(This item originally appeared at Forbes.com on November 7, 2016.)
A rocket scientist – he designed weapons systems for a defense contractor – once told me that monetary principles were more difficult than rocket science. The evidence supports his view: we have many rocket scientists fully capable of making rockets that fly; and few-to-none monetary experts capable of making currencies that work well. But have you ever seen a book on missile engineering? China’s first gold-based “banknotes” date from the second century B.C. They were made of deer hide. Maybe it’s not that complicated.
Although there are a lot of possibilities, in practical terms, it tends to boil down to two choices: fixed or floating. Let’s see what they entail:
Fixed: This means that the currency’s value is linked to some “standard of value.” Gold and silver were the most common. Some Japanese paper banknotes were based on umbrellas, string, and potter’s wheels. (I don’t recommend this.) Today, the “standard of value” for fixed-value systems is most likely a major international currency, like the euro or dollar. Other possibilities include currency baskets (the International Monetary Fund’s Special Drawing Rights, which may be undergoing a bit of a revival), or commodity baskets.
Once you make the decision to fix the currency’s value to something, quite a lot follows from this. First, there must be a mechanism to achieve the goal. This mechanism includes some sort of automatic adjustment of money supply, in the manner of a currency board. Thus, the money supply becomes a residual – the outcome of the mechanisms that maintain the value of the currency at the target value. This removes any “discretionary” element. Central bankers can no longer attempt to “manage” the economy, via changes in money supply. Also, interest rates can no longer be managed, but are generated by free market processes. Obviously, the value of the currency itself cannot be changed, with whatever foreign exchange or trade-related consequences may result, because the value is fixed.
Whether the “standard of value” is gold, another currency, a currency basket or a commodity basket, the goal is normally some sort of “stability of currency value,” which in turn is based on the idea that economies work best when you do not go messing with economic relationships by jiggering the unit of account.
Floating: A floating currency has no fixed value, but instead goes hither and thither somewhat unpredictably. Because there is no obligation to maintain a fixed currency value, the supply of currency is no longer an automatic residual, and can be altered at will. Now central bankers can attempt to manage the economy via changes in money supply, interest rates can be manipulated, and foreign exchange and trade relationships can be changed. The goal of a floating fiat system is often to “stabilize the economy,” with this to be accomplished by currency distortion.
In practice, there have been a lot of attempts at creating a hybrid of these two options, in which there is both an “external” fixed value and an “internal” discretionary monetary policy. This has a tendency to blow up – indeed, the failure of this strategy is the reason the Bretton Woods gold standard arrangement ended in 1971. Later, it led to a chain of currency failures during the Asian Crisis of 1997-1998, and in many other instances throughout the past sixty years.
Today, it would seem that the question of “fixed vs. floating” has been definitively settled in favor of “floating.” This is not true. Most of the countries in the world use a fixed system. In the Annual Report on Exchange Arrangements and Exchange Restrictions, 2014, the International Monetary Fund took a survey of currencies worldwide.
Of them, 56.6% were found to have some variant of a fixed-value system – many of them ill-designed “pegged” systems. However, the IMF categorized 18 euro-using countries as having a “free floating” system, while I (along with Milton Friedman and Robert Mundell) would call these common-currency arrangements a “fixed” system. Spain, Ireland and Greece have no independent discretionary monetary policy, and are effectively the same as those countries with “no separate legal tender” (including Ecuador, San Marino and Kiribati) that the IMF classifies as a “hard peg.” Reclassifying these would raise the percentage following a “fixed” system to about 67% of all countries worldwide.
This does not include those countries that would probably like to have a fixed system, but don’t know how to do it. This could include most of the smaller Asian countries, like Korea, Thailand, Malaysia, Indonesia and the Philippines, which had badly-designed dollar “pegs” that blew up, due to incompetence, in 1997-1998. The proper way to fix one currency’s value to another is with a currency board. For some reason, this lesson hasn’t been learned yet by governments worldwide.
There’s a fair amount of talk today about this, that or another “rules-based” system, to add to the existing cacophony including various monetary aggregate targets and CPI targets, and the seat-of-the-pants improvisation favored by the United States today. These are all variants on floating fiat currencies. In practice, they tend to be picked up and discarded over time, as convenient justifications for what politicians and central bankers wanted to do anyway.
The idea of giving up all discretionary monetary policy – and fixing the value of the dollar to some external benchmark — is somewhat abhorrent to many today in the United States. People still think that they are going to solve all their problems by jiggering the currency. But, it is already (arguably) the policy of France, Germany and China, and another hundred-plus countries listed by the IMF. It was the policy of the United States, before 1971.
The U.S. used gold as the “standard of value,” just as humans had done back to ancient times. Did it work? After nearly two centuries of this principle, the U.S. became a global superpower, the wealthiest country in the world; nay, in the history of the world. Most of the countries in the world already adhere to the principle of a “fixed” currency. Maybe it should be all of them.