horwitz do we need a monetary constitution

7/30/2019 Horwitz Do we need a monetary constitution

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Journal of Economic Behavior & Organization 80 (2011) 331338

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Journal ofEconomic Behavior & Organization

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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

Article history:

Received 6 March 2011Received 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 Achieve-

ment Award Conference in honor of James

M. Buchanan, Fairfax, VA, United States,

September 2010

JEL classification:

E58

N2

Keywords:Constitutional political economy

Monetary regimes

Free banking

inflation

a b s t r a c t

Elements of the Chicago and Virginia traditions of political economy have rejected both

competitivemoney production andmoneys politicization via post-constitutional bargain-ing, opting instead for constitutionalization. This paper argues that competitive money

production is not subject to the pro-cyclicality that concerns constitutional political econ-

omy. It alsomeets the standardofpredictability thatmotivates constitutionalperspectives,

although at the level ofindividual prices rather than the price level. An effectivemonetary

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.

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 ofmoney to the incentive structure produced bymodern American political institutions is a recipe for disaster, as

politicalactorsarealmost alwayswilling to take theshort-run illusionof economicwell-beingthat inflation creates andpass

the costs on to the future, whether those cost bearers are the citizenry or political actors, including their future selves. Thevalueofmoney is tooimportantof aninput into a functionalmarket economy to leaveto what JamesBuchananhastermed

the post-constitutional bargaining among political actors and interest groups. If we are to avoid a repeat of themesswe

are in now, we should be looking for ways to ensure thatmoneys value is not subject to those institutional incentives.

In his response to the financial crisis and Great Recession, Buchanan (2010) argues that money should be constitution-

alized. Buchanan argues that neither what he terms monetaryanarchy 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

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

further argues that theways inwhich money is different justify its inclusionat the constitutional level in contrast tomost

of the other goods thatmarkets 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 definitions of

weights andmeasures (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 tomakemoneys 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, aswell as the appropriate

prohibitionsonpoliticization, there isnoneed fora specificor distinctconstitutionalizationofmoney. If thoseprotections are

in place, the production ofmoney 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 specific constitutionalization of money production can be realized.

Historically, full competition in money production has been rejected by the Chicago-Virginia Constitutional Political

Economy perspective fromSimons (1936) to Brennan andBuchanan (1981). The language they use in rejectingcompetitive

money production is strikingly similar: such a systemwould 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, wedonotneed a specificmonetary constitution, noramonetary 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

prohibitthe state fromplaying sucha role, muchas the First Amendment to the USConstitutiondoeswith 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 systembeyondwhat it does in providing protection for private property and

contracts in general. Buchananargues 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 ofmoney 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

privatepropertyandcontracts,weshouldnot expect theemergence of a functionalmoney.But if monetaryanarchy simply

means that government does nothing to produce or restrict the production ofmoney, 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 specifically being absent at the

constitutional level. If that is the case then it is worth askingwhether money is sufficiently 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 thatmoney 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

expectmarkets themselves to produce a goodmoney, as itmoney is required for markets to operate in the first place. The

circularity of the argument seems to require some sort of bootstrapping in order for markets to produce goodmoney.

Distrust of the ability of self-interested private actors to produce a reliablemoney in the absence of some sort of specific

constitutional rule is probably as old as money itself. There are numerous economists who were quite concerned with the

politicization of money butwho also were highlydistrustful of completely unconstrainedmarkets. It is out of this tradition

that Buchanans work onmoney emerges. To illustrate this argument, I want to brieflysummarize the ideas of three authors

who make similar arguments, even if two of themmight reject being categorized with Buchanan in this fashion.

The first 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

somebefore him andmany since, Simons saw the root of the problem of the banking systems collapse in the early 1930s as

being causedbywhat hebelievedwas theinherently pro-cyclicalnatureof fractional reserve banking.Theintermediationof

short-term obligations in the form of demanddeposits into longer-termassets such as commercial loans through fractional

reservesmade the banking system vulnerable to shifts in the relative demand for basemoney versus bank liabilities. Once

a downturn began, the fall in confidence would lead to demands for redemption, forcing banks to call in loans, setting off a

multiplied decline in aggregatedemand. Each individual attempts to increase turn bankmoney into base money, but that is

notpossible, heargued, forthesystemasawhole. Duringa boom, thesameprocesseswouldwork in reverse, inappropriately

expanding the money supply as confidence soared and the demand for basemoney relative to deposits fell. The solution for


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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 thepro-cyclicality of the banking system. Laissez-faire in banking could not be trusted to generate stablemoney.

Friedman (1967) noted thatSimonss views hereare a result ofhis understanding of the forcesatwork in the early 1930s.

SimonsuncriticallyacceptedtheFedsown rationaleforwhathappenedduringthatperiod,andthusbelieved thatthe Federal

Reserve Systemwas unable to stem the decline in the money supply that deepened the depression. Friedman argued that

if Simons had known whatwe 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

themonetary system is sufficiently 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 reflects

a similar concern over thealternatives of monetary anarchy andpoliticization, namelyMurrayRothbard. 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 tomove from being warehouses to intermediating short-term liabilities into long-termassets via fractional reserves

was simply too great for themto resist. UnlikeSimons, who focused on instability, Rothbard believedthat fractional reserve

bankingwas a formof fraud, as, in his view, the bank could not possibly keep all the promises itwas making if theywere all

redeemed at once. As such, engaging in it should be illegal.

Rothbarddenied thatmaking fractionalreserve illegal requiresa specificconstitutionalizationofmoney, but to theextent

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 viewmight be seen a formof 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, requiresa distinct treatmentin theeyesof thelaw inthat this isonekindofvoluntarycontract thatweshouldprohibit.

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 specified 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 inflationary 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 financial 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 thebroader sense ashehasnoproblem both prohibitingmutually 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), evenwith constitutional protections for property and contract in place,

are insufficient to produce a money of sufficient stability and reliability such that post-constitutional market processes can

proceed aswell as possible. The clearest statement of this claim is in Brennan andBuchanan (1981, pp. 1718):

There seems to be nothing in the competitive-market structure to keep the supply of money in the economy frombeingexpanded toorapidly in fairweatherandcontracted toosharply in foulweather. Because of thepeculiarities

ofmoney,the competitivemarketwillfail.A government role indefining and/orregulatingthevalue of themonetary

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 regimeas a way to avoid the problems of fractional reserves under central banking. It is also

interesting that Friedmanassumed, at least in 1967, thebenevolence andcompetence of theFed as thebasis forhiscriticism of Simons. ThelaterFriedman

was more skeptical of the Feds benevolence thanks to developments in public choice theory. TheAustrian critique of centralplanning provides reasons to

question its competence even if one assumes its benevolence.2 [I]mposing a 100% reserve requirement [is] not an arbitrary administrative fiatof the government, but. . .part of the general legal defense of property

against fraud (Rothbard, 1962: 709). As hiscarefulwording there suggests,it requires a particular ethical-legal theoryto explain howoneis 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 bestleft tomarkets aswell.


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They later return to this argument in the concluding section of the essay by reiterating that they find the argument

persuasive, butwish to observe that evenwith its imperfections, a competitivemonetary systemmightwell be preferred to

an unrestrained government monopoly. They later argue that a third option, namely the sort of governmental definition 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 deficiencies in the money

supplyareproblemsthata constitutionalpoliticaleconomymusttake seriously.Modernpublicchoicehasgivenusnumerous

reasons to suspect that unrestrained democracieswill produce both deficit spending and inflation. Before responding to the

critique of competitive money offered above, further exploration of the costs of inflation 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 acceptedmediumof exchangemust be provided externally and the view

that competitivemoney production is prone to pro-cyclicality.

Theclaimthatmarkets cannotevolvewith a suitablemoneyprovidedexternally is rebuttedbyMengers (1892) theoryof

theoriginofmoney, an explanation ofmoneys emergence that does not require intentional institutional designby 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 find 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 whomake better guessesatwhichgoods aremost saleablewill be betterable to executemutually beneficial exchanges andwill increase theirwealth

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 theydonot completelyunderstandwhy theywork. As a small numberof goods gets used in thisway, 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 becomegenerally acceptedmediums 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 defined 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. ForMengers spontaneous order story to work, other

institutions have tobe inplacetosomedegreeor another. In theabsenceof such institutions,whether literallyconstitutional

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 sufficient confidence 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 bymarketprocesses framedby institutionsthat protect property, evenastheemergence of thosemoneys creatednewpractices

that requiredmarginal changes in the legal order.

The numerous examples of so-called free banking systems throughout the history of the capitalist west (see Schuler,

1988 andDowd, 1992) further suggest that unhamperedmarkets arecapable of producingfull-fledged systems ofmonetary

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 thatmonetary systems are capable of evolving their own rules and regulatory practices in

the absence of specific governmental interventions. Selgin andWhite (1994)offer anoverviewof the literature aswell as an

extended conjectural history that explainshow.4 If we agree that state involvement is not necessary to produce a generally

acceptedmedium of exchange, as inMenger, then the first step of the process is complete. For simplicity, we shall assume

thatgold is the choiceemergingout of thisprocess, thoughit isnot the onlypossibility.A nextkey stepis the development of

coinage, thehistory of which also demonstrates that unhampered marketprocesses canproduce 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 agoldsmith 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, theywould have tomake 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 claimswere issued in various denominations.

Soon thebank realizes it canattractmore gold byoffering another kind of contract to customers in addition to bailments.

They offered a debt claimto thevalue of thecoinsdeposited, redeemableondemandto thepossessor, that offered aninterest

payment rather than charging a storage fee. Competitionwith other goldsmiths pushed them to offer interest payments on

3 On theability of aMengerianconvergence process to select commodities that will have the relatively stableand reliable purchasing power that a good

money needs, seeWhite (2002). On thehistorical superiority of gold and silver standards inmeeting this criterion, seeRolnick andWeber (1997).4

Brennan andBuchanan (1981) notethisconjectural history butdo notrecognize thestability properties of thesystem in termsofmaintainingmonetaryequilibrium.


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these new debt claims. This arrangement enabled the banks to take the loan from the customerand lend that out at interest

to borrowers. As long as the rate they paid for depositswas less thanwhat they charged on loans (adjusting for risk), banks

profited. These last few steps are the invention of fractional reserve banking and the emergence of banks as true financial

intermediaries. It alsomakes clear that the nature of the contract between the bank and its depositors is a loan to the bank

rather than a bailment.

AsSelgin andWhiteargue, this sort ofbanking systemhasimportant stabilityproperties.Rather than monetaryanarchy

producing chaos, the result is a self-regulated order that ensures themonetary stability necessary for a functioningmarket

economy. Specifically, theirwork showshowanyattempt by such banks to expand thesupply ofmoneybeyondthepublics

demand to hold thatmoney at the current price level will initiate self-correcting processes. Such excesseswill 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 profit-reducing loss of reserves that can

ultimately threaten thebanks liquidityandsolvency. Seeing this signal, banks are ledto restrict thevolumeof their loans to

restore their liquidityandcorrect theexcess money supply. Even during times of growth, free banks arenot led to excessive

creditexpansion asproducingmore of their liabilities than their customerswish toholdwill initiate a costlyincrease 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 firms 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 thatmotivated Simonss concern with fractional reserve banking (Timberlake, 2005).

Conversely, banks that under-producemoney relative to demandwill see their excess reserves grow, which involves an

opportunitycost intermsof foregoneinterest on loans they couldbemaking. This profit-reducing increase inexcess reserves

serves as a signal that they should be creatingmoremoney given the level of demand and the current price level. During a

period of economic contraction, free banks can respond to falling velocityby 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 stableMV) 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

systemwill ensure that prices reflect underlying variables and that market rates of interest will reflect theunderlying 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 contractsgenerally,

there is no need for a constitution to speak specifically tomoney. The historical record is litteredwith attempts by govern-

ments tomanipulate themonetary systemfor 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 deficits that are themselves the

product of unconstrained political self-interest, hasbeen theprime sourceofmacroeconomic instability, both historical and

recent. Political interventionhasbeen amuch larger source of chaos than banking systems largely free of such intervention.

The history of the US financial 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 creationof the Fed, to the boomof the 20s and the bust of the 30s, through the inflation of the

70s and early 80 and then the boomand 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, oncewe recognize the option of privatizingmoney.

4. Price stability, predictability, and the productivitynorm

In a freelycompetitivemonetary system, theprofit incentives andknowledge signals of theprice systemwill lead banks

toproduce a quantityofmoney that enablespricestodoasbest as they canin accurately reflectingunderlying fundamentals.

The question is whether such a systemwill 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 toweights andmeasures (Buchanan,1962). Becauseweightsand

measures are used for comparative purposes, their users need confidence 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

definition 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)offersthemostdetailedand technicaltreatmentofwhathe termstheprincipleof adverseclearingsthatmaintainsmonetaryequilibrium

in the face of changes in velocity.6 On this point, see Horwitz (2000).


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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 timemust 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 thatwill fit it and that should also be three feet long, wemust both believe

that ourrulersaremeasuring three feet thesameway.Without such assurances,weightsandmeasuresaremuch 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 defining 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 ofGreenfield and

Yeager (1983). Of course once defined, all agree that it is preferred that firms and markets be the ones actually producing

the instruments people use. Those who see a constitutional role for defining 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

definition 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 upwith its non-money value as a commodity. Once a commodity becomes money, its anticipated exchange

value evolves with its experienced value as influenced 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

exchangewithout some sort of unbroken line back to a commodity with a non-monetary value. Even the fiat 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

disconnectedfromactualexchangebehaviorwill bedoomedto fail as itwill nothave emerged froma process throughwhich

its users have indicated a willingness to accept it in exchange (Selgin, 1994).

This insight indicates the problems with attempts to define monetary standards by imagining what a perfectly stable

systemmight look like. TheBFH systemandthebrickstandard areboth aresubject to this critique. The BFHsystemimagines

a unit of account thatwill behighly stable in value but that is distinct from themediumof exchange. Although this cleavage

is conceivable in theory, it tends to fail in practice for reasons articulated in Whites (1984b) response to Greenfield 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 theybothbegin toemerge in the sameprocess.Given how far back this connection runsand howdeep it is, it isdifficult

to imagine that imposing a unit of account that is distinct from the mediumof exchangewill be successful, especiallywhen

alternative means of achieving the same end are more likely towork.

The brick standard, by contrast, does not cleave the unit of account from the medium of exchange in the sameway as

Buchananallowsforthemediaof exchangeto be redeemedforbricks. Theproblemwith this proposal isdeveloping a plausi-

bleexplanation forhowbrickscame tobeused inboth capacities. Both theoryandhistory suggest thatMengerianprocesses

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 asmedia of exchange. Subjective value is necessary but not sufficient for

a commodity to be a usefulmoney. Buchanans desire to solve the problem of predictability leads him topropose a standard

that couldonly come about through exogenous imposition by thestateratherthan emergingoutof actualtrading.Thelatter,

as bothMenger and Mises demonstrate, is the onlyway 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 theprice level andmoneys value. By providinga release valve for excessmoney creation through theredemption

process, free banking cuts theinflationprocess short before it canhave anyreal effects. It also quickly raises thecost tobanks

of engaging in deflation aswell. As arguedearlier, such a systemwill minimize deviations frommonetary equilibrium, pre-

venting thedeviations from thenatural rate of interest that concernedpre-Keynesianmonetary theorists in theWicksellian

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 specifically, 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 reflect 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 fullcase for thisview ismade inSelgin (1997)where he also connects these arguments to a number of 20th century monetary theorists, many ofthempre-Keynesian.


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getting less relatively scarce, hence the relevant output prices should fall. Decreases in productivity, perhaps due to war or

a natural disaster, reflect increased scarcity and prices should move tomake that knowledge available to others.

Rather than attempting to keep the price level constant and therefore predictable, the so-called productivity norm

argues that thepredictability of relative prices being indicators of relative scarcity is a more important form of predictabil-

ity. 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 com-

municative abilities. Those injections of money, and the inevitable relative price effects they would produce as we noted

earlier,wouldmove pricesaway from their naturalvalues, which in turn induces resourcemisallocation.Althougha stable

overall price level enhancespredictability at themacro level, achieving that goal in a growing economy requiresdisruptions

in some number of the millions of prices that comprise that price level. Those disruptions cause the sorts of problems dis-

cussedearlier andreducepredictability at themicroeconomic level. Price level stability canonly achieve a crude notionof

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 finish the analogy:wemight prefer a world inwhich weather forecasters are

always a bit off about snowfall predictions, but where noneof the storms are big enough tomatter, to one inwhich theyare

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 tobe stable, yet its divergences fromstability are not problematic,while the latter

is the world of price level stability where wealways knowwhat the price level is going to do, but that the policy of injecting

money to offset productivity gains is still disruptive.

5. Conclusion: an implicitmonetary 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 finding 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,aswell as appearingelsewhereindebates overmonetarypolicy. Thegoal of removingdecisionsabout theproduction

of money from the realm of political self-interest is the right one, but it is not clear that monetary anarchy fails that testin the way Buchanan thinks. I have tried tomake the case that by his own criteria, a free banking systemperforms at least

aswell, if not better, thanwould 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% reserveswas 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 reflection 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 Inflation. That more recent work is, inmy view, sufficiently persuasive to reject

BrennanandBuchanansskepticism toward competitivemoneyproduction. A freely competitivebankingsystemwithbank-

issuedmoneyredeemable in an actualmoney commodity, resting on themore general constitutional protections forprivate

property, contract, and exchange, will keepmoney out of thepolitical arena, ensure that relative prices consistently reflectunderlying variablesof tastes, technology, and resources, andprovide thepredictability necessary for economic calculation

and long-termplanning by households andfirms. Generating those results requires, as Brennan andBuchanan (1981, p. 65)

note, that we engage the constitutional question and recognize that an unrestrained political monopoly overmoney is the

source ofmuch trouble. It need not, however, mean that explicit constitutional treatment ofmoney 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 andhuman freedom

more generally. They arefurther correct toconsidermoneyoneof thosekey frameworkinstitutions in thesense thatwithout

a sound monetary system, the spread of the division of labor, exchange, and social cooperation will be weakened. Money

8 Myuseof crudepredictability isintentionallymeant torecall theideaof crudecoordinationof thewagelevelassociatedwithHutt(1979). He argued

that using inflation 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 toreflecting theunderlying variablesof demandand supply.


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does need to be isolated frompost-constitutional bargaining, and in that sense needs to be thought of at the constitutional

level. However, rather than seeingthesolution as explicitly includingmoneyat theconstitutional level,we canconsider the

alternative of an implicitmonetary constitution. If constitutional protections forproperty, contract, andexchangearecapable

of generating a sound and non-politicized monetary system, then cannotwe 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 identified by the consti-

tutional 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.

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