By Warren Coats
After years of destabilizing monetary policy by the Federal Reserve, there is growing sentiment that our fiat currency system should be replaced with a hard anchor. Yet, the gold and silver standard anchors adopted in much of the world over the two centuries preceding the United States’ abandonment of gold in 1971, came with significant weaknesses that contributed to their ultimate abandonment. To avoid these, three key elements of the Fed’s operation should be modified. 1: The monetary policy determining how currency fixed to a hard anchor is issued and redeemed. 2: The monetary anchor. 3: What the currency is sold or redeemed for.
1. Monetary Policy
During the earlier gold standard from 1792 to 1934, the value of one U.S. dollar was fixed at $19.39 per ounce of fine gold, and then $35.00 per ounce from 1934 to 1971. At that point, as the U.S. no longer had enough gold to honor its commitment, Nixon ended the U.S. commitment to buy and sell gold at its official price. Yet, an official price remained, raised to $38.00 per ounce in 1971 and $42.22 in 1972. In 1974, President Ford abolished controls and freed the price of gold.
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, the Fed engaged in active monetary policy by buying and selling (or lending) its currency for U.S. treasury bills and other assets whenever it thought appropriate. Rather than being fully backed by gold, the Fed’s monetary liabilities, base money, were partially backed by 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 President Nixon closed the “gold window” altogether in 1971 for lack of gold.
A reformed monetary system should be required to adhere strictly to currency board rules. These were the rules that on paper governed monetary policy under the Gold Standard. They oblige the central bank to buy and sell its currency at a set price. Under the Gold Standard, the price of the currency was set as an amount of gold. For a currency board, the price is typically an amount of another currency or basket of currencies. The Federal Reserve can oversee the interbank payment and settlement systems. In response to market demand, it 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 in the forms of active purchases and sales of T-bills by the Fed or lending to banks would be forbidden.
2. The Anchor
Another weakness of the gold standard was that the relative price of the anchor, based on one single commodity, varied relative to 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 10 to 30 goods and services with 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 goods and would define the value of one dollar. The exact composition and amounts of the items in the valuation basket could be adjusted periodically just as the CPI basket is. 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, in combination with indirect redeemability discussed next, this would no longer pose that problem.
3. Indirect redeemability
Historically, gold and silver standards obliged the monetary authority to buy and sell its currency for actual gold or silver. 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 have 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, hence 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 this shortcoming of the traditional gold standard. Indirect redeemability means that regulation of the money supply does not require transacting in the actual anchor goods or commodities. Assets of equal market value can be exchanged by the monetary authority when issuing or redeeming its currency. Market actors will then have a profit incentive to keep the supply of money appropriate for its official value.
The gold standard worked this way. If the market dollar price of gold were higher than the official price, people would buy gold at the central bank and increase its market supply until the price came down again. With indirect redeemability, if the market value of the goods in the basket were higher than one dollar, anyone could buy them more cheaply by redeeming dollars at the Fed for an equivalent value of U.S. treasury bills. If, for example, the basket cost $1.20 in the market, anyone could buy $1.20 worth of T‐bills from the Fed for only one dollar. This arbitrage‐induced contraction of the money supply would reduce prices in the market until a dollar’s value in the market was the same as its official valuation basket 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.
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 of dollars. The Federal Reserve would be restricted to passive currency board rules. All active purchases and sales of T‐bills by the Fed (traditional open market operations) or lending to banks would be forbidden. During a five–year transition period it would be allowed to lend to banks against good collateral in order to allow banks time to adjust their operations and balance sheets to the new rules.
The gold standard was an international system for regulating the supply of money in each country and between countries and provided a single world currency (fixed exchange rates). 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.
~Dr. 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 is currently part of the IMF program negotiating team for Afghanistan, and is on the Editorial Board of the Cayman Financial Review.