In Defense Of The GOP’s Sound Money Candidate

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Alexander W. Salter Comparative Economics Research Fellow, Free Market Institute
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Noting Tuesday’s landslide results in Utah and John Kasich’s inability to win a significant amount of delegates, it seems likely that Ted Cruz is now the only Republican that could deny Donald Trump the GOP nomination. Now more than ever, it’s worthwhile to scrutinize his policy positions, especially those on which he’s been accused of inconsistency. One such issue is monetary policy.

Mr. Cruz has been excoriated for seemingly incompatible statements concerning the U.S. central bank, the Federal Reserve. On the one hand, he has advocated exploring a return to the gold standard, seemingly questioning the Fed’s purpose. On the other hand, he has accused the Fed of implicitly creating the Great Recession by not intervening strongly enough in 2008 to prevent the crash. How can someone want the Fed to do more sometimes, but call into question its existence at other times?

I do not want to put words in Mr. Cruz’s mouth, but in light of the increased public realization of the Fed’s role, it’s important to understand these positions are not inherently contradictory. Mr. Cruz’s critiques make sense if viewed in the context of the inherent knowledge problem monetary policy confronts.

In economics, the knowledge problem is an idea closely associated with the writings of Nobel laureate F. A. Hayek. Applied to monetary policy, the knowledge problem impels the question: how can monetary policymakers know what supply of money will best achieve economic stability? Because, under central banking, the production of money is not subject to market forces, we cannot rely on the usual mechanisms of supply and demand to ensure there is enough money in the economy to satisfy demand for it.  

Theoretically, an omniscient central bank would meet changes in money demand with offsetting changes in supply. If the public’s money demand spikes, without an increase in the money supply, a painful recession — rising unemployment and falling income across the economy — can result. But the public’s money demand is not stable, and it is incredibly difficult to predict. How can central bankers, even with sophisticated statistical tools at their disposal, know enough to supply sufficient money to keep the economy at its maximum potential?

Simply put, they can’t. Even monetary policy experts get it wrong, and when they do, the consequences can be disastrous. We saw this in 2008 when, according to Mr. Cruz, the Fed failed to expand the money supply rapidly enough to prevent a recession. But how does this apply to Mr. Cruz’s comments on the gold standard? While there’s no such thing as the gold standard — several monetary systems can be filed under that label — the relevant point is that a gold standard is one way to overcome the monetary knowledge problem, by introducing market mechanisms to regulate the money supply.

Imagine the dollar were defined in terms of gold, and that there was a sudden increase in the demand to hold money. As history shows, in gold standard countries, what the public uses as money is not physical gold, but bank liabilities redeemable in gold.  Suppose Bank of America were to issue its own liabilities, such as banknotes and checkable deposits, redeemable on demand for gold.  If money demand rises, individuals would be willing to hold on to more Bank of America liabilities. Bank of America would notice fewer liabilities being redeemed for gold. Thus the stock of gold it keeps on hand — a fraction of total gold liabilities, for the purpose of honoring expected redemptions — would rise. This signals to Bank of America that it’s safe to create new liabilities and spend them on interest-generating assets for its portfolio.

Notice what just happened: market mechanisms responded to an increase in money demand with an increase in money supply, which is exactly what omniscient central bankers would do! A gold standard, combined with a competitive banking sector, is one of history’s reliable methods for overcoming the monetary knowledge problem. Unfortunately this never fully developed in the U.S., due to poorly crafted regulations, but examples such as Scotland, Sweden, and Canada show that this system can deliver an extraordinary degree of financial tranquility.

The Republican convention in Cleveland is now within sight. Perhaps Mr. Cruz, despite his recent rise, will not be able to catch Mr. Trump. Nonetheless, it is important to note that Mr. Cruz’s views on monetary policy make sense as a solution to the monetary knowledge problem, and hence as a platform for economic stability.