There is an urgent need to rethink the basis of the world’s monetary arrangements. The end of the dollar standard is in sight. Its end will be hastened if the deadlock in Congress on US fiscal policy continues. Also, the dollar’s reserve currency role is already dangerously over-extended.
At the same time, the global financial crisis and recession of 2007-10 have led to a questioning of the existing models of monetary policy making throughout the world. Critics point out that if these monetary regimes did not merely precede but were a cause of the crisis, they should be replaced.
True, governments and central banks are resisting calls for radical reform. They are relying on stricter regulation of the financial sector, enhanced ‘macro-prudential surveillance’ and increased flexibility of exchange rates.
In other words, they are tinkering with their model, in the hope of returning to ‘business as usual’. Such hopes are likely to be disappointed. Given the imminent risks of more banking panics and recessions in Europe and America, it is time to rethink this entire approach.
Current policy-making models have four unsatisfactory features: Flawed objectives, an inbuilt liability to crisis, a damaging divorce between money and the real economy and the absence of an external anchor for the price level.
On the first, several distinguished economists, including Milton Friedman, argue that money holdings are likely to be optimal when the purchasing power of the currency unit is expected to appreciate .
Second, not only do floating exchange rates impede trade and investment but in the presence of large pools of internationally mobile capital they are also closely linked to the build-up of cross-border credit and currency bubbles and subsequent crashes.
Economist Robert Aliber has traced five such damaging waves in the period since the advent of floating in the early 1970s . Thirdly, the financial systems of developed countries have been characterised by a growing divorce between money and the real economy.
Many large companies do not need banks for credit; while many smaller companies cannot obtain it. Meanwhile, a huge growth in bank balance sheets in the period up to the crisis was dominated by an unprecedented rise in claims on other financial institutions.
The increase in pre-crisis reported profitability of banking stemmed from trading, increased risk-taking and leverage. Fourthly, because existing monies are not convertible into real assets, the price level has no anchor.
The decline of the dollar standard together with the faults of existing monetary regimes points to the need to find a new basis for global money. The money should be closely tied to the real economy and it should appreciate, in the long run, in purchasing power: call it an Asset-Backed Currency (ABC). There is one, and perhaps only one, way of combining these desirable characteristics.
The ABC should be defined as, and convertible into, a constant fraction of the global market portfolio, ie tradable equity claims on real assets, representing the productive potential of the global economy.
Adherence to such a standard would be secured if issuers of money were obliged to maintain the value of their liabilities (notes, coins and deposits) as defined in this way and if they stood ready to convert these liabilities at any time into shares in a defined basket of the global market portfolio (equity shares).
Under such a standard, the value of money would rise as the prices of goods and services fell in line with economic growth, as reflected in an increase in the value of the basket of shares.
The ABC would be defined by agreement among governments. If it were introduced simultaneously in all major economies, as would obviously be desirable, it would take the form of a new asset-backed SDR, issued by the IMF.
But if international agreement were not feasible, it could be introduced unilaterally by the US (a new dollar), Europe (a new euro) or the two together – a new eurodollar. The unit should be defined by governments because, like language, the more people use it, the better. There is also the practical consideration that, given inertia, existing monies would hang on indefinitely, despite their inefficiencies, until displaced by official action.
New monetary technology
The opportunity for the introduction of such an ABC has developed only recently, as a result of two leading trends in global finance. One is the decline of banking. Big banks have become zombies, and seem likely eventually to be broken up.
Banking has also become national again. Across Europe, cross-border lending has virtually ceased, as banks retrench. Globalisation is too dangerous for banks in a world of national monetary sovereignty – and too costly for taxpayers when the banks get into trouble.
Finance needs a new basis or foundation. The other trend is the globalisation of world equity markets linked to the dynamic growth of global asset management. At the same time, the range of securitised assets has vastly increased; that is, a growing fraction of the world’s total productive assets can be traded in paper form rather than just in physical form (eg land). This makes available a new monetary technology based on globally-diversified equity performance indexes.
Countries joining such an asset-backed or investment standard would enter into a monetary disarmament pact. Central banks would be banned from monetary manipulation. The actual production of money could be left to a Hayekian process of free competition .
Private banks would compete to offer products, including notes and coins, defined on this standard. In this case there would be no central bank or currency board. The new-style banks would be legally obliged to keep the value of their notes at all times within a certain margin linked to an agreed global equity index.
Alternatively, one could envisage a central bank system, where it would be the central bank that would target the index. When the index fell below the target level, the central bank would buy shares, financed by issuing money, thus reducing the value of money compared with shares and raising the index back into its target range. Another option would be a currency board version, where the monetary authority would be passive and only buy or sell currency units at the initiative of the public.
Such a unit would have many advantages. Currency harmony would replace currency war. It would give everybody holding money a stake in the world economy. It would link the world’s citizens, for the first time in history, with a chain composed of material more desirable even than pure gold.
Among other benefits, it would make redundant that part of the financial services industry that exists merely to retrieve for citizens the inflation tax levied by governments. As for the fear of ‘deflation’, as soon as people realised lower prices brought rising living standards, they would accept it.
Such a real-asset or investment standard would accommodate global financial integration without the need for political integration. Like the gold standard in the late 19th century, it would be regarded as a mark of modernity. Such a regime would unify people across time and space.
People would again feel comfortable leaving money to their descendants, as they did in the 19th century but which they were denied in the 20th century. Such money would open up long-term capital markets and increase incentives to save and invest.
A further advantage of such a standard would be its counter-cyclical properties. It would eliminate the reasons for the disappearance of investment opportunities and the difficulties facing governments (as at present) in reviving demand during a slump – what Keynes called ‘the liquidity trap’ and Austrians call ‘monetary disequilibrium’.
When the cost of finance, even at very low interest rates, exceeds the expected return on investment, businesses pile up cash. This could not occur if money were defined as a function of the market portfolio. This could reduce the amplitude of the business cycle. It would eliminate cross-border bubbles aggravated by self-perpetuating currency movements.
Defining the currency in terms of claims on global tradable assets emphasises what Keynes recognised to be the most important function of money – as a unit of account. It will be objected that stock markets are fickle – that this would be the ultimate ‘casino currency’.
But some of the sources of such instability, such as the business cycle, would be reduced. The regime would lend stability to markets. Monetary sources of disequilibrium – systematic risk – would be eliminated.
If the purchasing power of the global equity basket were unstable in the short run, the market would surely be quick to develop hedging and insurance services to offer users compensation for any deviation of the unit from an agreed price index over an agreed period.
As cash would be expected to gain value, so there will be a surplus with which to buy insurance against short-term variability in purchasing power. The chance of runaway inflation is excluded, as there would be no discretionary credit creation by the central bank.