payments (e.g., from fewer large transfers to more numerous but smaller ones); and it does not allow for the potentially disruptive effects of changes in interbank clearing arrangements or technology. In short, it only describes a tendency.

But that tendency is, I think, important–and it is important in a way that should be taken to heart, not just by free banking fans, but by all proponents of NGDP targeting. Because the prospects for such targeting are only as good as those for holding central bankers accountable for their failure to abide by it. Doing so becomes much easier to the extent that achieving any prescribed NGDP target is simply a matter of maintaining a stable growth rate for the monetary base itself, that is, to the extent that changes in the base aren’t needed to offset fluctuations in either the currency ratio or the velocity of money. The less need there is for central bank activity (meaning activity apart from that consistent with a predetermined schedule of open-market purchases), the stronger the case for a corresponding clipping of central bankers’ wings such as will curb their capacity for mischief-making.

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*This elasticity will, however, differ from that noted for centralized currency systems, in that the demand for reserves under free banking does not include a substantial “vault cash” component that itself varies along with the public’s preferred currency ratio. In a centralized arrangement lower interest rates, besides reducing the opportunity costs of reserve holding, are associated with an increase in the currency ratio and, hence, in bank’s vault cash requirements. Under free banking the “vault cash” effect is reduced or eliminated. Consequently reserve demand is not likely to be as interest-elastic.