As 2012 approaches, the prospects of the US dollar as the dominant international reserve currency and as a store of value are a matter for concern. Yet when rumours of instability and crisis roil global financial markets the ensuing “flight to safety” still manifests as a headlong rush into USD-denominated deposits and securities.
Likewise, despite loss of AAA status, the growing likelihood of further credit downgrades and a demonstrated inability of the US government to rein in fiscal deficits, yields on US Treasury obligations across the full spectrum of maturities are near record lows.
A major factor propping up the relative exchange value and purchasing power of the US dollar is the absence of a credible alternative. Similarly, at present no other asset can offer the liquidity of US sovereign debt instruments. Compared to the euro and the sovereign debts of euro zone nations the US dollar and Treasuries currently appear to be the safer bet.
Is an alternative needed? China seems to think so, as does the Vatican. The IMF prepares contingency plans to expand the role for SDRs, possibly culminating in global usage as a medium of exchange and settlement. Toward that end, rebranding SDRs as “Republic Credits” may advance their market appeal.
There is however a bizarre emperor’s-new-clothes element to all of the mainstream proposals for an alternative; all arrangements that entail a central bank share the weakness of existing monetary regimes – the unrestrainable tendency to become runaway engines of debt accumulation.
A currency board model in contrast is designed to eliminate discretion and thereby ultimately impose fiscal discipline for the polity associated with it. The weakness of this system for binding a government to rules is that, like any other well intentioned monetary convention – the classic gold standard comes to mind – it can be abrogated.
Every effort was made for instance during the 1991 establishment of the Argentine currency board to enable it to resist political pressure of successor regimes to monetise fiscal deficits. The historical fact, however, is that governments eventually find a way to repudiate inconvenient monetary obligations and when they do, the creditors who are inevitably damaged have no legal recourse.
A private sector firm can do what no state can. It can be effectively bound by contract.
Is it therefore possible that a private sector institution can offer a better monetary solution, or part of a solution, than nations with their vast resources?
Since the emergence of the commercial internet there have been a profusion of private initiatives that could be broadly categorised as payment systems. The vast majority are simply ways of moving quantities of existing currencies from payer to recipient. The term “currency” is used in this context to denote a distinct brand of money, in the sense that the US dollar is a different currency than the Russian ruble or the Cayman dollar.
Some are presented as new alternative “currencies”. There is a tendency however, for the promoters of these media – so-called “virtual currencies” such as Bitcoin or Linden dollars among the most egregious examples – to embrace a monetary fallacy.
The fallacy is twofold
Money is ultimately information, and offering better money is a matter of processing information via novel and improved transaction mechanisms.
The value of money stems from limiting the number of units issued; if one abstains from over-issue, “inflation” and loss of purchasing power is avoided.
Unquestionably, adroit capabilities for moving bits about are essential. Every major issuer of “real money”, a cohort that most regard to date as limited to government monetary authorities, offers a settlement platform for transfers of base money.
More importantly however, issuers of real money also attend to their balance sheets in recognition that, with the exception of certain full bodied bullion coins, real money constitutes someone’s current liability.
Picture a private entity offering jazzy but un-backed “numbers that are money” – in strictly limited quantities.
Now, imagine an entity with roughly comparable technology for transferring its “whatevers” from payer to recipient, but that stands ready at all times to buy back every bit of money it has spent into circulation.
A reliable rule of thumb is that the market value of any particular issued medium of exchange (again, minted bullion coins are another story) will always eventually equal the market value of the assets held against those liabilities. This becomes apparent, as with any Ponzi scheme, when demand for the media diminishes.
With this background, what sort of private sector firm could offer goods or services that might fulfil or help foster a systematic solution to the world’s apparent need for an alternative international reserve medium?
The only candidate type of institution, would offer not just payments technology, but must also undertake to issue an alternative global currency, a distinct new brand of money. It would be consciously organised as a private sector monetary authority.
A monetary authority, whether sovereign or private sector, issues the base money of a “real” currency (ie of a distinct brand of money), whose liabilities:
- cannot be construed as part of the broad money supply of another existing currency;
- have been issued explicitly to serve as a medium of exchange and as the medium in which other like-denominated liabilities are to be payable; and
- are continuously backed in full by otherwise unencumbered current assets held in readiness for their redemption.
“Cannot be construed as part of the broad money supply…” means the currency has its own defined unit of account. With national currencies, each is assigned a unique three letter code (codified in ISO-4217) allowing, for instance, multiple issuers of “dollars” to be distinguished.
While the Cayman Islands Monetary Authority is organised as a currency board that hard pegs its brand, the Cayman dollar (KYD), to US dollars (USD), Cayman dollars, whether base or broad money form, are not part of the broad money supply of USD.
A private sector issuer would likely face an uphill struggle to be listed in ISO-4217 but would be well advised to seek trademark protection of an otherwise unused unique three letter code.
In December 2001, Laurence Meyer, at that time serving on the board of governors for the Fed, delivered a lecture examining “The Future of Money and of Monetary Policy”. His major focus was to evaluate “the possibility of reintroducing private currency in the United States”.
His principal conclusion was the contention that would-be “private money issuers” could not match government central banks in achieving “freedom from default risk and finality of settlement” – critical attributes required for a serious alternative currency to emerge.
This contention correctly implies that the core processes for any currency are issuance of base money, and, settlement of base money transfers.
These attributes are essential; for any privately issued currency to emerge as a significant alternative ultimately requires that mainstream financial and non-financial institutions embrace it, respectively creating a like-denominated broad money supply and other debt instruments payable in it.
Emergence of such a broad money supply would entail financial institutions holding quantities of the privately issued base money as reserves, a goal that is only realistic if the medium can offer freedom from default risk to a degree comparable to the direct liabilities of government monetary authorities.
Finality of settlement can be achieved via a combination of contractual and technical means, discussion of which is beyond the scope of this article.
The more critical question is how to maximally assure freedom from default risk.
An instructive contrast can be drawn between the institutional concepts of a mint and an issuer. Both can be thought of as spending money into circulation. An issuer’s act of money creation is one of incurring additional liability, expanding its balance sheet.
The issuers of monetary liabilities have pretty much always been banks. Banks, as we are constantly reminded with every call for additional regulation, are in the risky business of “borrowing short and lending long”. A demand liability is as short as it gets – zero maturity. Money, at least the narrower forms of money, is accounted as a current liability, payable (theoretically, in the case of the base money of fiat currencies) on demand.
A bank of issue, any bank for that matter, offsets its liabilities – notes and deposits – with assets that can be classified as reserves or investments. Using the Fed as example, reserves consist of foreign currency balances including SDRs and gold.
The general idea of reserves is of money or money-like assets that are free of the financial risks that investments inevitably entail. The traditional downside of holding reserves has always been opportunity cost – foregoing the revenue stream provided by investments.
Investments held by a bank are remunerative assets, securities or direct loans. As financial instruments they carry credit risk, the risk that the obligor fails to pay on time or in full.
Interest rate risk, the inverse relationship between the market value of a debt instrument and prevailing interest rates, is a little more subtle. Central banks, like their historical antecedents that emerged in response to market forces – bankers’ banks – traditionally observed a tighter discipline than other banks with regard to maturity transformation.
As late as the Eisenhower years, for example, the Fed followed a “bills only” doctrine, eschewing the higher yields of Treasury bonds in favour of the safety of Treasury bills. Even during the so-called “Twist” experiment undertaken during the Kennedy administration, the average maturity of the Treasury holdings in the Fed’s SOMA (System Open Market Account) never exceeded 22 months.
Entering 2012, might a private sector issuer do a better job of maintaining a sound balance sheet? The Fed certainly isn’t setting that bar very high these days, borrowing shorter and lending longer than any commercial bank it regulates.
There is precedent for base money originating from a non-bank, the mint model. A synthesis of both paradigms is called for – a balance sheet-based issuance model without exposure to the financial risks inherent to an investment portfolio. This would be achieved by a 100 per cent reserve containing no financial instruments whatsoever, only gold.
A gold backed medium, denominated in weight units, would function strictly as an alternative, not a replacement or successor. It would circulate alongside conventional currencies and play a complementary role.