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Wealth, Economic Infrastructure, and Monetary Policy

address by
Jerry L. Jordan
President and Chief Executive Officer
Federal Reserve Bank of Cleveland

The Association of Private Enterprise Education
Twenty-Second Annual Conference
Arlington, Virginia
Sunday, April 13,1997

The premise of my remarks this morning is simple-a country’s choice of
institutions profoundly affects its wealth and development. Institutions constitute a
nation’s economic “infrastructure,” the framework on which enterprise is built. Perhaps
the most important element separating economic “haves” from “have-nots” is whether
these institutions— particularly public institutions—
either facilitate or confiscate
production. One of those institutional arrangements is the monetary regime.
The N ature and Causes of Economic Prosperity

In 1776, Adam Smith published An Inquiry into the Nature and Causes o f the
Wealth o f Nations. His motivation was to explain the large differences in economic
prosperity observed across countries. Smith argued that the wealth of a country is
measured by the productivity of its labor force and not, as the mercantilists claimed, by
its stocks of gold and silver. The wealth of a nation should be judged by its ability to
create things of value from its resources, not by its ability to transfer the fruits of such
creation to others.
The inquiry that Adam Smith began continues today, and for essentially the same
reason: the gaps that separate prosperous from foundering economies remain huge. As
we near the end of the 20th century, the richest countries in the world are roughly 30 to
50 times wealthier than the poorest ones— truly astounding difference.1 Not only do we
see large differences in wealth, but we also see tremendous variation in development. The
last several decades have revealed “development miracles” and “development disasters.”2
1 Measured by per capita gross domestic product (GDP). For perspective, consider that this is
approximately the same difference separating the U.S. standard o f living today from that o f approximately
200 years ago!
2 This term inology com es from Stephen L. Parente and Edward C. Prescott, “Barriers to Technology
Adoption and Developm ent,” Journal o f Political Economy, vol. 102, no. 2 (1994), pp. 298-321.

Saudi Arabia, Lesotho, and Taiwan tripled their wealth between 1960 and 1985. Yet,
other countries, such as Zambia, Mozambique, and Madagascar, were about three times
wealthier in 1960 than they were 25 years later!
If we ask simple questions like “Why are some nations rich and others poor?” or
“Why do countries grow at different rates?”, we get a simple answer: Rich nations have
greater resources per capita—
more capital, both human and nonhuman, and better
technology connecting the two. But this simple answer only begs another question:
“Why do some nations have high levels of capital and technology, while others don’t?”
To answer this question, it is useful to determine whether wealthier or fastergrowing economies share characteristics that are not observed in poorer or slowergrowing ones. Investigations into this issue have not been very revealing, and economists
have been frustrated by their inability to identify common policies that would explain a


significant share of the wealth differentials that separate nations. But the lack of a clear
linkage between specific “growth” policies of nations and their ultimate prosperity has
led us to think more broadly about the state and prosperity. That is, the policies that
nations adopt may not be individually revealing, but in their totality they reflect an
economic infrastructure that the state helps build.
For example, viewed in isolation, an increase in a nation’s educational effort
should have a decidedly positive influence on its wealth. However, such programs may
still fail if the rate of taxation on labor income is high, transfers between generations are

3 For an analytical examination o f this point, see Ross Levine and David Renelt, “A Sensitivity A nalysis o f
Cross-Country Growth Regressions,” Am erican Econom ic R eview, September 1992, 82, 942-63.


large, or other policies are in place that reduce people’s incentive to add to their stock of
human capital.
In the realm of economics, controlled experiments are not possible. At rare times,
though, natural experiments present themselves, and recently we have had a rather unique
opportunity to study the role of the economic infrastructure in influencing nations’
prosperity. In the last seven years, at least 15 newly created market economies have
emerged within the former Soviet Empire, in addition to the liberated Eastern European
countries. In each case, the measured level of economic well-being for the new nations
initially fell well short of that attained during the Soviet era. This is not particularly
surprising, even though the new economic order may be vastly more efficient than the
centralized organization it replaced. To begin with, we have no way to gauge the
accuracy of the national output estimates during the Soviet experience. Even so, we can
expect that during any economic transition, measured growth will slow or, in cases as
dramatic as these, output may even decline as resources are directed to the construction of
an economic infrastructure that is often outside the standard measures of national output.
Still, the emerging Eastern European economies have experienced vastly varying
rates of measured economic decline. Consider that since 1989, the five worst-performing
Soviet spin-offs have seen a decline in measured output about twice that of their five
best-performing counterparts. More specifically, the Central European countries appear
to have adjusted more easily than many of the Baltic states and Russia, which in turn
appear to have adjusted more easily than Kazakstan, Uzbekistan, and the other outlying
republics. A reasoned explanation, I think, is that the Central European countries have a

history as market economies and have maintained stronger ties with the West. This
implies that the economic infrastructure of these nations was more fully developed than
in the remote republics.4
A similar, and perhaps equally dramatic, revolution may be under way globally—
the new “technology revolution.” The world is replacing the capital of old technologies,
creating a new economic infrastructure. As that infrastructure develops, measured output
and productivity will understate the true wealth gains being made. Moreover, such
changes may create a prosperity gap between those that easily adopt the new technology
and those that are either heavily invested in the old technology, or have little ability to
gain from it.5 Note, however, that in some economies or in some industries, the barriers
to adopting new technology can be formidable. These barriers include regulatory
restrictions, the wealth-redistributive efforts of others, even sabotage.6
Nations which adopt an economic infrastructure that favors production over
diversion will be more prosperous than ones that don’t. In the case of the blossoming
Eastern European economies, the nations which build the infrastructure that enables
markets to flourish— assignment of property rights, a system for enforcing contracts
and adjudicating disputes, and the effective management of market failures— be the
ones that prosper. So, too, those quickest to adopt the emerging new technologies into
the workplace will show the greatest wealth gains.

4 O livier Blanchard and M ichael Kremer, “Disorganization,” Manuscript, N B E R E conom ic Fluctuations
and Growth M eetings, January 31, 1997.
5 A provocative paper on this subject is Jeremy Greenwood and Mehmet Yorukoglu, “ 1974,” manuscript.
6 Indeed, the word sabotage com es to us directly from the resistance to new technology, as it is said that
French revolutionaries, in an attempt to slow the introduction o f new machinery, threw their wooden shoes,
called sabot, into the machinery. Hence the word sabotage. (Although, know ing the value o f wooden
shoes to peasants, I suspect these stories are a bit apochryphal.)

The Public Infrastructure of Nations
An economy’s infrastructure, very broadly speaking, is the climate created by the
institutions that serve as conduits of commerce. Some of these institutions are private;
others are public. In either case, the role of the institution can be conversionary—
to transform resources into outputs— diversionary—
transferring resources to non­
producers. However, most private institutions are sustained by the value they add—
they produce or they fail. The same cannot be said of public institutions. These
institutions are sustained by the power of the state.
Given the seemingly inherent danger of public institutions, perhaps the natural
first question to ask is, “Why aren’t all institutions private?” This question has become
increasingly relevant for the monetary authority, to which I will turn shortly. At a most
basic level, there can be only two rationalizations for the state’s participation in an
economy. The first is as a social equalizer, redistributing a nation’s resources under the
presumption that some particular social need takes precedence over private desires. The
second justification for government is a failure of markets to produce an efficient
outcome, justifying state intervention in the name of economic efficiency.
In what way government becomes part of the economic infrastructure is crucial to
the prosperity of its citizenry. In the case of equity issues, the role of the state is
unambiguous. Society makes a choice to accept a lower level of wealth in exchange for
some presumably higher social objective.
But it may be as promoter of market efficiency that the role of the state raises the
most complex questions. Even if the objective is to overcome a particular market failure,


once the state has been introduced into the economic system, its influence can have wideranging and unanticipated consequences. And these institutions, which are not bound to
obey market forces, exert influence long after their usefulness has passed.
But market failures do occur, though probably not as often as activist policy
makers presume. Perhaps the most important failure involves so-called “public goods,”
where providing the good for anyone makes it possible, without additional cost, to
provide it for everyone. A legal system and national defense are such goods, as is, I
argue, the monetary authority. Cumulatively, these state activities are part of the
economic infrastructure called “the protection of property rights.” This means, more or
less, that individuals can expect to receive the product of their labor. Although people
could privately undertake actions to prevent the diversion of their output, from burglary
for example, it is widely accepted that a social institution (such as a police force) is a less
costly mechanism.
Indeed, the enforcement of property rights may be the single most important
function of the state, and it is in this function that the role of the state as contributor to
prosperity is least controversial among economists. Let us be clear, however, that in
order to pay for the police, or courts, or jails, resources must also be diverted to
government from private persons in the form of taxes. We can let the criminals steal, or
we can permit a government tax to prevent stealing. The economic question is, which is
Once introduced into the economic infrastructure, the state cannot help but to tax
the productive capacity of the system. Sometimes these taxes are direct and provide the

sustenance for the government enterprise. But, direct taxes are probably only a small part
of the overall cost to the economy. Also important are the costs on private agents who
now invest resources to minimize their tax burdens, either through tax avoidance schemes
or through attempts to influence the taxing authority.
This is the paradox of any state enterprise. While the state may be the most
effective instrument in minimizing the resource diversions of private agents in the
economy (for example, by protecting property rights and enforcing contracts), it
simultaneously introduces the potential for the debilitating diversion of resources for its
own account. It is here, I think, where the differences among nations are grossly
A common distinction among governments is whether they are so-called
“capitalist” or “socialist,” and in very broad terms they define the diversionary appetites
of some government entities. Certainly a government committed to allowing the private
ownership of capital is, all other things equal, more committed to putting in place an
economic infrastructure that favors creation over diversion. But this is only part of the
story. Laws, threat of expropriation, government repudiation of contracts— of the
things that cumulatively sum to the protection of property rights— important.
In a recent study of the productivity of nations, capitalist or mixed capitalist
countries were found to have the most effective governments with respect to antidiversionary commitment, but Hungary and Czechoslovakia, two non-capitalist countries
during the study, provided “approximately the same level of anti-diversion policies as
Taiwan, Italy, and Hong Kong.” On the other hand, Sierra Leone and Malawi, two

capitalist nations, offer little protection against diversionary activity. Similarly, many
nations which we loosely label capitalist or mixed-capitalist economies have borders that
are relatively closed to foreign trade. It is important to consider the totality of
government attitude toward diversion to appreciate that government’s role in either
fostering or inhibiting national productivity.
Jordan enjoys nearly twice the economic prosperity of Egypt, at least in terms of
per capita income levels. According to some recent estimates, all of that differential can
be attributed to productivity.7 And, it would certainly seem that government participation
in the economic infrastructure has been a prime determinant in that productivity
differential. Jordan’s anti-diversionary policies are stronger, it is more open to trade, and
its economic organization is less statist. These are the “common set” of characteristics
that make an economic infrastructure successful. According to some, these
characteristics are substantial enough to explain most, if not all, of the differences in
prosperity that separate nations today, and I suspect they are the same set of
characteristics that separated the wealth of nations in the time of Adam Smith.
M onetary Policy and the Economic Infrastructure

Applying this perspective to those of us who call ourselves monetary policy­
makers, we ask, “What is the role of a monetary authority in a free society?” Indeed,
“Why is the government in the money business at all?”
The Constitution of the United States gave Congress the power “to coin money”
and “to regulate the value thereof,” a language that some historians believe reflected a

7 Much o f this discussion is based on Robert Hall and Charles Jones, “The Productivity o f Nations,”
manuscript, N BE R Econom ic Fluctuations and Growth M eetings, January 31, 1997.


specific intent that the new nation adopt a specie standard. Indeed, the new Congress
quickly established its money standard to be a dollar, defined as 371.25 grains of fine
silver or 24.75 grains of fine gold.
Problems with a commodity, or commodity-backed monetary systems, are well
known. For example, commodity experts have an advantage in trade over non-experts,
bad money will drive good money out of circulation, and resources will be diverted
toward the creation of additional money, rather than toward the utility-providing goods
on which money represents a claim. The commodity money standard would seem to be
an inefficient medium of exchange, indeed, as James Madison observed.
Given these problems, it may be that modem fiat monetary systems—monies with
no commodity value—offer a less costly way to transact. Early fiat monies in North
America were products of a war economy. The Continental currency, issued by the
colonies during the American Revolution, and the Greenback and Confederate currencies,
issued by the Northern and Southern governments during the Civil War, offered their
respective governments a source of revenue that was not as readily available using
ordinary taxation. Because fiat money is virtually costless to produce, but has the
purchasing power of its face value, it offers the issuing government a current claim on an
economy’s resources with no clear obligation to repay at a future date, a tax called



“seigniorage.” Certainly, the seigniorage incentive—
particularly in the name of the
financial expedience prompted by a war—
provides ample motivation for governments
around the world to establish fiat monetary systems.







During wars, governments generally suspended the convertibility o f commodity-backed paper money,
generally with the promise to restore convertibility at a later date.


Yet, there may be economic reasons for fiat monetary standards other than the
seigniorage tax. Consider the new market economies in Eastern Europe, many of which
have chosen to finance a nontrivial portion of their new republics on the seigniorage from
fiat money. The overproduction of these monies, which diverted economic resources
from the private sector to the state, imposed large costs on those using the governmentprovided money. And many of these monetary systems have floundered. But, unlike the
early American failures with fiat money—
which were ultimately supplanted by
commodity money alternatives— alternative to the new Eastern European fiat monies
has been another fiat— U.S. dollar. Indeed, nearly two-thirds of all U.S. currency
currently circulates outside the United States. In fact, during the early 1990s, when the
newly emerging market economies were rapidly building an economic infrastructure,
roughly $100 million of U.S. currency creation was being exported abroad daily,
presumably as the preferred medium of exchange in many new economies.9
The lesson here, I think, is that the relatively stable purchasing power of the U.S.
dollar and a general confidence in its ability to hold its value over time has allowed the
dollar to become, for a time, a preferred alternative to any commodity-based substitute.
Fiat money economizes on scarce resources in at least two ways. First, the
printing press is a vastly more cost-effective production process than scouring the
landscape for a rare material. Second, in a fiat monetary system, all traders in the
economy have nearly the same advantage in judging the quality of a paper’s moneyness.

9 Richard D. Porter and Ruth A. Judson, “The Location o f U .S. Currency: H ow Much Is Abroad?”, Paper
presented at the Western Econom ic Association International Conference, San D iego, California, July 7,

And here is the public good in money— acceptance in transaction. Money is like .
language: It is part of the infrastructure that allows productive people to trade, and the
more people who use the language, the more efficient is the communication process. And
once created, its use is not diminished by the use of others. Indeed, its use by others only
strengthens its value in the economic infrastructure.
Some economists challenge the wisdom that fiat monetary standards are more
efficient than commodity money standards with the following analogy: “A similar
argument could be made for bicycle locks and chains. If metal locks could be replaced
with symbolic paper locks, resources would be released that could be used productively
elsewhere. As long as thieves honor paper locks as they would metal locks, your bike
will be perfectly secure.”1 This brings us directly to the question faced by modem
monetary authorities: Can the state be trusted to provide a relatively costless monetary
system without succumbing to the seigniorage incentive that redirects resources from the
private sector to the government sector? Or, stated alternatively, is commodity money—
which can be costly to produce and subject to the uncertainties of nature—
ultimately more
secure than the goodwill of the state? Only the passage of time will offer an answer.
The monetary authority, like any state institution, faces a clear conflict. As a
component of the economic infrastructure, it has the opportunity to provide an efficient
payments mechanism that would otherwise not be provided by a private enterprise and
thereby the opportunity to help the conversion of resources into their productive ends.
But, central banks also introduce the ability to divert the flow of resources to the state, or

10 Huston M cCulloch, M oney and Inflation. Academ ic Press, N ew York (1975).

to those favored by the state and, in so doing, represent a threat to the national
infrastructure. I believe it was the wisdom of Congress to recognize this conflict when it
established an independent central bank more than 80 years ago.
But even as an independent, state-sponsored enterprise, the Federal Reserve still
has a diversionary face. To begin with, we, like any public institution, are still subject to
political pressure, although perhaps less so than more direct forms of government
enterprise. Moreover, many economists, including in the Federal Reserve System,
continue to hold the view that markets are inherently unstable, and some degree of
“management” should be provided by the monetary authority. These are the economic
activist philosophies of the post-Depression era, where money is used to direct resources
toward the manipulation of national joblessness. Despite whatever good intentions
motivate such policies, this too, is a clear form of diversion— presumes that the
monetary authority is in a better position to judge the appropriate level and distribution of
national production than is the marketplace.
I believe that the failed attempts at fine-tuning economic performance during the
late 1960s and 1970s are a clear warning of the damaging diversionary power of the
central bank, and it is a policy that we must never again repeat. In the end, such efforts
broke down the efficient transmission of economic information through the monetary
standard, which in turn reduced national investment, discouraged productivity growth,
and diminished our position in the marketplace of international trade.


It’s easy to see that many of the development disasters of the post-World War II
era have been orchestrated by brutes whose economic agendas have been dictated by
military force, and whose political tenure has often been short-lived and bloody. But we
needn’t go to such extremes to find examples where the state commandeers resources.
We can point to the extent to which government controls or manufactures goods, creates
barriers to trade, or impedes the adoption of new technologies; the tax regimes imposed
by the fiscal authority; and, of course, the choices made by the monetary authority.
Today, the Federal Reserve has restored much of its lost credibility as the provider
of a monetary standard, and we have committed ourselves to the achievement of a stable
currency— that among the uncertainties that always confront private enterprise, the
value of the trade medium, the dollar, is not among them.
Is our promise not to repeat the failures of the past sufficient? Perhaps for the
moment it will have to be. But, we continue to call for a change in the environment in
which monetary policy is conducted. We believe specific and verifiable objectives must
be imposed on the monetary authority so that in addition to its good intention, the power
of the state is brought to bear on the monetary authority to ensure the protection of money
holders’ property rights. Rather than being an instrument of diversion, the central bank
must remain a strong and stable component of the national infrastructure, an
infrastructure that has become the model for nations around the world and a foundation
for the strongest economy in the history of the world.



1. Blanchard, Olivier and Michael Kremer, “Disorganization,” Manuscript, NBER
Economic Fluctuations and Growth Meetings, January 31,1997.
2. Greenwood, Jeremy and Mehmet Yorukoglu, “1974,” manuscript.
3. Hall, Robert and Charles Jones, “The Productivity of Nations,” Manuscript, NBER
Economic Fluctuations and1Growth Meetings, January 31,1997.
4. Levine, Ross and David Renelt, “A Sensitivity Analysis of Cross-Country Growth
Regressions,” American Economic Review, September 1992, 82, 942-63.
5. McCulloch, Huston, Money and Inflation. Academic Press, New York (1975).
6. Parente, Stephen L., and Edward C. Prescott, “Barriers to Technology Adoption and
Development.” Journal of Political Economy. 1994, vol. 102, no. 2, pg. 298-321.
7. Porter, Richard D., and Ruth A. Judson, “The Location of U.S. Currency: How Much
is Abroad?”, Paper presented at the Western Economic Association International
Conference, San Diego California, July 7, 1995.
8. Schmitz, James A, Jr., The Role Played by Public Enterprises: How Much Does It
Differ Across Countries?,” Federal Reserve Bank of Minneapolis Review, Spring 1996,
pg. 2-15.
9. “Central Banking in the United States: A Fragile Commitment to Price Stability and
Independence,” Annual Report of the Federal Reserve Bank of Cleveland, 1991.