Category: Money

Discussion of John Tamny’s: Who Needs the Fed?

John concludes that we do not need the Fed because the Fed has become irrelevant. He argues that the interest rate “set” by the Fed is not relevant for the rest of the economy and that the Fed’s influence on bank credit is unimportant because not much credit comes from banks anymore, and that in any event the Fed can’t really control money and credit. While I think that John and I agree on many of the basic propositions that he sets out in his book, I disagree with many of his specific statements and with all of the propositions in my opening two sentences above.  To be blunt, John reveals a shocking lack of understanding of how the Fed and monetary policy more broadly work. The book has three Parts: Credit; Banking; and The Fed. I will set out my agreement with John on some important broad principles and then quote only a few of the many statements I disagree with.

For starters, John, Dan [Dan Mitchel, the moderator of this debate between John Tamny and myself at FreedomFest] and I all agree that it is what government spends that determines the resources it has taken from us and thus limiting that spending to the essentials is more important than cutting taxes. Of course how the government takes our incomes to finance its activities is also important. Some taxes are worse than others. On the other hand, it is surely not true that anything the government spends reduces the economy’s output. Government provided public safety, national security, and contract enforcement increase private economic output.

We agree that bailing out banks is bad for the health and efficiency of the banking sector.

We agree that failure of private sector firms that can’t make a profit and the market’s reallocation of those resources to better uses is good for economic efficiency and growth and rarely happens in government.

We agree that the market should determine the supply of money whose value is fixed to something tangible. But many of John’s statements suggest that he does not understand what the Feds does and what it is mandated to do. I will have a lot to say about this shortly.

Credit

The first of the books three parts is about Credit. When I get past some unusual usage of the word Credit to what I think is John’s fundamental point, I agree with him that those borrowing to invest in the real economy can only acquire and invest real resources. They cannot build factories, buy equipment, hire and organize workers with money created by the Fed, though a sound currency and efficient payment system lowers to the cost of connecting savers and investors. At the end of the day, real investment requires the saving and provision of real resources. This is what economists call the “neutrality of money, the idea that in the long run a change in the stock of money affects only nominal variables in the economy such as prices, wages, and exchange rates, with no effect on real variables, like employment, real GDP, and real consumption.” [Wikipedia] Unfortunately, throughout his book John fails to distinguish between real and nominal magnitudes.

John states this in several ways: “The Fed can’t create credit” [p. 4] However, it is not helpful when John defines credit as real resources when he means wealth or capital. Quoting him again: “Never forget that credit is the resources created in the actual economy.” [p. 26] And again: “Credit is just the name for real economic resources.” [p. 87] But near the end of his book he reverts to a more traditional definition of credit as a loan: “Credit is access to real economic resources.” [p. 178] There is a big difference between saying that credit “is real resources” and saying that it is “access to real resources.”

John talks a lot about what it takes for firms to attract funding of their activities. He provides many interesting examples of shifting credit risks in the economy and the credit market’s response in shifting resources away from higher risks to more promising uses, but these examples have nothing to do with monetary policy or the Fed. The Fed is not a credit institution. It does not allocate credit in the economy. The Fed is a monetary institution, whose job is to provide our currency and regulate its market value. John does not seem to understand the difference.

Banking

“It will never be a lack of money that fells Amazon [or any other company]. Only a lousy strategy will take it down.” [page 98] I sort of agree, but John then mistakenly applies this thinking to banks, which have a legal and business obligation to back all of their deposit and other liabilities with assets of equal or greater value, i.e. they must have positive capital. They must be solvent. John is mistaken to say that: “Because banks never simply run out of money, lack of investor patience is what causes them to file for bankruptcy.” [page 98] While banks can borrow when they are short of funds (credit in the usual sense of the word) as long as lenders and depositor think they are solvent, deposit and interbank funding runs can occur when depositors think the bank is not solvent. Solvency means having positive capital. Bank capital is difficult to assess because many of its assets are loans and it is not possible to know for sure how may of these loans will be repaid in the future. The real world, practical challenge with banks is to determine when they become insolvent as promptly as possible to prevent their continued borrowing and deposit taking as their capital hole grows so that most depositors and other creditors can be repaid when the bank is liquidated. A bank that continues to operate when insolvent is a ponzi scheme.

John correctly attack’s Murray Rothbard’s claim that fractional reserve banking is fraudulent. When banks lend out some or most of what we deposit with them—so called fractional reserve banking—they are doing exactly what they say they will. There is nothing fraudulent about it. It does make banks vulnerable to runs, however, which is why central banks are empowered to be lenders of last resort. John focuses his discussion on whether banks hold enough reserves (liquid deposits with the central bank and cash in their vaults) for unexpected deposit withdrawals and notes that any credit worthy bank can borrow what ever it need for this purpose from other banks. He says little about bank capital, however, which is the basis of whether a bank is credit worthy in the first place. If the market suspects that the bank has little or no capital, it will not lend to the bank.

John’s rejection of the broadly accepted proposition that banks multiple the money created by the central bank into a much larger quantity of bank deposits is completely wrong, as is his implicit rejection of the Chicago Plan of 100% reserve requirements by saying that “Banks can’t pay to stare at or warehouse dollars—they would quickly go out of business or be acquired—so logically they lend them.” [page 87]. Of course they can. If they are providing a valuable safekeeping and payment function, they can charge for it. Who remembers to old days when banks levied a service charge on demand deposits? Rather than focus exclusively on reserve requirements John should focus on the role of capital requirements for protecting depositor money. Positive capital means that the value of a bank’s assets exceeds its deposit and other liabilities.

John’s attempt to disprove the money multiplier fails to reflect or understand the intermediary nature of banks. They sit between the savers and the investors; between depositors and borrowers. He illustrates his claim with four friends at a table, one with a $100 who lends 90 to the next friend who lends ten percent of that to the next one and so on mimicking the standard text book explanation of the creation of money by banks. The correct game would have the friend with the $100 depositing it with the imaginary banker in the center of the table. The banker then lends $90 to the next friend by recording a deposit liability to the second friend of $90. The two friends between them now have $190 in deposits with the bank, which now lends $81 to the third friend by creating a $81 deposit for the third friend, etc. The example reflects a 10% reserve requirement. For some reason John doesn’t get this very real world phenomenon. The creation of deposit money by banks is only inflationary if their growth exceeds the growth of the public’s demand for them. It is forgivable if Joe six pack doesn’t understand the money multiplier by banks, but it is shocking for someone writing about the subject to failure so completely to understand it.

Banks are one of many financial intermediaries lending other peoples’ money, but they are the foundation of the payment system. Capital protects depositors’ money from the occasional non-performing loan made with those deposits. Historically virtually every country in the world bailed out insolvent banks rather than let depositors lose money. This created terrible moral hazard as John notes. Deposit insurance has improved the picture and the US has closed thousand of banks without serious disruption, but not the biggest ones viewed as too big to fail.

My recommendation is to separate the payment from the lending functions of banks, requiring 100 % reserves on demand and savings deposits, and requiring equity (capital) to finance bank lending and its other investments. Thus deposits and the payment system would be risk free and require very little further regulation.[1] The intermediated lending would be all equity financed, like a mutual fund investment, and require very little further regulation as well, as its investors would have total skin in the game and could take whatever amount of risk they wanted as they would reap the rewards or suffer the losses. Losses of loans and investments would no longer threaten bank deposits and the payment system. There would no longer be a need for the Lender of Last Resort function of the Fed or other central banks. This is the Chicago Plan put forth during the great depression by such notable economists as Irving Fisher, Frank H. Knight, Lloyd W. Mints, Henry Schultz, Henry C. Simons, Garfield V. Cox, Aaron Director, Paul H. Douglas, and Albert G. Hart.

The Fed

Most central banks these days have the legal mandate to regulate the supply of their currencies so as to keep its value stable— the so-called price stability mandate. The Fed has a problematic “dual mandate” of maximizing employment and stabilizing prices, which I will not discuss further here. There are several basic approaches to fulfilling this price stability mandate, ranging from fixing the price of the dollar to gold at one end of the spectrum to targeting inflation with market determined, i.e. freely floating, exchange rates at the other end. The policy debate is or should be about which of the rules for managing the money supply would be best for the U.S.

John says that “Friedman was the modern father of monetarism, a theory of money that says the central bank should closely regulate its supply.” [p 136] Friedman said no such thing.

Monetarism says that, like every other good, the value of money is determined by its supply and demand. The demand for money comes from the public and has been empirically related to their incomes. The supply is determined by the central bank in accordance with the policy rule it adopts. The gold standard was one such rule. A fixed monetary growth rate rule, once advocated by Friedman, is another. Inflation targeting, now in vogue, is yet another.

John makes a number of statements that suggest that he understands none of this. He says that: “Production is the source of money.” [p 136] We can make sense out of this strange statement if we change it to say that production is the source of the demand for money. Given that demand, monetarism says that the price or value of money (its purchasing power) will be determined by its supply and its supply will depend on the policy rule the central bank follows. If the Fed creates more money than the public wants to hold, people will spend the extra money. But as John and I agree, spending such money doesn’t create the goods people want to buy. Thus a money supply that exceeds its demand will drive up the prices of goods and services. That is the monetarist story of inflation.

John goes on to say that: “Friedman viewed inflation solely as a money-supply phenomenon. Inflation was a function of too much money, as opposed to a decline in the value of money.” [p 136] I can’t make sense of this strange statement. The statement that “inflation was a function of too much money” is a statement about the cause of inflation. The final clause of John’s statement says that: “inflation was a function of…a decline in the value of money.” But inflation is a decline in the value of money by definition. So what does John mean? His effort to explain why these are difference seems to concern the allocation of money around the country. He says: “money migrates to where production is.” Yes it goes to where it is demanded. John confuses the markets role in allocating credit around the country with the Fed’s role in controlling the aggregate supply of money. It is shocking that someone who writes regularly on this subject fails completely to understand its basics. I cannot find any evidence that John understands the basics of monetary theory of the supply and demand for money and its price, i.e., its value.

Another indicator of John’s confusion comes from the first Part of the book when he compares the Fed’s lowering the fed funds rate to Nixon fixing gasoline prices below the market price. Fixing the price of gas lower than the market price reduces its supply and increases its demand and produced long lines at gas stations in the hope of tanking up before the station runs out. But the Fed does not fix the fed funds rate; it sets a target for it. The difference is profound. The Federal funds rate is determined in the market by banks. When the Fed reduces its target for the Fed funds rate it increases its supply of liquidity to banks so that supply and demand force the interbank rate down. John repeats this fundamental misunderstanding throughout the book. In order to emphasize the importance of the distinction between fixing the Fed funds rate and targeting it, let me in Donald Trump fashion, repeat the point. The Fed does not fix the Fed funds rate. It enters the market as a buyer or seller of t-bills in order to increase or reduce the supply of bank reserves in order to stimulate the market to move the rate to the Fed’s target value.

John repeatedly describes the folly of the Fed trying to increase the money supply in Baltimore or Cincinnati to stimulate growth there, as markets will attract it away to healthier areas that demand it. He repeatedly discusses money as if it is credit. The Fed does almost no lending and then only to banks temporarily short of liquidity. When the Fed wants to lower the Fed funds rate in the market, it buys U.S. treasury bills from the market. The transactions (so called open market transactions) take place in New York but the sellers of these t-bills to the Fed are scattered all over the country and the newly created money is deposited in the sellers banks all around the country. John failures to reflect a basic understanding of how monetary policy works.

John’s misunderstanding of how the Fed operations is further illustrated in his following statements: “The Federal Reserve… proceeded to borrow reserves from the banking system so that it could buy trillions worth of U.S. Treasuries and mortgage back securities…. The Fed has credit to allocate only insofar as it extracts it from the real economy.” [p 149] This is completely wrong. The Fed supplied reserves to the banking system by buying Treasuries with money it created. Understanding this is absolutely fundamental to understanding what central banks do. John documents over and over again that he does not understand these basics.

John and I are both skeptical of the Fed’s ability to managing its monetary policy (the fed funds rate and/or the money supply) so as to smooth out business fluctuations while maintaining a stable value of the dollar. We both think that keeping short-term rates near zero for so long has been a mistake. In the long run, monetary policy determines the price level and its rate of inflation, not full employment and real income. John and I agree that the health of the economy, or its lack of it, is much more the result of stifling regulations, not monetary policy.

These suggest that the Fed would do better to adopt a different policy strategy or rule. John suggests that we can do away with banks and the Fed altogether, but says almost nothing about their replacements. I favor a supply of money determined by market demand whose value is fixed to a basket of goods. The Fed would supply currency under currency board rules whenever people wanted it and paid its official price and could redeem it at its official price, i.e. the market value of its valuation basket, if they had too much of it. In the case of the gold standard the only good in the valuation basket was gold, whose price is not as stable as would be a basket of goods. This proposal is discussed in my Real SDR Currency Board and other articles. Unfortunately you will not find John’s proposal for determining the money supply in his book.

John’s arguments that we do not need the Fed because it has no (or only negligible) affect on market interest rates and credit and because the Fed and banks cannot create money, are wrong. While interbank interest rates (the Fed funds rate) are a tiny fraction of all interest rates, market arbitrage insures that all interest rates are related to each other given the unique risks and characteristics of individual borrowers and classes of borrowers and of the appetites for risk of lenders. The Fed can and does “print money” expanding the currency held by the public and bank reserve deposits with the Fed (so called base money) and banks can and do multiply this base money into a much larger supply of money (currency and bank deposits) by lending it. While in the long run these activities of the Fed and banks only affect the value of money (inflation) with no affect on the real economy, they can and do have important real economy affects for good or ill in the short run. The question we need to answer is what monetary policy rules should the Fed adopt and follow in order to best fulfill its price stability and full employment mandate.

[1] “Changing direction on bank regulation” Cayman Financial Review, April 2015

Postscript

A few Booboos

“Housing is not investment…. Housing is consumption” [p 113]   Buying a house is an investment (it is a capital good). Living in or renting it is consumption.

“The Fed can’t create the credit that is economic resources” [p. 159] No but it can create money.

The Fed believes “that economic growth is the cause of inflation” [p. 159] Throughout John fails to distinguish real and nominal magnitudes (real exchange rate vs. nominal exchange rate; real interest rate vs. nominal interest rate; real income vs. Nominal income; real quantity of money vs. nominal quantity of money, etc.). Real economic growth with a constant money supply will cause deflation. Nominal economic growth when real income is constant is all inflation, etc.

“For those who still believe we need the Fed to keep a lid on the ‘money supply,’ what can’t be stressed enough is that our central bank cannot control that supply.” [p. 161] Not true.

References

Coats, Warren, 1982   “The SDR as a Means of Payment,” IMF Staff Papers, Vol. 29, No. 3 (September 1982) (reprinted in Spanish in Centro de Estudios Monetarios Latinoamericanos Boletin, Vol. XXIX, Numero 4, Julio–Agosto de 1983).

1983, “The SDR as a Means of Payment, Response to Colin, van den Boogaerde, and Kennen,” IMF Staff Papers, Vol. 30, No. 3 (September 1983).

2009, “Time for a New Global Currency?” New Global Studies: Vol. 3: Issue.1, Article 5. (2009).

2011, “Real SDR Currency Board”, Central Banking Journal XXII.2 (2011), also available at http://works.bepress.com/warren_coats/25

2014, “Implementing a Real SDR Currency Board”

_____. Dongsheng Di, and Yuxaun Zhao, 2016, Why the World needs a Reserve Asset with a Hard Anchor, http://works.bepress.com/warren_coats/34/

 

 

A Modest Proposal—Helicopter Money and Pension Reform

It is possible to fix the bankrupt Social Security System and the Federal Reserve’s failure to achieve its inflation target painlessly. Yes, really.

The Fed has failed to raise inflation to its 2% target because over regulated banks can’t find over regulated firms wanting to borrow and invest. As a result, the increases in the Fed’s base money from its Quantitative Easing and other efforts to stimulate the economy has piled up as bank excess reserve deposits at the Federal Reserve Banks.[1] If the Fed pushes too hard (e.g., by lowering the interest it pays on these bank reserves, potentially even to negative levels) it feeds asset price bubbles (stock and housing prices), which do great damage when they burst.[2] If the Fed just printed more money and sprinkled it around to the general public—what Milton Friedman called helicopter money—there is no doubt that the public would spend more and drive up prices.

Leaving aside whether it is really a good idea to create a steady 2% rate of inflation, there is an easy way of doing it that would also facilitate badly needed reform of the government’s retirement system. Contrary to the myth that our Social Security pensions reflect what we paid in (saved) to the system, Social Security pension payments are now fully pay as you go. This means that the revenue from payroll taxes approximately matches the outflow for current pensions, i.e. nothing is being saved for the future. As our population continues to age and the number of retired pensioners increases relative to the shrinking number of workers paying into the system, the modest amounts that have been accumulated in the Social Security “Trust Fund” will be drawn down to zero in about 15 years at which time the government will not be able to meet existing promises.[3]

The following proposal combines helicopter money sufficient to bring the inflation rate to its target with badly needed reform of our government pension system. Under this proposal all individuals will receive a minimum government guaranteed pension for life whether they paid in anything or not. This might be implemented as part of a Friedman like negative income tax and other badly needed tax reforms,[4] or stand alone. Before retirement, individuals who are working but with incomes below the poverty level (to be politically established) will not pay a wage tax as they do now. The subsequent pensions of such people will be paid with helicopter money (the Federal Reserve will print the money to buy government bonds sufficient to finance these expenditures). All workers with incomes above the poverty level will be required (as they are now) to set aside the amount of income needed to finance their minimum guaranteed pension on a fully funded basis. They are free to save more if they would like a higher pension. The funds set aside must be invested in government licensed and approved private pension funds chosen by each worker rather than in the almost fictitious Social Security Trust Fund.

This would establish the three pillars of good pension policy proposed by the World Bank in 1998: a means tested minimum pension financed by the government’s general revenue, a mandatory minimum pension paid for and privately invested by all working individuals, and additional, optional, supplemental retirement saving privately invested. Such a model was first adopted in Chile over 35 years ago with great success. Central and Eastern European countries have adopted similar models as part of their transition from centrally planned to market based economies. Financing income subsidies to the poor from general revenues (via printing money), and a user fee approach to mandatory saving (mandatory saving matched to the actuarial value of the pension received), conforms more closely to the principles of good tax policy.[5] The alternative sometimes proposed of raising the income cap on the payroll tax is closer to general revenue financing (if the government guaranteed minimum is only paid to the poor), but leaves out non-wage income and thus fails the good tax criteria.

As new workers would be truly saving for retirement, their savings would not be available to finance those currently retired, as is now the case with our pay as you go system. Thus transitional arrangements will be needed (for several decades) to deal with existing unfunded promises. If the promises remain unchanged, the money to pay for them will have to come from somewhere (higher taxes or reduced defense or other expenditures). Usually, in such cases the government spreads the burden around (burden sharing). Two simple and sensible changes to the current promises would absorb the greater part of the shortfall. The first is to adjust the pensionable retirement age to the fact that the average person lives much longer than when the current retirement ages were fixed. People are living longer and can (and most would like to and do) work longer. The other is to change the index to people’s pensions from a wage index (which generally increases pensions in real terms over time) to the cost of living (CPI), which would preserve their real value against any inflation over time.

For today, this means that the wage tax on the poor would be abolished and paid for with new Fed money that would thus be put in the hands of those who would spend it, increasing employment (though we are really at full employment now) and/or wages and prices. It would both raise inflation a bit and launch a genuine, long over due pension reform.

[1] “US Monetary Policy–QE3” Cayman Financial Review, January 2013

[2] “The D E Fs of the Financial Markets Crisis” CATO Institute, September 26, 2008.

[3] https://wcoats.wordpress.com/2008/08/28/saving-social-security/

[4] http://www.compasscayman.com/cfr/2009/07/07/US-federal-tax-policy/

[5] http://www.compasscayman.com/cfr/2013/07/12/The-principles-of-tax-reform/

The Asian Infrastructure Investment Bank and the SDR

By Warren Coats and Dongsheng Di

Jin Liqun, President of the new Asian Infrastructure Investment Bank (AIIB) announced on January 17, 2016 that all of its loans would be in U.S. dollars, “signaling that Beijing will not use the development bank as a platform to promote renminbi internationalization.”[1] In this note we argue that the AIIB should make all of its loans in SDRs. Doing so would make a major contribution to promoting the replacement/supplementation of the U.S. dollar for international payments that was called for by People’s Bank of China’s Governor, Zhou Xiaochuan in 2009.[2] As the SDR valuation basket will include the Chinese renminbi after October 1, 2016[3] it will also contribute, but more modestly, to the international use of the renmimbi.[4]

As the AIIB is a Chinese initiative and is headquartered in China, it was initially thought by some that its operations would be denominated in RMB. However, denominating its loans in RMB and actually disbursing RMB would suffer several disadvantages for the AIIB and for its loan recipients. There was concern by some that the use of the RMB might further strain the already complicated US-China bilateral relationship. In might also force the pace of China’s financial and capital account liberalization faster than other conditions warrant. Moreover, with greater exchange rate volatility of late, loan recipients would be exposed to greater exchange rate risk. The AIIB’s choice of the U.S. dollar avoids these risks but continues to subject its borrows to exchange risks associate with the dollar, which has varied considerably over the years. For these reasons the IMF, for example, denominates its loans and other financial operations in its Special Drawing Right (SDR), whose value is based on the market value of specific amounts of the five freely useable currencies in its valuation basket.[5] Thus for most countries, the international value of the SDR is more stabile than is the value of the dollar or another of the other currencies in its valuation basket. This logic applies fully to the operations of the AIIB and other development banks. The case for creating “private” SDRs to disburse to AIIB loan recipients rests on the contribution it would make toward developing the SDR issued by the IMF into a global reserve asset to supplement or replace the U.S. dollar, Euro and other national currencies in countries foreign exchange reserves.

The development and use of private SDRs, SDR denominated bank liabilities, is described in detail in an article one of us wrote over thirty four years ago in the IMF Staff Papers.[6] The AIIB would establish SDR denominated deposits with its bank (e.g., the BIS) and instruct its loan recipients to establish SDR accounts with their banks. AIIB loans would be disbursed by transferring the appropriate amounts of its SDR balances at the BIS to the recipients’ account at its banks. The dollar value of these SDRs would be determined in the same way as is the IMF’s official SDR. Following the procedures used by the IMF when disbursing its SDR denominated loans, recipients could request to receive their loans in the equivalent value of a freely usable currency of their choice (or in any or all of the five currencies in the valuation basket). In the first instance, AIIB loan recipients are likely to be governments with accounts in their central banks. Thus these central banks would need, in addition to their SDR accounts with the IMF, to establish (private) SDR accounts for their governments and commercial banks. If the loan recipient is able to spend these SDRs (pay its contractors and suppliers) directly it would do so, but most often it would need to exchange them for the currency wanted the ultimate recipients. This exchange would most likely be executed by its bank providing the SDR deposit.

Cross border private SDRs payments would be cleared and settled in the same general way as are U.S. dollar payments. Net outflows of SDRs from the banks of one country via their central bank to another country via its central bank, would be settled by the transfer of official SDRs on the books of the SDR Department of the IMF. Alternative clearinghouse arrangements are also possible has suggested by Peter Kennan in his comments on the 1982 IMF Staff Papers article. When such loans are repaid, if the repaying government (or other loan recipient) doesn’t have sufficient balances in its private SDR account with its central bank to transfer to the AIIB’s account with the BIS it would use other currencies to buy additional private SDRs. It might also use its official IMF allocated SDRs to either buy private ones or to transfer directly to the AIIB (assuming that like most other development banks and the BIS it has become an “other holder” of official SDRs). Private and official SDRs would have essentially the same relationship with each other as do base money and bank money in national currencies.

China and the AIIB are in a strong position, working through the IMF or bilateral discussions, to urge central banks to open private SDR accounts for their governments and their commercial banks toward the fulfillment of their obligation under the IMF’s Articles of Agreement to make the SDR “the principal reserve asset in the international monetary system” (IMF Article XXII). Through their representatives at the World Bank, Asian Development Bank, and their New BRICS Development Bank they could press these institutions to disburse in SDRs (private and/or official) as well. As an important purchaser of oil and other globally traded commodities they could encourage their pricing in SDRs. In the first instance, many loan recipients would choose to convert their SDRs into one or more of its basket currencies. But as private SDRs and supporting clearing and settlement arrangements proliferated, holding and using SDRs for international transactions would become more convenient and would potentially grow rapidly. This is an opportunity that should not be missed.

References

Coats, Warren, 1982   “The SDR as a Means of Payment,” IMF Staff Papers, Vol. 29, No. 3 (September 1982) (reprinted in Spanish in Centro de Estudios Monetarios Latinoamericanos Boletin, Vol. XXIX, Numero 4, Julio–Agosto de 1983).

1983, “The SDR as a Means of Payment, Response to Colin, van den Boogaerde, and Kennen,” IMF Staff Papers, Vol. 30, No. 3 (September 1983).

2009, “Time for a New Global Currency?” New Global Studies: Vol. 3: Issue.1, Article 5. (2009).

2011, “Real SDR Currency Board”, Central Banking Journal XXII.2 (2011), also available at http://works.bepress.com/warren_coats/25

2014, “Implementing a Real SDR Currency Board”

_____. Dongsheng Di, and Yuxaun Zhao, 2016, Why the World needs a Reserve Asset with a Hard Anchor, http://works.bepress.com/warren_coats/34/

Footnotes

Dr. Warren Coats retired from the International Monetary Fund in 2003 where he led technical assistance missions to more than twenty countries (including Afghanistan, Bosnia, Egypt, Iraq, Kenya, Serbia, Turkey, and Zimbabwe). He was Chief of the SDR Division of the Finance Department from 1982-88. His PhD from the University of Chicago was supervised by Milton Friedman. He was part of the IMF’s program team for Afghanistan from 2010-2013 and is a U.S. citizen. Wcoats@aol.com

Dr. Dongsheng DI is an associate professor of International Political Economy with School of International Studies, Renmin University of China and also a Research fellow with International Monetary Institute of RUC. In 2015 he is a visiting researcher at Edmund A. Walsh School of Foreign Service of Georgetown University. His research interests include the political economy of global monetary affairs, RMB internationalization, and Chinese Domestic Reforms. He is also a policy advisor to NDRC and China Development Bank and is a citizen of the People’s Republic of China. didongsheng@vip.sina.com

[1] China’s New Asia Development Bank will lend in US dollars, Financial Times Jan 17, 2016 http://www.ft.com/intl/cms/s/0/762ce968-bcee-11e5-a8c6-deeeb63d6d4b.html#axzz3xWiTvQZD

[2] Zhou Xiaochuan, “Reform the International Monetary System”, Website of the People’s Bank of China, March 23, 2009;

[3] The amount of the China currency in the SDR valuation basket will be determined on September 30, 2016 such that its weight in the basket on that day is 10.92% of the total value of one SDR.

[4] Banks offering SDR denominated deposits will generally balance them with SDR denominated assets or assets in the five currencies in the SDR’s valuation basket similarly weighted.

[5] The RMB will be added to the existing basket of four currencies—USD, Euro, GBP, JPY—from October 1, 2016.

[6] Warren Coats, “The SDR as a Means of Payment,” IMF Staff Papers, Vol. 29, No. 3 (September 1982); “The SDR as a Means of Payment, Response to Colin, van den Boogaerde, and Kennen,” IMF Staff Papers, Vol. 30, No. 3 (September 1983).

The Cayman Financial Review

I have three articles in the latest issue of the quarterly Cayman Financial Review, on whose editorial board I serve. The first is the Letter from the Editorial Board, which explores my thoughts on restoring more market discipline of bank risk taking rather than piling on more government regulations: http://www.compasscayman.com/cfr/2015/04/22/Changing-direction-on-bank-regulation/ The second is the second installment of The Kabul Bank Scandal series, http://www.compasscayman.com/cfr/2015/04/22/The-Kabulbank-Scandal–Part-II/   And the third is my review of Martin Wolf’s new book, “Shifts and Shocks.”   http://www.compasscayman.com/cfr/2015/04/22/%E2%80%9CThe-Shifts-and-the-Shocks%E2%80%9D-by-Martin-Wolf/ If any of these topics interest you please click on its link.

Economics Lesson: Is deflation bad?

Fortunately the key insights about inflation or deflation are fairly intuitive and easy to understand. Stable prices—i.e., zero inflation—is best, fully anticipated inflation (or deflation) is second best, and inflation/deflation surprises are bad. If you would like a bit more detail, read on.

Inflation refers to the rate at which the value of money (average prices usually measure by a consumer price index—CPI) changes over time. Zero inflation, constant purchasing power of a currency over time in its local market (e.g. the value of the US dollar in the US), is best because all of the other factors impacting the supply and demand for individual goods that potentially change their prices relative to other goods and services can be expressed in terms of a constant unit account, a constant measuring rod. This makes comparing prices stated in that unit of account, especially over time, much easier. Imagine if the length or weight of something had to be expressed in units of weights and measure that themselves were always changing. Economic resources are better allocated to the satisfaction of public demand when the relative scarcity of each good and service can be clearly discerned. Decisions about the allocation of resources (whether to build a new factory to produce a new product or more of an old one and/or to hire more workers, etc.) are necessarily forward looking. The entrepreneurs’ question is what will people pay for something next year and the year after and what will it cost to produce it and how does this compare with producing something else. This is more difficult to do when the forecast of prices need to mix in the changing value of the currency in which they are stated.

However, a decent second best is a rate of inflation (positive or negative) that is steady and predictable. The inflation target of 2 percent chosen by many central banks, if reliably achieved, provides an example. If the inflation rate is fully and correctly anticipated, whether positive or negative, all other relative prices, including interest rates and wage contracts, can and will take the anticipated rate into account when setting prices in contracts for the future (e.g., a wage contract). If borrowers and lenders are willing to contract for a loan for five years at 3% per year with zero inflation in the value of the money borrowed and repaid, they would both be willing to undertake the same loan at 5% if they both expected inflation of 2% per year over those five years. If that expectation were rather uncertain, a suitable risk premium would need to be added to the interest rate. If everyone expected with certainty a 2% deflation over the same period, the loan would carry a 1% nominal rate. In both of these examples, the so-called real rate of interest—the rate adjusted for inflation—would be 3%. Thus, modest deflation does no harm if everyone fully and correctly anticipates it.

As an aside for the more advanced students, Milton Friedman explained why a fully anticipated, mild deflation was actually good because it would reduce or eliminate the opportunity cost of holding money and thus encourage people to hold larger cash balances on average without any cost to themselves or society. The money we hold in our wallets or nightstands or in our checking accounts at the bank is like any other inventory of goods that shop keepers keep on their shelves. Without an adequate inventory of what they sell, they would occasionally run out and miss some potential sales. But it cost money to hold an inventory of something. The cost can be measured by the interest you could have earned investing the money you spent to acquire the inventory (called “opportunity cost” by economists), plus any storage costs. Deflation reduces the opportunity cost of holding money by generating a real return from holding it (it is worth more in the future).

Unanticipated inflation, however, is bad because contracts written in dollar terms (so called “nominal” terms) will turn out to have a different real value than was expected. Normally a voluntary contract benefits both parties to it; it is win win. But when the inflation outcome was not anticipated, it will produce unexpected winners and losers. Debtors benefit from unanticipated inflation and creditors lose. More to the point in our current, over indebted environment, a deflation that was not anticipated when the money was borrowed, will increase the real value of the money that must be repaid. Lenders will benefit from the unexpected windfall only if borrowers actually repay their loans. But the unexpected increase in the real value of the debt being repaid may result in a larger number of defaults. So central banks are trying to avoid deflation, or more accurately are trying to achieve their inflation targets (generally 2%) in order to avoid making the economy’s excessive indebtedness even worse.

The above discussion concerns the value of a currency in its own country. But given the very extensive commerce across borders and the fact that most countries use their own currencies, cross border payments require exchanging one currency for the other. If the exchange rates of all currencies were fixed and never changed, the above analysis would apply globally as well. However, the exchange rates of many currencies, such as the USD/Euro rate, vary continuously and sometimes very significantly. The USD/Euro rate has fallen (i.e., the dollar has appreciated) 30% in the last 12 months (on April 9, 2015). This represents an enormous and very disruptive shock to the value of US trade with Europe, increasing the cost of our exports and reducing the cost of imports from Europe by very large, unpredicted amounts. Following the collapse of the gold standard, which fixed the exchange rates of most currencies, in the early 1970s, a costly financial market of insurance against exchange rate movements has developed. The total daily value of FX related transactions (spot, forwards, swaps, options) are estimated at around 4 trillion US dollars. Yes, that is daily and yes, that is trillions. These added costs of international trade would be eliminated if all or most countries returned to credibly fixed exchange rates or better still one globally used currency. The enormous gains in the standard of living from this trade could be extended even further.

The world is now “blessed” with a variety of monetary policy regimes. All of them aim in one way or another to deliver stable value for their currency either domestically or relative to another currency. The major industrial countries generally target inflation domestically and allow the exchange rates of their currency to float against other currencies. Many smaller countries fix or target the exchange rate of their currency to the US dollar or the Euro or the IMF’s Special Drawing Rights (SDR) thus causing the domestic values of their currencies to reflect the inflation rates of the currency to which they are fixed.

Two major reforms would establish a global monetary system with stable money (zero inflation). The first would be to change the IMF’s international reserve asset, the SDR, from a currency whose value is determined by a basket of key currencies (the USD, Euro, UK pound, and Japanese Yen) and allocated on the basis of political decisions, to a currency whose value is determined by a basket of real goods that is issued on the basis of market demand in accordance with currency board rules. These reforms are explained in more detail in earlier articles such as https://wcoats.wordpress.com/2010/01/21/the-u-s-dollar-and-the-sdr-as-international-reserve-currencies/ and https://wcoats.wordpress.com/2013/07/31/a-hard-anchor-for-the-dollar/. The above reforms in the SDR would include an international agreement to replace the US dollar and Euro in international pricing and payments with the reformed SDR, which I call the Real SDR.  http://works.bepress.com/warren_coats/25/

The second reform would follow naturally given the greater stability of the Real SDR. Countries would fix the exchange rate of their national currencies to the Real SDR or replace them all together with the Real SDR (the equivalent of dollarization). If all or most countries did this, the world would enjoy the benefits described above of a global currency with a completely predictable and stable value relative to a “typical household consumption basket” across the globe. It is worth fighting for.

Ukraine Monetary Regime Options

On March 12th I participated in the Emergency Economic Summit for Ukraine in Kyiv. The summit was organized by Tom Palmer (Atlas Foundation) and Dalibor Rohac (Cato Institute) and several Ukrainian free market think tanks. My charge was to evaluate monetary policy regime options. The following paper prepared for this meeting and published in the current issue of the Cayman Financial Review,  presents my assessment. If, like most people, you are not interested in monetary policy issues, you should skip this paper:  http://www.compasscayman.com/cfr/2014/04/07/The-future-of-Ukraine-%E2%80%93-and-the-role-of-sound-money/

President Putin’s welcome to Crimea

Anyone interested in current events in Ukraine should read Russian President Putin’s address to the Russian people on March 18, 2014 welcoming Crimea back into Russia: “Putin’s speech on Crimea”. It is very clever in playing to the insecurities of the Russian people while also speaking to the international community. Putin says many things we can hardly disagree with along with (and often packed in) some amazing lies and some embarrassing truths.

Here is one example of the former: “I would like to reiterate that I understand those who came out on Maidan with peaceful slogans against corruption, inefficient state management and poverty. The right to peaceful protest, democratic procedures and elections exist for the sole purpose of replacing the authorities that do not satisfy the people. However, those who stood behind the latest events in Ukraine had a different agenda: they were preparing yet another government takeover; they wanted to seize power and would stop short of nothing. They resorted to terror, murder and riots. Nationalists, neo-Nazis, Russophobes and anti-Semites executed this coup. They continue to set the tone in Ukraine to this day.” Perhaps Putin’s virtual shut down of a free press in Russia has kept the Russian people from knowing of his suppression of political opposition there. Or perhaps he thought that the recent release from prison of Mikhail Khodorkovsky (after over ten years of political incarceration) and Pussy Riot demonstrated that the “right to peaceful protest” was alive and well in Putin’s Russia. His statement that the murder of over 100 Maidan demonstrators was at their own hand is just a bald faced lie.

Examples of embarrassing truths include President Obama’s pledge not to bomb Libya. Quoting Stephen Cohen, a professor emeritus at New York University and Princeton University, on the Charlie Rose show:  “The United States said to Russia, support of the United Nations’ [authorization of] a no-fly zone over Libya so that Gaddafi can’t take his planes up and attack the insurgents.  Russia said, so it’s just a no-fly zone?  You’re not going to bomb Gaddafi?  [But] we did and it led to his assassination. From that moment on, Putin never trusted anything that came out of the White House.”

I had intended to start the previous paragraph with the often repeated claim that, to quote former U.S. defense secretary Robert McNamara, ‘‘the United States pledged never to expand NATO eastward if Moscow would agree to the unification of Germany.’’ According to this view, ‘‘the Clinton administration reneged on that commitment when it decided to expand NATO to Eastern Europe.’’ Quoted in Mark Kramer: TWQ article on Germany and NATO. Recently available documentary evidence cited by Kramer clearly refutes this “myth.”

I want to share an account of a famous meeting I attended in Tashkent on May 20-21, 1992. The account was written by me many years ago but never shared until now. It presents the truth of another mini lie in Putin’s speech contained in the following passage:

“The USSR fell apart. Things developed so swiftly that few people realized how truly dramatic those events and their consequences would be. Many people both in Russia and in Ukraine, as well as in other republics hoped that the Commonwealth of Independent States that was created at the time would become the new common form of statehood. They were told that there would be a single currency, a single economic space, joint armed forces; however, all this remained empty promises, while the big country was gone.” The following account reveals just how committed Russia was to “a single currency” for the newly independent Former Soviet Republics.

Tashkent, May 20 1992

A.   Background: Monetary Babylon

The sudden formation of 15 central banks out of Gosbank in the Former Soviet Union created a strange and ultimately unsustainable situation. One monetary system suddenly had 15 suppliers of “rubles.” The ruble banknotes supplied by the new Central Bank of Russia (they were initially the USSR ruble notes that had already been printed by the Central Bank of the USSR) were issued in their respective areas by each of the 15 FSU central banks. In addition, ruble deposits with banks where used in payments throughout the entire FSU region using the settlement accounts each bank maintained with its newly independent central bank. When payment orders from FSU republics outside Russia began piling up at the Central Bank of Russia in Moscow, we were forced to start sorting out what was wrong with the “system.”

Initially the payment system continued to function as it had previously under Gosbank. The system was decentralized. All that was needed under that system was to verify that the sender (payer) had sufficient funds in its account with its bank. As there was only one bank in the Soviet system, Gosbank, there was no issue of the sender’s bank having enough money in its “settlement” account. All deposit transfer payments were in effect “on us” (i.e., intrabank transfers). Thus a valid payment order could be and was safely accepted at which ever branch or office of Gosbank it was delivered to (the one closest to the recipient of the payment). However, with the introduction of a two tiered banking system several years earlier, the adequacy of a depositor’s bank’s settlement account with the central bank potentially became important.

In early 1992 we were confused by the system being described to us. It was very difficult for us to understand how it really worked. Our counterparts who were explaining the system to us, either didn’t really understand the system either or understood it in terms of its functioning in monobank days. On top of this, the system we were trying to understand was being described to us in Russian and then being translated into English for us by interpreters with no real knowledge of the subject they were interpreting.

Under the old, inherited system, a payment order was sent directly from the central bank branch office used by the sender to the central bank branch office used by the receiver. We were concerned with the potential for credit creation by overdrafts that seemed to be automatically generated when payment orders were accepted wherever they landed without being able to verify the sending bank’s settlement balance with its respective central bank. Bruce Summers of the Federal Reserve Bank of Richmond, complained that each of the fifteen central banks created out of Gosbank needed to centralize the information on account balances if they were to avoid accepting payment orders that might result in overdrafts. Furthermore, something was needed to ensure that net payments among the fifteen central banks did not result in unauthorized overdrafts.

In a series of quick steps, the Central Bank of Russia centralized all incoming payment orders from FSU payers outside of Russia in its Regional Branches and ultimately in Moscow. Furthermore, payment orders that had earlier been sent directly from the Gosbank office servicing the payer to the Gosbank office serving the payee, were now redirected to the new central bank of the republic of the payer, which forwarded it to Moscow (if the payee was somewhere in Russia). Quite aside from whether the bank of the payer had sufficient settlement funds, the sheer volume of payment orders now directed to Moscow overwhelmed the CBR staff there. The time for processing cross border ruble payments was measured in months.

In addition, no one seemed to know the terms under which the CBR supplied its ruble bank notes to the new FSU central banks. Under the inherited system, banknotes were shipped from the mints to the regional branches and offices of Gosbank as needed. They were issued to enterprises against debits to the enterprises’ account balances with the central bank or as credits to the enterprises. The rest was just internal bookkeeping. This arrangement continued for a while until the new FSU central banks began to realize that they were no longer part of the new central Central Bank of Russia and would need to pay for the banknotes of the CBR.

I remember being told by bewildered staff of the National Bank of Kazakhstan and National Bank of Kyrgyzstan that of course the CBR would continue sending banknotes when needed because they always had. And why should they “charge” for them as they had never charged for them before. And indeed, the CBR did continue to send their banknotes for a while and no one knew what the terms for providing them was or might be. This was new territory for everyone and no one seemed to understand exactly where the system was going or how it should work.

As almost all of the new republics had a balance of payments deficit with Russia, the settlement accounts of their new central banks with the CBR in Moscow were always over drawn. The CBR periodically extended credits to these FSU central banks in order to put the overdraft credits on a more explicit basis. But in fact, as the whole process was not really understood and the CBR’s policy not yet really established, the terms of these credits were often unspecified for many months after the fact. Russia seemed to use the undefined terms for political leverage. More politically cooperative Republics negotiated better terms than others.

Resolving the settlement problem was further complicated by the fact that the system was not designed to produce up-to-date account balances. I remember when our accounting expert, Alan Vedren Lacohm from the Bank of France, reported to me that the central bank did not seem to know the current balances of the deposits banks held with it. As hard as it was for him to believe or understand, the central bank seemed to maintain separate debit and credit accounts that were only compared and balanced once a year. An enterprise could issue payment orders against its account on the basis of a central plan authorization. It didn’t matter if it had enough money in its combined debit and credit accounts, and in fact no one really knew whether it had a positive balance or not. This astounding fact mystified us because we were seeing it from the prospective of the systems familiar to us designed for market economies. When we came to understand that the Soviet system, obviously designed to serve a centrally planned economy, was really a budget tracking tool, we suddenly understood its logic. None-the-less, it would not work for a market economy. (Alan later married my assistant after they met on my second mission to Kazakhstan and Kyrgyzstan)

When a bank did not have sufficient balances in its settlement account at the central bank, the central bank could extend it credit to permit payment settlement to proceed. However, such credit did not help when “rubles” were being transferred from Kazakhstan (for example) to Russia. The National Bank of Kazakhstan could not extend credit to its own account with the CBR. The system was designed to work with one central bank and it continued to operate throughout the ruble area as if it still had one central bank when it in fact had 15. The fact that the CBR more or less automatically extended credit to the other FSU central banks and supplied them with what ever ruble bank notes they needed (a very soft budget—balance of payments—constraint), encouraged the FSU central banks to create ruble credit at an ever increasing rate.

B.   A Blue print for monetary union

The emerging system was not viable. The USSR had been one economic and monetary space. With its break up, the ruble continued to circulate and to be used for payment through out the entire area. In the case of bank notes, a ruble was a ruble (until new versions were introduced later in the year and in 1993). But in the case of deposit rubles, 15 central banks now issued them. And they continued to be transferred from one account to another as if they were one currency in one system. As we more fully appreciated later, the ruble area of 1992 consisted of one cash ruble and 15 different non cash rubles. Each central bank was issuing its own ruble credits. A ruble claim on the National Bank of Kazakhstan was not the same as a ruble claim on the CBR even though they had the same name.

If an FSU central bank was going to create credit as it saw fit, it would need to introduce its own currency (bank notes as well as central bank account money). If an FSU republic wished to continue using the “traditional” ruble, it’s monetary policy would need to be subordinated to or coordinated with that of the CBR and any other central banks that remained a part of the ruble system. We developed a set of rules for central bank cooperation within a ruble area that we thought would be needed to make the system coherent and stable and invited the governors of all 15 FSU central banks to a meeting to discuss them. The meeting took place in Tashkent on May 20 and 21 following a heads of state meeting there as part of the Russian effort to organize the Commonwealth of Independent States (CIS).

This meeting was preceded by building tensions between the CBR and most of the other FSU central banks as they raced to out do one another in creating ruble credit and as payment orders piled up in Moscow. The situation was further complicated by conflicting signals from Moscow. Depending on who was speaking on any given day, Russia seemed to support the introduction by the FSU republics of their own currencies (thus leaving the ruble area) or the surrender of monetary autonomy to the CBR. Either of these Russian positions was coherent. Our own proposal was meant to provide coherence and central, but collective, control of monetary policy (along the lines of the subsequent ECB), without full surrender to the CBR (These can be found in IMF [Occasional Paper 51]). The Russian terms for staying in the ruble area were cleaner, but because they required complete subservience to the CBR, we felt they would drive out (into their own currencies) even those countries that wanted to stay in a ruble area.

After helping to develop the guidelines to be discussed, I attended the meeting. Other IMF staff attending where Malcomb Knight (later the Sr. Deputy Governor of the Bank of Canada and the General Manager and CEO of the BIS), John Oling-Smee (head of the IMF’s newly established European II Department consisting of the FSU countries), Ernesto Hernadus Catan and Ishan Kapur (both from the IMF’s European I Department). Most of us met in Geneva in order to take a charter flight on May 19. We stopped in Moscow on the way to pick up Ernesto. May 19, 1992 happened to be my 50th birthday. We celebrated on the plane with a bottle of Dom Perignon. It was a memorable birthday.

We were met at the airport in Tashkent by the Deputy Prime Minister. A caravan of three Chaikas and several police cars took us to the compound in which we would stay and our meeting would be held. It was 10:00 pm when we arrived and a formal welcoming dinner had regrettably been planned that required our attendance.

Following the dinner, sometime after midnight, I slept moderately well, despite my excitement, because I was so tired. We had no idea what the current Russian position on use of the Russian ruble would be. It had been changing back and forth in the work up to these meetings almost daily. Clearly views within the Russian hierarchy were divided. Relations between Russian and most of the FSU republics had grown increasingly tense. No one trusted anyone. I had found trying to understand the existing monetary arrangements and working out principles that could make it work intellectually very challenging and interesting. I was filled with excitement and anticipation to hear the reactions of the delegates.

The meeting on the 20th was opened by the Prime Minister, Abdulhashim Mutalov, and the Governor of the State Bank of Uzbekistan. The substantive part of the meeting, which was attended by the Governors of most of the FSU central banks and the Deputy Governors of the rest, was led by John [Odling-Smee]. After a general introduction of the purpose of the guidelines, we proceeded through the sixteen points one after the other. Questions were raised by one chair or another to clarify some of the points. The general suspicion that the IMF would take the Russian position gradually melted (this was helped by the fact that we had fielded technical assistance missions to all of the FSU central banks by then and established the beginnings of relationships of trust). Very few political statements were made and everyone kept glancing at the Russian chair trying to read their position. The Russian Chair, headed by Governor Georgy Matyukhin, said nothing at all that day. It seemed that Russia was not going to challenge our proposal, which was enthusiastically supported by all of the other central banks. At the conclusion of the day it was agreed that a communiqué signed by each of the fifteen governments would be prepared that would set out the sixteen points.

Following the long day’s meetings, we were taken in a long police escorted motorcade to a lake on the outskirts of Tashkent for a celebratory banquet. Our banquet tables were on a large wooden pontoon floating at the edge of the lake. By that time I knew the routine (toasts from each governor, lots of food and lots of vodka). Between the 15 central bank representatives, Uzbek/Tashkent government representatives, and our group, there were a guaranteed minimum of 18 toasts. And indeed, we exceed the minimum. My routine of minimal sips was again subverted by yet another Russian woman sitting across the table. Nothing but “bottoms up” was acceptable. The spirit of the group was exuberant. Each toast became more friendly and gushier than the one before it. Governor’s who were barely willing to speak to each other in the morning had become the best of friends—brothers (“comrades” was no longer a forbidden term).

We arrived back at our compound around midnight. Galinda, our translator from Washington went to work translating the draft communiqué into Russian. John had asked me to be ready to respond the next morning to any questions about inter-enterprise arrears. I started down the hall to my room to brush up on my potential presentation and the First Deputy Governor of the State Bank of Kazakhstan (Mr. Tadjeokof) grabbed me and insisted that I join him in his room for another drink. I had met him two months earlier in Alma Ata (now called Almaty) during my first mission to Kazakhstan. He wished, it seemed, to thank me for our technical assistance and to explain how much they needed lots more. Mr. Tadjiokof did not speak English and I do not speak Russian (or Kazakh), but we proceeded to speak to each other and to lift our glasses of Vodka and toast whatever warm words had been said.

I had assumed that Mr. Tadjiokof had wanted company for another drink, but he persisted in efforts to communicate. It was only possible to go on as if we understood each other for a limited time. I was soon forced to seek help from one of our interpreters. Galinda agreed to suspend her translations of the draft communiqué to interpret for us. Several toasts late, I had second thoughts about the seriousness of Mr. Tajiokof’s communications, which remained focused on his gratitude for our assistance. Galinda was complaining that she needed to return to her work on the communiqué. I was beginning to lose patience and focus. As Galinda left, I spotted Ernesto in the hall. He had been taking Russian lessons and agreed to practice on Mr. Tadjiokof. It was 3:00 am and I stagger off to my bed.

I awoke a few hours later still fully dressed where I had fallen on the bed. I had one of the worst hangovers I can remember. I had serious doubts that I could clearly explain the interrelationships between inter-enterprise arrears and monetary policy. I wanted to sleep for a few more days. But the meeting resumed. No one raised the issue of inter-enterprise arrears thank God. The Russians remained silent. The text of the communiqué was agreed on and the Uzbek hosts agreed to obtain the signatures of the fifteen FSU republics.

The communiqué was never issued nor heard of again. The Russian’s had quietly killed it. In the end, Russia required each FSU republic to choose subordination to the CBT or to introduce their own currency. All but Tajikistan chose the latter. Within several months the Baltic states introduced their own currency and one year later Kyrgyzstan became the first FSU country beyond the Baltics to introduce its own currency. Most of the rest followed before the end of 1993 and the ruble crisis came to an end. Inflation in 1992 is thought to have been several thousand percent dropping to 875% in 1993 and 307% in 1994.

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The quiet disappearance of the central bank cooperation communiqué is reminiscent of the mysterious disappearance of President Yanukovych on February 22, 2014, one day after signing an EU brokered truce with opposition leaders following two days of the worst violence between demonstrators and police in 70 years in which almost 100 were killed. According to witnesses in the room, Yanukovych only agreed to sign the agreement after being instructed to do so by President Putin in a phone call during the meeting. The agreement has not been heard of since. Though Yanukovych was removed from office by an overwhelming vote of the Ukrainian Parliament on February 22, Putin and Yanukovych called it a coup.

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.