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A rocket scientist – he designed weapons systems for a defense
contractor – once told me that monetary principles were more difficult
than rocket science. The evidence supports his view: we have many
rocket scientists fully capable of making rockets that fly; and
few-to-none monetary experts capable of making currencies that work
well. But have you ever seen a book on missile engineering? China’s first gold-based “banknotes” date from the second century B.C. They were made of deer hide. Maybe it’s not that complicated.
Although there are a lot of possibilities, in practical terms, it tends
to boil down to two choices: fixed or floating. Let’s see what they
entail:
Fixed: This means that the
currency’s value is linked to some “standard of value.” Gold and silver
were the most common. Some Japanese paper banknotes were based on
umbrellas, string, and potter’s wheels. (I don’t recommend this.)
Today, the “standard of value” for fixed-value systems is most likely a
major international currency, like the euro or dollar. Other
possibilities include currency baskets (the International Monetary
Fund’s Special Drawing Rights, which may be undergoing a bit of a revival), or commodity baskets.
Once you make the decision to fix the currency’s value to something,
quite a lot follows from this. First, there must be a mechanism to
achieve the goal. This mechanism includes some sort of automatic
adjustment of money supply, in the manner of a currency board. Thus,
the money supply becomes a residual – the outcome of the mechanisms
that maintain the value of the currency at the target value. This
removes any “discretionary” element. Central bankers can no longer
attempt to “manage” the economy, via changes in money supply. Also,
interest rates can no longer be managed, but are generated by free
market processes. Obviously, the value of the currency itself cannot be
changed, with whatever foreign exchange or trade-related consequences
may result, because the value is fixed.
Whether the “standard of value” is gold, another currency, a currency
basket or a commodity basket, the goal is normally some sort of
“stability of currency value,” which in turn is based on the idea that economies work best when you do not go messing with economic relationships by jiggering the unit of account.
Floating: A floating currency
has no fixed value, but instead goes hither and thither somewhat
unpredictably. Because there is no obligation to maintain a fixed
currency value, the supply of currency is no longer an automatic
residual, and can be altered at will. Now central bankers can attempt
to manage the economy via changes in money supply, interest rates can
be manipulated, and foreign exchange and trade relationships can be
changed. The goal of a floating fiat system is often to “stabilize the
economy,” with this to be accomplished by currency distortion.
In practice, there have been a lot of attempts at creating a hybrid of
these two options, in which there is both an “external” fixed value and
an “internal” discretionary monetary policy. This has a tendency to
blow up – indeed, the failure of this strategy is the reason the
Bretton Woods gold standard arrangement ended in 1971. Later, it led to
a chain of currency failures during the Asian Crisis of 1997-1998, and
in many other instances throughout the past sixty years.
Today, it would seem that the question of “fixed vs. floating” has been
definitively settled in favor of “floating.” This is not true. Most of
the countries in the world use a fixed system. In the Annual Report on Exchange Arrangements and Exchange Restrictions, 2014, the International Monetary Fund took a survey of currencies worldwide.
Of them, 56.6% were found to have some variant of a fixed-value system
– many of them ill-designed “pegged” systems. However, the IMF
categorized 18 euro-using countries as having a “free floating” system,
while I (along with Milton Friedman and Robert Mundell) would call
these common-currency arrangements a “fixed” system. Spain, Ireland and
Greece have no independent discretionary monetary policy, and are
effectively the same as those countries with “no separate legal tender”
(including Ecuador, San Marino and Kiribati) that the IMF classifies as
a “hard peg.” Reclassifying these would raise the percentage following
a “fixed” system to about 67% of all countries worldwide.
This does not include those countries that would probably like to have
a fixed system, but don’t know how to do it. This could include most of
the smaller Asian countries, like Korea, Thailand, Malaysia, Indonesia
and the Philippines, which had badly-designed dollar “pegs” that blew
up, due to incompetence, in 1997-1998. The proper way to fix one
currency’s value to another is with a currency board. For some reason,
this lesson hasn’t been learned yet by governments worldwide.
There’s a fair amount of talk today about this, that or another
“rules-based” system, to add to the existing cacophony including
various monetary aggregate targets and CPI targets, and the
seat-of-the-pants improvisation favored by the United States today.
These are all variants on floating fiat currencies. In practice, they
tend to be picked up and discarded over time, as convenient
justifications for what politicians and central bankers wanted to do
anyway.
The idea of giving up all discretionary monetary policy – and fixing
the value of the dollar to some external benchmark — is somewhat
abhorrent to many today in the United States. People still think that
they are going to solve all their problems by jiggering the currency.
But, it is already (arguably) the policy of France, Germany and China,
and another hundred-plus countries listed by the IMF. It was the policy
of the United States, before 1971.
The U.S. used gold as the “standard of value,” just as humans had done back to ancient times. Did it work? After
nearly two centuries of this principle, the U.S. became a global
superpower, the wealthiest country in the world; nay, in the history of
the world. Most of the countries in the world already adhere to the
principle of a “fixed” currency. Maybe it should be all of them.
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