Robust Political Economy: An Institutional Alternative Against Monetary Disequilibrium and Market Discoordination Pablo Paniagua

First Draft, September 2013

Abstract The scope of this essay seeks to understand how we can achieve a more stable and dynamically self-correcting monetary arrangement which will minimize the likelihood of having severe monetary disruptions on the economic system. We wish to find systems that minimize systemic macroeconomic disequilibrium, which arises whenever money severely distorts the structure of relative prices, creating market discoordination and hampering economic exchanges. Monetary equilibrium theory provides the propitious theoretical tool allowing us to comprehend how monetary disequilibrium may arise within the economic system. It also serves as a benchmark to which we can compare different monetary institutions; this enables us to determine which system might perform closer to our monetary equilibrium benchmark. Under this framework, we analyze two monetary arrangements: central banking and free-banking. Through a process of institutional comparison, we can establish which one can minimize overall market discoordination and therefore will do the least harm to the epistemic role of prices and other market signals in communicating the embedded information present in them. Finally using the framework of Robust Political Economy, we reevaluate the main assumptions which sustain the case for a centralized monetary institution on being capable of reaching the monetary equilibrium benchmark. We specifically reevaluate the assumptions concerning political pressure, self-interest, aligned incentives and the degree of decisionmakers’ omniscience present in central banking and free-banking. By relaxing these assumptions, we analyze how different monetary arrangements would be considered robust or fragile in achieving and maintaining monetary equilibrium.

Key Words: monetary disequilibrium, Federal Reserve, monetary policy, robust political economy, central banking, free-banking, Hayek.

* An earlier draft of this paper has been presented at the Institute of Economic Affairs, London, in August 2013. I would like to thank Steven Davies and the Institute of Economic Affairs for the intellectual stimulus and support during my academic sojourn. I am extremely grateful to the editor, Victoria Finn, for contributing to this draft, as well as to prior essays; her insightful comments and outstanding editing were invaluable in making this article comprehensible. I take full responsibility for any existent error that may remain. This paper is a draft- please do not cite it. For comments and suggestions please contact me at


“One of the great defects of our kind of monetary system is that its performance depends so much on the quality of the people who are put in charge. […] That raises a question about the desirability of our present monetary system. It is one in which a group of unelected people have enormous power, power which can lead to a great depression or which can lead to a great inflation. Is it wise to have that power in those hands?” Friedman, 2007 “With the exception of only the 200-year period of the gold standard, practically all governments of history have used their exclusive power to issue money in order to defraud and plunder the people. There is less ground than ever for hoping that, so long as the people have no choice but to use the money their government provides, governments will become more trust-worthy. […] money is [therefore] certainly too dangerous an instrument to leave to the fortuitous expediency of politicians – or, it seems, economists.” Hayek, 1976b 1. Introduction During the last century, economists have been particularly concerned with the role of central banks in generating exogenous disturbances in the patterns of relative prices and on the general price level, which leads to periods of market discoordination and sometimes even to severe boom-bust economic cycles. Economists have been interested in how to minimize the level of systemic discoordination that money might produce in the market order. Some economists have considered utilizing systems with rigid rules to bind central banks' decision makers and their policies. Others have thought about decentralizing money issuance and the money supply altogether in order to minimize the concentration of systemic mistakes and to align market incentives with the market needs for the money supply. Milton Friedman, Friedrich Hayek and James Buchanan have been leaders in promoting different institutional solutions to deal with the problem of the “right supply of money”. These three economists all saw monetary problems not in specific technical plans of action for policy makers to follow, but rather in the more general framework of institutional robustness (Boettke & Smith, 2012). Friedman looked for monetary rules-based constraints on central banks’ discretion, particularly through binding and limiting the growth of the monetary base (Friedman, 1993); on the other hand, Buchanan thought that defined constitutional limitations on the powers of the Fed's capacity of issuing money was a better approach (Buchanan, 1999); finally Hayek, by the end of his academic career proposed instead a radical decentralization and denationalization of the issuing and supplying of money (Hayek, 1976c). Based on and driven by these economists' insights and their extreme worries regarding the institutional level structure of the issuing of money, I believe that in order to improve our current monetary condition and avoid further extreme and severe crises leading to money mismanagement, we should add emphasis on a critical appraisal of our current existing monetary institutions and evaluate possible alternatives. This concern for a critical study and analysis of our social-economic institutions lies deep in the interests of the field of economics in understanding human action and individuals’ interactions in the context of institutional constrains; additionally, as we have seen in the case of the three aforementioned Nobel economists, it has also been a key question in political economy. It can even be said that: “The key question for political economy is to ascertain which institutions are best 2

suited to operate in a world where the assumptions [about human endowments] that underlie the neo-classical model simply cannot exist.” (Pennington, 2007, p. 9, emphasis added). Borrowing from the analytical scheme of Robust Political Economy: Classical Liberalism and the Future of Public Policy (Pennington, 2011), we apply the concept of robust political economy (RPE from here on out) to a more realistic and world-based critique and understanding of different monetary institutions and monetary regimes. Under this context of social-economic institutions, robustness makes reference to “a political economic [or institutional] arrangement’s ability to produce social welfare-enhancing outcomes in the face of deviations from ideal assumptions about individuals’ motivations and information” (Leeson and Subrick, 2006). The degree to which socialeconomic institutions will be determined robust or fragile will depend first on the benchmark or ideal goal that those institutions aim and secondly on how well that goal could still be maintained or achieved if we put pressure on those institutions under worst-case scenarios concerning the motivations and knowledge (or lack of therefore) of the agents involved. Pennington (2011) borrows heavily from the political-economic insights of four major Nobel laureates: Friedrich Hayek, James Buchanan, Ronald Coase and Elinor Ostrom, who represent major modern schools of economic thought. Pennington seeks to provide a framework that will help scrutinize existent political-economic institutions through a conscious reevaluation of the assumptions in which they are founded; in addition it provides a view of classical liberalism as a congruent and robust political-economic system corresponding to a theoretical and analytical unification of the major insights of the aforementioned Nobel laureates. In that context and according to Pennington, political-economic institutions are resilient only if they are able to support the systemic tensions and strains that continuously arise from human imperfections. In particular the RPE framework focuses on relaxing two major assumptions concerning those human imperfections: “limited human rationality” and “limited benevolence” and seek to understand the robustness and how well different social arrangements promote abundance and prosperity even under worst-case scenarios of the human condition. The chimerical assumptions concerning complete knowledge or perfect information, frictionless market adjustment, perfect rationality, political actor benevolence and lack of political pressure need to be severely reevaluated. These assumptions do not seem to be reconcilable with the world in which we live. Therefore in order to accurately and seriously evaluate and compare monetary institutional arrangements, we need a set of realistic assumptions that actually represent human reality. This would eventually lead to a better understanding of the level of robustness or fragility of the different institutional monetary arrangements which currently exist and those which will be proposed in the future. The RPE framework therefore “consists in postulating less than idealized conditions for the system at hand and determining to what extent the system retains its desirable attributes” (Boettke and Leeson, 2004, p. 100). The framework thus informs us as to how each system, either under central banking or freebanking,1 would be able to alleviate and cope with the less-than-ideal conditions concerning our

It is relevant at this point to define what a central banking system and a free-banking system signify in the scope of this paper. A central bank system is a monetary arrangement that entails a national or international centralized institution or bank that possesses a legally granted monopoly of note issuing and either a monopoly or a virtual one of guiding the supply of money (Selgin, 1988). After issuance, private banks hold these notes as reserves in order to expand credit to the rest of the economy. It is also assumed that under this system, liabilities are irredeemable in commodities. A free-banking system is a monetary arrangement that consists of a decentralized arrangement of the


human knowledge and self-interest. Moreover, understanding human fallibility would allow us to realize how to promote economic coordination and maintain a form of an “optimal monetary equilibrium” in which prosperity and economic activity could be enhanced in a world with less than perfect human beings. The concept of institutional robustness is similar to institutional resilience; it would provide a point of reference by which we could evaluate and compare monetary arrangements and discover how well they would promote economic coordination under real world conditions. In other words, we must possess robust political, social and economic institutions which can assist and defend us from our own human mistakes (rapacious or shortsighted, individual, selfinterested decisions) and which help us to circumvent our severe individual and collective cognitive limitations. We seek to understand the role and also key shortcomings of a single centralized national issuer and supplier of money as well as understanding the level of robustness of a single centralized entity that guides the money supply. In order to fully understand real world problems that centralized monetary institutions face, we need to apply the principles of RPE. This evaluation will consist of relaxing the rather unrealistic assumptions concerning omniscience, incentives, benevolence and political pressure that decision makers face under the institutional arrangements of central banking. Under those real world assumptions of pressure and fallibility, decision makers will be better or worse at achieving an “optimal” supply of money that meets economic actors’ real demand for money balances. The mentioned “optimal”' quantity of money will in theory minimize the distortionary effects of monetary disequilibrium on relative prices. That level of “money neutrality” on relative prices will be achievable exclusively whenever monetary institutions avoid situations in which the supply of money exceeds or falls short of the exact quantity of money that individuals in the economy desire to hold. The relaxation of the aforementioned assumptions regarding decision makers’ human endowments and conditions will shed light on how robust or fragile our current central banking institutions are aiming towards achieving “money neutrality” or towards “stabilizing” the macroeconomic order. It will also illuminate which alternative institutional arrangements, under more realistic assumptions concerning our human capabilities, could better cope with human fallibility and be more resilient in promoting economic coordination through maintaining monetary equilibrium. More realistic assumptions about human nature will show how likely different systems will be able to meet the “right” demand for money with the “right” supply of liquidity, minimizing the systemic risk of market discoordination. In other words we analyze the epistemic and motivational assumptions and limitations that influence and bind decision makers’ capacity in providing an “optimal” guidance of the supply of money in a centralized fashion. This helps us to understand the current limitations and fragility of existent institutional monetary arrangements and to evaluate which system is most prone (robust) to minimizing human mistakes and cope with human fallibility regarding incentive problems and knowledge limitations. A more robust system would provide a better and timelier supply of money that minimizes the dangers of discoordination that monetary disequilibrium could entail. Economists usually begin analyzing central banking policies on the misguided base assumption that centralized monetary institutions are independent from political influences. In addition to this unrealistic assumption, economists assume that central bank economic experts and decision makers
money supply and a lack of overarching guidance of it, based on the free entry and free competition of banks in the supply of banknotes, which can be redeemed by the public in an agreed form of a commodity or a bundle of commodities.


do not suffer from severe epistemic and cognitive limitations regarding which monetary policy (in form, magnitude and velocity of execution) will be the most ideal to meet the entire economy’s money demand. It is implicit in the studies on central banking and monetary policy that central banks can achieve higher levels of omniscience, knowing or be close to knowing the “best” policy which leads to the most efficient and less distortionary money supply.2 Regarding these epistemological and political concerns, Hayek commented: “A single monopolistic governmental agency can neither possess the information which should govern the supply of money nor would it, if it knew what it ought to do in the general interest, usually be in a position to act in that manner. … Money is not a tool of policy that can achieve particular foreseeable results by control of its quantity. But it should be part of the self-steering mechanism by which individuals are constantly induced to adjust their activities to circumstances on which they have information only through the abstract signal of prices. It should be a serviceable link in the process that communicates the effects of events never wholly known to anybody and that is required to maintain an order in which the plans of participating persons match.” (Hayek, 1976c, p.102; emphasis added) Here Hayek echoes the renowned “knowledge problem”, which he himself first stressed in the socialist calculation debate in the thirties and forties. Following Mises (2009 [1920]), he argued the impossibility of socialism due to central planner's epistemological limitations of knowing the specific, dispersed and contextual “knowledge of [the] particular circumstances of time and place” (Hayek, 1948, p.77). Similarly, Hayek is concerned with monetary authorities' severe knowledge limitations in the real world concerning their capacity of knowing the true demand for money. This therefore clearly limits their knowledge of perceiving and grasping the 'optimal' equilibrating supply of money. We see from the passage how Hayek, by the late seventies, began to relax the monetary policy’s epistemological and incentive assumptions as a necessary exercise to elucidate a more robust monetary institutional arrangement. An RPE system, such as that established by Pennington (2011), helps us achieve a more realistic and dispassionate assessment of the institutional robustness of a centralized monetary system, like that of the United States which established the Federal Reserve in 1913. The process of RPE deals with reducing and downplaying the unrealistic assumptions concerning human nature and the assumptions concerning the capacities and self-interest of human decision makers. Once we realize which institutional arrangements are more prone to minimize human mistakes and political biases (while promoting monetary equilibrium), the goal is to then answer the following question: which form of monetary institutional arrangement, once we take into account human limitations and selfinterest, will still be able to minimize monetary disequilibrium and therefore promote a more stable framework for economic coordination? Understanding the world under the assumptions of perfect knowledge, omniscience, benevolence,

This is particularly the case when studies on efficient and stabilizing monetary policies seek to utilize different knowledge surrogates as to find a way to solve their cognitive limitations and a lack of market mechanisms to determine the “right” money supply. Schemes seeking a proxy for the natural interest rate in order to use the Wicksellian rule of aiming at an equalization between the market interest rate and the natural interest rate to achieve market equilibrium and market coordination are good examples of the extremely high implicit level of omniscience of policy makers that monetary economists assume in their theories of equilibrating monetary policies. For a view of the applicability of this concept, as viable monetary policy assuming a high degree of knowledge concerning the natural interest rate, see Arestis and Chortareas (2007) and Amato (2005).


and even sainthood of men is the wrong framework because it is based on the false premises of human nature runs; it therefore runs the risk of designing and evaluating with overconfidence, weak and fragile institutions that might be in reality damaging our capacities of development. This would contribute to creating a systemic and endemic social fragility and hinder our capacity to coordinate and generate prosperity. The RPE framework is particularly relevant in economics and political science since it sheds new light on comprehending existent and future social institutions; it also illuminates our current social-economic institutions' robustness and resilience as well as shows how we can make structural reforms to further increase robustness. This line of inquiry concerning the evaluation and understanding of emergent social institutions in light of human imperfection is far from being a new theoretical framework; it follows an old tradition of economic and social inquiry with its major intellectual foundations in the Scottish Enlightenment, particularly the works of Adam Smith, David Hume and Adam Ferguson. Two centuries later Friedrich Hayek evaluated the Scottish Enlightenment, particularly Adam Smith’s work, as a foundation in the analysis of social-economic institutions. In most of his work, Hayek stressed the fundamental necessity of basing our comprehension of the economic order, the market process and monetary institutions on more realistic premises of the human condition; in particular, he stressed fallibility, radical uncertainty, self-interested men, economic incentives and the limitation of knowledge (Caldwell, 2004). In Hayek's words: “the main point about which there can be little doubt is that Smith's chief concern was not so much with what man might occasionally achieve when he was at his best but that he should have as little opportunity as possible to do harm when he was at his worst. It would scarcely be too much to claim that the main merit of the individualism which he and his contemporaries advocated is that is a system under which bad men can do least harm [robust institutions]. It is a social system which does not depend for its functioning on our finding good men for running it, or on all men becoming better than they now are, but which makes use of men in all their given variety and complexity, sometimes good and sometimes bad, sometimes intelligent and more often stupid.” (Hayek, 1948, p.11). It would be simple for a centralized monetary institution to promote monetary equilibrium and conceive an “optimal” quantity of money supply if one assumes that policy makers within that institutional arrangement are free from political pressure and are both omniscient as well as extremely benevolent individuals. But what would happen to monetary equilibrium and market coordination within a centralized institution if the policy makers have severe epistemological and cognitive limitations? What would happen if they prove to be self-interested, short-sighted and sensitive to political manipulation? We can clearly begin to comprehend that the capacities of achieving monetary equilibrium and providing the “right monetary policy” becomes extremely difficult, if not unachievable, the farther we remove ourselves from unrealistic assumptions. Instead, a robust monetary institutional arrangement would be able to deal with these imperfections and despite them would move towards a more “optimal quantity of money” consistent with maintaining monetary equilibrium. A fragile monetary system, on the other hand, would produce an economically suboptimal but politically optimal money supply, generating severe monetary disequilibria and economic discoordination. Analyzing social-economic institutions’ robustness or fragility therefore requires relaxation of the best-case assumptions regarding our human condition. In Section 2, I review the monetary equilibrium theory as a framework in which we can apply the 6

concept of RPE and then evaluate the robustness of different institutional arrangements. Based on a subjective understanding of the individual's demand for money, I develop a dynamic framework in which monetary equilibrium could be theoretically maintained. Section 3 explores the theme of “monetary neutrality” of F.A. Hayek and the concept of price fluctuation based on changes in real economic productivity. Section 4 covers a reevaluation of the assumptions concerning political pressure, self-interest and incentives alignment, with particular emphasis on the Federal Reserve and its robustness level. Section 5 reevaluates the assumptions concerning the degree of decision makers’ omniscience within different institutional settings and how their epistemological limitations are minimized according to different monetary institutions’ varying robustness levels. Section 6 concludes. 2. Monetary equilibrium as a framework for a robust political economic analysis Monetary equilibrium theory here is understood as “the state of affairs that prevails when there is neither an excess demand for money nor an excess supply of it at the existing level of prices” (Selgin, 1988, p. 49). In other words, monetary equilibrium is achieved whenever money supply meets economic actors’ real demand to hold money at the current price level. Following this thinking, we should understand what constitutes the demand for money and then how a theoretical monetary equilibrium could be achieved whenever the supply of money meets that established definition of the money demand. We will later use monetary equilibrium as the framework in which the assumptions concerning human knowledge, human benevolence and political pressure will be reevaluated in order to understand which monetary institutional arrangement will be more prone and robust in maintaining and achieving monetary equilibrium through time. The demand for money as understood by Yeager, and other economists such as Mises, is based on the “cash balance” approach; it entails that money demand originally stems from the preferences of every single individual within a market economy, based on their subjective predilections to hold a certain amount of readability of purchasing power (Horwitz, 2013). Individuals hold cash balances in many forms such as bills, bank accounts and electronic wallets. Economic actors possess a personal and subjective preference to hold money according to their predilections and expectations concerning their necessities of purchasing power in the form of money.3 Thus if individuals accumulate more money balances, it reflects their increased money demand; in contrast whenever individuals spend their money they reduce their money holdings, reflecting a reduction of its demand. “One can view the choice to hold money as a decision to “purchase” availability [of purchasing power], just as the choice to hold wealth in the form of a book is a decision to purchase book services” (Horwitz, 1990, p.465). In other words, individuals desire to hold cash balances based on their personal subjective utility that money might yield to them (Horwitz, 1990). In particular, individuals’ cash balances and desire to hold money will be determined according to their liquidity preferences which will be dependent upon their expected utility from holding wealth in the form of “purchase availability.” Those preferences will affect the form and magnitude of economic transactions thus the “desired money balances depend, in large part, on the economy's physical volume of transactions contemplated and on the prices at which goods and services change hands. Actual money balances add up to the

Considering a subjectivist approach to demand and the desire of heterogeneous individuals to hold money as cash balances could be considered part of a broader tradition of the “subjectivist monetary theory” which began with the theory of the origin of money by Carl Menger (2009 [1892]) and has seen some advances in the subjectivist approach to the demand of money by Selgin (1987) and Horwitz (1990).


money supply, and if it equals the total of desired money balances, the flow of transactions continues without monetary impediment” (Greenfield & Yeager, 1989, p.405, emphasis added). In Greenfield and Yeager's quote, I highlighted the point that will be crucial for maintaining monetary equilibrium: the total desirability of individuals in holding money against the actual existent demand for holding money. People's actual money balances in the economy does not necessarily mean that they will always match individuals’ desire for money balances. As a matter of fact, the inconsistency between desirability and actual money balances will be the main source of monetary disequilibrium on relative prices. Following a subjectivist approach on the demand for money in the economy allows us to comprehend the main sources of monetary disturbance that sprung from the system's lack of capacity in matching individuals’ desirability of holding money balances with money supply. This approach also illuminates the discoordination effects that sprung from microeconomic problems with money; whenever the demand for holding money balances exceeds (or falls behind) the supply of money, this mismatch between preferences and supply may create disturbances at the individual or micro level. Eventually those disturbances, which had started at the micro level, will be reflected at the macro level in the form of economic cycles and depressions due to radical changes in the price mechanism and changes in the pattern of consumption and production of various groups of economic actors. Following Yeager’s argument, the mismatch between the desire and actual level of holding money will generate substantial changes in individuals’ consumption and spending patterns, then later those pattern alternations will spread throughout the whole economy (Horwitz, 2013). In particular, depending on the disequilibrium’s direction (which is unknown a priori), spending and investments throughout the economy will vary significantly. Economic agents’ changes in consumption and investment decisions are the reflection of monetary disequilibrium which generates inflation or deflation through the disequilibrating effects of the inconsistent supply of money. These effects are particularly pernicious on the aggregate since they will hamper the functioning of the market process as a dynamic coordinative mechanism; particularly through altering the previous structure of relative prices due to the agent's pattern shifts in consumption and investment prone by the disequilibrating money supply. This thereafter curtails the prospects of the market economy in creating prosperity and wealth. The fact that money is used as the counterpart of every single economic transaction makes it an important and distinctive element of the market process. If money is unstable and misaligned with individuals’ complex and dynamic necessities within the economy, it will create real econom ic disequilibria from the monetary mismatch. Moreover those monetary disequilibria will permeate and hamper market exchanges in unforeseen ways since: “… goods [are] exchanged for each other not directly but through the intermediary of money (or of claims to be settled in money). Trouble occurs when a discrepancy develops between actual and desired holdings of money at the prevailing price level. Such discrepancies can develop when the actual growth of the money supply falls short [or exceeds] of the long-run trend” (Yeager, 1983, p.306). Hypothetically, behind the so-called “veil of money”, every single market transaction is fundamentally a voluntary exchange in which economic actors specialize in the production of a specific good or service. Therefore in order to incur an economic exchange, individuals receive a 8

good or service but also have to give something back in the form of production, thus moneyless markets clear and production meets the demand of goods. Thus behind the “veil of money,” every individual’s output or production is the other side of the demand for a certain good and service and supply constitutes demand. However, as mentioned before, exchanges in modern economies are made through money, thus money is the virtual counterpart of every single transaction in the market process. Exchanges of good and services are therefore performed through the intermediary of money; this role of money is what makes it an extremely important mechanism in an exchange economy. It is under this intermediary role that the real “money veil” could have the potential to be severely unstable and pernicious to the market coordination process, depending on which institutional arrangement is supplying the money. Thus different institutional arrangements can make money a market-enhancing institution, or a market-curtailing one. Therefore, “money's role as half of every exchange points out the way in which such exchanges cannot even occur if money does not exist, and how potential exchanges that are of mutual benefit might not take place if the supply of money is insufficient… Finally, it is through the monetary exchange process that goods acquire prices reckoned in money, which enables actors to engage in economic calculation” (Horwitz, 2006, p.167). Exchanges and the market order could suffer a pervasive disruption through disequilibrium in the supply and demand for money. In other words, “It is hard to imagine what that pervasive disruption could be other than a discrepancy between actual and desired holdings of money at the prevailing price level” (Yeager, 1986, p. 370). Since money lacks its own market and is the other half of every economic transaction, the pervasiveness of money comes from the “disequilibria in the money market spill over into all other markets” (Horwitz, 1990, p. 466); this makes it pernicious to socialeconomic coordination. This is one of the fundamental problems of creating monetary disequilibrium through excess [or lack of] money supply. Thus, “imbalance between the actual quantity of money and the total of desired cash balances cannot readily be forestalled or corrected through adjustment of the price of money on the market for money; because money, in contrast with all other goods and services, does not have a single price and a single market of its own. Monetary imbalances [and disequilibrium] has to be corrected through the roundabout and sluggish process of adjusting the prices of a great many individual good and services” (Yeager, 1983, p.307). According to Yeager, monetary disequilibrium will manifest itself through other markets and prices for goods and services, hampering economic exchanges and thus altering relative prices and the market structure. Furthermore Yeager adds, since “prices do not immediately absorb the full impact of the supply and demand imbalances for individual goods and services that are the counterpart of an overall monetary imbalance [in the money system], quantities traded and produced are affected also” (Yeager, 1983, p.307). This then leads to radical changes in the patterns of economic activity and changes in the structure of production and allocation of capital; following this, severe damages will occur in the market process of decentralized social coordination. But even more dangerous, Yeager reminds us that “not merely coordination but, more broadly, economic calculation is at stake” (Yeager, 1983, p.307). The solution to this monetary disequilibrium problem is to match the quantity of money as close as 9

possible to the desired money demand. It is important to note that although adjustments of individuals' preferences of holding money could (in theory) work itself out through cumbersome and excruciating price adjustments, this mechanism is not preferable.4 Instead of relying on pernicious and sluggish effects on price fluctuations that might severely affect markets for goods and services, in order to adjust for the changes in the demand for money, it will be far better to rely on a robust institutional monetary arrangement that will change the money supply than putting all the burden on the price system, increasing the epistemological burden of the whole market process. A robust monetary system will be able to dynamically change the total quantity of money (nominal money supply), supplying (withdrawing) money, whenever an increase (decrease) in the demand of money appears in the market process. Accommodating changes in the supply of money will alleviate the adjustment process that depended solely on changes in the price level, which are usually extremely cumbersome, costly and uneven (Selgin, 1990; Yeager, 1986). This will serve as a monetary measure to reestablish monetary equilibria over time, rather than relying on discoordinating alterations in the structure of the real economy to help maintain market coordination through time.5 Consequently, a robust system will seek to control and adjust the quantity of money that will meet the desire of real demand for holding money balances. The simplest way to achieve this form of robust monetary institutional arrangement could be - according to Yeager (2010) - through a sort of privatized free-banking gold standard:6

Prices and wages in the real world possess “stickiness” due to real market frict ions and dynamic market processes that unfold through different time frames. This real market “stickiness” makes the adjustments of the real quantity of money severely slow and harmful. If money is not supplied or withdrawn due to changes in the desire to hold money balances, individuals will have to adjust their asset holdings and consumption patterns in order to respond to the changes in their liquidity preferences. In this case, adjustments will occur through changes in the price level and relative prices, making the accommodation difficult, sluggish and economically impractical. Relying on monetary alterations of the relatives prices to match the changes in the demand for money is as pernicious as altering relative prices to match changes in unwanted excesses in the money supply (see Yeager 1986 and 2010). In addition if “ the ability of the price level to adjust to restore equilibrium will depend upon the degree to which the various individual prices are able to adjust quickly and accurately in the face of monetary disequilibria, and if prices do not adjust quickly to either excess supplies or demand for money, the economic cost of those disequilibria will be revealed during the transition [and discoordination] process” (Horwitz, 2013, p.170). Monetary equilibrium is used in this paper as a framework to understand severe disequilibrium processes that arise from the mismanagement of the money supply, both whenever a monetary system experiences an excess in the nominal money supply (pervasive inflation) or excesses in the demand for real balances (pervasive deflation). This broader monetary framework serves as a theoretical instrument to evaluate different monetary institutional arrangements and how they will be more robust (or fragile) under realistic assumptions concerning human capabilities in order to achieve an “as close as possible” monetary equilibrating environment. For a more comprehensive work on monetary equilibrium theory and its historic evolution, see Myrdal (1965 [1939]) and Warburton (1981). Additionally, for a review of the historic evolution of the idea of monetary disequilibrium in classical economics, see Montgomery (2006). It is interesting to note that although a private “free -market” gold standard is the easiest and most standard way of exposing the theory of free-banking and the decentralized supply of money, gold may actually (according to Yeager, 2010) not be the best commodity to serve as a base for a free-banking system. This is due to its volatility in value compared to other goods, since the price level is tied to the relative price of the ‘anchor’ or based commodity in which the free-banking institutional arrangement is based. Yeager (2010) develops an interesting case for a multicommodity basket standard. In order to obtain a higher level of stability, Yeager proposes a basket-like assortment of commodities and goods as a base for a free-banking system. Yeager adds that although prices in the economy will be established according to the basket, redemption of the currency can still be performed by a single commodity and this will most likely be gold. Under this scheme, “ governments would merely designate a new unit of account [based on a basket of goods] and promote its general voluntary adoption” (Yeager, 1996, p.97 ). Thus it follows, “private banks would issue notes… The quantities of these media of exchange would accommodate




“Under a privatized gold standard, banks issuing notes and deposits must conduct their business to stay ready to redeem their issues in gold, even or especially when arbitrageurs demand the gold. Banks’ prudence keeps the quantity of money from growing beyond what is willingly held at the price level corresponding to the dollar’s gold content and gold’s relative price against other goods and services. If, in the opposite direction, the actual quantity of money should start to fall short of the quantity demanded and cause incipient price deflation, banks would have an opportunity and an incentive to buy gold relatively cheap to back an expanded volume of their money and their lending... The discipline of [decentralized] redeemability would be tighter under a privatized gold standard, since each bank would have to stand ready in effect to redeem any adverse clearing balances in the routine daily clearings of notes issued by and checks drawn on the various banks” (Yeager, 2010, p.421,422). Under this scheme, the supply of money will be determined strictly by market incentives which banks face in providing or restricting liquidity, according to the people's demand and desires for holding money. A robust monetary system should accordingly provide an alignment of incentives for banks to incur in arbitrage whenever the supply of money exceeds or falls short of the real demand for holding money.7 Therefore it seems that under a decentralized system of supplying money, the “issuing institutions supply the quantity of money that the public desires to hold at the price level predetermined by the dollar’s basket [or commodity] definition” (Yeager, 2010, p.425). This institutional arrangement consists of moving to a dynamic competitive system which seeks, under aligned market incentives, to move towards a closer supply of the quantity of money that will be compatible with what individuals in the economy wish to hold. It will use market mechanisms such as profit and loss and other market signals to achieve a “fitter” money supply. This in turn , (i) minimizes the possibilities of generating extreme monetary disequilibria; and (ii) avoids extreme deviations in the supply of money, which reduces the epistemic danger of market discoordination. In other words, the competitive market for the supply of money seems (thus far) to meet some criteria of robustness when we consider the alignment of banks’ incentives and market discipline which bind and reward their actions towards monetary equilibrium. This suggests that, “under free banking economic forces reward bankers who make decisions consistent with the maintenance of monetary equilibrium (and minimization of costs) and punish bankers who make decisions inconsistent with these goals” (Selgin, 1988, p.144).

themselves to the demand for them at the price level corresponding to the definition of the unit [defined by the government]. Incipient imbalances would trigger corrective arbitrage. This automatic equilibration of demand for and supply of media of exchange at a stable price level would prevent price inflation and major recessions” (Yeager, 1996, p.97). Yeager's view of a free-banking system based on a composite abstract unit of account contrast with the more standard emergent single commodity versions stated by Selgin and White (1985). Another solution for a freebanking system’s money base could easily be one based on “freezing” the current fiat money base and use thereafter a “frozen” fiat currency as “fiat base money” (see Selgin, 1988, chapter 11).

It is important to clarify that a commodity-based free-banking system allows entrepreneurial activity and arbitrage on the use of the base commodity in the system; specifically, the quantity of money will fluctuate accordingly until it equilibrates the marginal value of the base-commodity in both its ordinary and monetary uses. Therefore “[I]f its marginal values are not equal, some of it shifts into the greater-valued use. A shift in the money-expanding direction can work by free monetization (e.g., coinage). In the opposite case of the commodity’s being worth more in its ordinary uses than as money, some money is redeemed or melted. The value of money is determined by demand for holdings of it interacting with its commodity-constrained supply” (Yeager, 2010, p.421).


According to the monetary equilibrium theory, individuals' demand for money is the original source of banks' credit. Banks will exclusively loan funds on the basis of what will be made available to them (as a result of people's necessity to hold liabilities), rather than spending them. In this system of free-banking, “liability holders are the ultimate granters and generators of credit, banks cannot create more credit than the public is willing to hold. If banks attempt to do so, they will be penalized through the clearing system. Free banks are pure intermediaries, taking in loanable funds from holders of liabilities and loaning out funds to spenders of liabilities” (Horwitz, 1994, pp. 228, 229). In addition, a decentralized system seems to be more epistemologically robust since money issuers must be alert and compete under profit and losses. This generates a fragmentation of knowledge which is more prone to deal with the epistemic limitations of a centralized authority in achieving or at least trying to find - the “right quantity of money” for the aggregate economy. A decentralized dynamic system which depends on market mechanisms seems more epistemologically robust, at least on a preliminary basis, since it minimizes political pressure and relies on specific knowledge of time and place to dynamically supply the equilibrating quantity of money. This form of institutional arrangement suggests a higher degree of robustness in dealing with human limitations (regarding what we could possibly elucidate about millions of individuals’ subjective money demand preferences). It also uses market competition as a means to align private issuers’ incentives towards an environment of monetary market equilibrium, reducing the possibilities of severe monetary disequilibrium and large socioeconomic disorder. In contrast, a centralized system of supplying money seems to be extremely fragile to problems concerning human imperfection; in particular, when it addresses motivational incentives, political pressure and the cognitive impossibility to fully understand the market's complexity of the necessities of holding money. Sections 4 and 5 will address these problems in the context of RPE. Finally, in order to understand how different monetary arrangements promote economic prosperity and market coordination, we must keep in mind that since we live in an imperfect world, “The economy never reaches a state of full coordination. How close or how far away it is depends on how severe and how recent shocks have been in 'wants, resources, and technology'—and monetary conditions [and its institutions]. The impossibility of perpetual full coordination is no defect of the market system. It is an inevitable consequence, rather, of the circumstances with which any economic system must cope” (Yeager, 1986, p.376). We must recognize the inevitable fact that human beings are imperfect and fallible. This limits our capacities of achieving a perpetually perfect environment that enhances perfect social-economic coordination; human limitations make perfect market equilibrium an institutional impossibility. However those imperfections within the economic order should not be the foundation for a denial or radical attack on the market process, but rather the recognition of market discoordination and disequilibrium should be the very realistic foundation for which we strive for better institutional arrangements. Following this line of thought, no single monetary arrangement could be a perfect system of perpetual market coordination. Nonetheless this fact should not impede us to compare monetary arrangements and recognize which are most resilient in response to fundamental human imperfections on which all monetary systems should be founded. In addition, if we wish to assess and compare different economic institutions, we must enrich the 12

monetary equilibrium framework. As mentioned, monetary equilibrium will be beneficial to the market coordination process since it diminishes the price structure’s monetary distortions. Therefore if we wish to appreciate the coordinative role that the market processes may achieve, we need to possess deeper understandings of the role of relative prices on the decentralized market process. We must also notice how money prices will accomplish a fundamental epistemological role in coordinating economic activity. Prices act as “knowledge surrogates” which allow market actors to make rational economic decisions when facing personal preferences, different conflicting possibilities and multiple alternative uses for the same factors of production. The surrogates allow them to be engaged in and to make rational economic calculations. Money prices allow individuals to formulate plans and form expectations about their present and future conditions, allowing them to make economic actions based on previous evaluations of money prices within an environment soaked in highly radical uncertainty (Thornsen, 1992). A complex society based on heterogeneous ends and dispersed knowledge, which relies on decentralized market processes and seeks to coordinate economic activity, will need to find ways to utilize and disseminate all real dispersed knowledge which individuals not only hold and communicate imperfectly but also eventually create through entrepreneurial and market interactions. Market societies utilize the dynamic fluctuations of market prices as a communication mechanism to conspicuously convey information to knowledge surrogates.8 Prices therefore act as a non-linguistic medium of communicating tacit, relevant and vital information to various market participants. The emergent and communicated information concerns the contextual economic reality in which economic actors make decisions, innovations and allocate resources. Under this context we can see that monetary equilibrium is extremely and epistemologically relevant to society since it provides a propitious institutional environment which facilitates the coordinative and communicative task of relative prices through a neutral (less distortionary) money supply. Market coordination and social-economic order will fundamentally rely on epistemological communicative systems like money prices, interest rates and other market signals; this means that economic orders must essentially rest on monetary institutional regimes which provide the money or medium of exchange in which monetary prices will be “objectified” or expressed in the real economy. How different regimes either maintain monetary equilibrium or generate monetary disequilibrium will alter the money supply. Consequently it will affect prices as well as the entire communication and epistemological system coordinating social-economic activity (which is the main source of social-economic fragility). It is a problem that needs to be elucidated with a comparative institutional analysis with monetary equilibrium theory as a foundation. In conclusion, if market prices are expressed as money prices, the whole epistemic function will directly depend on the monetary regime in which those relative prices are expressed in monetary terms. Thus “… it is the use of money in exchanges that activates the epistemic properties of the price system” (Horwitz, 2004, p. 311). Therefore a fragile institutional monetary system that promotes monetary disturbances will, epistemologically speaking, be pernicious to such a significant degree because it will “overtax the knowledge-mobilizing and signaling processes of the market” (Yeager, 1986, p.376). Moreover monetary disequilibrium- in the form of excess money supply or excess money demand- will be economically harmful in complex and unforeseen ways. If

It is important to stress that money prices do not “convey” knowledge in the same sense in which “convey” refers to simply passing knowledge to another person. Money prices instead, “make knowledge 'socially accessible'. When we 'use' a price, we don’t know what others know, rather we simply are able to act as if we knew what others knew. Prices are, in that sense, surrogates for knowledge” (Horwitz, 2004, p. 314).


we consider that real economic orders suffer from sticky prices, wages and other real market frictions, disequilibrium and discoordination will be unevenly diffused over different goods and services markets in various magnitudes and timeframes.9 These monetary effects will alter quantities produced, production and capital structures, resource allocation among economic sectors, and relative prices in dangerous and unforeseen manners; these would render corrections and movements towards coordination, which would be sluggish and difficult to achieve. In other words, “The effects of inflation are dispersed and uneven precisely because money has no market of its own and the excess supplies of money will therefore affect each and every market [differently, with which] the excess supply comes into contact... The result of this process is that the entire array of market prices is changed in unpredictable and varying ways by inflation. This creates additional epistemic burdens for entrepreneurs as they must attempt to disentangle the effects of inflation from underlying real changes… Inflation undermines the process of economic calculation that Austrians see as a partner with entrepreneurship in making economic coordination and growth possible” (Horwitz, 2006, p.175). After better understanding the epistemic and coordinative role of prices in the economic order, the solution to maintain an imperfect yet robust monetary framework promoting economic growth will be a system which seeks to minimize the likelihood of monetary disequilibria damage (stemming from inflictions on market coordination, relative price structure, or capital formation). As seen in the endogenous theory of the supply of money by Yeager (2010), that ideal system would be able to increase (decrease) the nominal supply of money in order to restore monetary equilibrium between money supply and demand. Such a system would simultaneously bring the market interest rate back down (or up) in accordance to individuals’ intertemporal preferences to save and consume, making a monetary framework more likely to maintain the market interest rate corresponding to the natural interest rate; this in turn lessens distortions in the long-term capital structures and enhances intertemporal equilibrium. It also lowers the degree and severity of the capital structure’s discoordination and possible radical reallocation of capital across industries due to interest rate distortions arising from money imbalances. Maintaining those equilibria will enable economic actors, as both consumers and producers in the marketplace, to move closer to a condition of intertemporal coordination that reflect their heterogeneous and decentralized decisions, while being guided by a more “accurate” market interest rate reflecting individuals’ preferences to save and spend. It appears that economic coordination would be more prone to be maintained if a dynamic robust monetary process is able to usufruct from contextual, additional, faster and more accurate decentralized market mechanisms generating cardinal knowledge surrogates; such examples would be competition, local knowledge, economic incentives and other social and market signals that emerge from the local and contextualized interaction among self-interested economic actors. Those prompt and more accurate knowledge inputs would assure dynamic responses in the money supply, which would move the monetary system towards monetary equilibrium. Hayek emphasized the benefits of the aforementioned better and prompt market mechanisms and knowledge surrogates to

In Horwitz (2013) there is a novel attempt to synthesize and enrich monetary disequilibrium theory with an Austrian macroeconomic framework. In particular, Horwitz brings the concept of the Wicksellian natural rate system of coordination, the Austrian theory of heterogeneous capital and time-length structure of production, and the Hayekian triangle into Yeager's monetary disequilibrium framework. This creates a more integrated and rich approach to fully grasp the pernicious effects of monetary disequilibria and market discoordination.


make better decisions regarding the money supply when he stated that: “The threat of the speedy loss of their [the suppliers of money] whole business if they failed to meet expectations … would provide a much stronger safeguard than any that could be devised against a government monopoly. Competition would certainly prove a more effective constraint, forcing the issuing institutions to keep the value of their currency constant” (Hayek, 1976c, p.47). 3. “Good” and “bad” price structure changes and maintaining a constant “money stream” According to Hayek, a monetary system would be more robust whenever it could “create the conditions in which responsibility for the control of the quantity of the currency is placed on agencies whose self-interest would make them control it in such a manner as to make it most acceptable to the users” (Hayek, 1976c, p.92). As mentioned in the previous section, monetary disequilibrium arises whenever there is an inconsistency between the supply and demand of money at the current general price level. Therefore in this monetary context, it is justifiable to talk about inflation and deflation only as a monetary phenomenon. Inflation alters relative and overall prices whenever the supply of money exceeds people's desire to hold cash balances. On the other hand, monetary deflation appears whenever the supply of money falls short of individuals' desire to hold cash balances. It is important to stress that disequilibrium- brought about by changes in the quantity of money as well as and its failure to adapt to dynamic, endogenous changing demand for holding money- will not strictly cause all changes in the general price level; general prices can also change due to real productivity modifications within the economy. However only those general price level changes brought about through monetary disequilibrium are the ones that can be properly called inflation or deflation, in the monetary sense, since they are the offspring of an exclusive monetary phenomenon (Hayek, 1976c). Under this consideration, variations in real economic factors such as increases in productivity and other technological changes alter the general price level as well as generate fluctuations in the relative prices structure. Changes in prices, brought about by the real economic factors do not necessarily produce monetary mismanagement (disequilibrium) outcomes but rather reflect real changes in the production structure, innovation as well as economic actors’ preferences and consumption patterns, hence they accomplish a relevant coordinative function. Real economic factors affecting the price structure therefore cannot be considered as the outcome of inflation and deflation in the monetary sense of the word. General price level changes that stem from real factors are necessary and fundamental elements of the market process and should not be avoided or obscured. Price fluctuations and relative price changes convey and transmit new tacit information regarding changes in productivity, technological improvements and changing preferences in the economy. They are fundamental information which the price mechanism needs to transmit. On the other hand, when monetary disequilibrium brings about general price changes, they do not play the same economic coordinating epistemic role, but quite the opposite: a pernicious and discoordinating one. We could understand good and bad changes in relative prices as a matter of “value added” on the epistemic functionality of the market prices. ‘Good’ changes will actually transmit relevant information concerning innovation and real structural and technological changes in the production of good and services; instead ‘bad’ changes in the market prices structure come from disequilibrating fluctuations in the money supply, which increase the “epistemic burden” for economic actors rather than transmit relevant market information about scarcity, preferences and productivity. A schematic way to differentiate between coordinative or discoordinative (good and bad) changes on the price structure is to utilize the fundamental equation of exchange (MV=PY) 15

complemented with the idea of the constancy of the “money stream”. Thus far we have seen how a free-banking system, which generates an endogenous money supply according to economic actors’ preferences, would seek (although imperfectly) to maintain economic coordination through moving toward the ideal type of monetary equilibrium. The concept of monetary equilibrium is extremely related to what Hayek mentioned as a monetary ideal which seeks to maintain a constant “money stream”. Hayek referred to this money stream as a theoretical equilibrium point in the relationship, found on the left side of the equation of exchange. According to Hayek, a “money stream” constancy is a situation that arises whenever the quantity of money supply (M) perfectly varies according to counteract changes in the velocity of money (V), which is the inverse function of the aggregated individual's demand to hold bank liabilities. This balancing mechanism desires to maintain the money stream invariant, or “the effective amount of money in circulation” (Hayek, 1935, p.27). In other words, it keeps the right side of the exchange equation (MV) constant. The “money stream” constancy helps us to understand the price level’s 'good' changes (value added, epistemologically speaking). If the “money stream” (MV) is kept constant, then the left side of the equation (PY) must also be kept constant if we wish to hold the equation’s equality. Therefore this equilibration suggests that if the interacting forces of the money stream are kept balanced, any changes that might appear ion the general price level (P) will only be a product of real changes in the economy’s productivity (Horwitz, 1996).10 Hence a monetary institutional arrangement that endogenously supplies money and seeks to maintain the “money stream” constant will break the pernicious link between the quantity of money supply and the price level defined in the quantitative theory of money. In other words, under a free-banking system, “the price level is determined not by the supply of money, but by the value of the base money and the amount of real production taking place” (Horwitz, 1996, p.229). This is extremely relevant for monetary theory since a constant money stream will greatly alter our understanding of the relationship between the general price level and the quantity of money. By maintaining a stable “money stream”, money will be neutral while money being supplied attempts to meet the real demand in order to hold bank liabilities. The constant “money stream” will be “neutral” on the structure of relative prices, production, and consumption. In other words, money will be a ‘veil’ at this specific theoretical point - which will not alter the economy’s real variables and prices. For Hayek, the neutrality of money “refers to the set of conditions, under which it would be conceivable that events in a monetary economy would take place, and particularly under which, in such an economy, relative prices would be formed, as if they were influenced only by the 'real' factors” (Hayek 1935, p. 130). Furthermore he stressed that in order to achieve this idealistic price structure neutrality, it was not necessary to seek a macroeconomic policy focusing on statistical aggregates and proxies to maintain constant growth in the quantity of money, but rather: “A stable price level and a high and stable level of employment do not require or

0 In theory, if a free-banking system maintains the “money stream” (MV) constant, then the general price level will change inversely to the level of real production increases of the economy; Selgin (1988 & 1997) concludes that under a free-banking system, we should expect, a secular decrease in the general price level (P), as long as the economy increases its real productivity and efficiency. Therefore following a free-banking system promoting a neutrality of money, will not aim to stabilize the price level (P). Selgin (1997) explains how this deflation is positive for the economy and should not be associated with deflation’s negatives effects, brought about by monetary disequilibrium under a central banking arrangement.


permit the total quantity of money to be kept constant or to change at a constant rate. It demands something similar yet still significantly different, namely that the quantity of money (or rather the aggregate value of all the most liquid assets) be kept such that people will not reduce or increase their outlay for the purpose of adapting their balances to their altered liquidity preferences” (Hayek, 1976c, p.81). Here Hayek implies that money neutrality should be the outcome of a robust monetary system rather than the policy guidance for a pernicious one. According to Hayek, it was an unreachable goal in practice, for any monetary institution to hold this theoretical framework of understanding money's capacity of being theoretically neutral. However this should not mean that money neutrality could be used as a quality benchmark and framework in which we should analyze how pernicious and fragile different institutional arrangements are. Different monetary institutions, according to their degree of robustness, will allow different degrees of “money stream” fluctuations. How far these fluctuations move away from (or close to), the money neutrality situation will determine their fragility (robustness) level.11 More robust systems will have milder variations, therefore creating minor economic discoordination. Overall, “Alternative monetary regimes can be evaluated by their ability to maintain, or penalize deviations from, monetary equilibrium” (Horwitz, 1996, p.305); the framework therefore not only allows us to follow an institutional comparative study, but also helps us to understand how different monetary arrangements will use different market or legal mechanisms to penalize deviations from the money stream constancy and from the neutrality-monetary ‘veil’, in order to avoid or diminish bad changes in the price level. The monetary equilibrium framework can be substantially enriched through understanding both good and bad price fluctuations that arise from understanding the equation of exchange as well as from the “money stream” constancy solution envisioned by Hayek. Although the neutrality of money is an abstract, unreachable, and theoretical construction - unfit for an imperfect world - it has been shown that it could nonetheless serve as a successful institutional benchmark. As such it would allow us to evaluate which institutional arrangements, based on real world assumptions concerning our human capacities and nature, would be the most prone to move toward the abstract money neutrality benchmark. Moving closer to the benchmark would increase our economic system’s robustness by decreasing the epistemic burden that monetary disequilibrium may put on the price mechanism and on economic actors. Hayek shared these institutional worries and he understood that monetary equilibrium theory was not a prescription for an optimal monetary policy that we could have followed through a centralized fashion. Instead it is the foundation for a more robust monetary institutional comparative study, one that allows us to elucidate which monetary institutional arrangement would be best at fostering economic coordination and socioeconomic order. In Hayek’s words: “I have myself given currency to the expression 'neutral money'… it was intended to describe this almost universally made assumption of theoretical analysis and to raise

1 One of the major advantages of following a theoretical framework such as the monetary equilibrium (Myrdal, 1939), is that we could use this theoretical situation to divide the neutrality-monetary wall which separates monetary disequilibria on both sides; at the same time it allows us to merge theoretical insights from monetary disequilibrium theory and monetarist and Austrian macroeconomics. On one side of the neutrality wall we expect inflation and on the other deflation, both deeply and inherently harmful to the market process’ coordinating capacity. For a more thorough comprehension of how Austrian cycle theory and monetary disequilibrium are harmonious and operate together under a monetary equilibrium framework, see Horwitz (1996). To complement the monetary equilibrium theory with the main theoretical ideas of free-banking, see Selgin (1988, chapter 4).


the question whether any real money [or monetary system] could ever possess this property, and not as a model to be aimed at by monetary policy. I have long since come to the conclusion that no real money can ever be neutral in this sense, and that we must be content with a system that rapidly corrects the inevitable errors [of excess or deficiency of the supply of money]” (Hayek, 1976c, p.88; emphasis added) Hayek understood that money will never be neutral and will never be a pure and transparent “monetary veil” over the real economy. Money, according to Hayek, will always be a potential destabilizing agent (unfortunately for the economic order). Despite being extremely beneficial for enhancing economic exchanges and trade, money will always be, simultaneously to some degree, a source of disequilibrium and distortion within the economy. In the words of Hayek, money will always be a “loose joint” in the overall dynamically equilibrating market process. During real market activity, money “allows for deviations between the quantities of non-monetary goods supplied and the quantities demanded” (Garrison, 1984). Despite the negative effects of money’s use in the economic order, there remains much we can do to maximize money's good role and minimize its bad aspects. This is precisely the point that Hayek emphasized in the quote above; what we need to focus on in monetary theory should not be prescribing monetary neutrality as a form of best monetary policy but rather to discard that policy possibility from the beginning since we understand our human limitations. We should form our monetary understanding base on realistic assumptions concerning human capabilities at an institutional robustness level. We can use the neutrality concept as a pivotal point for a comparative institutional exercise in order to identify which institutional arrangement possesses a rapid and dynamic response to inherent human errors. These faults are certain to emerge from utilizing a human-emergent socioeconomic institution that acts as a “loose joint” in our socioeconomic wealth-enhancing activities. 4. Reevaluating the assumptions of political pressure, self-interest and incentive alignment Thus far, in sections 2 and 3, we have discussed the main theoretical benchmark to judge the level of different monetary institutional arrangements’ robustness or fragility; specifically we have examined how they promote or discourage a resilient economic coordination through maintaining “money neutrality”. We will now continue the process of RPE suggested by Pennington (2011) and Peter Boettke and Peter Leeson (2004). We will reevaluate the assumptions concerning political pressure, self-interest and incentive alignment that decision makers within a centralized monetary institutional arrangement face, with particular emphasis on the Federal Reserve. Through this reevaluation we wish to establish more accurate and realistic assumptions that reflect real human behavior and its conditions. Consequently we will elucidate which institutional arrangements will be better at coping with these human limitations and self-motivations while simultaneously moving closer to our monetary equilibrium and “money neutrality” theoretical institutional benchmark. Under current institutional central banking systems across the world that dominate today, particularly the Federal Reserve System, we are in one way or another using forms of centralized monetary money supply management. In particular, the Federal Reserve System in the United States which was established by the Federal Reserve Act in 1913, with the specific intention to create an independent entity for the guidance and control of the monetary policy of the economic system. The scope was to possess an “independent” guide for the money supply with a high degree of “political independence” which would free Fed decision makers towards focusing solely on guiding “optimal” “technically based” monetary policies. In the specific case of the Federal Reserve System, the Fed possesses direct control of the monetary base, which is approximately 15% of the estimated money 18

supply (Hanke, 2013). Therefore Fed officials directly control and manage the monetary base. The remaining money supply across the economy is not directly “controlled” in the strict sense of the word, but nonetheless is indirectly influenced and “guided” by those same authorities and experts at the Fed. The rest of the money supply that gets generated within the economy depends directly on the monetary base that the Fed officials control and on the manipulations of the banks reserves and other mechanisms (Horwitz, 2013). The current institutional arrangements in the majority of the world today are systems which rely mainly on similar national centralized institutions following the spirit of the aforementioned Fed. These, too, have technocrats and politically appointed functionaries to influence, guide and indirectly manage the economy’s money supply. The main problematic feature of these arrangements is that elected politicians appoint decision makers for certain limited periods of time, usually open to politically manipulated reappointment processes, which generates severe questions regarding the systems’ founding assumptions of independence. As mentioned, most countries are currently under a monetary system in which politicians appoint key central bankers and decision makers. Therefore it does not seem implausible that politicians can somewhat systematically influence key decisions regarding monetary policy and the growth of the money supply. In this situation, it is likely to discover a tendency of politicians trying to steer the money supply towards their short-term political and economic interests. They could achieve this through applying political pressure on central bankers (Nordhaus, 1975; Toma, 2004). Having just brief political terms and always facing further elections, politicians (seeking to promote their own self-interests) want to be reelected thus maximize their own potential benefits while in power. These strong incentives for politicians seeking reelection will entail higher potential political pressures on behalf of the central banks’ monetary authorities in order to align the centralized institution’s monetary policies with the politicians’ short-term necessities and government programs. Thus it seems that under the current monetary institutional arrangement, “The management of money is always and everywhere political: for every policy choice, there is an alternative that some actors would prefer” (Kirshner, 2003, p. 645). Through political pressure politicians will seek to influence and accommodate central banking policies towards their self-motivated actions and maximize their benefits. Incumbent politicians seeking reelection will attempt to influence monetary policies in order to seize political gain from managing the money supply (Nordhaus, 1975; Toma, 2004). Thus politically-engineered monetary booms are more likely to emerge under these arrangements. These political money supply manipulations will increase the perceived level of “prosperity”, creating forms of “monetary political business cycles” (Nordhaus, 1975). Hence if we wish to understand the robustness level that a centralized political institution possesses in maintaining the money neutrality and monetary equilibrium, we have to reevaluate the assumptions of benevolence, lack of political pressure and the alignment of incentives that politicians and monetary policy decision makers face in real world situations. Under the assumptions in which “independent” central banks were founded, technocrats were believed to be concerned just with technical and economic aspects of the supply of money; thus in theory they were supposed to be unengaged and isolated from political actions and its influences. This theoretical environment would allow them to concentrate on achieving the ‘right’ supply of money or as close to the ‘right’ quantity as possible. That “optimal” and technically-guided supply of money was supposed to match individuals’ desires for holding money in the economy, thus 19

putting the central bank's decision makers’ political pressure and political self-interest aside.12 The Fed's independence was founded on the assumption that the monetary policies crafted at the Federal Reserve would be only technically-based in order to meet the requirements of the economic system’s complex necessities. The assumptions of lack of political pressure and high degree of independence, led to the belief that monetary authorities would be exempted from rent-seeking behavior and from self-interest motivations that could be pernicious to the money supply. These extreme assumptions about the degree of benevolence and the incentives that the authorities would face therefore created the appearance that monetary authorities would always prefer economic and technically-sound policies over disequilibrating policies. Based on the assumption that Fed officials would be free from political pressure as well as assuming that Fed decision makers would follow only the optimal policies - those best for the whole economic system in preference over those policies that would have been better for themselves - assumes an extremely high degree of benevolence, which it appears to be at least unusual in real world settings. It is easy to understand how the Federal Reserve seems rather robust 'on paper' as a monetary arrangement. However, by following Pennington (2011) and relaxing the unrealistic assumptions of non-existent political pressure and political self-interest, the Fed's capacity to guide and conduct the 'right' money supply to maintain economic coordination and minimize the distortions of the 'veil of money' on market signals, are put in jeopardy. Under the current Federal Reserve System, the President of the United States appoints all seven Board of Governors members, which the Senate must afterwards confirm and ratify. Board members serve for 14 years. The US President also designates the Fed's Chairman as well as the Vice Chairman, who each serve four year terms, open to reappointment by the President; the Senate must also ratify these appointments. Those seven Fed Board members, which were appointed through political processes, constitute a majority of the 12 members who comprise the Federal Open Market Committee (FOMC), which dictates the main monetary policies that alter the money supply and affects the quantity of money. In addition, the chairman of the Fed meets periodically with the US Treasury Secretary and with the President’s Council of Economic Advisers, which are key political positions within the US Federal Government. In particular, the US Treasury Secretary is one of the most influential members of the US President's cabinet. Based on the political structure in which Fed monetary authorities are nominated, appointed and later possibly reappointed, it is evident to see that the whole incentive structure for Fed decision makers are aligned toward consenting and allowing political manipulations and permitting congressional and governmental influences to take place. Due to the appointment structure, there is substantial room for political pressure; specifically, there is room for the Federal Government to nudge Fed policies through the appointment and accountability structures. Particular pressure could be exercised regarding future Fed positions and reappointments. Moreover, it is not only potential political pressures that are present in the distorted incentives system, but there is clearly an overall perverse incentive alignment in which Fed officials

2 It is relevant to emphasize once again that the Federal Reserve does not control the supply of money in the full meaning of the term “control”. What the Fed can do is guide and alter overarching monetary policies which indirectly impact the banking system’s capacity to generate the money supply. Hence the Fed does not directly control the money supply but yet possesses an extremely relevant and unique role in affecting it indirectly through different tools such as: reserve bank ratios, the discount rate, and open market operations. For a comprehensive guide of the Federal Reserve’s role in altering the money supply and its policies, see Horwitz (2013).


- under their maximizing own self-interest - will tend to align Fed policies with politicians’ own self-interest maximization. The whole incentive structure therefore is aligned and reoriented toward forms of “politically optimal” supplies of money which are usually characterized with an excessive expansionary supply of money; this commonly exceeds the real money demand whenever politicians exercise political pressure through their appointment powers (Keech and Morris, 1997). Hence the US President, seeking reelection, will be prone to promote short-sighted over-expansions of money and artificially stimulate the economy through inflation. Simultaneously Fed decision makers will be prone to condone the President's position since they are also seeking reelection through reappointment by that same President. Both actors would be following perfectly rational individual actions which maximize their individual potential benefits as well as political positions. Additionally, Fed authorities would have even more incentives to follow the President's position on monetary policy since there exist large asymmetries between the cost and benefits they will face if they pursue disequilibrating “politically optimal” monetary policies. The benefits they receive are concentrated and quantifiable; instead the policy’s cost is externalized by both politicians and Fed decision makers through the remaining economic actors. The cost of monetary disequilibrium as seen from section 2 and 3 will be felt through different markets in various ways; in addition we have seen how inflation and the distortion on relative prices is a cost that impacts economic actors’ epistemological and coordinative capacities; thus it is a hidden cost very unlikely to be quantifiable, in particularly when monetary disequilibrium comes in the form of secular mild inflation (Barro, 1996).13 Unfortunately the long-term cost of “politically optimal” money supplies will be distributed across different markets affecting economic actors unevenly. This dispersion appears through monetary disequilibrium, changes in consumption patterns, and distortion of relative prices; economic agents will acknowledge or recognize these changes only after severe time lags (Friedman, 1968). It seems that key decision makers at the Fed have incentives to follow and to accommodate the money supply towards politicians’ and the President’s desires. We have seen that presidents who seek reelection will have many incentives to apply pressure for money supply increases which extend well beyond the existent demand for money. This distorted oversupply of money would stimulate the economy, raise consumption and increase expected profits; in other words the quantity of money affects the total level of spending and investment in the economy (Friedman, 1968). It seems then that under the current monetary institutional arrangement, the incentives structures show a secular political bias of money supply excesses, therefore tilted towards one form of monetary disequilibrium. This rather unbalanced process of determining the supply of money makes the current system politically fragile and unable to maintain monetary equilibrium. We have seen that once we relax the assumptions concerning political pressure, self-interest and the incentive structures, a centralized institution will be particularly susceptible to interest groups; these would make it inherently unable to achieve a robust environment for monetary equilibrium. In other words, “money deliberately controlled in supply by an agency whose self-interest forced it to satisfy the wishes of the users might be the best. A money regulated to satisfy the demands of group interests [in particular politician seeking reelection] is bound to be the worst possible” (Hayek, 1976c, p.31, emphasis added).

3 For a stimulating analysis of the real cost of inflation, see Horwitz (2003). In that paper, Horwitz seeks to enrich the undervaluation of the cost of inflation on the economic order that the neoclassical treatment projects. Through recognizing the epistemological properties of prices and the process by which inflation is generated at an institutional level, Horwitz unveils that the costs of inflation are much larger and widespread than usually acknowledged in standard neoclassical economics.


Following the RPE procedure, Hayek understood that when even just one assumption remained (in particular a high level of omniscience of central bankers, which we will address in the next section), the decision makers would still be vulnerable to other human fallibilities. When relaxing the other assumptions, specifically self-interest and political interests, it would motivate them to maintain politically optimal monetary policies over the market requirements, which usually lie on the side of money supply over expansion: “I am by no means re-assured by the fact that, at least in some countries, the civil servants who run affairs are mostly intelligent, well-meaning, and honest men. The point is that, if governments are to remain in office in the prevailing political order, they have no choice but to use their powers for the benefit of particular groups - and one strong interest is always to get additional money for extra expenditure” (Hayek, 1976b, p.14). We can see how these political pressures and incentive misalignments are reflected in Fed policies towards secular monetary disturbances and ever-increasing money supplies (Boettke and Smith, 2012). This institutional arrangement constantly produces politically optimal supplies of money which maximize decision makers' political necessities over the 'technically optimal' equilibrating market money supply that maximizes social coordination and maintains money neutrality. Fed policies are therefore created within a politically-biased context since they adjust to the political reality in which they are embedded; this usually falls into the accommodating spectrum of easing the Federal debt burden, thus it is no surprise that they possess strong incentives to create policies which will be path dependent upon and aligned with the Federal Government's long-term debt and political strategy (O'Driscoll, 2011).The Federal Reserve and its main decision makers will possess all the incentives to align their monetary policies toward benefiting the current Federal Government’s political and budgetary goals. In addition, the Federal Government also exercises influence over the Federal Reserve by appointing and setting the salaries of the Fed's highest-level employees, skewing their performances and incentives towards politicians’ interests.14 Overall we see how the authority of the Federal Reserve System’s leadership is subject to congressional and presidential oversight and political soft pressure, which skews their incentives and self-interest towards accommodating monetary policy, providing a non-market-optimal money supply. Thus it is not only naïve and unrealistic, but even dangerous, to analyze the current central banking monetary institutional systems as if decision makers possess such a high degree of benevolence, lack of self-interest and non-political pressure. Evidence of the current financial crisis and the massive asset and market bubbles - exacerbated for almost a decade by Fed Chairman Greenspan’s expansionary policies - are examples of how the Fed's monetary policies are prone to political influences. The Fed followed a systematic guidance for an oversupply of money and artificially low interest rates, which were politically aligned with

4 We are not arguing whether the Fed is independent or dependent from Congress, the Senate or the FederalGovernment; the answer to that question would depend on the understanding and de finition of “independence.” Moreover as O'Driscoll (2011) points out, the Fed possesses various degrees of independence and dependence at different points in time. Thus evidence seems to show that the Fed’s level of independence fluctuates according to the ir mandates and political contingencies, such as a severe economic crisis or war. The point I wish to stress here is the danger of assuming a lack of political pressure and self-interest during comparative institutional analysis, which may skew conclusions of institutional arrangements’ fragility levels.


the Federal Government's long-term national affordable housing strategy. Those policies generated severe market disequilibria and misallocation of resources and one of the greatest housing bubbles in history (White, 2009). Further quantitative evidence has been provided supporting our previous claims: Grier (1989 and 1991) has provided statistical evidence showing how Fed policy makers suffer from a high degree of political pressure. He found that there is a strong correlation between the shift of leadership inside the Senate Banking Committee and the growth of the monetary base, controlled by the Fed. Additionally, Weintraub also found through interviews with Fed employees, that the “monetization of [government] deficits was often cited as [a primordial] reason for rapid money growth” (Weintraub, 1978, p.359).15 We have historical and empirical evidence that shows how particularly naïve and pernicious it is to design a centralized institution to deal with controlling the monetary base and the guiding of the money supply, when we fail to address the problematic assumptions concerning our human fallibilities and self-interests (Pennington, 2011). In the case of the Fed, we have seen how it suffers from severe political pressure and political self-interest which hampers its own capacity of equilibrating the money supply with the desired market demand, even in the extreme hypothetical case that the Fed could know the equilibrating money supply (maintaining the omniscience assumption). Even if we believed in the omniscience assumption and that market optimality could be achieved under a centralized system of monetary policy, we would still have to face the question if it would be politically plausible or efficient for monetary authorities to follow that policy. As shown earlier, misaligned political incentives can result in sacrificing economic optimality for personal maximizing optimality. It is true that sound economic reasoning, high degrees of technicality and professionalism will bind the effective range of monetary policy. However the final choice of the guidance of the money supply will always be inevitably determined by “the inescapable politics of money” (Kirshner, 2003, p. 647), thus “the [current] outcomes observed [in monetary policy] are largely attributable to politics – ideas, interest groups conflict, and international relations [among governments]” (Kirshner, 2003, p. 655). The cost of such choices are distributed and dispersed through the market economy in the form of altering market signals, such as monetary distortions in the structure of relative prices, market interest rate, and capital structure alterations. We see how this institutional arrangement does not successfully deal with human nature’s core problems; political incentives and political pressures make the centralized system particularly fragile to political short-sightedness and misconduct. This suggests that: “instead of seeking technical optimums [of the money supply] that are never realized in practice due to the frailty of the Federal Reserve to the pressures and shortcomings of the contemporary democratic setting in which policy is actually enacted. A free market in banking, just as the Scottish Enlightenment thinkers realized for any free market, is robust to [human] short-sightedness and knavery” (Boettke and Smith, 2012, p.27). 5. Reevaluating the assumption concerning decision makers’ degree of omniscience After reevaluating the core assumptions concerning benevolence, self-interest and incentives alignment, the RPE process (Pennington 2011) focuses on reevaluating the assumptions concerning human knowledge and individuals’ as well as society’s cognitive limitations. In other words, we

5 For a more comprehensive literature review concerning the statistical and empirical evidence between political pressure on the Fed and its positive effects and relationships with monetary policy, see Boettke and Smith (2012) and Nordhaus, W. (1975).


will now reevaluate the degree of “bounded rationality” afflicting decision makers in differe nt institutional settings. Emphasis should be placed on the assumptions concerning how easily and efficiently society properly manages, transmits and encourages the emergence of epistemic resources. Special attention is also given to the availability of potential dispersed knowledge sources which could be easily disseminated and available throughout society. In addition, robust epistemological institutions will be able to transmit 'relevant information' from different contexts to the specific decision makers who properly utilize it in their economic calculations. Real social orders therefore appear to experience a problem of a societal “division of knowledge,” 16 that consists of individuals not only possessing different bits of knowledge in the sense described as skills and facts, but also “the knowledge of alternative possibilities of action of which he [individuals] makes no direct use” (Hayek, 1948 [1936], p. 51). Social-economic institutions that cope with human ignorance and are able to generate and disseminate more relevant epistemic resources, that are necessary to make rational allocation of resources, are more robust in dealing with humans' inherently radical ignorance and uncertainty. Under this particular cognitive context, and based on the monetary equilibrium theory and the subjective demand for money, we are able to understand the complex and dynamic epistemological conditions for knowing the money demand and its formation. The demand for money in society, as seen in section 2, will be heterogeneous, contextually based, and tacitly held at the individual level. After understanding individuals’ complex formation of preferences for holding money- as well as how those preferences will affect any policy seeking to maintain monetary equilibrium- we should doubt any severe degree of omniscience within institutional assumptions. In particular, it presents a severe challenge in the cognitive capacities of achieving an equilibrating money supply under central banking. Hence we need to evaluate how well a centralized institution can deal with these cognitive limitations, which are incorporated in the Hayekian “knowledge problem” (Lavoie, 1985). The “knowledge problem” was at the core of Hayek's argument (Hayek, 1936, 1945). In the socialist calculation debate (Caldwell, 1997), Hayek stressed the problem of how a central economic planner or a planning board would not be able to obtain the necessary knowledge to successfully plan an economy. The “knowledge problem” - putting it succinctly – consists of questioning: “How can the combination of fragments of knowledge existing in different minds [thus subjectively held] bring about results which, if they were to be brought about deliberately, would require a knowledge on the part of the directing mind which no single person can possess?” (Hayek, 1948 [1936], p. 54). Specifically in the socialist calculation debate,17 Hayek stressed the central planner’s incapacity,

6 It was originally Mises (1981 [1922]) who coined the term art geistige Arbeitsteilung, meaning a “kind of mental division of labor” within a social order. The fact that individuals possess different kn owledge and different subjective interpretations of objective facts was already very clear for Mises during the 20's. However, the idea was further developed as it became the main point in which Hayek challenged the epistemological assumptions of socialist arrangements. Mises however deserves a large amount of the credit in unveiling the fundamental problem that afflicts every single decision maker under scarcity through showing how market prices under an institutional context of private property of the factors of production allow economic orders to deal with allocation problems. 7 For a comprehensive review of the socialist calculation debate and the main contributions of Viennese Austrian School in the eyes of the modern Austrian school of economics, see Lavoie (1985) and Boettke (1998). For a exhaustive and detailed oriented analysis of the history, forms and content of the debate on an Austrian perspective,



under a socialist institutional arrangement, of obtaining and using emergent market prices of the factors of production in order to attain a rational economic calculation and therefore be engaged in an efficient allocation of the scarce resources between different competing activities (Boettke, 1998). During the socialist calculation debate, Hayek thought to challenge the core epistemological assumptions of the institutional arrangements of socialism as well as the neoclassical economic theory’s hypothetical foundations. He did this through challenging the core assumptions concerning individuals' perfect knowledge (using more realistic premises of fragmented and dispersed knowledge), which is subjectively held by economic actors. Hayek, in Economics and Knowledge (1936), exercised an early form of the RPE framework. In fact, Hayek stated his robust political economic goals at the very beginning of the article: “Its main subject [of the article] is, of course, the role which assumptions and propositions about the knowledge possessed by the different members of society play in economic analysis” (p. 33). Following Hayek's robust political economic framework, we have to contextualize his inquiry into the monetary equilibrium framework. The same challenge of the assumption concerning how central planners and economic actors could possibly know and recollect the relevant facts and individuals’ “fragments of knowledge” necessary to plan an economic order should be applied analogously in the context of monetary policy. We must reevaluate the capacity of a centralized supplier or centralized money supply guidance in achieving “monetary neutrality” due to those same limitations of knowledge and lack of market “knowledge surrogates” that afflicted centralized planners in socialist economies. Different market “knowledge surrogates” allow ‘transmission’ of relevant information concerning individuals’ preferences and desires of the individuals to hold money balances more accurately and promptly, as well as contribute to a “better” equilibrating money supply. The lack of some of these surrogates under a centralized context, as in the case of socialist institutions that lacked some market prices, is the core problem that any form of centralized institutional arrangement will face, thus increasing their epistemological fragility. The supply of money, as we have seen through the subjective theory of demand for money in section 2, is individually held and dependent upon economic actors’ personal marginal utility of holding purchasing power availability. Any authority will face severe epistemological limitations if they attempt to gather all the knowledge required to discover the “correct” guidance for the “right” supply of money that will meet all individuals’ subjective preferences to hold money. Furthermore, a monetary policy aimed to achieve the 'optimal quantity of money' to maintain monetary equilibrium would have to be based on unattainable knowledge, since it is impossible to collect all individuals’ relevant subjectively-held knowledge under the context of a centralized institutional arrangement. As a matter of fact, those “knowledge surrogates”, even if central bankers would have the technological capacity to gather them, would not even exist. This is because the most relevant knowledge generated in society, specifically the knowledge that individuals hold in their minds is rarely linguistically articulated, would only be contextually available and institutionally restricted. People's knowledge, preferences and appraisals emerge, evolve and then gets somewhat transmitted solely under the context of market competition and only through specific market surrogates. Under a competitive market order in the free-banking context, there would be different money suppliers within a competitive market process. Different money suppliers, following market signals of profit and loss would want to elucidate which quantity of money would be the most preferable for heterogeneous individuals at particular points in time. The context of decentralized competition
see De Soto (2010 [1992]).


would open the environment in which those suppliers, following the profit motive, would use their entrepreneurial discovery capacities in order to obtain, or better estimate, individuals’ knowledge and preferences for holding money. Thus, just like in a capitalist institutional environment, prices emerge which allow better social coordination over the socialist arrangement; under decentralized competition for supplying money, better and more knowledge concerning the subjective demand for money will emerge, allowing entrepreneurs and individuals to be engaged in the discovery process. In addition, discovery procedure will also occur: “on both sides of the market as knowledge ripples out from a multiplicity of decision-making nodes. On the supply side, each entrepreneurial act, such as the offering of a new price/product [money] or changing the organisational form of production actively creates new knowledge. … On the demand side, meanwhile, knowledge about new prices [quantity of money] and consumer goods snowballs through the market, as individuals emulate the purchases [or holding of money] of their neighbours and/or learn about new ways of living” (Pennington, 2003, p.728). Consumers and economic actors subjectively and personally hold the aforementioned knowledge and wish to hold different money balances at different points in time. “Knowledge surrogates” are the only ones who could 'transmit' or provide substitutes for that tacit knowledge, in the form of different market signals, to decision makers of the money supply. Those market signals are only available under the context of a competitive market process, thus they are unapproachable for a centralized authority. This suggests a severe epistemological fragility level for a centralized institution that seeks to maintain “money neutrality”. The fact that the primordial kn owledge by which a monetary equilibrium could possibly be maintained will only emerge and be transmittable in the market process context, and would then create a massive epistemological impediment for the centralized authority. As Hayek put it: “Monetary management cannot aim at a particular predetermined volume of circulation, not even in the case of a territorial monopolist of issue, and still less in the case of competing issues, but only at finding out what quantity will keep prices constant. No authority can beforehand ascertain, and only the market can discover, the 'optimal quantity of money'” (Hayek, 1976c, p.81). Hayek is clearly emphasizing the role of decentralized socioeconomic institutions- such as the market process and the price mechanism- in making the propitious conditions in which the emergence, transfer and utilization of knowledge would improve and make society more robust (Boettke, Schaeffer and Snow, 2010). In the socialist calculation debate, it was also Hayek’s view that “the utilization of an individual’s dispersed and incomplete knowledge was the central property of the complex social order within the system of exchange” (Boettke, Schaeffer and Snow, 2010, p.4). The same properties could be extended to a system of free-banking, in which individuals’ incomplete knowledge can be enhanced and made accessible under a system of exchanges and interactions between suppliers and holders of money. Hence, a significant part of the relevant tacit knowledge necessary to coordinate society can only be transmitted in the market process under a dynamic interaction between consumers and producers; the knowledge generated and transmitted is, as mentioned, contextual to the market itself and will not emerge nor exist without a market procedure (Hayek, 1935b). Therefore without the market process producing and communicating new contextual knowledge, it will be not only cumbersome 26

but epistemologically impossible for a central authority to accumulate a significant segment of societal knowledge since it would have never arisen in the first place (Hayek, 1948). In other words, the “knowledge problem” is “a contextual argument” (Boettke, 1998, p. 145). The fundamental knowledge necessary to maintain “money neutrality” or a systemic monetary equilibrium is particularly dependent upon economic actors’ monetary preferences. This is a form of tacit and contextual knowledge particularly limited to the "time and place" in which those preferences emerge. In addition to generating information and knowledge, the market process also promotes further heuristic processes through which decentralized issuers of money gradually learn more resilient mechanisms to move towards a better understanding of what the “optimal quantity of money” could possibly be in a particular time and place. That process of competition and learning thus “facilitates learning under conditions of ‘radical ignorance’ where actors on both the demand and supply sides become aware of information which they previously did not know was in existence” (Pennington, 2007, p. 7, emphasis in original). In other words, it seems that “A central bank that wants to behave neutrally is shown to lack the market feedback mechanism [and local knowledge] that informs competitive banks in supplying money” (White, 1987, p.8). On top of that, even if we concede the possibility that central bankers might approach higher degrees of omniscience, they would still have to deal with the other unrealistic assumptions such as political pressures and personal self-interests that afflict them; these alone would move monetary policies away from the real market necessities for what the desire for money demand would be (the assumptions reevaluated in section 4). A decentralized competitive and dynamic approach to the money supply instead promptly obtains “contextual market signals” and is also profit motivated towards unveiling individuals’ preferences and knowledge of time and place. It also possesses a far better alignment of the capitalistic market incentives through profit and loss, which better guide the supply of currency. A market system of profit and loss within the context of a free-banking system utilizes those profit and loss mechanisms as tools for promoting incentives for monetary equilibrium and penalizations for disequilibrium. In particular the mechanism of adverse clearing provides a market pressure not to over-expand the money supply, by increasing the bank's liquidity risk through draining their reserves. This aligns the supply of money closer to the market's necessities, without being severely affected by alignments between decision makers’ and politicians' incentives. Overall a free-banking institutional arrangement possesses far more decentralized market mechanisms and market signals on which to base their economic decisions regarding supplying a “correct” market quantity of money. 18 In other words: “since the market is comprised of the complex interactions of the subjective perceptions of actors (both their wants and their opportunity costs), there is no way

8 The scope of this paper has been simply to (i) utilize the “robust political economic” framework in order to challenge the assumptions that govern the supply of money under a centralized institution, and (ii) at the same time illuminate how by using a monetary equilibrium theory, a system close to free-banking appears to be more robust and better deal with more accurate assumptions of our human conditions. For a more thorough and technical exposition of the internal dynamic market mechanism present in a free-banking system such as the rule of excess reserve and the principle of adverse clearing, which a free-banking system will exercise in order to contain and punish an overexpansion of unwanted notes, see Selgin (1998, chapters 3 and 6). In addition, those interested in an empirical-historical case of a banking system close to a free-banking model, in particular the successful case of Scotland during 1792-1844, see White (1995 [1984]).


that a planner could hope to match the job done by exchange, prices, and profits in making this subjective knowledge available socially” (Horwitz, 1990, p.468). Those institutional arrangements relying more on decentralized market processes additionally generate better incentive alignments that overall encourage enhanced entrepreneurial activity in the banking industry. In addition, as Buchanan and Vanberg (1991) pointed out, the market process encourages a higher degree of entrepreneurship, enabling greater levels of entrepreneurial discovery, emergent creativity and innovations which generate still unknown or soon to be discovered brand new information concerning the money supply and demand. Under these dynamic markets, entrepreneurs will create and better innovate through finding more efficient (and accurate) ways and systems to circulate money into the market and to alert potential market disequilibria in the money supply in order to obtain profits from them. When the market process allows profit (losses) opportunities to emerge, coupled with the possibilities to close market disequilibrium (or coupled with penalization for generating monetary disequilibrium), banking entrepreneurs will have incentives to seek more efficient ways to provide money and financial services in order to reap those arbitrage opportunities (or correct their disequilibrating actions) that arise from monetary disequilibrium. Profit (losses) opportunities will in turn nudge them towards promptly and more accurately supplying (withdrawing) the money required to close those gaps (excesses) in order to seize the profit opportunities (avoid losses and avoid losing reserves) each time they mend (generate) monetary disequilibria. In other words, free-banking will be able to generate, discover, accumulate and leverage better and faster market information concerning societies' necessities of liquidity; thus free-banking will increase the robustness level and move closer to a dynamic money supply which will fluctuate near monetary equilibrium and promote money neutrality. It is important to notice that not only central bankers and centralized institutions lack the sufficient knowledge to obtain a perfect “money neutrality” and curtail market processes, but also single individuals and entrepreneurs within the free-banking context also possess severe epistemological limitations. It follows then that not only central planners but society in general has severe knowledge limitations. We have mentioned that knowledge is dispersed, unevenly fragmented and subjectively held by different individuals in various forms, quantities, timeframes and places. Hence epistemological imperfections that affect central planners will also be present to certain degree within a free-banking system. The imperfections that arise from the natural human condition of ignorance, our limited capacities in dealing with higher degrees of complexities and the severe limitations of what humans can possibly process cognitively should be acknowledged and considered as the foundation on which we base our understanding of free-banking. The scope then is to acknowledge imperfections and human cognitive limits as our assumptions, then understand which institutional arrangement will best cope with these limitations in order to lead us closer to a state of monetary equilibrium. The particular epistemological problem is extremely relevant in the process of analyzing the monetary institutions’ robustness within the RPE framework. The “knowledge problem” is highly problematic for a centralized institution seeking to achieve monetary equilibrium. If the knowledge concerning people's preferences concerning their optimum individual demand for holding money balances cannot be fully articulated, nor expressed linguistically and transmitted, it will not be timely and amply aggregated in a centralized fashion; as a matter of fact, suppliers of money are dealing with forms of information that “by its nature cannot enter into statistics” (Hayek, 1945, p. 83). The cognitive limitations afflicting centralized decision makers will prove to be severe. This problem, as showed, challenges the very core of the epistemological assumptions made regarding 28

central bankers’ capacity to achieve optimal policies aiming for monetary equilibrium. In contrast, we have seen that a decentralized market process will allow consumers and producers to meet in the marketplace in a more timely fashion and then suppliers of goods and services (and money) will be able to utilize more propitious local market signals that arise from the competitive and dynamic consumer-supplier interaction. This provides the suppliers with additional local and specific contextual knowledge of “time and place” necessary to make better decisions concerning the optimum quantity of money demanded in the economy. Decentralized producers will then provide their money supply accordingly as if they possessed direct knowledge regarding consumers’ personal money preferences (Selgin, 1988). Decentralized competitive market systems are more robust since they rely on more timely and reliable market signals such as clearing mechanisms of redemption, dynamic fluctuations of reserves, credit and debit signals and profits and losses signals from money disequilibrium. These market signals reveal ex post the degree of accuracy of prior economic decisions concerning past experiences with dealing with the money supply. In other words, a competition among several decision makers that aligns market incentives of the monetary players with the individuals’ necessities for holding money will provide a more equilibrating liquidity to the system. In turn, competition enables a heuristic process (like a decentralized trial-and-error learning process) that will dynamically minimize the damage and disequilibrium brought about by any individual error in the money supply made by different competitors (Selgin, 1988; Hayek, 1976c). In contrast, a centralized monopolizing institution of money issuance appears to be extremely fragile to the scrutiny of RPE. A centralized institutional arrangement that seeks to 'manage' or 'guide' the supply of money will lack several market mechanisms, such as the clearing mechanism, that would have retrospectively served to acknowledge their monetary mistakes. The lack of prompt and accurate feedback concerning the degrees and severity of the monetary disequilibrium that authorities might have caused, hinder any robust form of learning from previous mistakes in order to improve and avoid future severe market discoordinations. Instead, they will have to rely on costly, more visible and tangible “knowledge surrogates” as signs or proxies of market discoordination; they will rely on lagged and inefficient aggregate “knowledge proxies” such as changes in the structures of production, changes in the general price-level and structural misallocation of resources, which are less prompt and based on an already-realized and manifested severe monetary disequilibria within the visible structures of production. Regarding the inefficiency and epistemological fragility of knowledge surrogates that centralized monetary institutions use, Friedman commented: “we cannot predict at all accurately just what effect a particular monetary action will have on the price level and, equally important, just when it will have that effect. … monetary authorities have on occasion moved in the wrong direction … More frequently, they have moved in the right direction, albeit often too late, but have erred by moving too far. Too late and too much have been the general practice. … The reason for the propensity to overreact seems clear: the failure of monetary authorities to allow for the delay between their actions and the subsequent effects on the economy” (Friedman, 1968, p.15-16). Therefore, their corrective policies will be enacted and decided ex post, when the severe monetary disequilibrating damages on the real economy have already permeated throughout several different markets through money disequilibrium’s pervasiveness. This lack of prompt “knowledge 29

surrogates” and market mechanisms - that would guide a faster and accurate fluctuation of the money supply - makes centralized institutions’ correction policies posthumous and responses excessive, showing how epistemologically and heuristically fragile they are. Likewise, due to their lack of prompt and accurate information, they will be more prone to permit severe market discoordination for longer periods of time, allowing severely harmful lagged monetary fluctuations. 6. Conclusion Recent experiences with centralized institutions that guide and manage the supply of money have been proven extremely fragile in maintaining monetary stability and “money neutrality”. The last couple of decades have left us with asset bubbles and massive processes of capital misallocation, due to severe monetary distortions in relative prices. We have seen how by reassessing the basic assumptions concerning human fallibility and political pressures, the robustness of a central banking institution appears suboptimal, inherently disequilibrating, and thus extremely fragile. To the extent which individuals believe it is not a good idea to have a sponsored monopoly or a centralized government agency supplying goods such as cars and food, we consider that the same normal principle of dubiousness and skepticism should apply to governments’ centralized monetary institutions for the money supply.19 In order to promote a healthy level of skepticism regarding the robustness of our existent institutional arrangements, the Robust Political Economy framework proves to be extremely insightful. As a reminder we need to also realize and recognize that an institutional free-banking arrangement will never be perfect. As a matter of fact, since we live in a social world comprised of imperfect human beings, the institutions arising from imperfect human interactions are also prone to fallibility and imperfections; as such, no social or monetary institution could ever be perfect. Human fallibilities, however, could be used in our favor to make conscious and critical institutional comparisons. Recognizing human fallibilities, self-interest, epistemological limitations and political pressures should not be a matter of shame and misfortune, but rather a humble, healthy and realistic foundation for a better understanding of how to move towards more robust institutions that promote social prosperity and economic coordination. “We have always had bad money because private enterprise was not permitted to give us a better one. In a world governed by the pressure of organized interests, the important truth to keep in mind is that we cannot count on intelligence or understanding but only on sheer selfinterest to give us the institutions we need. Blessed indeed will be the day when it will no longer be from the benevolence of the government that we expect good money but from the regard of the banks for their own interest.” Hayek, 1976c “I strongly feel that the chief task of the economic theorist or political philosopher should be to operate on public opinion to make politically possible what today may be politically

9 Although a free-banking system like the one mentioned in this article and the theoretical one envisioned in the work of Selgin (1988) have, strictly speaking, not yet existed, we have some historical cases which may be called upon in the practical sense of the term, free-banking systems. Successful systems which shared characteristics of a free-banking mechanism have been rare but nonetheless existent in history; examples of free-banking are found in Australia, Canada, China, Colombia, France, Scotland and Switzerland; for a historical account and review of these cases, see Dowd (1992).


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