Monetary Policy and Libertarianism

At the risk of oversimplification, I see two types of libertarians:

Dogmatic libertarians start from the premise that voluntary private sector activities are superior to government coercion.

Pragmatic libertarians notice that in the vast majority of cases government intervention into the economy is counterproductive. When I came to this realization, I thought to myself; I guess that means I’m sort of a libertarian.

At a recent Reason magazine weekend event, I was interviewed in a session entitled Should the Fed Be Abolished? I anticipated that my answer — “No” — would not be what most participants expected and/or hoped for. The interview was conducted by Leonard Gilroy, who was kind enough to send me a tentative list of nine questions. We did not get to all of the topics, but I thought it might be useful to provide some written responses here, especially given that I can write more coherently than I can speak in front of a large crowd.

Leonard’s questions will be italicized, and I will only cover the topics that I believe readers would find of interest:

(1) Before we dive in too deep, let’s touch on some definitions first, in order to ground things for later.

1. What is monetary policy, and is that a loaded question?
2. What is the “monetary base” and why is it important?
3. What is the Federal Reserve, and what are its primary responsibilities?

The monetary base is US currency in circulation plus bank deposits at the Fed. I’ll skip the question of what the Fed does, which most of you already know. Instead, I’ll focus on the question of what is monetary policy?

Let’s start with what monetary policy is not—interest rates. Rates move around for all sorts of reasons, not just monetary policy. And that’s true even if the Fed is targeting rates. When the equilibrium interest rate moves up or down, the Fed is eventually forced to follow along to prevent the economy from spiraling into hyperinflation or extreme deflation. These rate adjustments don’t represent “monetary policy” in any sort of useful sense of the term. For instance, the high interest rates of the 1970s were not a “tight money” policy, rather they represented the market reaction to high inflation that had been caused by an ongoing expansionary monetary policy.

A better argument can be made that changes in the monetary base represent monetary policy. But there are also problems with this view. Start with the fact that hardly anyone monitors the base—they don’t seem to view it as important. Base growth stalled in late 2007 and early 2008, and yet hardly anyone saw this as “tight money”. (It was!) In many cases the Fed injects or removes money merely to accommodate changes in the public’s demand for money, and these actions often have no impact on interest rates, inflation or exchange rates.

In my view, the most useful way to evaluate monetary policy under a fiat money system is to focus on the specific nominal aggregate being targeted. Because the Fed’s dual mandate can be best achieved with stable nominal GDP growth, I look at NGDP (and especially market forecasts of future NGDP) as the most useful indicator of the stance of monetary policy. In this framework, above target growth in NGDP is an expansionary policy and below target growth in NGDP is a contractionary policy. During certain time periods, alternative measures such as total labor compensation can represent an even more useful policy indicator.

This approach does not work when there is a commodity money standard and the government’s ability to target NGDP is limited. In The Midas Paradox, I used changes in the government’s gold reserve ratio as an indicator of monetary policy during the 1920s and 1930s. For 1933-34, I used changes in the price of gold as a policy indicator.

Libertarians occasionally object that NGDP targeting is “central planning”. It isn’t, it is money planning. The 19th century gold standard was also money planning—a government set price of gold.

(2) How would you evaluate the usual libertarian concerns about fiat currency, such as that it is inherently inflationary and self-debasing, declining by over 90% in value since the early 1970s? Are these critiques fair, or would you offer a challenge?

Libertarians are correct that Fed policy has been far too inflationary for much of the period since the 1970s, indeed since the mid-1960s. (The US finally left gold in March 1968, when the $35 gold price peg was dropped.) I do not believe, however, that fiat money is “inherently” inflationary. Here’s the Swiss price level, which rose by less that 20% between 1995 and 2025:

That’s about 0.6%/year, which is roughly the bias that many economists see in consumer price indices. In other words, Switzerland has had 30 years of inflation that is within the margin of error of zero.

In some respects, the Japanese case is even more revealing. Between 1993 and 2022, Japan had virtually no increase in their CPI, and other indices such as the GDP deflator showed considerable deflation. They did have a modest post-Covid inflation episode, peaking at slightly over 3%, but clearly a central bank can create stable prices for long periods if it chooses to do so.

Keep in mind that the US price level soared by 33.3% between 1918-1920, when the Spanish flu was impacting the economy, despite the fact that we were on the gold standard at the time. Our recent post-Covid inflation was certainly excessive, but much less severe than 1918-20.

Instead of saying that fiat money systems are inherently inflationary, I’d argue that countries that are determined to have persistent inflation will inevitably adopt fiat money regimes. But there is no technical reason why the purchasing power of a fiat currency could not be stabilized. Indeed, Japan’s price level during 1993-2022 was actually more stable than the US experienced under the classical gold standard. The Swiss inflation of 0.6%/year since 1995 is roughly half the 1.2% annual inflation the US experienced during 1897-1914.

(3) The Federal Reserve was created in 1913 (literally during the night over Christmas when few legislators were even in town). But before the Fed, the US wasn’t a monetary free for all. We still had US dollars, and we had a federal monetary policy.

(a) Can you please describe what federal monetary policy looked like prior to 1913? (two components: (1) dollar, which = specified quantity of gold. (2) government gold holdings, which changed over time influencing the value/purchasing power of gold.)

(b) How did things generally work under that regime?

Beginning in 1879, the US dollar was defined as 1/20.67 oz. of gold, which is consistent with the price of gold being $20.67/oz. To be clear, a gold standard does not require government backed currencies, you can merely define the dollar as a specific quantity of gold and let private sector firms (such as banks) produce however much currency is demanded by the public. As an analogy, the government can define the length of a meter and then let private firms produce measuring sticks. But even during the classical gold standard of the late 1800s, a significant portion of the US currency stock was produced by the government, which issued and redeemed currency on demand in order to maintain the official price of gold.

The US price level gradually fell until the mid-1890s, and then rose slowly until 1914. This deflation was mild enough so that it was not a significant problem, except for a period in the mid-1890s when “silver agitation” was at its peak. Whenever there is concern that the gold standard will be abandoned (such as in the 1890s and 1930s), people tend to hoard gold. The increased demand for gold raises its value, i.e., its purchasing power. A rise in the purchasing power of money is the flip side of a fall in the price of goods and services. Unemployment rose sharply when deflation became significant in the mid-1890s. After the election of McKinley restored confidence in the dollar, the deflation ended and increased global gold production led to a period of very mild inflation.

AFAIK, there wasn’t much “monetary policy” prior to 1913, in the modern sense of the term. But governments did have some impact on monetary conditions by adjusting their demand for gold reserves. Even before the Fed was created, the Treasury held significant stocks of gold bullion, and adjustments in the size of that stock would impact monetary conditions.

In my view, the key monetary event of 1914 was the onset of WWI, not the fact that the Fed began operating. If WWI had not happened, I suspect that monetary conditions in the US would have continued in much the same way they had in previous decades, even with the Federal Reserve in operation. Instead, the war dramatically reduced European gold demand, creating high inflation between 1915 and 1920. Returning to the pre-war price level required severe deflation after the war.

In some ways, it seems like a weird coincidence that the Fed started operation at almost exactly the same time that WWI began. But was it a coincidence? Consider:

1913: US institutes an income tax. Federal Reserve Act passed.

1914: The Fed begin operation. Harrison Act bans narcotics.

1916: First zoning laws.

1919: 18th Amendment prohibits alcohol.

See a pattern? In the 1910s, the US government became much more activist. Was WWI part of a global pattern of much more activist governments—the so-called progressive era?

In any case, it is hard to know whether the economic problems of the 1930s were the effect of the creation of the Fed or the aftereffects of WWI. (I’d say both, but with more weight on the war.)

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