Bernholz, Monetary Regimes and Inflation, 2

3 Jun 2010 by Jim Fickett.

The main message of Chapter 2 is that governments have a natural tendency to deficit spending and inflation, and inflation is only absent if somehow the hands of the leaders are bound. This happens most dependably with a gold standard, but an independent central bank, or a fixed exchange rate with another stable currency, can also help.

Chapter 1 was reviewed in Bernholz, Monetary Regimes and Inflation, 1.

In Chapter 2, “Inflation and monetary regimes”, Bernholz introduces the main theme of the book:

With the inflationary bias of governments, inflation can only be absent in the long run if the hands of the rulers are bound by an adequate monetary regime or constitution.

This is jumping ahead a bit. Bernholz first gathers data, then makes definitions, then adduces evidence, and finally comes to conclusions. The key definition that gives rise to the book's title is:

By a monetary regime we understand the set of rules governing the institutions and organisations which finally determine the amount of money supplied. If we turn out attention to the laws and decrees containing all such formal rules we speak of a monetary constitution.

Bernholz argues that monetary regimes are important because all governments have a tendency to spend more than they take in, and the populace pays more attention to special favors than to the diffuse and delayed costs of inflation. This is evident even without much argument.

By looking at the history of several countries over long periods, Bernholz makes a very strong case that the only monetary regime where inflation is essentially absent is a metallic standard, i.e., where paper money is fully convertible into gold or silver. A particularly impressive analysis shows the course of inflation in the US and some European countries as the gold standard is lifted, reinstated, weakened, and finally abandoned.

Two other regimes that provide significant restraint on governments are (1) an independent central bank and (2) a fixed exchange rate with some other, stable currency. Again looking at examples from different nations in different periods of history, Bernholz shows that in such cases inflation is less controlled than with a gold standard, but more controlled than in the worst cases.

The worst cases are where the currency is not tied to anything of real value, and the money supply is under the direct control of the government.

Bernholz has compiled a table of all 29 hyperinflations in history (a hyperinflation reaches rates of 50% price increases per month for at least one month). Not surprisingly, all of these occurred with regimes using paper money not tied to anything of real value. Also noteworthy is that they are all modern – the only one prior to 1920 was the French revolution. Unbacked paper money is a relatively recent experiment.

Anyone who looks at long-term charts of inflation will notice a strong correspondence with wars, and some authors have claimed that war is, in fact, the key explanatory variable. But Bernholz points to wars under the gold standard (even wars that bankrupted governments), where inflation did not occur. Rather, the problem is deficit spending (which is, of course, correlated with war) coupled with a monetary regime that fails to restrain the government.

This book is about the facts, and Bernholz leaves emotion out of the picture. At the end of Chapter 2 he points out that different monetary regimes have other effects beside controlling or not controlling inflation. For example the variance of GDP may be lower under a paper currency managed by a central bank than under the gold standard. The theme is not greatly developed, but the point is made – this book is about inflation, but in the real world inflation is not the only criterion for choosing the monetary regime.