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I think there is a little too much abstraction in discussion of monetary
topics today. For example, here’s former Fed Chairman Paul Volcker, speaking
last June:
By now I think we can agree that the absence of an
official, rules-based, cooperatively managed monetary system has not been a
great success. In fact, international financial crises seem at least as
frequent and more destructive in impeding economic stability and growth.
There’s a fair amount of talk these days about “rules-based” monetary
systems, in no small part because, as
Volcker notes, the absence of rules has tended to cause a lot of chaos
and destruction. Today’s monetary affairs are typically conducted in a
somewhat ad-hoc, seat-of-the-pants fashion, with floating fiat currencies
mismanaged by unelected bureaucrats. If there are “rules,” such as the
occasional mention of a Taylor Rule or other such guideline, these tend to be
fleeting public justifications for doing whatever the central bank head felt
was appropriate that month, and are discarded whenever their usefulness in
that role wanes.
At some point, we might have a public discussion about these topics in
Congress, if Kevin Brady’s Centennial
Monetary Commission bill passes. So, let’s do some homework today.
If we want a “rules-based system,” what should the rule be? One such rule is
what I’ve called a “fixed-value
system,” which is a rule that the value of the currency will be kept
stable against some definite benchmark. A common variant of the fixed-value
rule is a gold standard system. For over a century, the United States held
the principle of a dollar whose value was equivalent to 23.2 troy grains of
gold, or 1/20.67th of a troy ounce. Later, during the Bretton Woods era of
the 1950s and 1960s, the dollar’s fixed-value parity was 1/35th of an ounce.
Other countries did much the same thing.
Unfortunately, the currency managers of that time didn’t have much idea of
how they were supposed to maintain this fixed-value policy goal (hint: something like a currency
board), and so it fell apart from ignorance
and mismanagement. The present rules-less anti-system we have today was
the accidental outcome of this failure in 1971.
But, a gold standard system is not the only kind of fixed-value rule that has
been found in history. Today, we have quite
a number of countries (27 at last count) which have a fixed-value
arrangement with the floating fiat euro, plus another 28 that use the euro
itself as a common currency. I would consider a common currency to be a
variant of the fixed-value approach. In practical monetary terms, it has much
the same characteristics as a separate currency linked to the euro with a
currency board. Estonia had its own euro-based currency board until 2011, when
it transitioned to using the euro itself. In monetary terms, the outcome was
about the same either way.
There are other kinds of fixed-value rules you could create. Currency baskets
are a common notion today, with the International Monetary Fund still pushing
its SDR idea. Commodity baskets have been proposed since the mid-19th
century. Other single commodities, from silver to umbrellas, have been used
as fixed-value benchmarks. A group in Ithaca, New York, even has a “community
currency” based on one hour of labor.
All of these fixed-value approaches have a few things in common: they are
definite rules, and consequently, there is no particular role for an
independent money bureaucrat to make stuff up as he goes along, except
perhaps in some of the minor details of its execution.
And so, I note that, whether in the form of a gold-basis fixed-value rule in
the past, or a euro-or-dollar-basis fixed-value rule today, these fixed-value
rules-based systems have been very common throughout history, and work fine
for decades at a stretch, as long as you manage and maintain them properly.
Alas, there are quite a few other “rules-based” proposals out there. In the
past, it was a popular notion to suggest that the U.S. dollar monetary base
should expand by perhaps 3% per year. Others have suggested, somewhat
vaguely, that the monetary base should not expand at all, and that any
expansion whatsoever constitutes “inflation.” More vague suggestions have
included the notions that base money supply should expand in line with gold
mining production (in practice, about 2% per year), or should be the
reciprocal of some amount of gold already held in a vault somewhere. Somewhat
more complicated proposals have been along the lines of “inflation
targeting,” or “nominal GDP targeting,” or a Taylor-rule-like arrangement.
You could make up many more such rules. One thing they all have in common is:
they have never been tried. Another thing is: the value of the currency is
basically an unpredictable residual of the rule. Since these are
hard-and-fast rules-based frameworks, not just momentary guidelines for
making it up as you go along, you would have to live with whatever you get,
for better or worse. One advantage of the seat-of-the-pants method is that
you can attempt to fix things if they get out of hand.
In practice, if anyone did try such a thing – as Paul Volcker arguably did in
late 1979 – it would probably cause intolerable problems and would soon be
abandoned. You would soon be back to an ad-hoc approach, probably in less
than twelve months.
Actually, there is a recent example of using a variant of the “3% per year
increase in supply” rule: Bitcoin.
The extreme volatility of that experiment simply demonstrates that the people
who said years ago that exactly that outcome would happen, if it was applied
to the U.S. dollar as proposed, were right. Actually, there have now been
dozens of Bitcoin-like experiments, and, after taking their owners on a roller-coaster
ride, they tend to go to zero when people tire of fooling around with them.
Thus, we find: gold-standard fixed-value systems used by many, many
countries, for very long periods of time stretching centuries, and a long
history of success; fiat-currency fixed-value systems today which are as good
(or bad) as the fiat currencies they are linked to; and a number of untested
hypotheses that are rather badly flawed in principle.
I suggest that this simplifies things somewhat: the only feasible “rules-based”
system is a fixed-value system. Maybe, depending on the conditions of the
day, this could be a link to a major international fiat currency, or even a
currency basket. Possibly a commodity basket. Or, it could be a link to gold.
There really isn’t much left on the menu of “rules-based” systems.
Since the U.S. itself is not likely to link the dollar to a “major
international fiat currency,” or a currency basket, the list of options gets
very short indeed.
Fortunately, a gold standard system, which the United States used until 1971,
actually works very well in practice. It helped the U.S. become the
wealthiest and most powerful country of that era. The final two decades, the
1950s and 1960s, were an especially fine time to be an American. So, our remaining
choices are not particularly unattractive.
For some reason, people make this stuff so complicated. It seems pretty
simple to me.
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