The case for sound money

Over the course of history, trust in fiat currency has most often been weakened by erratic and high inflation, and shattered after episodes of hyperinflation


Before the great financial crisis, and even for some time following it, the consensus fixed on inflation targeting, which we are also now practising in India. Photo: iStock
Before the great financial crisis, and even for some time following it, the consensus fixed on inflation targeting, which we are also now practising in India. Photo: iStock

The debate around the recent demonetization of high-denomination currency notes has once again reopened an old debate. Does demonetization threaten the trust that people have in the legal tender? This is, in reality, a deeper systemic question that has little to do with demonetization specifically but has to do much more broadly with the faith we do, or do not have, in fiat currency.

After all, over the course of history, trust in fiat currency has most often been weakened by erratic and high inflation, and shattered after episodes of hyperinflation. This is a much bigger problem than the one-time wealth effect on holders of black money due to demonetization. Yet few in India (or anywhere else for that matter) are probing the deeper questions that are raised.

Let us recall one of the great aphorisms of Robert Mundell, “Money is a bubble”. This is a reminder that fiat money is a convention. It has value because everyone believes it has value. It’s the world’s greatest confidence trick, in a sense, endowing trust and value in what would be otherwise worthless pieces of paper.

We should also remind ourselves that this state of affairs has not been the norm throughout history. For much of recorded human history, money has been either commodity money, or paper money tied to commodities—precious metals, for the most part, such as gold, silver, or some combination thereof, known as bimetallism. Automatically, with each currency, in effect, a name for a certain weight of gold (or silver, or their combination), the world, thereby, got a system of fixed exchange rates.

Exchange rates, which could remain fixed over long periods, simply represented the ratios of the metallic contents of different currencies. Thus, for instance, the historical exchange rate between the pound sterling and the US dollar, 4.86 dollars to the pound, simply meant that the gold content of the pound was 4.86 times greater than that of the dollar.

Our last experience with this global monetary order was the period 1944-71, when most of the world was on a dollar-gold standard: with countries fixing to the dollar, and the dollar fixing the price of gold at $35 an ounce. Since the breakup of that system, as we all know, the world has experienced the non-system of fiat currencies tied together by floating exchange rates, a subject I have explored often and in some depth in these pages.

The question that arises, therefore, is whether this non-system is a sensible way both for national fiat currencies to set their monetary policies and for such currencies to be linked together through exchange rates? In a world of fiat currency, there is of necessity the imperative to select a nominal anchor, given that it is no longer the price of gold or some other commodity. Before the great financial crisis, and even for some time following it, the consensus fixed on inflation targeting, which we are also now practising in India. Thus, the anchor of monetary policy is the rate of consumer price index (CPI) inflation, which is stipulated to fall within a band.

In the advanced economies, at least, this policy regime delivered low and predictable inflation rates before the crisis, and, in the last few years of the recovery after the crisis, has offered inflation rates at or below target levels—that, too, unleashed through the unconventional monetary policies (UMPs) that I have discussed on numerous occasions.

The cost of UMPs has been to distort seriously the structure of the economy, with zero or negative interest rates penalizing savers and rewarding those who can park large amounts of idle cash in bubbly assets, whether property, vintage cars, or old master artworks. Asset price bubbles have been created, and they will be pricked in one way or another—painlessly, perhaps, or more likely, by inflicting pain on the real economy, as in the great crisis we have lived through.

With the advent of the incoming Trump administration in the US, one which is sympathetic to the Mundell-Laffer policy mix I wrote about recently in this space, there is the opportunity to engage in a serious debate, at long last, on whether the US, and by extension other economies that wish to fix to the dollar, is ready to embrace sound money and cast aside the fragile and ephemeral trust in a non-commodity based fiat currency as at present.

Before partisans wheel out the old John Maynard Keynes chestnut that gold has been rendered a “barbarous relic”, one might hasten to point out that a modern commodity-based currency need not reproduce the classical gold standard, but be based on a weighted basket of commodities. The idea would be that the stock of money would grow and contract as a function of a broad measure of the world’s stock of resources and not be a function of the whim of a particular central banker in thrall to today’s fads and fashions.

In the first instance, it would need to be the de facto international reserve currency, the US dollar, which moves in this direction, before other economies might, perhaps, follow suit. Or, others need only fix on to a sound dollar, and we would reproduce some version of the Bretton Woods system which served the world so well.

Seen as outlandish a short time ago, with the advent of Trump, sound money is an idea which may soon gain currency.

Every fortnight, In The Margins explores the intersection of economics, politics and public policy to help cast light on current affairs.

Comments are welcome at views@livemint.com. Read Vivek’s Mint columns at www.livemint.com/vivekdehejia.

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