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Returning to currencies with hard anchors?

Summary:
After years of discretionary management of monetary policy by the Federal Reserve, there is a strong case for re-fixing our fiat currency system to a hard anchor. Though the dollar was far more stable under the gold and gold exchange standard era than after it’s delinking from gold in 1971, those systems came with significant weaknesses that contributed to their ultimate abandonment. To avoid these, three key elements of the Fed’s operation should be modified. These are: 1. The monetary policy rules determining how currency fixed to a hard anchor is issued and redeemed; 2. The monetary anchor itself; and 3. What the currency is issued or redeemed for.Monetary PolicyBecause of loose adherence to strict gold standard rules, the U.S. no longer had enough gold to honour its redemption

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After years of discretionary management of monetary policy by the Federal Reserve, there is a strong case for re-fixing our fiat currency system to a hard anchor. Though the dollar was far more stable under the gold and gold exchange standard era than after it’s delinking from gold in 1971, those systems came with significant weaknesses that contributed to their ultimate abandonment. To avoid these, three key elements of the Fed’s operation should be modified. These are: 1. The monetary policy rules determining how currency fixed to a hard anchor is issued and redeemed; 2. The monetary anchor itself; and 3. What the currency is issued or redeemed for.

Monetary Policy

Because of loose adherence to strict gold standard rules, the U.S. no longer had enough gold to honour its redemption commitment by the 1960s. On Aug 15, 1971, Nixon ended the U.S. commitment to buy and sell gold at its official price and in 1974, President Ford abolished controls on and freed the price of gold, which rose to a high of  $2,128 in February 1980 before falling back to $1,293 on March 29, 2019.

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 Fed’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, which 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 lost confidence in the Fed’s ability to honour its redemption commitment and President Nixon closed the “gold window” in 1971 rather than tighten monetary policy.

A reformed monetary system 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. 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 or lending to banks would be forbidden.

The Anchor

Another weakness of the 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 10 to 30 with greater collective stability relative to the goods and services people actually buy (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 of 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 were 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, the 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 will 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 price.

Towards a global anchor

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. 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.

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 bank’s 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 as outlined in my Real SDR Currency Board proposal. 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. Embedding the system in the governance structures that already exist in the IMF's Articles of Agreement would elevate monetary policy rules to the constitutional level recommended by James Buchanan.

William Coats retired from the IMF after 26 years 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. His latest book is One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina, which chronicles his work in establishing the CBBH, a currency board, in 1997.  He has a PhD in economics from the University of Chicago.

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