Econ 101: The Value of Money

During a discussion of Bitcoin with friends, it became clear to me that it might be helpful if I explained some fundamentals of how the value of money is determined. Like most everything else, money’s value is ultimately determined by its supply and demand.

Demand for money reflects the public’s need to keep an inventory of it in order to use it for making payments.  Bitcoin are generally held as a speculative asset rather than for payments as almost no one will accept them in payment. “Cryptocurrencies-the bitcoin phenomena”

The supply of money is determined by those who created it, generally central banks. Generally central banks issue their currency, thus increasing its supply, by lending it (generally to banks) or by buying assets, generally their government’s debt.  When anyone holding that currency no longer wants it and has the right to redeem it, the central bank takes it back in exchange for the asset it purchased in the first place, thus reducing the money supply.  Under the gold standard, currency was redeemed for gold.  The rules governing a central bank’s issuing and redeeming its currency defines the nature of its monetary regime.  That is the topic of this econ 101 lesson.

As none of us has ever redeemed our currency, it is understandable that my friends confused spending their money with redeeming it.  Spending it transfers it to someone else without changing its supply, while redeeming it reduces its supply.  Cryptocurrencies add a new category to our discussion of money.  As noted by “a billionaire hedge-fund manager… cryptocurrencies are a ‘limited supply of nothing.’”  “Crypto skeptics growing”

As discussed further below, the supply of Bitcoin increases slowly and steadily over time as determined by an unchangeable formula and Bitcoin cannot be redeemed for anything.  The U.S. dollar and virtually every other national currency in the world grow at more erratic rates as determined by their issuing central banks.  So what makes the value of the dollar relatively stable over long periods of time?  The fall in its value by about 8% over the last month is nothing compared to bitcoin’s fall of 23% over the same period and over 50% over the last half year.  Over the past 15 years the dollar’s value has declined less than 2% each year.  Unlike Bitcoin, dollars are widely accepted for payments that are denominated in dollars, including our taxes, and thus held (demanded) to make such payments.  Almost no Bitcoins are held to make payments as almost no one will accept them for payments.  But I want to focus on a currency’s supply.

There are fundamentally three broad approaches to determining the supply of a currency.  Historically, the supply of most currencies were determined by fixing their price to what they could be redeemed for, such as gold or silver. I have called such a system for regulating money’s supply, a hard anchor. “Real SDR Currency Board”  The value of a currency can be fixed (the price set) to something real such as gold or a basket of goods.  A country with a strict gold standard, which the U.S. never really had, issues its currency (dollars) whenever anyone wants to pay the fixed gold price for more of them.  If the dollar price of gold in the market rises above its official price, there would be an arbitrage profit from buying gold from the central bank at its lower official price.  Such gold could be resold in the market at the higher price.  But the key point is that this mechanism (what I call currency board rules) of redeeming currency reduces its supply and thus reduces prices in this currency in the market (deflation).  Several of the monetary systems I helped establish, work in this way (Bulgaria and Bosnia and Herzegovina). “One Currency for Bosnia”

The most common system of monetary control today is for the central bank to determine its currency’s supply by buying or selling it in the market (the Federal Reserve can buy treasury bills, etc. to increase the supply of dollars).  Most central banks today adjust their money supplies in an effort to achieve an inflation target (a much more complicated subject). “Czech National Bank: Inflation Targeting in Transition Economies”  Generally they do so by setting an intermediate target for a short-term interest at which market participants (banks) can borrow from the central bank.  Such fiat currencies, such as the U.S. dollar, are not redeemable but are widely accepted in payment for goods, services and debts.

This brings us to Bitcoin.  The supply of Bitcoin is determined by a formula that predetermines its gradual growth to 21 million by 2140.  There are currently about 19 million in existence.  The supply is increased by giving them to successful miners for verifying the legitimacy of each transaction (another complicated subject).  Thus, the issuer (the formula) received services (protection against double spending the same coin) but no assets such as gold or treasury bills for creating and issuing new Bitcoins.  Once created, an issued bitcoin can never be redeemed (i.e. the outstanding supply can never be reduced).  When you spend or give away your Bitcoins you are circulating them to other holders, not redeeming them.

When my imaginary aunt Sally discusses Bitcoin and cryptocurrencies more generally, she tends to mix up the marvelous new payment technologies for paying my dollars all over the world with private money such as Bitcoin and Tether.  She also doesn’t seem to quite understand that most money has always been privately produced including the U.S. dollars that we spend in various ways (occasionally even by handing over cash).  “A shift in monetary regimes”

But these distinctions are critical when considering what role the government should play in our monetary system.  The truly amazing technical progress we have experienced and the dramatic increase in the standard of living of the average person it has delivered over the last century was made possible by a government that provided a general framework in which we, the consuming beneficiaries of this progress, could make informed choices.  Our government, wisely, generally did not make such decisions for use.

With that in mind consider “a letter addressed to Senate Majority Leader Charles E. Schumer (D-N.Y.), Senate Minority Leader Mitch McConnell (R-Ky.), House Speaker Nancy Pelosi (D-Calif.) and other congressional leaders, [from 26 influential technology personalities that] outlined what it described as potentially grave dangers of cryptocurrencies.” They are absolutely correct to expose and condemn the technical and economic weaknesses of blockchain technology—the distributed ledger with which Bitcoin claims to avoid the need for trusted third parties to record and document payment transaction (as happens on a centralized ledger when you pay from your bank deposit). 

But the fact that foolish people invest in Bitcoin and other cryptocurrencies does not justify our government prohibiting and restricting them from doing so.  The government requires the banks in which we put our money to publish properly audited financial statements of the assets backing our deposits and to set minimum capital requirements to protect against the possible loss of bank asset value (e.g., loan defaults).  Cryptocurrencies claiming redeemability at a stable value (so called stable coins) should similarly be required to disclose the rules by which they operate and the composition and value of the assets backing their digital coins.  In short, government regulations should help us decide what we want to buy and/or hold without restricting the ability of fintech pioneers to explore and innovate products to offer.

Overly restrictive regulations create incentives for incumbents to create barriers to competition.  Large and intrusive governments tend toward corruption.  The Federal Reserve System seems quite aware of these risks as it cautiously explores whether to compete with the private sector in developing a central bank digital currency.  “Econ 101-Central  Bank digital currency-CBDC”

So when considering the government’s role in money and payments be sure to clearly distinguish money from payment technology and limit government to setting the rules of the game that maximize the ability of private consumers to make wise choices. But perhaps the biggest policy decision of all is how the government should determine/regulate the supply of its currency, most of which is privately created.  I support a currency whose value is fixed to something real (a hard anchor) and whose supply is determined by the market via currency board rules.  “A libertarian money”  

A Libertarian Money

The long history of money began to take its modern form with the development of national central banks. “The story of central banking goes back at least to the seventeenth century, to the founding of the first institution recognized as a central bank, the Swedish Riksbank. Established in 1668 as a joint stock bank, it was chartered to lend the government funds and to act as a clearing house for commerce. A few decades later (1694), the most famous central bank of the era, the Bank of England, was founded also as a joint stock company to purchase government debt.”[1] Over time central banks were given a monopoly over issuing their country’s currency and usually for regulating the country’s banks, which create most of each country’s money.

Generally, the currencies issued by central banks (or commercial banks) were claims on, and thus redeemable for, gold or silver. The gold standard oversaw a long period of trade expansion and economic flourishing. A currency’s fixed price for gold regulated the money supply both domestically and between other countries also on the gold standard, keeping its supply consistent with the fixed gold price. Countries, like individual families, cannot buy more that they sell over their live time (whatever the lifetime of a country might be). The gold standard, via the price-specie flow mechanism, preserved such balance of trade between gold standard countries.

Two countries on the gold standard, with fixed prices for gold for their currencies, have an unchangeably fixed exchange rate for their two currencies. But if the domestic purchasing power of each currency changes (inflation or deflation) the real value of the nominal exchange rate will appreciate or depreciate. The real exchange rate adjusts via changes in the domestic prices of one country relative to the other.  If a country buys more abroad than it sells abroad, the outflow of its money to pay for its trade deficit will reduce its money supply if gold standard rules are observed (gold flows out and the supply of currency backed by that gold contracts). The reduction in its money supply will reduce domestic (and thus foreign) prices in that money. This adjustment in domestic prices relative to foreign prices, which make foreign goods relatively more expensive domestically and domestic goods cheaper abroad, will reduce and eventually eliminated the trade deficit.

When the United States established the Federal Reserve System, its central bank, in 1913, it continued to fix the price of the currency it issued in gold. But it only adhered to gold stand rules loosely and in 1971 no longer had enough gold to honor its commitment to foreign central banks to redeem its currency for gold. Thus, on August 15, 1971, President Richard Nixon “closed the gold window.” The era of the value of currencies anchored by (fixed to) gold or some other hard anchor was over. The Federal Reserve and other central banks needed to develop other criteria for determining the supply of their currencies.

Following the inflationary experience in the U.S. in the 1960s and 70s, there were more and more demands for clear rules for the Fed’s regulation of is money supply, now that it was no longer constrained by a hard anchor (e.g., the price of gold). The objective of monetary policy was broadly accepted around the world to provide a stable value for the currency, though the Federal Reserve was shackled with the dual mandate of price stability and maximum employment. The short-term demand for money was not sufficiently stable for a Friedman rule (fixed growth rate for base, narrow, or broad money – M0, M1, or M2). Inflation forecast targeting (IFT) has evolved to become the state of the art of fiat money supply rules.

In IFT regimes, the central banks’ policy instruments (primarily the interest rate at which it lends to banks) are transparently set on the expectation (based on model forecasts and judgement) that in one to two years in the future they will produce (or maintain) the central bank’s target for inflation. While this approach has performed relatively well, its management of the money supply has been far from perfect and central banks are experiencing increasing government pressure to relax their price stability mandates. And then there are a few countries whose central banks have caved to fiscal dominance and behaved terribly.

Would some cryptocurrency, ala Hayek, provide a better monetary system? Some people claim that libertarians like cryptocurrencies like bitcoin because they do not rely in any way on government. Perhaps those people meant “anarchists” because libertarians accept the critical importance of government in defining and protecting property rights and personal safety. Cryptocurrency providers have been lobbying the U.S. congress (and others) to set out the rules for their legal operations. Are they money or speculative assets?  Bitcoin and most other cryptocurrencies do not satisfy the requirements for a good libertarian money because they do not satisfy the requirements for good money. This article explains why this is so and defines properties of a good libertarian money.

Are Cryptocurrencies the Answer?

Economists note the incredible power of markets and market prices in directing our scarce resources (our labor, capital, and technology) to their best uses. But prices are expressed in terms of money, the common unit of account that facilitates comparing relative values.

The presumption, and actual reality, is that within each market prices are expressed in terms of the same money. It would not facilitate our choices if apples were priced at $6 per bushel and oranges at 3 bitcoin per bag. Presently, virtually nothing is priced in bitcoin. In addition, sellers don’t generally accept payment in a currency other than the one in which the good’s price is expressed, thus very few sellers will accept bitcoin in payment. Moreover, you can only accept bitcoin in payment if you have a bitcoin account together with the software required (a bitcoin wallet).

None of these are insurmountable barriers to growth in the use of bitcoins or other cryptocurrencies, but they do require strong incentives for putting up with and/or overcoming them. I explained the basics of bitcoin’s value in the linked blog in 2014: “Cryptocurrencies-the bitcoin phenomena”[2] One incentive would be to replace the established currency in a market (a country’s legal tender) that has very unstable value (think Zimbabwe, Venezuela, Argentina, Brazil at various times in their histories). Another would be the need for anonymity (as is achieved with paper currency) that an illegal drug dealer or a political dissident in a repressive regime might require and find convenient.

Some mistook Fredrick Hayek’s “Competition in Currency” as an endorsement of what we now call cryptocurrencies. In the Preface to that book Arthur Seldon explained “The requirement is not to deprive government of the power to issue money but to deny it the exclusive right to do so and to force the citizenry to use it at the price it specifies. It is thus the government monopoly of money that is objectionable, and history is full of examples of governments that have attempted to enforce their power by extreme measures, including the ultimate sanction of death. The solution is therefore to allow people to use the money they find most convenient, whether the money issued by their own government or by other governments.”[3]

When the Zimbabwean dollar became worthless, reaching annual inflation rates of 10,000 percent in 2007 and exploding in 2008 with an estimated peaked rate in September 2008 of about 500 billion percent per annum, the Zimbabwean government legalized the use of foreign currencies and the country immediately dollarized (priced and paid in U.S. dollars flown in from South Africa). This was the remedy Hayek proposed and it ended inflation almost instantly.[4]

Later in 1976 Hayek followed up his Competition in Currency proposal with the more radical broadening to private currencies in his AEI pamphlet Denationalization of Money, An Analysis of the Theory and Practice of Concurrent Currencies.[5] Most money these days is privately produced by your and my banks (our deposits), but they are fixed in value to and ultimately exchangeable for the U.S. dollars created by our central bank. They are part of the U.S. dollar money supply. Bank deposits are not alternative, private units of account. In this second book Hayek was broadening his call for currency competition to the bitcoins of the world. Hayek was proposing that inflating central bank currencies should face competition from privately produced units of account and monetary assets (medium of exchange and payment).

Otmar Issing, Chief Economist of the ECB and member of its Executive Board from 1998 – 2006, concluded that adopting Hayek’s proposal “We would ‘discover’ that private currency competition – at least nowadays – would not work and would not serve the people affected.”[6] I made the same point to Hayek directly in a debate at the 1976 Mont Pelerin Society meetings in St. Andrews, Scotland. Competing private units of account would undermine an essential function of money in market economies (communicating the relative value of things). In high inflation countries, such as Venezuela, many things are priced in U.S. dollars. However, the Venezuelan government has made payments in dollars illegal. In such cases, Bitcoin and other cryptocurrencies are used to some extent to make dollar denominated payments. But as the value of Bitcoin is so unstable, holding on to then is very risky.

In El Salvador, which had successfully dealt with inflation by dollarizing a decade ago, President Nayib Bukele added Bitcoin as legal tender as of September 7, 2021. Though this legally obliges merchants to accept Bitcoin in payment, “few ordinary folk use…. Bitcoin, which has lost 70% of its value since November, is far too volatile to be a good store of value, especially in a country where GDP per person is $4,400.” according to a June 16, 2022, article in The Economist.[7] No one prices in Bitcoin.

Cryptocurrencies that use a Block Chain or Distributed Ledger Technology suffer from other problems as well. Bitcoin’s claim to eliminate the trusted third party (bank accounting systems) required by existing electronic (digital) payments with bank deposits, is particularly attractive to libertarians.  But this claim is a gross exaggeration. To prevent the double spending of the same bitcoin, each transaction must be verified by so called miners (third parties you don’t need to trust) which takes five to ten minutes and very large amounts of electricity to process as miners race to solve increasingly difficult mathematical puzzles. Also, all transactions are very public on block chains, though accounts may be held under pseudonyms and are thus described as pseudo-anonymous.

Though actual bitcoin transactions have been made easier via the development of software wallets, many assign their bitcoins to exchanges (trusted third parties).[8]  The loss of a bitcoin owner’s password to his account is fatal and final. Those bitcoins are lost forever. But more deadly to the use of bitcoin as money (unit of account and medium of payment) is the volatility of its value.  The price of a bitcoin has ranged from just under $30,000 to over $67,500 over the last year. It fell to $18,958 on June 18, 2022. Thus, payments of bitcoin generally involve temporarily purchasing them with dollars or some other stable currency and then exchanging them back to dollars as quickly as possible after receipt. The costs of these exchanges are often overlooked when claiming that bitcoin transfers are cheaper than traditional means of electronic payments. Of equal importance is that for an asset to function as money, it must be generally or at least broadly accepted for payments. Bitcoin fails this requirement miserably. Most buyers and sellers of bitcoin are indulging in a form of gambling rather seeking a “good” medium of payment.

Bloomberg exposes a false “libertarian” attraction to Cryptocurrencies on blockchains:

“An app running on, say, Ethereum, can’t easily be taken offline, since there’s no particular host or entity that can take it down.

“This architecture is inherently oppositional to governments and large corporations, and it’s for this reason that crypto has so much embedded politics. The whole space traces its roots back decades to hippies and hackers in Northern California, who anticipated that in an online world, pure cash-like peer-to-peer transactions would be impossible. When you pay a friend using Zelle or something, the payment goes through a series of intermediaries. You can get kicked off Venmo for buying a Cuban sandwich. Bitcoin can’t kick you off the network for anything.

“Take away the uncensorability of crypto, and all you’re left with is Ponzi schemes, dog coins, and drawings of monkeys. (Wait! That’s basically all that exists right now in the space, so ignore that thought.)”[9]

Unlike bitcoin, which are not redeemable for anything, so called stable coins have a fixed price for some other legal tender currency or even, potential, gold. The quality of the assurance of a stable price, and redemption at that price, vary considerably. Appropriate regulation that required transparency and external audit would be good. But the payment technology that has emerged in recent years such as PayPal, Venmo, or Zelle to transfer U.S. dollars (claims on bank accounts and ultimately on the Federal Reserve) have already introduced efficient, low cost, and fast payments of legal tender currency. The Federal Reserve is also modernizing its interbank settlement system. FedNow, which will operate real time 24/7 began testing in September and is expected to be operational in the summer of 2023. It is hard to see any further advantages introduced by so called stable coins.

The Libertarian Alternative

There are monetary regimes, however, that satisfy libertarian preferences for minimal government involvement and manipulation while satisfying truly valuable needs. The Constitution of the United States provides the authority for such a regime in Article I Section 8 “To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures;” The classical gold standard was such a system. However, its “rules” were diluted when taken over by central banks. Moreover, the practice of actually buying and storing gold distorted its market price and was costly, flaws that are avoided in the system I propose below.

In the U.S. today, as well as every other country in the world, there are thousands of private companies that create and offer their own currency. Most of them are banks. While that would seem to make libertarians happy, thousands of individual bank producers of money would not constitute an efficient monetary system without rules and mechanisms for linking them into what we think of as one currency–in our case the U.S. dollar.

While the dollars deposited in my bank are my bank’s liability, I am protected from the bank’s failure by deposit insurance. Your bank accepts my deposits in my bank because my bank credits your bank’s account with the Federal Reserve (by debiting its account with the Fed). In short, the deposits at thousands of different banks are accepted by every other bank because they are all ultimately claims on the Fed. This is similar to the gold standard in which the money created by thousands of banks were accepted everywhere because they were redeemable for a well-defined amount of gold.

Libertarians want a currency and monetary system that can’t be manipulated by the government (central bank).  The dollar is now a fiat currency, redeemable for a deposit with the Federal Reserve, and very importantly, acceptable by the government for the payment of taxes. Thus, its supply is determined by the Fed’s judgement of what is needed for “price stability and maximum sustainable employment.” We libertarians want a currency that we each individually control the supply of. In short, we want a currency with a hard anchor (which was the case for the gold standard) supplied according to currency board rules (which historically were violated by central banks nominally anchored by gold).

Currency board rules require the currency issuer to sell or repurchase its currency at its fixed price in response to public demand. Any number of private producers of dollars redeemable at an officially fixed price for a well-defined anchor (gold, aluminium, a basket of goods, etc.) would result in a money supply determined by the public that was consistent with and appropriate for its fixed price to the anchor and that was fully interchangeable. The central bank would be passive. It would have no monetary policy (beyond the fixed price for the anchor). This seems like libertarian heaven.

In addition to being anchored to a single commodity whose relative price could vary more than would the price of a basket (portfolio) of commodities, the gold standard was flawed by central banks actually buying and storing gold and thus distorting its market price. An ideal regime would use the anchor for setting the currency’s issue and redemption price but the anchor itself would not be purchased and stored by the central bank. Instead, the central bank would issue its currency for assets (such as treasury bills) of equivalent market value to the anchor. The arbitrage mechanism works just as well with this “indirect redeemability”[10]

I led the IMF teams that established the Central Bank of Bosnia and Herzegovina, which follows currency board rules. I have written a book about that experience.[11]  I also participated in Bulgaria’s central bank’s adoption of currency board rules. The currencies of both countries are anchored to the Euro and their currency experiences have been outstanding. Their money supplies are basically regulated by market arbitrage. If the market exchange rate of the Bulgarian lev to the Euro rises above its official rate, it would be cheaper for the banks that issue lev to buy Euros from the Bulgarian National Bank thus reducing the supply of lev in the market and lowering its market price for Euro. See my article on Bulgaria’s experience.[12]

A Libertarian International Reserve Currency

What about cross border payments? In brief, cross border transactors have found it economical to price and settle transactions in a vehicle currency, usually the US dollar. The increasingly frequent deployment of sanctions enforced by restricting the use of the dollar has intensified the search for alternatives. See my more detailed discussion in “The Empire and the Dollar”[13]  The search for alternatives to the dollar as proposed by Russia’s Sergey Glazyev[14] risks fragmenting the global market place.

The International Monetary Fund has already created such an alternative. An internationally established unit (anchor) is much less likely to be abused for national political purposes, but the IMF’s Special Drawing Right (SDR) suffers from some serious defects. However, these can be fixed.[15] [16]  

The SDR can be “fixed” in two stages. The first is to develop the private sector’s uses of the SDR unit of account (invoicing oil and other globally traded commodities in SDRs, borrowing and lending denominated in SDRs, SDR bonds and bills, and digital SDR deposits–eSDRs). See my more detailed discussion in “Proposal for an IMF Staff Executive Board Paper on Promoting Market SDRs.”[17] As with national currencies, where hundreds of individual producers of the national currency are made interchangeable by being claims on the central bank, the market SDRs of many competitive producers would be interchangeable as the result of being redeemable for the official SDR of the IMF.[18]

The second stage would require a reform of the IMF’s official SDR. Rather than allocating them from time to time to all IMF members, they should be issued according to currency board rules. In addition, the valuation of the official SDR should be changed from its current basket of five currencies to a small basket of homogeneous, globally traded commodities. The IMF’s existing rules for periodically adjusting the SDR’s valuation basket are transparent and appropriate and should continue to be used. In one sense, this would re-establish an improved international gold standard like system. It would be improved on the gold standard by replacing a single commodity anchor with a small portfolio of commodities and its supply would be improved by adopting the market driven rules of a currency board. Such a Real SDR issued by the IMF would bring to international payments the same hard anchor and currency board rules favored by libertarians for domestic currencies.[19]


[1] Michael D. Bordo, “A Brief History of Central Banks” Federal Reserve Bank of Cleveland, Dec 2007 https://core.ac.uk/download/pdf/6670255.pdf

[2] Warren Coats: “Cryptocurrencies—the Bitcoin Phenomena,” Feb 14, 2014, https://wcoats.blog/2014/01/25/cryptocurrencies-the-bitcoin-phenomena/

[3] F. A. Hayek: Competition in Currency, A way to stop inflation, The Institute of Economic Affairs, Feb 1976, London

[4] Warren Coats: “Hyperinflation in Zimbabwe” Jan 25, 2014, https://wcoats.blog/2009/05/29/hyperinflation-in-zimbabwe/

[5] F. A. Hayek: Denationalization of Money The Institute of Economic Affairs Oct 1968 London

[6] Otmar Issing: “Hayek’s Suggestion for Currency Competition: A Central Banker’s View,” Chapter 8 of Stephen F. Frowen (editor): Hayek: Economist and Social Philosopher, A Critical Retrospect, Macmillan Press, 1997, London

[7] The Economist, “El-Salvador’s Government is Gambling on Bitcoin” June 16, 2022. https://www.economist.com/the-americas/2022/06/16/el-salvadors-government-is-gambling-on-bitcoin

[8] Warren Coats: “The Future of Bitcoin Exchanges, March 3, 2014,
  https://wcoats.blog/2014/03/03/the-future-of-bitcoin-exchanges/

[9] Bloomberg: https://www.bloomberg.com/news/newsletters/2022-08-18/five-things-you-need-to-know-to-start-your day?cmpid=BBD081822_MKT&utm_medium=email&utm_source=newsletter&utm_term=220818&utm_campaign=markets  Aug 18, 2022

[10] R. L. Greenfield and L. B. Yeager, 1983, “A Laissez Faire Approach to Monetary Stability”, Journal of Money, Credit, and Banking 15: 302-15.

[11] Warren Coats, 2007: “One Currency for Bosnia – Creating the Central Bank of Bosnia and Herzegovina” Jameson Books, Chicago Ill.   https://wcoats.blog/2008/08/13/one-currency-for-bosnia-creating-the-central-bank-of-bosnia-and-herzegovina/ or  “Amazon– One Currency for Bosnia”

[12] Warren Coats: “Bulgaria and the Chicago Plan” Central Banking Vol. XXX Issue 3 (2020)
Available at: http://works.bepress.com/warren_coats/51/

[13] Warren Coats, “The Empire and the Dollar”, John Hopkins Institute for Applied Economics, Global Health, and the Study of Business Enterprise, Studies in Applied Economics, SAE./No.207/March, 2022, https://www.dropbox.com/s/7bnvejb5zhqzatj/The-Empire-and-the-Dollar-by-Warren-Coats.pdf?dl=0

[14] Pepe Escabar, “Exclusive: Russia’s Sergey Glazyev introduces the new global financial system” The Cradle April 14, 2022

[15] Warren Coats. “Time for a New Global Currency?” New Global Studies Vol. 3 Iss. 1 (2010)
Available at: http://works.bepress.com/warren_coats/1/

[16] Warren Coats, Dongsheng Di and Yuxuan Zhao. “Why the World needs a Reserve Asset with a Hard Anchor” Frontiers of Economics in China (2017)
Available at: http://works.bepress.com/warren_coats/34/

[17] Warren Coats: “Proposal for an IMF Staff Executive Board Paper on Promoting Market SDRs” The Bretton Woods Committee Feb 19, 2019 :  “Promoting Market SDRs”

[18] Warren Coats: “Real SDR Currency Board” Central Banking Journal Vol. XXII Iss. 2 (2011)
Available at: http://works.bepress.com/warren_coats/25/

[19] Warren Coats. “Free Banking in the Digital Age” Banking & Finance Law Review Vol. 33 Iss. 3 (2018) p. 415 – 421 ISSN: 0832-8722 Available at: http://works.bepress.com/warren_coats/45/

The Empire and the Dollar

Committee for the Republic Salon

March 24, 2022

Warren Coats[1]

In our multicurrency world, the U.S. dollar is widely used for pricing internationally traded goods, for international payments, and for denominating the assets governments and companies hold as reserves. Why is that and what are its implications for U.S. behavior? What would a better system look like?

In a world of many different national currencies, the payment for international trade has found economy in using an intermediate, so-called vehicle currency to facilitate the exchange of the buyer’s currency into and delivery of the seller’s currency. Following the collapse in 1971 of the dollar-based gold exchange standard overseen by the International Monetary Fund, the dollar continues to dominate in this role. This role has given the United States important political power and financial benefits.

I will quickly review these benefits, and how they have come to encourage the U.S. to exploit them in exercising its international power, the forces that are building to seek an alternative, and the potential for the IMF’s Special Drawing Rights (SDRs) to provide an alternative.

The Dollar’s International Reserve Status

Cross border commerce and investments require a common currency to price and denominate them and the mechanisms for cross border payments. While modern technologies continue to increase the speed and ease and lower the cost of domestic payments of domestic currencies, cross border payments remain relatively slow and costly.

The payment and receipt of a currency is ultimately reflected/settled on the books of that currency’s issuer. If I pay you for something and your account is in a different bank than mine, the transfer of funds from my bank to your bank and to you will pass through a Federal Reserve Bank. My bank’s account at the Fed will be debited and yours will be credited.  A fundamental difference between national and international currencies is that the central bank issuers of national currencies only hold deposits for banks that are domestically licensed, while the issuers of international currencies, such as the Special Drawing Right (SDR) of the International Monetary Fund, hold deposits from banks almost anywhere in the world, enabling the settlement of their payments to enjoy the efficiencies of domestic payments in domestic currencies.

The older gold standard functioned more like an international central bank issuer of currencies but without such an international central bank. Instead, national currencies were tied to gold by virtue of the commitment of central banks on the gold standard to redeem their currency for gold at a fixed price. Thus, any net flow of payments from one country to another was ultimately settled by transferring the ownership of the gold it was fixed to from the deficit to the surplus country. This could occur by debiting the deficit country’s gold account at the New York Federal Reserve Bank and crediting the surplus country’s gold account at the same place or by physically shipping the gold.

In today’s world, cross border payments generally involve the need to exchange one currency for another at exchange rates that fluctuate. To facilitate the comparison of prices of globally traded goods (e.g., oil, gold, copper, and other commodities) they are generally priced in one common currency. The U.S. dollar is the currency most widely used for this purpose (79%). This contributes to the use of the dollar for cross boarder payments as well even when the buyer’s currency differs from the seller’s ultimate currency (the currency paid to its workers, etc.). https://www.federalreserve.gov/econres/notes/feds-notes/the-international-role-of-the-u-s-dollar-20211006.htm

Some economy is brought to the markets for foreign exchange needed for cross boarder payments by using a common so called vehicle currency as a common go between. The adoption by airlines of a hub and spoke model for connecting all airports in a country or the world illustrates the economy of a single or small number of vehicle currencies (hubs) to exchange currency X for currency Y. The U.S. dollar is the most widely used vehicle currency for this purpose. This is supported by and reflected in the dominance of the dollar in invoicing internationally traded goods and in the foreign exchange reserves of banks (central and commercial) around the world. The Euro is the second most used currency in these ways.

In 2021 40.5% of international payments were made in US dollars.  The use of Euros in international payments and in reserves has moved up to second place behind the dollar at 36.7% of payments.  The Pound sterling is a distant third at 5.9%. Having passed the Japanese yen a few years back for fourth place the Chinese RMB achieved 3.2% of international payments in January of this year from almost zero a decade ago. “China’s currency scores a win during the Olympics”  The Federal Reserve has constructed an “aggregate index of international currency usage.” The dollar has remained in the neighborhood of 70% for the last two decades. https://www.federalreserve.gov/econres/notes/feds-notes/the-international-role-of-the-u-s-dollar-20211006.htm

To pay for things with a currency, one must hold some amount of that currency. It is this demand for dollar reserves resulting from the widespread international invoicing and payments in dollars, that underlies foreign financing of US debt. For starters, about half of dollar currency (actual banknotes) are held abroad. That is the extent to which we pay for imports with cash and the sellers just hold the cash. Foreign central banks hold almost 13 trillion dollars in foreign exchange reserves of which over 7 trillion is in U.S. dollars (much of that is held in the form of US government debt). About 60% of the foreign currency claims of banks are dollar claims.

The dollar grew into its vehicle and reserve currency roles because of the size of the U.S. economy and its extensive trade with the rest of the world, the size and liquidity of financial assets denominated in dollars, public confidence in the stability of the dollar’s purchasing power, and in its trusted contract enforcement (rule of law).

U.S. Benefits from reserve currency status

The so-called exorbitant privilege of a reserve currency–the ability to borrow abroad in your own currency–makes it easier for the U.S. government to finance its military and other expenditures with debt. For countries to accumulate dollar reserves they must have a balance of payments surplus, i.e., they must sell more to the U.S. than they buy from the U.S.. As a result, American’s enjoy cheaper imports and the excess of dollars paid for such imports over those paid back for US exports are held in foreign reserves (generally in the form of US treasury debt).

As an aside, it is simply wrong to attribute much of the so-called offshoring of our manufacturing to the above phenomenon. The somewhat lower exchange rate for the dollar needed to generate the surplus China and other countries need for the trade surplus with which they buy American debt, does make imports somewhat cheaper. However, even if the dollar was totally replaced in foreign reserves and trade balanced, we would continue to be better off producing what we export and importing what China and the others produce and sell to us. Freely pursuing our comparative advantages increases our incomes and the incomes of the Chinese and others selling to us. Free trade is win-win. Contrary to the myth, U.S. manufacturing is at an all-time high. (Manufacturing employment is lower because of increased labor productivity). https://www.macrotrends.net/countries/USA/united-states/manufacturing-output

The U.S. dollar’s dominance in global trade and finance contributes to the existence of the American Empire in two ways. It attracts foreign financing of the U.S. government and its military industrial complex thus reducing the burden of the empire on the American taxpayer and it provides a tool by which the U.S. can impose its will on other countries or individuals in managing its empire. Borrowing to pay our government’s bills is politically easier than raising taxes and avoids (or delays) a debate over guns versus butter. 

Three factors now challenge the dollars reserve currency role. 1) Cumbersome payment technology: Existing arrangements for cross border payments via the Society for Worldwide Interbank Financial Telecommunication (SWIFT) are technically crude and outmoded. 2) Weaponization of the dollar: The U.S. has abused the importance of its currency for cross border payments to force compliance with its policy preferences not always shared by other countries, by threatening to block the use of the dollar. 3) Growing risk of a decline in the dollar’s value: The growing expectation of dollar inflation and the skyrocketing increase in the U.S. fiscal deficit are increasing the risk of holding and dealing in dollars.

The first factor–payment technology–is temporary. It is being modernized. While payment technology (ease, speed, security, and cost of making cross border payments) is important, it is not as important as the features of the currency being paid. As a currency, the dollar excels for the reasons given earlier.

The second factor–weaponization of the dollar–has been growing in importance as the U.S. has increasingly sanctioned trade and dollar payments without broad international support–Iran, etc.  The EU has sought work arounds in Euros. China and Russia are building alternative payment arrangement using China’s Renminbi. Even with the dramatic increase in coordinated sanctions against Russia, restricting the use of dollars is less effective than directly blocking trade. https://wcoats.blog/2022/03/04/how-to-stop-russia-in-ukraine/  The broad support for sanctions on Russia more likely increases support from the dollar as the dominant international currency rather than reducing it. On the other hand, those on the other side (e.g., Russia and China) will work harder to find alternatives. The balance of these contradictory forces is difficult to assess.

The third factor has never been taken very seriously until now. At the end of February (2022) the US national debt was over 30.1 trillion dollars or 125% of US output (GDP). Federal government interest payments on its net debt were $426 billion per annum. But with the increase in inflation, interest rates are rising. Uncle Sam’s debt service payments are likely to double or triple over the next five to ten years, rising to 15% to 20% of the Federal budget. The world still expects the US to regain control of its spending, but the risks of default are creeping up. Paul “Samuelson stated in 2005 that at some uncertain future period these pressures would precipitate a run against the U.S. dollar with serious global financial consequences.” https://en.wikipedia.org/wiki/International_use_of_the_U.S._dollar

It is the second factor, US abuse of its ability to sanction the use of the dollar that is most threatening to push the dollar over the cliff.

The Alternative to the dollar

An internationally defined and issued currency would have a number of advantages over the use of a national currency for cross border payments.

While the value of the dollar has been quite stable for many years, using a basket of major currencies for pricing internationally traded goods and financial instruments would be even more stable. This is what the International Monetary Fund’s unit of account–the Special Drawing Rights (SDR)– offers. The value of one SDR is equal to the current market value of fixed amounts of the US Dollar, Euro, British pound, Japanese yen, and Chinese yuan. Thus, its widespread use for pricing internationally traded goods and financial instruments would provide even greater stability than would any one of these currencies. Every morning when I check movements in the price of oil, I must ask myself whether it was really a change in the price of oil or in the exchange rate of the dollar. See my: “Why the World Needs a Reserve Asset with a Hard Anchor”

The IMF’s SDR can only be held and used by member central banks and a few international bodies. Thus, private SDRs–so called Market SDRs–are needed for payments by the private sector (perhaps issued by the IMF or the BIS). Being issued by an international body, such Market SDRs would have the equivalent of a central bank for settling cross boarder payments allowing the simplifications and economy increasingly available for domestic payments in the domestic currency. `

Moreover, as an internationally issued currency the SDR would be far better protected from the political abuse increasingly experienced with the US dollar and might be expected with the Chinese RMB or other national currencies.

Getting from here to there

But first things first. Before considering the reform of the international monetary system, let’s consider the reform of the dollar–the reform of U.S. monetary policy. The price of the dollar should be fixed to a hard anchor and issued according to currency board rules.

During the heydays of the gold standard (1820-1913) international trade flourished dramatically increasing global incomes and reducing poverty. According to Antoni Estevadeordal, Brian Frantz and Alan M. Taylor “Until 1913 the rise of the gold standard and the fall in transport costs were the main trade-creating forces.” https://www.jstor.org/stable/25053910  However, to cope with WWI, the Great Depression, and WWII, the gold standard failed and was abandoned because of weaknesses in banking systems and because the countries that fixed the value of their currencies to gold did not fully play by the gold standard’s rules.

Under a strict gold standard, the central bank would issue and redeem its currency whenever anyone bought it for gold at the official price of gold. In fact, however, by actively buying and selling (or lending) its currency for other assets whenever it thought appropriate, the Federal Reserve’s monetary liabilities (base money) were partially backed by U.S. treasury bills and other assets. In addition, the fractional reserve banking system allowed banks to create deposit money that was also not backed by gold. The market’s ability to redeem dollars for gold kept the market value of gold close to its official dollar value. However, the gap between the Fed’s monetary liabilities and its gold backing grew until the market (most conspicuously, France) lost confidence in the Fed’s ability to honor its redemption commitment and President Nixon closed the “gold window” in 1971 rather than tighten monetary policy.

Currency Board Rules

A reformed monetary system that returns to a hard anchor (firmly fixed price of the currency for gold or some other asset) should require the Fed to adhere strictly to currency board rules. Such rules oblige a central bank to buy and sell its currency at a set price in response to public demand. Under the Gold Standard, the price of the currency was set as an amount of gold (a gold anchor). For existing currency boards, the price is typically an amount of another currency or basket of currencies. See my book on the establishment of the Central Bank of Bosnia and Herzegovina (“One currency for Bosnia-creating the Central Bank of Bosnia and Herzegovina”).    The Fed would 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. All traditional open market operations by the Fed in the forms of active purchases and sales of T-bills or other assets would be forbidden.

The Anchor

Another weakness of the historical gold standard was that the price of the anchor, based on one single commodity, varied relative to other goods, services and wages. While the purchasing power of the gold dollar was relatively stable over long periods of time, gold did not prove a stable anchor over shorter periods relevant for investment.

Expanding the anchor from one commodity to a basket of 5 to 10 commodities with greater collective stability relative to the goods and services people actually buy (as measured by, e.g., the CPI index), would reduce this volatility. The basket would consist of fixed amounts of each of these commodities and their collective market value would define the value of one dollar.  There have been similar proposals in the past, but the high transaction and storage costs of dealing with all the goods in the valuation basket doomed them. However, with indirect redeemability discussed next, the valuation basket would not suffer from this problem.

Indirect redeemability

Historically, gold and silver standards obliged the monetary authority to buy and sell its currency for actual gold or silver. If the dollar price of gold in the market was higher than its official price, people would buy gold at the central bank increasing its market supply and reducing the money supply until the market price came down again. These precious metals had to be stored and guarded at considerable cost. More importantly, taking large amounts of gold and silver off the market distorted their price by creating an artificial demand for them. A new gold standard would see the relative price of gold rising over time due to the increasing cost of discovery and extraction. The fixed dollar price of gold means that the dollar prices of everything else would fall (deflation). While the predictability of the value of money is one of its most important qualities, stability of its value, such as approximately zero inflation, is also desirable.

Indirect redeemability eliminates these shortcomings of the traditional gold standard. Indirect redeemability means that currency is issued or redeemed for assets of equal market value rather than the actual anchor commodities.  Market actors would still have an arbitrage profit incentive to keep the supply of money appropriate for its official value.  As the economy grows and the demand for money increases, this mechanism would increase the money supply as people sell their T-bills to the Fed for additional dollars at its official (gold or whatever) price.

Towards a global anchor

The United States could easily amend its monetary policy to incorporate the above features – adopting 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. The Federal Reserve would be restricted by law to passive currency board rules. Additional financial sector stability would be achieved by also adopting the Chicago Plan of 100% reserve requirements against demand deposits. This would be a natural byproduct of the Fed creating a two-tier Central Bank Digital Currency (CBCD) now under consideration.

The gold standard was an international system for regulating the supply of money and thus prices in each country and between countries and provided a single world currency (via fixed exchange rates). Balance of trade and payments between countries was maintained (when central banks played by the rules) because deficit countries lost money (gold) to surplus countries, reducing prices in the former and increasing them in the latter. 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. One way or the other, replacing the fluctuating exchange rates between the dollar and other currencies with the equivalent of a single currency 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.  

In a small step to create an internationally issued currency the IMF created its Special Drawing Right (SDR) in 1969 in the expectation of supplementing the gold-based US dollar. But in today’s world of fiat currencies with floating exchange rates the SDR has several limitations as a reserve currency, most of which can be lived with for a while. The SDR allocated by the IMF can only be held and used by the central banks of IMF member countries and a few international organizations such as the World Bank and BIS. The SDR falls short as a challenger to the US dollar because of the absence of widespread private market use of the unit.

To become a serious supplement to, if not replacement for, the US dollar in the international monetary system the SDR would need to be usable for payments by private sector parties. This would require the creation of private or Market SDRs. This could be done in much the same way banks now create dollar deposits.

Digital SDR currency

As with national currencies, the internationally issued SDR needs a central issuer of the base money version of market SDRs (M-SDRs). The IMF should oversee the develop of a procedure for issuing M-SDRs following currency board rules and backed 100% by official SDRs or by an appropriate mix of sovereign debt of the five basket currencies.

The IMF might establish an IMF trust fund that would issue M-SDRs to AAA or AA international banks upon their request and payment of the equivalent value of one or more of the five basket currencies (and would redeem them under similar arrangements). As with other IMF trusts, the IMF might approach the BIS to operationally manage the issuance and redemption of M-SDRs and the maintenance of the official SDR asset backing (or its equivalent in the five currencies in the valuation basket).

Banks offering M-SDR deposits/currency to their customers would hold an M-SDR reserve backing with the IMF SDR trust fund. The base money M-SDRs issued by the IMF trust fund would perform the same payment settlement function as do central banks for the base money they issue, with the critical difference that its depositors/participants would be global rather than national. This would enable virtually instantaneous final settlement of M-SDR payments globally.

An M-SDR would facilitate and be facilitated by invoicing internationally traded goods and financial instruments in SDRs. More, if not most, internationally traded commodities could and should be priced in SDRs. Cross border borrowing can and should be denominated in SDR starting with bond issues and lending by international development institutions (as is now the case with the IMF, and to a very limited extent the World Bank).  https://www.brettonwoods.org/article/proposal-for-an-imf-staff-executive-board-paper-on-promoting-market-sdrs

To go all the way with SDRs, the IMF’s Articles of Agreement would need to be amended to replace the allocation of SDRs with issuing them according to currency board rules as discussed earlier. Furthermore, the valuation basket that now consists of key currencies would need to be replaced with a commodity basket as outlined in my Real SDR Currency Board proposal: (http://works.bepress.com/warren_coats/25/).

The shift from dollar to SDR international reserves, payments, and invoicing would give the world a more stable currency for all of these purposes. This would further promote trade because of more efficient cross boarder payments thus further lifting incomes around the world. Being an internationally issued and controlled currency, the potential for its political abuse by the U.S. would be greatly reduced. But eliminating the seigniorage that the U.S. now enjoys supplying its currency to the rest of the world, i.e., the foreign financing of some of its debt, would remain without further measures.

As central banks and foreign firms shifted from dollars to SDRs they might simply transfer the US treasury bills (and other US investments) that they now hold to the issuers of the M-SDRs. In that case the U.S. would continue to enjoy its exorbitant privilege of foreign financing in exchange for holding its currency. In this case M-SDRs rather than USD would also be backed by US debt. Thus, rules are need for what currency or assets must be paid to buy M-SDRs and/or what assets M-SDRs are backed by. This could take the form of buying M-SDRs with USD but the issuer exchanging the dollars for a more balanced portfolio of assets. While the SDR value continues to be defined by a basket of currencies, the assets backing issued SDR might reflect the same proportions of the same currencies.

The reduction in this way of the role of the dollar as a reserve currency would be win win. It would provide for more stable and more efficient international trade and payments. It would help demilitarize money and it would modestly increase the cost of US debt finance, hopefully encouraging more careful spending.


[1] Dr. Coats retired from the IMF after 26 years of service in May 2003 to join the Board of Directors of the Cayman Islands Monetary Authority. He was chief of the SDR division in the Finance Department of the IMF from 1982–88 and a visiting economist to the Board of Governors of the Federal Reserve in 1979.  In March 2019 Central Banking Journal awarded him for his “Outstanding Contribution for Capacity Building.”  His recent books are One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina; My Travels in the Former Soviet Union; My Travels to Afghanistan; My Travels to Jerusalem; and My Travels to Baghdad. He has a B.A. degree in Economics from U of California, Berkeley, and a Ph.D. in economics from the U of Chicago. He is a fellow of Johns Hopkins Krieger School of Arts and Sciences, Institute for Applied Economics, Global Health, and the Study of Business Enterprise.