A “Rules-Based” Monetary System Means A Fixed-Value System

A “Rules-Based” Monetary System Means A Fixed-Value System
November 19, 2014

(This item originally appeared at Forbes.com on November 19, 2014.)


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.