Which anchor for money?

The supply of money needs to be limited or ‘anchored’ to prevent excessive supply reducing its value. At present money is supposed to be limited by central banks following inflation targeting models. However, this paradigm has lost traction under the strain of the crisis. In effect we have returned to a discretionary monetary policy, where there is no hard anchor to money or prices.

In this situation, which is full of danger, the subject of the monetary anchor needs more attention than it is usually given – in my view, it is the biggest lacuna in most proposals for reform of the international monetary system.

Proposals involving a world central bank issuing money subject to some rule such as inflation targeting raise the objection  that a world central bank presupposes a world government; there is no world government, and no prospect of one, therefore there can be no world central bank.

Under the proposal outlined here, governance arrangements would take the form of a simple currency board structure – the articles of agreement can be put down in only two pages – under the auspices of the IMF or BIS. Absence of discretionary monetary policy would leave less room for disputes among the currency board’s directors, as their duties will have been strictly defined and limited by international treaty. I argue that it is possible to have the benefits of a world currency without a world central bank. Means can be found to regulate its supply by an agreed, automatic procedure. Many currencies are issued by currency boards without discretionary monetary policy. The same can apply to a world currency. The classical gold standard (or an idealised form thereof) provides the historical precedent. The gold standard required no coordinated decision-making.

The present monetary system leads to repeated cycles of crises and recessions – the money trap – as it is subject to abuse by governments and banks. Right now, financial markets remain fragile as participants are aware that governments are not tackling the underlying problems with the system.

In order to focus on the features than an anchor should have, let us abstract from other factors and conditions required for a world currency unit. Assume flexible prices and wages; assume nations have learnt to live with fixed exchange rates, and with fluctuations in the general price level. Assume that confidence in the US dollar has collapsed, so that it cannot serve as an anchor. Nor can the euro. Assume that the public has lost confidence in central banks’ discretionary monetary policies, such as the inflation targeting regime currently in existence.

There are only a few options for an anchor: gold, a ‘real’ SDR, or a commodity currency (e.g. proposals made by Warren Coats for a ‘real’ SDR, a currency basket kept constant in terms of an index of world prices, and by Leanne Ussher for a modern commodity currency).

The Ikon

As an anchor please imagine a gold standard where instead of fixing money to gold it is fixed to a bundle of equity shares. [1] It would function in much the same way as a gold standard. You would not need a central bank following a monetary policy. I call this currency unit the Ikon – a classical Greek word, eikon, meaning ‘likeness, image’ for a visual representation of an object of great value, mystery and significance.

With money tied to an equity basket, the value of money would be determined by the performance of the basket or index to which it was tied. Over the long run, equity values can be expected to rise with the growth in productivity and other factors. Commodity prices decline pari passu with the rise in the value of the currency. There would be strong demand for such a currency because it would be also an investment.

With nominal rates on risk-free assets zero, real yields will depend on the profitability of the specific investment project undertaken and the rate of decline in commodity prices, which reflect growth productivity of capital and other forces tending to raise long-term equity market returns.  International adjustment takes place along gold-standard lines. Countries adjust naturally to imbalances just as States in the US.

Would purchasing power become so unstable as to be unacceptable? I don’t think so. Tying money to stock market values will tend to stabilise markets, just as the relative price of gold is more stable under the gold standard than it has been since. This is because the demand for money, which is quite stable, dominates speculative influences. Also, it seems likely that banks issuing notes under this standard would offer derivative services/accounts to clients who prefer stability in terms of consumer purchasing power. As the banks will hold an asset expected to appreciate in real terms over the medium to long term, they would expect to make a profit by offering accounts guaranteed to hold their (commodity) value constant.

Given a free choice, such a unit would be chosen by debtors and creditors to a contract, becasue it minimiees their aggregate risk, but because of network effects and incumbency advantages of existing currencies it will not come about by natural evolution.

The monetary unit is defined by the State, such that, for example, one Ikon equals one-trillionth of the market capitalisation of shares quoted on the world’s recognised stock markets (about $60). One dollar is fixed at (say) $60 to one Ikon. Measured in Ikon, the share price index is constant over time.  Commodity prices would fluctuate. The big question is how volatile commodity prices would become, and whether the disadvantages outweigh the benefits of the scheme. You have to compare these costs with the escalating high costs of fiat money, which is gamed by governments and bankers and has caused recent global recessions with falls in output approximating those caused by a world war. I think that commodity prices would not be as unstable as stock market returns have been historically – when they become money, the demand for them as money will dominate speculative demand, and will be more stable. They will not be subject to ‘monetary’ shocks. Long-term returns on equities might decline somewhat but woudl remain positive.

This provides an anchor because a share is a claim on a real asset, an object, like gold, which has a ‘real’ supply and demand independent of monetary influences.

[1] This is based on a proposal made by Wolfram Engels, a professor of economics at Frankfurt University and a free-market economics commentator, who died in 1995. See his publication, “The Optimal Monetary Unit”, Campus Verlag, 1981.  I worked on the idea with him (as he notes on page 12).

These notes are based on the brief talk I gave to a meeting of the Santa Colomba group, Siena, Italy, earlier this month.