The Euro Shows That A Fiat Money System Is More Expensive Than We Thought

The traditional argument for fiduciary media and ultimately unbacked fiat money was based on the costs of production. The real resources otherwise used for gold mining and minting could, under a fiat standard, be used for other productive purposes and thus enrich society as a whole. The argument goes back at least to such great names as Adam Smith and David Ricardo.

More recently, Milton Friedman reinvigorated the argument, and we are still today presented with it in standard textbooks. However, a recent study published in the Economics Bulletin demonstrates that the argument, at least in the case of the eurosystem, does not carry much weight.

In fact, the total annual expenses of the eurosystem are more than three times as high as Lawrence White’s estimate of the annual costs of a fractional reserve gold standard. Assuming a fractional reserve ratio of 2% on M1, White (1999, pp. 42-48) estimated the costs to lie around 0,025% of GDP by using the dynamic version of the equation of exchange.

The annual operating expenses of the 12 founding members of the eurosystem over time


It turns out that the annual operating expenses of the eurosystem in the past two years have been closer to 0.090% of the GDP of the eurozone, or in absolute terms around €10 billion. Now, it must be admitted that White’s estimate may be biased, since 2% reserves on M1 could be considered excessively low, although such cases existed historically, for example, during the free banking era in Scotland in the first half of the 19th century.

Israel (2019) shows that even when the reserve ratio on M1 is substantially increased the actual costs of the eurosystem remain in the same ballpark as the estimated costs of a generic gold standard. With 25% reserves, the costs would be about the same. With full reserves on M1, the estimated costs of the gold standard would only be 0.375% of GDP. This is merely four times as high as the actual costs of the eurosystem at the moment. And it needs to be emphasized that this calculation does not take into account the important argument raised by Garrison (1985), namely, that the equilibrium price inflation rate in a free banking system under the gold standard would be negative, which would further reduce the estimated costs of the gold standard.1 And contrary to popular belief, a negative price inflation rate, or price deflation, does not prevent economic growth and prosperity (Bagus, 2015; Borio & Filardo, 2004).

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