The Sovereign Debt Crisis in the European Monetary Union in 2010—12/13 Triggered Huge Demand for the Swiss Franc as Safe Haven

Both countries (Canada and Australia) remained loyal and committed members of the 2% inflation standard. And so did that once hard money country Switzerland. In the 1990s it slowly drifted away from its monetarist past and adopted an inflation-targeting regime, albeit not so laser fixated on 2% as was more broadly the case. The sovereign debt crisis within the European Monetary Union in 2010—12/13 triggered huge demand for the Swiss franc as safe haven, to which the Swiss authorities responded by massive foreign exchange market intervention, a spell of  fixing a ceiling to the currency, and ultimately a journey into an emergency negative interest rate regime which persisted for years. The big difference from the Australian and Canadian experiences was the massive foreign exchange market intervention and the adoption of radical monetary-easing measures—perhaps indicative of an even greater potential “overshoot” of the currency which might have occurred if the Swiss had held their hard money ground.

—Brendan Brown, The Case Against 2 Per Cent Inflation: From Negative Interest Rates to a 21st Century Gold Standard (Cham, CH: Springer International Publishing, 2018), 142-143.

Japan Is the Battleground for Monetary Theorists; The Architects of the 2% Inflation Standard Can View Japan as a Laboratory Where the Most Powerful Non-Conventional Tools Have Been Deployed

And in looking further back, to before the journey started, the huge scope of the Japanese bubble and bubble economy in the late 1980s is a challenge to any serious purveyor of monetary or broader economic theory. Can this theory explain what happened and what went wrong in Japan? Our examination should also test any such theory in the story of Japanese deflation (itself largely myth rather than fact). The battle has been joined by sound money theorists drawing on Austrian School economics, who argue that Japan’s and indeed the globe’s economic outcome would have been much better if in fact there had been some period of declining prices.

We could describe Japan as the battleground for monetary theorists. The architects of the 2% inflation standard can view Japan as a laboratory where in recent years the most powerful non-conventional tools yet have been deployed. The Abe government was victorious in the political arena in terms of taking Japan on to the 2% inflation standard and in authorizing such tools. And at the time of writing, the world is basking in a stock market boom and global economic upturn in which Japan is fully sharing. Its apparent successes could be pyrrhic if indeed Japan adds to the evidence that the 2% global inflation standard is harmful to prosperity.

—Brendan Brown, The Case Against 2 Per Cent Inflation: From Negative Interest Rates to a 21st Century Gold Standard (Cham, CH: Springer International Publishing, 2018), 96.

The Reserve Bank of New Zealand Led the Way to Formal Inflation Targeting Followed by the Bank of Canada, the Bank of England, and the Reserve Bank of Australia

A tiny country on the southern edge of the earth, New Zealand, led the way into formal inflation targeting, followed soon by Canada and the UK. Additionally New Zealand had a connection to a central part of the neo-Keynesian doctrine that featured backstage to inflation targeting—the so-called Phillips curve (an empirical relationship between inflation and unemployment which had its origin in the work of a once New Zealand war hero, later a professor at the London School of Economics). The inflation targets as determined by these countries were very much improvised and set by governments seeking to keep their central banks on course to lowering inflation rather than growing out of a considered economic blueprint for a new experiment in fiat money stabilization. Work on that had been going on for many years within the economics profession as we shall see—but the implementation of an inflation-targeting regime in a large economy was still some time away.

Specifically, in the New Zealand launch, the impetus came from a finance minister keen to make the central bank accountable in a transparent way for its actions—with the action plan to bring inflation down from a then high level (around 5%). In 1989 the Reserve Bank of New Zealand Act came into force. The Act established the operational independence of the Reserve Bank in respect of monetary policy and specified price stability as the single monetary policy objective. Simultaneously the Minister of finance and the governor signed the first Policy Targets Agreement which specified an annual inflation target of 0–2%. (3–5% target for 1990, with a gradual reduction into the 0–2% range by 1992 (changed to 1993).

Canada followed New Zealand. In February 1991 a joint announcement by the minister of finance and the governor of the Bank of Canada established formal inflation targets. The target ranges were 2–4% by the end of 1992 and 1.5–3.5% by December 1995. Subsequently the range was lowered to 1–3%. The Bank of Canada is not directly accountable to the government via formal sanctions if it misses its targets as in New Zealand but rather like the Reserve Bank of Australia is accountable to the public in general.

The UK was the next country to adopt formal inflation targeting, following that country’s exit from ERM in October 1992. The government set the target (initially 1–4%) and invited the governor of the Bank of England to begin producing an Inflation Report on a regular quarterly basis which would report on the progress being made in achieving the target. At the time of adoption, inflation was at 4%. The British inflation-targeting regime was similar in flexibility to the Canadian framework (and Australian which started around this same time).

—Brendan Brown, The Case Against 2 Per Cent Inflation: From Negative Interest Rates to a 21st Century Gold Standard (Cham, CH: Springer International Publishing, 2018), 13-14.

Most Germans Wanted Hard Money Because a Single Generation Had Lost Its Monetary Savings Twice: In the Hyperinflation of 1923 and in the Currency Reform of 1948

The EMS [European Monetary System] tried to fix exchange rates that had been allowed to float in a corridor of ±2.25 percent around the official rate. But the intention of fixed exchange rates was incompatible with the system built to achieve that aim. The idea was that when the exchange rate would threaten to leave the corridor, central banks would intervene to bring the rate back into the corridor. For this to happen, a central bank would have to sell its currency, or in other words, produce more money when the currency was appreciating and moving above the corridor. It would have to buy its currency, selling assets such as foreign exchange reserves, if its currency was depreciating, falling below the corridor.

The Spanish Central Bank provides us with a good example. If the peseta appreciated too much in relation to the Deutschmark, the Bank of Spain had to inflate and produce pesetas to bring the peseta's price down. The central bank was probably very happy to do so. As it could produce pesetas without limits, nothing could stop the Bank of Spain from preventing an appreciation of the peseta. However, if the peseta depreciated against the Deutschmark, the Bank of Spain would have to buy its currency and sell its Deutschmark reserves or other assets, thereby propping up the exchange rate. This could not be done without limits, but was strictly limited to the reserves of the Bank of Spain. This was the basic misconstruction of the EMS and the reason it could not work. It was not possible to force another central bank to cooperate, i.e., to force the Bundesbank to buy peseta with newly produced Deutschmarks when the peseta was depreciating. In fact, the absence of such an obligation was a result of the resistance of the Bundesbank. France called for a course of required action that would reduce the independence of the Bundesbank. Bundesbank president Otmar Emminger resisted being obliged to intervene on part of falling currencies in the EMS. He finally got his way and the permission from Helmut Schmidt to suspend interventions leading to the purchase of foreign currencies within the EMS agreements. Countries with falling currencies had to support their currencies themselves.

Indeed, an obligation to intervene in favor of falling currencies would have created perverse incentives. A central bank that inflated rapidly would have forced others to follow. Fiat paper currencies are introduced for redistribution within a country. Fixed fiat exchange rates coupled with an obligation to intervene allowed for redistribution between countries. In such a setup, the faster inflating central bank (Bank of Spain) would force another central bank (Bundesbank) to follow and buy up faster, inflating one’s currency. The Bank of Spain could produce pesetas that would be exchanged into Deutschmarks buying German goods. Later the Bundesbank would have to produce Deutschmarks to buy peseta and stabilize the exchange rate. There would be a redistribution from the slower-inflating central bank to the faster-inflating central bank.

Yet, in the EMS there was no obligation to buy the faster-inflating currency. This implied also that the EMS could not fulfil its purpose of guaranteeing stable exchange rates. Fixed fiat exchange rates are impossible to guarantee when participating central banks are independent. Governments wanted both fiat money production for redistributive internal reasons and stable exchange rates. This desire makes voluntary cooperation in the pace of inflation necessary. Without voluntary cooperation, coordinated inflation is impossible. The Bundesbank was usually the spoilsport of coordinated inflation. It did not inflate fast enough when other central banks, such as the Bank of Italy, inflated the money supply to finance Italian public deficits.

The Bundesbank did not inflate as much on account of German monetary history. A single generation had lost almost all monetary savings two times, namely, after two world wars: in the hyperinflation of 1923 and the currency reform in 1948. Most Germans wanted hard money, and expressed that through the institutional set up of the Bundesbank, which was relatively independent of the government. What all of this means is that, in practice, the EMS would only function if central banks were only able to inflate as much as the slowest links in the chain: the Bundesbank and its traditional ally, De Nederlandsche Bank.

—Philipp Bagus, The Tragedy of the Euro, 2nd ed. (Auburn, AL: Ludwig von Mises Institute, 2012), 24-26.

Another Way of Looking at the Essential and Inherent Unsoundness of Fractional Reserve Banking Is to Look at the Maturity Mismatching Problem, A Violation of the “Golden Rule of Banking”

Another way of looking at the essential and inherent unsoundness of fractional reserve banking is to note a crucial rule of sound financial management—one that is observed everywhere except in the banking business. Namely, that the time structure of the firm’s assets should be no longer than the time structure of its liabilities. In short, suppose that a firm has a note of $1 million due to creditors next January 1, and $5 million due the following January 1. If it knows what is good for it, it will arrange to have assets of the same amount falling due on these dates or a bit earlier. That is, it will have $1 million coming due to it before or on January 1, and $5 million by the year following. Its time structure of assets is no longer, and preferably a bit shorter, than its liabilities coming due. But deposit banks do not and cannot observe this rule. On the contrary, its liabilities—its warehouse receipts—are due instantly, on demand, while its outstanding loans to debtors are inevitably available only after some time period, short or long as the case may be. A bank’s assets are always “longer” than its liabilities, which are instantaneous. Put another way, a bank is always inherently bankrupt, and would actually become so if its depositors all woke up to the fact that the money they believe to be available on demand is actually not there.

—Murray N. Rothbard, The Mystery of Banking, 2nd ed. (Auburn, AL: Ludwig von Mises Institute, 2008), 98-99.

According to Ludwig von Mises, the Standard Textbook Equation of Exchange, MV = PT, Is a Superficial and Unsatisfactory Theory of the Purchasing Power of Money

One of the main contributions of Mises’s TMC [The Theory of Money and Credit] is his trenchant criticism of the classical equation of exchange MV = PT. This equation, however, is still used today in every standard textbook—what is more, it is often the only formulation of the quantitative theory of money that is offered to students. The criticism by Mises is clearly unknown to the current writers belonging to the “orthodox” paradigm. This is unfortunate because Mises has convincingly shown that the equation of exchange is a superficial and ultimately unsatisfactory theory of the purchasing power of money. His main criticism is aimed at the concept of velocity of money: counting how many times a unit of money changes hands on average in a year cannot replace the concept of the subjective demand for money. The velocity of money is only a manifestation of the effects of the demand for money, and it obfuscates the causal processes through which the value of money is determined. The concept of the subjective demand for money is, as we have seen in the previous section, the necessary foundation for an explanation of the PPM. Mankiw (2011) and Milton Friedman (in his entry “Quantity Theory of Money” in the New Palgrave) both recognize this fact. They begin their respective presentations of the quantity theory with the subjectivist theory expounded above, but then they fall back and focus on the holistic and mathematical equation only.

—Renaud Fillieule, “The Monetary Theory in Current Textbooks in Light of The Theory of Money and Credit,” in Theory of Money and Fiduciary Media: Essays in Celebration of the Centennial, ed. Jörg Guido Hülsmann (Auburn, AL: Ludwig von Mises Institute, 2012), 256.

In 1913 Ludwig von Mises Warned That There Is a Serious Danger for the Future of the Individualistic Organization of the Economy in the Development of Fiduciary Media

As I have explained elsewhere, there is a serious danger for the future of the individualistic organization of the economy in the development of fiduciary media; if the legislature does not put some obstacle in the way of its expansion, an unrestrained inflation could easily come about, the destructive effects of which cannot really be imagined. Even if we ignore this, as yet, not immediate threat, there is sufficient risk from the very nature of the system of fiduciary media. We have already mentioned that it would be desirable to put an end to the artificial expansion of fiduciary media. It would not only slow down the rate of devaluation, but it would also be the best way of preventing economic crises.

Mises defined “money substitutes” as claims to a commodity money such as gold in the form of banknotes or checks that are readily and generally accepted in transactions and that are believed to be fully redeemable on demand at the banking institution that has issued them. Mises distinguished between money substitutes that are backed 100 percent by commodity money reserves at the issuing institution (“money certificates”) and those money substitutes issued by a bank that are less than fully backed (“fiduciary media”). Loans extended on the basis of 100 percent reserve backing were referred to as “commodity credit” and those loans extended on the basis of less than 100 percent reserve backing were called “circulation credit.” Mises argued that it was the extension of fiduciary media not covered by 100 percent reserves that was the source of business cycles, in that it created the illusion of more savings available in society (in the form of money loans extended through the banking system) to support and sustain investment and capital formation than really existed.

—Ludwig von Mises, “The General Rise in Prices in the Light of Economic Theory,” in Selected Writings of Ludwig von Mises, vol. 1, Monetary and Economic Policy Problems Before, During, and After the Great War, ed. Richard M. Ebeling (Indianapolis: Liberty Fund, 2012), 155, 135n5.

European Politicians Introduced the “Stability and Growth Pact” (SGP) in 1997 in order to “Manage the Commons”; However, the Regulation of the Commons Failed

These tragic incentives stem from the unique institutional setup in the EMU [European Monetary Union]: one central bank. These incentives were not unknown when the EMU was planned. The Treaty of Maastricht (Treaty on the European Union), in fact, adopted a no-bailout principle (Article 104b) that states that there will be no bailout in case of fiscal crisis of member states. Along with the no bailout clause came the independence of the ECB. This was to ensure that the central bank would not be used for a bailout.

But political interests and the will to go on with the Euro project have proven stronger than the paper on which the no bailout clause has been written. Moreover, the independence of the ECB [European Central Bank] does not guarantee that it will not assist a bailout. In fact and as we have seen, the ECB is supporting all governments continuously by accepting their government bonds in its lending operation. It does not matter that it is forbidden for the ECB to buy bonds from governments directly. With the mechanism of accepting bonds as collateral it can finance governments equally well.

There was another attempt to curb the perverse incentives of incurring in excessive deficits. Politicians introduced “managed commons” regulations to reduce the external effects of the tragedy of the commons. The Stability and Growth Pact (SGP) was adopted in 1997 to limit the tragedy in response to German pressure. The pact permits certain “quotas,” similar to fishing quotas, for the exploitation of the common central bank. The quota sets limits to the exploitation in that deficits are not allowed to exceed three percent of the GDP and total government debt not sixty percent of the GDP. If these limits had been enforced, the incentive would have been to always be at the maximum of the three percent deficit financed indirectly by the ECB. Countries with a three percent deficit would partially externalize their costs on countries with lower deficits.

However, the regulation of the commons failed. The main problem is that the SGP is an agreement of independent states without credible enforcement. Fishing quotas may be enforced by a particular state. But inflation and deficit quotas of independent states are more difficult to enforce. Automatic sanctions, as initially proposed by the German government, were not included in the SGP. Even though countries violated the limits, warnings were issued, but penalties were never enforced. Politically influential countries such as France and Germany, which could have defended the SGP, violated its provisions by having more than three percent deficits from 2003 onward. With a larger number of votes, they and other countries could prevent the imposition of penalties. Consequently, the SGP was a total failure. It could not close the Pandora’s Box of a tragedy of the commons. For 2010, all but one member state are expected to violate the three percent maximum limit on deficits. The general European debt ratio to GDP is eighty-eight percent.

—Philipp Bagus, The Tragedy of the Euro, 2nd ed. (Auburn, AL: Ludwig von Mises Institute, 2012), 108-110.

The Theory of the “Tragedy of the Commons” Should Be Applied to Fractional-Reserve Banking Since the Expansive Process Derives from a Privilege Against Property Rights

We first had the opportunity to defend the thesis that the theory of the “tragedy of the commons” should be applied to fractional-reserve banking at the Regional Meeting of the Mont-Pèlerin Society which took place in Rio de Janeiro, September 5–8, 1993. There we pointed out that the typical “tragedy of the commons” clearly applies to banking, given that the entire expansive process derives from a privilege against property rights, since each bank entirely internalizes the benefits of expanding its credit while letting the other banks and the whole economic system share the corresponding costs. Moreover, an interbank clearing mechanism within a free banking system may thwart individual, isolated attempts at expansion, but it is useless if all banks, moved by the desire for profit in a typical “tragedy of the commons” process, are more or less carried away by “optimism” in the granting of loans.

—Jesús Huerta de Soto, Money, Bank Credit, and Economic Cycles, trans. Melinda A. Stroup (Auburn, AL: Ludwig von Mises Institute, 2006), 394n.