All Commentary
Tuesday, June 1, 1999

Money and the Nation State: The Financial Revolution, Government and the World Monetary System

This Book's Policy Prescriptions Are Based on Outdated Understanding

Bert Ely is a financial institutions and monetary policy consultant in Alexandria, Virginia.

This is a book on a vital—and much misunderstood—topic. It is sometimes excellent, but largely disappointing.

The book consists of 13 chapters divided into three sections: The History of the Modern International Monetary System, Modern Money and Central Banking, and Foundations for Monetary and Banking Reform. The editors’ introduction provides a good summary of each chapter. As Merton Miller notes in the foreword, the authors felt free to “disagree among themselves in their interpretations of key events, empirical evidence on devaluations, and a variety of other monetary issues.”

The book’s first section is its strongest. The late Murray Rothbard’s contribution, “The Gold-Exchange Standard in the Interwar Years,” alone is worth the price. Rothbard is especially effective in differentiating the “gold-exchange” standard, which Britain adopted in 1925, from pre-World War I monetary arrangements when gold coins circulated freely. Another noteworthy chapter is Frank van Dun’s “National Sovereignty and International Monetary Regimes,” in which the author draws on the work of political philosophers to explain why governments seek to dominate monetary systems at the expense of market efficiency.

The latter two sections generally reflect a weakness characterized by the first word in the book’s title—an excessive emphasis on money that disregards how electronic technology has altered the financial marketplace in recent years. By failing to describe how this marketplace actually works today, particularly in the industrialized nations, the authors misinterpret recent monetary events, which leads to policy prescriptions based on outdated understandings of that marketplace.

Today, all forms of money are merely credit instruments that also readily serve as media of exchange. That is, coins, currency, and checkable bank deposits represent credit extended to the issuers of media of exchange.

The authors seem not to understand that inflation is caused by excessively rapid credit expansion, because it is credit, not media of exchange per se, that gives individuals, businesses, and governments the ability to own assets or mortgage future income and tax collections. Media of exchange merely represent one way to facilitate a purchase; using a credit card or a check drawn against a pre-established line of credit represents an increasingly common way of buying something without any “money” changing hands.

Such transactions create credit; credit growth in turn is controlled by interest rates. If rates are too low, in real or inflation-adjusted terms, credit will grow too rapidly, causing inflation, regardless of what happens to the money supply. If rates are too high, credit demand will contract, eventually causing a recession, again regardless of changes in the money supply.

Interest, of course, is a price. Therefore, price stability depends on how accurately the credit markets price interest. Inflation’s decline in recent years reflects the improved functioning of the increasingly globalized financial marketplace in which debtors and creditors, acting out of self-interest, negotiate interest rates whose cumulative effect is to foster non-inflationary credit growth.

Unfortunately, the essays provide no sense of how the credit markets work and the overriding importance of properly priced interest even as they acknowledge the importance of the pricing mechanism generally. Consequently, they present worn-out, statist solutions, usually involving central banks, for ensuring price stability. For example, Steve Hanke and Kurt Schuler advocate currency boards (backing the local currency with the currency of another country). However, currency boards are unnecessary: merely guaranteeing the convertibility of government-issued currency into debt carrying a market rate of interest will protect any economy from a currency-driven inflation.

Lawrence White, Richard Timberlake, and others write fondly of a gold-based monetary standard. Gold and other specie standards, however, have never provided price stability, except over the very long term, nor have they been sustainable.

Several authors advocate fixed exchange rates, but they are unsustainable and wreak economic havoc when the inevitable devaluation occurs—witness today’s Asian crisis. Robert Keleher, for example, argues in “Global Economic Integration: Trends and Alternative Policy Responses” that fixed exchange rates “minimize the variability and dispersion of many other prices, and so further improve the workings of the price system.” Such price smoothing, though, distorts important price signals coming from the rest of the world. What advocates of fixed exchange rates ignore is that an exchange rate is a price, and therefore should no more be manipulated than the price of crude oil or toothpaste. Instead of distorting the pricing mechanism, public policy should ensure price stability by relying on market-determined prices, especially the price of credit and prices expressed in other currencies.

The subject of this book—ideal modern monetary and credit policies and institutions—desperately needs a penetrating analysis. Sadly, this book fails to deliver it. I hope that the next book to address this subject will.

  • Richard H. Timberlake, Jr. (born June 24, 1922) is an American economist who was Professor of Economics at the University of Georgia for much of his career. He also has become a leading advocate of free banking, the belief that money should be issued by private companies, not by a government monopoly.

  • Kevin Dowd is an adjunct scholar at the Cato Institute, and a professor of finance and economics at Durham University in England. He holds a Ph.D. in economics from Sheffield University.