What would be the ideal money?

To prevent a new eruption of the financial volcano we need deep monetary reform – much more radical change than anything discussed by governments or economists as yet. So any signs of such an interest are encouraging. On July 8 and 14 of this year, Gerald Braunberger, economics editor of the Frankfurter Allgemeine Zeitung,  wrote two articles in FAZIT reviewing various proposals for radical monetary reform. It is even more encouraging that he focussed his articles on the proposals made by the Frankfurt-based economist Prof Wolfram Engels (1933-95). Readers will know that these inspired the concept of the Ikon, an ideal currency.

The following is a summary of the articles:

Several proposals have been put forward for a radical reform of the monetary system. Examples include a return to precious metals or limiting the creation of base money (100% reserve money). However,  a completely different, highly original idea was proposed back in the 1980s: a real asset or equity-based money. This was the brainchild  of the Frankfurt economist Wolfram Engels.  

The search for a long-term stable money

According to Engels, paper money is not a reliable basis for the monetary system because there can  be no certainty about its future value. This discourages new capital investment, the engine of economic growth. Engels argued for a monetary order that not only promised a value secure for decades to come but also one that would facilitate long-term capital formation. This must be a unit that links the present and the future. It must, in particular, allow savers to transfer consumption potential to the future.

“A capitalist society can best ensure that the savings are invested as productively as possible, that investments are well managed and monitored effectively, when agents  can diversify and mobilize these tangible assets.. The highest degree of mobilization would be represented by the transformation of property assets into money.”

This is not new;  a precious-metals currency or a commodity currency functions on the same basis. The decisive factor for Engels is the type of tangible asset to which money would be linked. He cites modern capital market theory to argue that it is optimal (for reasons of risk diversification) to hold savings in the form of shares in the so-called market portfolio, ie the total tangible assets of an economy. The state could thus decree the following (Engels wrote before introduction of the euro):

“A German Mark is defined as a billionth part of German national wealth on 1 January 1999.”

The state would therefore define the monetary unit. (The principle applied to the D-Mark could be transferred to the euro or any other currency.)

How would that work in practice?

Tangible assets consist of “land, houses, farms, woodlands, companies, railways, etc.”. Obviously it is impossible to determine the value of the total tangible assets on a daily basis: a performance index of share prices would be an appropriate approximation.  And that brings us to the investment currency. The value of money would be measured in terms of a representative stock index, where undistributed profits are factored back into the price. This is what is meant by the term “total return index”.

The determination of the value of money is achieved by keeping the money price of such an index constant. That is to say: “A bill of 100 German marks would be a share in a fund that contains the national capital and its price will be determined under the assumption that all proceeds are reinvested.”

The value of money in terms of the index remains constant. This also implies that the nominal interest rate, assuming a competitive market in banking, is zero. The low interest rates that many people regarded as scandalous should be seen as normal. Accordingly, the quality of money is higher, the lower the nominal interest rate, and the highest quality of money is achieved at a nominal interest rate of zero.

And what happens when a positive real interest rate develops, for example as a result of technological progress? This will be reflected in falling prices of goods at a constant nominal wage. Engels: “The productivity gains thus manifest themselves not in rising wages, pensions, etc., but in the growing purchasing power of constant wages. Since the nominal interest rate is zero, there is no nominal capital income. The real return on capital also manifests itself in increasing purchasing power. The share of labor income in national income is 100 percent. So, productivity growth leads to higher real wages.

As Engels presents his concept, it raises many questions. One is: How can you expect a stable currency by linking it to a stock index, when stock prices fluctuate sharply? Engels argues that the high price fluctuations (volatility) of stock prices are mainly the result of paper money and of the effects of swimgs in monetary policy on the financial markets. According to Engels, prices of non-financial assets should normally not vary greatly, because the market price of an asset is calculated as the discounted future income from a non-financial investment good. If the monetary base were not a single good such as gold, but the physical capital stock of a whole national economy, one should not expect large short-term fluctuations.

Engels described his currency as a “standard” and in his opinion the world would be entirely different if such a standard would have been realised earlier:

“The history books would look different, if people had reckoned according to the market portfolio … If this unit had been around earlier in the history of civilisation there would have been neither interest nor profit … In short, under such a monetary standard, capitalism would be not only more efficient and rational; it would have been seen as more honourable. “

Comparison with rival concepts of money

Let us imagine a zero hour, in which there is no monetary system in a country. Now we invite several central banks with different concepts of money to enter a competition. Which concept would be chosen? Here are the results of such a competition as viewed by Wolfram Engels:

Paper money

Engels found it inconceivable that fiat money with a central bank promising stable goods prices would win a competition with other monetary orders. This was because he thought it impossible that a central bank could redeem a credible promise of stability.

A precious metal money

The supporters of gold share the contempt for unfunded paper money. Nevertheless, Engels held the gold standard to be flawed. One reason is that gold does not generate current income. This leads to the situation that a bank which issues bank notes against gold has no income. But it incurs costs arising from the storage of the precious metal. Thus Engels considered the (historically well-documented) development, whereby an issuing bank issues notes, the proceeds of which are invested in interest-bearing assets, for almost a natural necessity: “You (holders of the notes) must trust that not all holders come to the issuing bank at the same time to demand gold … The higher the gold coverage, the more solvent is the bank in question, but the less profitable it is.” It faces a dilemma, in that it can achieve a higher credit only at the cost of lower profitability.

According to Engels, a second reason why a gold standard would have no chance in a competition of different monetary systems is this:

“A money tied to a commodity, which varies greatly in its relative price, would be perceived by the business community as an insecure money … The stability of the relative price of gold or relative price of silver under precious metal currencies was mainly based on the fact that the metal in question served as the basis for the currency;  its use as a currency base stabilised  its relative price. In a world of competing banks, this effect would obviously be much weaker. ”

In addition, it must be remembered that the extraction and processing costs of gold (or silver) tie up economic resources.

Commodity money

In Engels’ view this concept does not deal with the basic defects mentioned above : a bundle of goods does not generate current income. Conversely, the running costs of the storage of raw materials can be significant. On the last point Milton Friedman agreed with Hayek. Again, the issuing bank cannot assure full coverage of money in circulation. To be sure, commodity currencies and precious metals currencies are better, by Engels’ criteria,  than fiat money, but they are not able to guarantee long-term fulfilment of a promise of stability. This also means that the distribution of risk between money lenders and money is uncertain: “Every loan agreement contains an element of the bet; the risks of both together are larger than they should be. ”

Land Money

Now we come to the currencies that are backed by assets that yield income. Engels valued this type of monetary order more. We start with the idea of linking the value of money to land – an idea realized in the French Revolution with the so-called “assignats”  (4) The idea is simple: plots of land cannot not be increased at will and can, in contrast to commodities, generate a steady income by renting or leasing. Engels wrote: “The advantage of a land central bank consists in the fact that a 100% coverage (of the note issue) is possible because the land itself yields enough revenue to more than cover the costs of the central bank. In principle, therefore, an Assignatbank could have been more solid than a gold or silver-based central bank ”

The second advantage of a land currency lies in the predictability of relative prices. The value of the precious metals depends on the accidents of gold and silver discoveries on the one hand and on the development of payments technology on the other side from … The land price level is less exposed to such influences.

“In practice, however, it would not be easy to introduce a monetary order, based on convertibility into  plots of land. Engels mentioned “an abundance of difficult problems”, but concluded: “The idea of financing the revolutionary war by a real estate money was probably one of the greatest inventions in financial history… ”

Equity-based or investment money

In Engels’ ideal, money is covered (backed) by the market portfolio, ie the total physical capital stock of an economy, with the equity shares included in a representative market index used as a practicable approximation of  the market portfolio.

Engels’ conclusion: “The competitive superiority of the market portfolio bank is therefore overwhelming by comparison with any commodity bank:  its credit rating is higher because it can achieve a 100% note coverage; its profitability is considerably larger, so that it can keep the cost of holding cash in this money lower than a commodity bank can, and it offers also the creditors and debtors in their currency an optimal risk exposure that cannot be offered by a commodity bank. In terms of credit quality and profitability only the Assignatenbank can compete ; but the market portfolio bank achieves an optimum risk distribution superior to any other model. The market portfolio bank would be preferred in competition with rival models. ”

NB Gerald Braunberger does not necessarily share the views attrbuted to Wolfram Engels on the ideal monetary constitution.