Listening to the economic establishment, one would think that fixed exchange rates were a vestige of times past, and the gold standard a thoroughly discredited idea. After all, didn’t the Great Depression hit countries on the gold standard harder? Didn’t the collapse of the Bretton Woods system sound the death knell for regulation of the value of a currency? Wasn’t it a pegged currency which led to the Asian Financial Crisis?
It’s easy to look at the character of a currency pegged to a particular value (whether dollars or gold) as regulation, and a floating currency as letting the market have its say about the relative values of currencies. But this abdicates from money its role as the unit of exchange – the anchor by which all prices are reckoned.
One might well ask, why does money need to be an anchor? Have we not done fine since the collapse of the Bretton Woods system of fixed exchange rates? This misses the point: there must always be a price anchor. We function well enough without an anchor because currencies are depreciating slowly enough that we can act as if they were anchored in the short run. Yet in the long run, all currencies must tend towards the value of their base – in the case of a floating currency zero. Indeed, the history of all floating currencies is a tendency, sometimes quick and sometimes slow, towards worthlessness.
If our current system of floating fiat currencies then is insufficient and unstable, then what alternative is there? Has not the failure of fixed currencies been made manifest?
The characteristic feature of pegged currencies is that they impose a limit upon central banks: the monetary base may not inflate unduly, either through cheap credit or printing money. If this happens, the market value of the currency drops – and to prop it up, the central bank must buy the currency with reserves at the fixed price. Eventually the reserves run out, and either the government goes bankrupt (as was the case in Thailand, which had fueled the widening disparity between the Baht and the Dollar to which it was pegged by cheap credit), or it is forced to devalue (as Mexico had to do with the Peso in the early 1990s when investors determined the government’s 3.5 pesos/dollar policy was out of line with its market value).
Every case where a pegged currency collapsed was due to governments failing to heed this constraint. Indeed, one of the causes of the Great Depression was the attempt to return to prewar gold parity after massive inflation to pay for World War I. It is not the case that “economies got too big for gold”; it is the case that a pegged currency made the consequences of fiscal and monetary irresponsibility more immediately manifest. And of course what better justification for irresponsibility than the necessity of paying for a world war?
This is perhaps the most evident form of price distortion caused by inflation and deflation. Right now, central banks manipulate their currencies’ value by buying and selling reserves in order to improve the competitiveness of their exports. China in particular, by pegging their currency to the dollar as it weakens, stands to gain enormously on the world market. This should be the first sign that something isn’t working right: when an industry can become more competitive relative to its foreign competitors simply by adjustments by the central bank. There is no productivity increase – the exporting industries in this inflationary country have done nothing at all to merit their more favorable position.
What then is the buying of foreign reserves with new money, except an indirect and general subsidy on exports? The central bank spends money, in the process giving unmerited help to domestic industries. And since everybody’s doing it, everyone is forced to do the same. Like Mali, ruthlessly impoverished by America’s cotton subsidies which made Mali’s cottons uncompetitive with less productive American cotton, the country which does not send its currency along with everyone else’s down on the spiral towards worthlessness will be plundered by these implicit subsidies.
This is not a merely hypothetical fear: Nobel Laureate Paul Krugman is worried that China is plundering us in exactly this manner. Thailand, South Korea, Russia and the Philippines are scrambling to devalue their currencies relative to the dollar to protect their exports from Chinese competition.
What then is to be done? Perhaps government fiat has permanently spoiled the character of money as an anchor, at least until the slide towards worthlessness begins to accelerate worldwide. I see no impetus for governments to reconsider the wisdom passed down from Keynes until world prices begin to skyrocket uncontrollably. Perhaps a Bretton Woods II would be appropriate: a multilateral agreement to peg currencies to the current market price of gold, and more importantly, not to inflate after that point.
Or, the power of the determination of the unit of account could be removed from governments entirely. As it is now, the effects of inflation on investors are offset so long as governments are willing to pay interest plus expected inflation on government bonds, which they always are, for the lavish and irresponsible spending of Western governments is funded by these bonds (in the absence of the trust required to issue bonds, governments may choose to fund by print-inflation, as Zimbabwe – which compresses the long-term doom of fiat currency into a much shorter time period). Without control of the currency, interest rates can no longer mask the pernicious effects of inflation. No longer will one be guaranteed a return by investing in nonproductive activity.
The benefits of private currencies are numerous. For one, they may not rely on fiat, and so they must necessarily be anchored to a particular base (UPDATE – not necessarily; however the main point still stands). Without a bond market, this allows the market to equalize relative prices among the various currencies, an incontrovertibly good and natural process of the market which is nevertheless subverted by inflationary distortions made manifest in exchange rate fluctuations. This adjustment in turn prevents both the indirect subsidies of devaluation and the subsequent plunder of one economy by another.
Government control of money is a major conflict of interest. The incentives are to inflate, devalue, and fiddle in order to improve one’s lot relative to other currencies. Central banks, knowing well that rational expectations will thwart the effect of many of their attempted policies, must to some degree or another rely on either the element of surprise (most Western banks), or outright secrecy (the Chinese bank). Private competition without the use of fiat will necessarily increase transparency, for the incentive is stability, thus eliminating the need for secrecy and surprise. Well-managed currencies with strong reserves backing them will prosper, while any damage done by poorly managed currencies will be quickly cauterized, for holders will not allow a currency much leeway before moving to another. In this way, we get a system of well-managed currencies with a stable value, and disconnected from national interests.
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Ben Triplett says: Nov 17, 2009 at 19:34Money is ugly.
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Noah Brisbin says: Nov 17, 2009 at 20:36Whew. I think reading this and just thinking about the nature of money took what energy I would have needed to respond intelligently.
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Joseph Sileo says: Nov 18, 2009 at 0:14Floating currency is not inherently worthless. If certain rules (or a certain rule) is applied to its creation.
As we men have learned the rules of the game (economics) we have manipulated money and used currency for more then its original purpose. eg money used to make money, as opposed to goods and services in exchange for money.
Consider the Pennsylvania Pound. In response to looming economic failure the British colony of Pennsylvania created a floating currency, which was subsequently outlawed by the British. What made this currency so stable was that only enough of it would be in circulation at any given time to satisfy the demands of trade. A 1:1 ratio if you will. This prevented inflation/deflation because if the sum value of the goods and services in its economic sphere dropped then an equivalent portion of notes would be removed from circulation, and would be added if the sum value of goods and services increased.
http://en.wikipedia.org/wiki/Colonial_scrip#Pennsylvania
That having been said their is an Achilles heel to this system. Its value relative to other currencies could still be manipulated by the regulators of other currencies. As China has been doing to the US.
In order for this system to work at an international level, other floating currency regulators would have to start following the 1:1 ratio rule OR all currencies be done away with and a single world-wide currency created using the 1:1 ratio.
I favor the latter because it simplifies and stabilizes a currently erratic world-market, and as our technology for communication and travel increases its something we are going to have to deal with anyway. Or to put it another way, isolationist (national) markets are antiquated and getting phased out whether we like it or not.
oh and the Pennsylvanian pound could be thought of as a pegged currency in that it is pegged to everything at once.
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thrica says: Nov 18, 2009 at 0:52Maybe that would work way back in the day. But the actual amount of money nowadays is incredibly hard to even measure, much less control. People can’t even agree on what counts as money, which is why we have M0, M1, and M2 measures (we used to even have an M3). Credit also throws a wrench in things, which is why they have to fiddle with interest rates in addition to the actual amount of currency.
The nice thing about private currencies is that the competition works to drive the interest rate to the time preference of the people, just the same as the price of any other good. Any higher is unnecessarily constrictive on the economy, and any lower fuels a boom. There’s no way the government can know what that time preference is and decree it, just like it can’t know what the price of milk is to set it without the interplay of supply and demand.
So if we assume monetary stability is even possible to attain from a centrally managed bank, if that was their aim, maybe floating fiat currencies could work in the long run. But the reason governments switched to floating currencies in the first place was so they could disregard monetary stability. Even if they could stabilize, would they?
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Joseph Sileo says: Nov 18, 2009 at 2:05The amount of money in a single currency system shouldn’t be hard at all to track. A single organization creates and destroys it. As far as credit is concerned it is the same problem we have now. If money is created and sold at interest then the whole can never be repaid. Both however have the same solution. interest pegged to potential resource creation. eg I buy a lot of land with a coal mine on it. I mine the coal and sell it i make more then my original investment plus interest. The earth has a finite but unknown resource value. I must rape the earth in order to pay the whole. (Ben is right money is ugly)
Private currencies run into the problem of not being able to be private. If I own a store what keeps me from denying your currency? (aside from government mandate) That effectively devalues your currency because its purchasing power is reduced. A shop owner cannot be expected to accept all currencies because some are riskier then others and why should they be forced to hold a currency whose value fluctuates erratically when given the option of accepting other currencies. On the consumer side potentially many peoples entire savings could be wiped out because of this. Instead of mass depressions (due to mass panics/speculations) occurring once every 100 years we will have smaller depressions happening everyday due to daily panics/speculations. Dozens of currencies coming into creation and failing on a regular basis with people caught in the crossfire.
On the flip side if currencies trend toward a stable peg (gold/silver) then whats the point in having a lot of currencies pegged to the same thing? Is it not essentially the same thing? 1 gram of gold=10 ameros=20 africanos….both currencies fluctuating relative to gold. Also if we have all these currencies floating around there is no possible way individuals could keep track of them all. Are we to expect our minimum wage sales clerk to know all the different prices for a double cheeseburger or which currencies their company accepts and which they don’t? It would be completely unmaintainable. This adds to the speculation/panic problem not to mention it blows the door wide open for counterfeiting.
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Matt Richmond says: Nov 18, 2009 at 10:06The gold standard was great back when the lower classes had nearly no say in government; they’re the ones that have to deal with the fluctuations of price and wage adjustments. It’s just another example of economics in a pure sense, trying to do what is best for the economy overall without taking the people who are hurt by it into account.
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thrica says: Nov 18, 2009 at 17:25@Joseph: The problem with credit is a relatively recent problem, since technology has allowed it to happen en masse, rather than just on small scales. Credit is a huge component of the money available, and it’s extremely sensitive to changes.
Also, I think you overestimate the degree to which currencies would be volatile. Maybe it would be initially chaotic as the market weeded out overambitious currenceers. You’re right that nothing can force sellers to accept currencies, but since currencies are convertible among their various bases, transaction costs should be quite low.
I compare it to the credit card market now: no one is forced to accept Visa or Mastercard, but nearly everyone does. These are companies which effectively create temporary money by lending. Many places even accept Discover, American Express, and a number of smaller ones. Credit cards are extremely widespread; the technological and transactional problems of private currencies are therefore not insurmountable.
As for the point of having multiple currencies with the same peg, even these can be managed well or badly. If I sense one currency is stretching out its reserves too thinly, I can very easily sell them and buy an equivalent amount in a different currency backed by the same commodity (due allowance being made for people who sensed the same thing before me and drove the value down already).
Regardless, the process of a failed currency will be very quick because of transparency and expectations, and maybe painful for the people who were slowest in selling, but nevertheless less painful than the collapse of a currency which people are mandated by the government to use – a pain which affects everyone since you have no other domestically useful options.
@Matt: By poor I’m guessing you mean debtor? That equivalence was great back in the day, but as it is now the rich are often more debtors than the poor.
Monetary inflation and deflation only affect the real burden of debt so far as they are unexpected, because the terms of loans can be adjusted beforehand. As it is now, this element of surprise hurts alternately the debtor and the creditor, depending on whether we overestimated or underestimated the level of inflation.
What is fair then? Predictable and transparent monetary policy under a stable pegged currency, a system which favors neither the debtor nor the creditor unfairly.
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thrica says: Nov 18, 2009 at 18:04In addition, the poor are hurt immensely by the boom-bust cycle engendered by monetary instability. The sob stories should make us clamor for stable money, not for regulation and welfarism. Unfortunately the link between monetary expansion and economic collapse isn’t quite so clear or immediate.
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Joseph Sileo says: Nov 18, 2009 at 23:40What do you say to the practicality issue? I speak of the minimum wage sales clerk needing to know the different prices for a double cheeseburger and which currencies their employers will accept at any given time, and the potential increase in counterfeiting.
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thrica says: Nov 19, 2009 at 0:12I say technology obviates it. What does the sales clerk need to do if you can swipe your card into the machine (made by a company which deals in currency exchange) and the correct amount is automatically deducted? That deduction could even be traded for whatever currency the employer wants automatically. Just because an establishment doesn’t want a particular currency doesn’t mean it can’t be used there.
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Joseph Sileo says: Nov 19, 2009 at 0:30At that rate screw currency all together. If we must use cards to make the system work then why have the currency in the first place. Its just an extra step. We might as well trade the commodity directly since all transactions are digital. After all the only reason a gold certificate exists in the first place is because its a lot easier to move around then the gold itself.
Of course the idea of being forced to use digital transactions doesn’t work well for small business. The fact that its extra overhead aside, If there is a network outage at any point in the system the business is forced to shut down. I don’t know how many times this has happened to me in gas stations.
Also the counterfeiting issue is not eliminated its just transformed into a hacking issue. Remember the economic black hole visa created, with the multi-quadrillion dollar charge, then made it worse by adding an insufficient funds fee. (I realize that wasn’t a deliberate hack but it doesn’t mean it can’t happen.)
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thrica says: Nov 21, 2009 at 0:27Currency is just time-agnostic barter which allows for exact accounting. The time-agnosticism and exactness require that it have a value, whether backed by gold or the government force. I’d love to see currency become as transparent as possible though; measured in virtual gold certificates (gold certificates which are virtual, not certificates for virtual gold). As increased technology lubricates the market, that becomes more possible.
Likewise, hacking and network outages are not technologically insurmountable problems. We just have yet to arrive at the day when it becomes feasible.
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Joseph Sileo says: Nov 21, 2009 at 1:54I agree. My point in the previous comment was that the gold certificate is irrelevant when its digital because you’re really just trading gold at that point. In other words trading gold in dollars if digital currency exists (alone) is the same as trading gold in grams. The only difference is which number inflates. For example If i have 10 grams of gold on my card then I will always have 10 grams but its value will inflate/deflate. If I have 10 gold dollars on my card then my dollar amount never changes but the amount of grams of gold that $10 represents inflates/deflates.
Of Course at that point inflation isn’t measurable. By that I mean all inflation is is a decrease in the purchasing power of goods because the value of gold dropped. But that purchasing power is highly variable. For example if a gallon of gas and a gallon of milk each cost $1.00 then in the future a gallon of gas costs $5.00 a gallon of milk does not necessarily increase in price to $5.00.
It just occurred to me that inflation/deflation is just the market attempting to hit the 1:1 ratio. If we think about it in terms of price. if one side of the equation represents the sum price of all goods and services and the other side represents the money supply….
Sum Price of all goods:Money Supply
…then if the money supply is increased so must the SPG because inflation will drive prices up to match the Money Supply (as the increase in the money supply resulted in a loss in value). I could create more examples but suffice to say if one side moves the other side moves equally (or close to it). Inflation and deflation are the growing pains of the market attempting to stabilize itself. Pegged or not private or fiat, if we don’t strive to keep in step with the 1:1 ratio the market will do it for us. The thing about pegged currency is that its value moves independently of the 1:1 ratio. (The market fighting itself in a way) But a floating Fiat currency can be kept within that 1:1 ratio.
To go back to your asking about credit and the PA pound. To use a physics analogy. Price represents kinetic energy and value represents potential energy. Therefore we can solve the credit issue and keep within the 1:1 ratio by doing the following. The central Bank (money maker) lends directly to consumer banks at 0% interest, and will only lend to them based on their business model (as private banks do with other businesses). The consumer banks must show that their potential energy (value) is greater then the loan (price). They show this by having an interest rate above 0%. These banks follow the same rule, lending what they have borrowed from the central bank. Now this keeps the market in the 1:1 ratio because even though the money supply increases the sum price of goods and services will increase in a short time (relatively speaking)
To answer your question about why would the central bank want a stable market…
The central bank being an arm of the government is not concerned with making a profit it is concerned with growing the economy. (hence the 0% interest rate to the consumer banks). Also it is in the governments interest to keep the economy stable therefore by growing the money supply only by the appraised value is a smart route.
In theory we do this now, but in practice we violate two big rules. First we are increasing the money supply in large quantities to grow the economy but are not paying attention the consequences of inflation. (A continued failure to think long term). Second, the consumer banks aren’t lending like they should be out of fear of failure. This prevents the potential from becoming the kinetic thus driving inflation. My god, Its a self fulfilling prophecy!
In summation if we follow Four simple steps we should get a stable growing economy.
1. The central bank can only lend out at 0% interest.
2. Banks both central and consumer can only lend out an amount equal to appraised value OR collateral of the borrower to prevent a chain reaction due to failure on the side of the borrower. Whichever is least. (In the case of credit cards, no limit is not an option anymore)
3. Consumer banks may not horde large quantities of money that they have borrowed lest the economy inflates.
4. Government bailouts are illegal, as they keep bad businessmen from learning a well deserved lesson.
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thrica says: Nov 21, 2009 at 2:27>”For example if a gallon of gas and a gallon of milk each cost $1.00 then in the future a gallon of gas costs $5.00 a gallon of milk does not necessarily increase in price to $5.00.”
Exactly! That’s not a problem with gold certificates; that’s the problem with inflation in general. It distorts prices, and the bust part of the boom-bust cycle is the economy getting back to that 1:1 ratio.
So the problem isn’t price inflation or deflation per se, but price distortions. There will be mild price deflation under a gold standard, but so long as the money supply doesn’t inflate or deflate, the prices will not distort.
Regarding principle 1: 0% interest from the central bank would be massively unstable; the booms and busts would be of epic proportions as banks reacted to economic headwinds.
Regarding principle 3: It’s actually the other way around. The banks are now hoarding money (excess reserves have gone from $2 billion earlier this decade to over a trillion this month), and the worry is that it’ll be hugely inflationary if they all of a sudden start lending that money.
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Joseph Sileo says: Nov 21, 2009 at 3:02“So the problem isn’t price inflation or deflation per se, but price distortions. There will be mild price deflation under a gold standard, but so long as the money supply doesn’t inflate or deflate, the prices will not distort.”
The printer can only print enough notes to equal the amount of gold (value) in the reserve. The value of the gold itself can plummet or skyrocket due to exterior factors. Scarcity decrease/increase, speculation in trade, etc. As the value of the gold fluctuates the printer must still print/recall notes, or its currency will most certainly boom/bust. It really doesn’t matter what you peg something to if at all.
Currency is a grand illusion we must all buy into in order for trade to work.
Principle 2 limits on how much can be borrowed (and therefore printed). The equal collateral mandate is a safety net to considerably soften or eliminate the bust. Individual credit lines will still bust as they do today but the currency is protected.
In regards to your response on principle 3. Sorry I meant deflationary. Your right it would be hugely inflationary if they did it all at once. They should have been doing it in small bursts to begin with. The credit freeze (ie Panic of 2008/09/10?) was a horrible event in our planets history. Though I rather did like the gas prices.