Month: July 2013

A Hard Anchor for the Dollar

For the last three years with zero interest rates and “quantitative easing” the Federal Reserve has been pushing on a string. It has been trying to stimulate an economy that suffers from problems that are not basically monetary. In the process it is distorting the limping economic recovery and potentially reflating housing and other asset bubbles. The Federal Reserve has jeopardized its revered independence by undertaking quasi-fiscal operations (buying long-term government debt and MBS to push down longer term interest rates in those markets while paying banks interest on their deposits at the Fed to keep them from lending the proceeds). The result has been an explosion of the Fed’s balance sheet (base money—the Fed’s monetary liabilities—jumped from around $800 billion in mid 2008 to over $3,200 billion in July 2013) while the money supply only grew modestly (over the same period M2 increased from about $8,000 billion to about $10,700 billion- about the same increase as over the five year earlier period from mid 2003 to mid 2008).

There is growing sentiment that our fiat currency system should be replaced with a hard anchor, such as the gold or silver standards in place in much of the world over the two centuries preceding gold’s abandonment by the United States in 1971. In order to avoid the weaknesses of the earlier gold standard, which contributed to its ultimate abandonment, three key elements of its operation should be modified. These are: a) the conditions under which currency fixed to a hard anchor is issued and redeemed; b) what the currency is sold or redeemed for; and c) what the anchor is.

Monetary Policy

During the earlier gold standard, the value of one U.S. dollar was fixed at $19.39 per ounce of fine gold from 1792 to 1934 and $35.00 per ounce from 1934 to 1971 when Nixon ended the U.S. commitment to buy and sell gold at its official price because the U.S. no longer had enough gold to honor its commitment.  None-the-less, the official price was raised to $38.00 per ounce in 1971 and to $42.22 in 1972 before President Ford abolished controls on and freed the price of gold in 1974.

Under a strict gold standard, operated under currency board rules, the central bank would issue its currency whenever anyone bought it for gold at the official price of gold and would redeem it at the same price. In fact, however, the Fed engaged in active monetary policy, buying and selling (or lending) its currency for U.S. treasury bills and other assets when it thought appropriate. Thus rather than being fully backed by gold, the Fed’s monetary liabilities (base money) were partially backed by other assets. Moreover the fractional reserve banking system allowed banks to create deposit money, which was also not backed by gold. The market’s ability to redeem dollars for gold kept the market value of gold and hence the dollar close to the official value. Because the Fed could offset the monetary contraction resulting from redeeming dollars, this link was broken and in 1971 President Nixon closed the “gold window” altogether for lack of gold.

A reformed monetary system should be required to adhere strictly to currency board rules. The Federal Reserve should oversee the interbank payment and settlement systems and provide the amount of dollars demanded by the market by passively buying and selling them at the dollar’s officially fixed price for its anchor (gold, in a gold standard system) in response to market demand. Banks should be denied their current privilege to create deposit money by replacing the fractional reserve system with a 100% reserve requirement (a subject for another time).

Indirect redeemability

Historically, gold and silver standards required that the monetary authority buy and sell its currency for actual gold or silver. These precious metals had to be stored and guarded at considerable cost. More importantly, taking large amounts of gold and/or silver off the market distorted their price by creating an artificial demand for them. Under a restored gold standard the relative price of gold would rise over time due to its limited supply, and the increasing cost of discovery and extraction. The fix dollar price of gold would mean that the dollar prices of everything else would have to fall (perpetual deflation). While the predictability of the value of money is one of its most important qualities, stability of its value (approximately zero inflation) is also desirable.

This shortcoming of the traditional gold standard can be easily overcome via indirect redeemability. The market’s regulation of the money supply in line with the official price of money in terms of its anchor does not require transacting in the actual anchor goods or commodities. As long as an asset of equal market value is exchanged by the monetary authority when issuing or redeeming its currency, the market will have an arbitrage profit incentive to keep the supply of money appropriate for its official value. In a future, hard anchor monetary system, the Federal Reserve could issue and redeem its currency for U.S. treasury bills rather than gold or other anchor goods and services. The difference between that and current open market operations by the Fed is that such transactions would be fully at the initiative of the market rather than of the central bank. The storage cost of such assets would be negligible and in fact would generate interest income for the Fed.

The Anchor

The final weakness of the gold standard was that the relative price of the anchor, based on a single commodity, varied relative to the goods and services (and wages) purchase by the public. In short, though the purchasing power of the gold dollar was highly stable historically over long periods of time, gold did not provide a stable anchor over shorter periods relevant to most business decisions.

Expanding the anchor from one commodity to 10 to 30 goods and services carefully chosen for their collective stability relative to the goods and services people actually buy (e.g. the CPI index) would be an important improvement over anchoring the dollar to just one commodity (gold). There have been many such proposals in the past, but the high transaction and storage costs of dealing with all of the goods in the valuation basket doomed them. Replacing such transactions with the indirect convertibility described above eliminates this objection.

A Proposal

The United States could easily amend its monetary policy to incorporate the above features – a government defined value of the dollar as called for in Article 1 Section 8 of the U.S. Constitution and a market determined supply of dollars. First Congress would adopt a valuation basket of 10 to 30 goods and services chosen to give the dollar the most stable value possible in terms of an average family’s consumption (i.e. the Consumer Price Index). The basket would consist of fixed amounts of each of these goods and would define the value of one dollar. As with the gold standard, if the value of the goods in the basket were more in the market than one dollar, anyone could buy them more cheaply by redeeming dollars at the fed for an equivalent value of U.S. treasury bills (indirect redeemability). The resulting contraction of the money supply would reduce prices in the market until a dollar’s value in the market was the same as its official valuation basket value. The money supply would grow with its demand (as the economy grows) in the same way (selling t-bills to the fed for additional dollars). The Federal Reserve would be restricted to passive currency board rules. All active purchases and sales of t-bills by the fed (traditional open market operations) or lending to banks would be forbidden. During a two year transition period the fed would be allowed to lend to banks against good collateral in order to allow banks time to adjust their operations and balance sheets to the new rules.

A global anchor

The gold standard was an international system for regulating the supply of money in each country and between countries and provided a single world currency (fixed exchange rates). This led to a flourishing of trade between countries. This was a highly desirable feature for liberal market economies.

The United States could adopt the hard anchor currency board system described above on its own and others might follow by fixing their currencies to the dollar as in the past. The amendments to the historic gold standard system proposed above would significantly tighten the rules under which it would operate and strengthen the prospects of its survival.

However, there would be significant benefits to developing such a standard internationally as outlined in my Real SDR Currency Board proposal (http://works.bepress.com/warren_coats/25/). One way or the other, replacing the widely fluctuating exchange rates between the dollar and other currencies would be a significant boon to world trade and world prosperity.  Replacing the U.S. dollar as the world’s reserve currency with an international unit would have additional benefits for the smooth functioning of the global trading and payments system.

The Egyptian Coup

Ousted Egyptian President Muhammad Morsi had been a miserable leader. He broke many promises starting with the Muslim Brotherhood’s promise not to run a candidate for President just yet and to lead an inclusive government. He forced through a new constitution without proper consultation or broad support, and failed to address Egypt’s many economy and political problems. He deserved to be replaced, but doing so by military coup seriously harms Egypt and the entire Middle East in several ways. The failure of the Obama administration to acknowledge the act as a coup deprives the English language of any meaning.

Obviously it is a set back for democracy. Morsi’s growing opposition should have organized to defeat him in the next election. Given his miserable performance it shouldn’t have been difficult. That would have strengthened democracy rather than weakened it.  One coup begets another until a leader can coop the military.

The more serious harm is to the social and political conditions needed for diverse people (Muslims, Christians, secularists, Jews) to live peacefully together. What, pray tell, do the secularists and military think the Brotherhood and their supporters will do after being removed from their elected positions and arrested? Go sulk in the Old Cataract in Aswan (of which I have very fond memories)? There is a high probability that they will resort to violence. As the Army kills more and more demonstrating Morsi supporters, the prospects of an insurgency increase rapidly, as occurred in Iraq and so many other places.

It has already started. In Egypt’s Sinai Peninsula: “The rapid thud of machine-gun fire and the explosions of rocket-propelled grenades have begun to shatter the silence of the desert days and nights here with startling regularity, as militants assault the military and police forces stationed across this volatile territory that borders Israel and the Gaza Strip.” (The Washington Post, July 29, 2013, page 1) Hundreds have already been kill by the military or insurgents and the violence is growing rapidly. How could it be otherwise?

And it is spreading. Tunis has been the most promising model of transition to democracy. Following the assassination of two opposition leaders in Tunis, mass demonstrations have escalated into terrorist attacks that killed eight Tunisian solders Monday. President Moncef Marzouki, Tunisia’s moderate Islamist president, stated in a television address that “In all countries of the world, when the state faces a terrorist attack people come together. But I don’t see anything like that happening in Tunisia. All we see is divisions and chaos.”

U.S. law requires the administration to cut off aid to governments that came to power by coups. This is clearly the case in Egypt and aid should be immediately suspended. For decades U.S. aid to Egypt has ranged between 1.5 and 2 billion dollars per year, over 80% of which is to the military. Congress would surely quickly suspend this provision for Egypt but should attach conditions for any resumption of aid. These conditions should call for restraint on the part of the military, free and open public debate, quick elections, and broad participation in the redrafting of the constitution.

The already troubled Arab Spring has had a series set back.

Trayvon Martin and George Zimmerman Tragedy Update

Over a year ago I expressed confidence that our judicial process and public good will would clarify the facts of the tragic shooting death of Trayvon Martin by George Zimmerman:  https://wcoats.wordpress.com/2012/04/01/the-trayvan-martin-tragedy/. Indeed, after carefully listening to and weighing the evidence presented to it the six women jury rendered its unanimous verdict a week ago that Zimmerman had lawfully, but no less tragically, shot and killed Martin in self-defense and was therefore not guilty of the charges against him. At the time a year ago, the failure of local Florida law enforcement officials to arrest Zimmerman, a neighborhood watch volunteer, seemed to me and many others a potentially racially tinged judgment. I supported the call for his arrest. Once all of the obtainable facts had been presented and evaluated by the Jury that earlier decision turned out to be a sound professional judgment by the police. But I still think it was desirable to go through the process of this trial.

I did not follow the trial closely but have no reason to question the judgment of the jury. The utterly disgraceful misreporting and doctoring of the conversation between Zimmerman and the 911 dispatcher aired by NBC made it seem that Zimmerman might be racist in his reaction to Martin (a claim no one made during the trial because there is apparently no basis for it) tarnishing the professionalism of at least NBC. https://wcoats.wordpress.com/2012/04/03/the-trayvon-martin-tragedy-continues/.  Sadly the press has continued to reproduce the young, handsome picture of Martin and the thuggish picture of Zimmerman long after more neutral pictures became available.

The slanted reporting of the press is nothing, however, compared to the highly inappropriate statements from our increasingly discredited Attorney General, who suggested that the federal government was investigation the possibility of trying Zimmerman for civil rights violations for which no evidence was introduced in the just finished trail. But my heart stopped when President Obama chimed in that “Trayvon Martin could have been me 35 years ago.” How could the President of the United States join the cheap political babbling of Attorney General Holder? And thus I started this blog.

This is an example of how fragments out of context can be totally misleading. The President’s full statement yesterday, when he joined the White House press briefing unannounced, was quite the opposite of my impression from the news headline. President Obama has disappointed me on many things (promoting bigger government generally, higher taxes, expanding snooping on Americans, drone assassinations of Americans without trial, and poor leadership in general), but I have always found him an honest and thoughtful commenter on race issues. His statements yesterday were no exception. Zimmerman’s trial produced no evidence of racism in anything that happened that tragic night in Florida, but the President rightly noted that each of us carries impressions (“priors”), often from personal experience, that frame our views of the world and events and that it is better that we acknowledge them and open ourselves to an examination of the role they play in our everyday judgments. This was exactly the point I was trying to make a year ago, though Obama said it better. The President is right on this issue and an excessive political correctness has stifled this discussion for too long.