“Rules-Based” Monetary Proposals Won’t Create Stable Money

In Full Archive by Nathan Lewis

(This item originally appeared at Forbes.com on February 9, 2018.)


I often say that governments should follow the “Magic Formula,” which is: Low Taxes and Stable Money. Good things happen to governments that do this, and bad things happen to those that don’t.

“Stable Money” means: money that is stable in value. The traditional way to accomplish this is to link currencies to gold. Today, most of the governments in the world link their currencies to one of the major international currencies, the dollar or the euro. The dollar or euro are not as stable as gold – their values “float” by design. However, a smaller country that links its currency to one of these major “currency blocs” can at least enjoy stable exchange rates, which vastly simplify trade and investment. Also, the dollar and euro, though they are not particularly stable (the dollar is worth less than one-thirtieth its value vs. gold today compared to 1970), have been more reliable than small, independent currencies.

The ad-hoc, seat-of-the-pants manner in which major central banks manage their currencies today makes a lot of people queasy. This includes central bankers: Mervyn King, who was the head of the Bank of England for ten years, wrote a book called The End of Alchemy (2017) that said, basically, that the way we do things today is ridiculous. On the other side of the pond, ten-year Federal Reserve veteran Danielle DiMartino Booth wrote Fed Up: An Insider’s Take on Why the Federal Reserve Is Bad For America (2017), in which she explains why the Federal Reserve is bad for America.

This has generated a response, mostly from conservative sources, arguing that our economy should not be at the mercy of some unelected dingbat’s monetary daydreaming. We need rules! Thus, a “rules-based” approach to monetary policy.

This is not the first time we’ve heard this from conservatives. Milton Friedman, in A Program For Monetary Stability (1960), argued that we should have a Constitutional Amendment (oh really?) that required the monetary base to grow by about 4% per year. Fortunately, nobody took him very seriously, as this is almost precisely the model of Bitcoin, which, as we know, has produced mind-bending volatility of value. It was replaced by the idea that some other measure of “money,” namely M2, should grow at some sort of steady, stable rate. This was the “monetarist experiment” that Paul Volcker put into practice in the early 1980s. It was also a horrible mess, and was soon abandoned. The Monetarists want to be given a third chance, this time with “nominal GDP targeting.” They argue that the whole point of a steady increase in the monetary base, or a steady increase in M2, was to produce a steady increase in NGDP, so why not just target that?

There are more rules-based systems: CPI targets, Taylor rules, and whatever else some creative assistant professor might dream up to give people something to talk about.

One thing these all have in common is: they do not produce a stable currency value. That is not their goal at all. They are all various attempts to manipulate and distort the macroeconomy, to produce whatever outcome they aim for. To accomplish their goals, they must have an unstable currency.

For example, no country that presently uses a fixed-value link with the dollar or euro could implement one of these policies. It would immediately come into conflict with the fixed-value policy. If Greece wanted to implement an NGDP target system, it would need a separate floating currency. This floating currency would then have had to fall in value, a lot, to turn the -8.3% nominal GDP contraction of 2011 into a nominal GDP growth of +4%, or whatever the target happened to be. The stability in NGDP comes about by variability in the value of the currency.

A high-growth economy often has a high rate of measured CPI inflation. This has nothing to do with “monetary inflation” caused by a decline in currency value. It is a simple result of getting rich quickly. For example, the CPI in Japan rose 6.6% in 1965. This was while the yen was linked to gold at 12,600/oz., and to the dollar at 360/dollar. To reduce this “inflation” to, for example, a 2% target, the yen would have had to rise in value. CPI “inflation” in Hong Kong was 11.2% in 1991. This was again due to high growth. The Hong Kong dollar had been solidly linked to the U.S. dollar for many years, with a highly reliable currency board. To produce a 2% CPI, the Hong Kong dollar would have had to soar in value.

Taylor Rule fans claim that the experience of the 1990s showed that the Taylor Rule could produce a similarly productive result today.

But Alan Greenspan, who was the head of the Fed in those days, wasn’t following the Taylor Rule. He was following another rule. He was following gold. How do we know this? Because he said so, several times. This is from 2017:

[During my term] U.S. monetary policy tried to follow signals that a gold standard would have created. That is sound monetary policy even with a fiat currency. … even if we had gone back to the gold standard, policy would not have changed that much.

Speaking before the Council on Foreign Relations in 2010, he said:

Fiat money has no place to go but gold. If all currencies are moving up or down together, the question is: relative to what? Gold is the canary in the coal mine. It signals problems with respect to currency markets. Central banks should pay attention to it.

Again before the Council on Foreign Relations in 2014, he said:

Gold is a currency. It is still, by all evidence, a premier currency. No fiat currency, including the dollar, can match it.

George Gilder, in The Scandal of Money (2016) gave a wonderfully detailed and insightful description of why an economy needs Stable Money. Borrowing from the principles of information theory, Gilder showed how money is the information carrier in the economy. When the price of oil rises from $50 to $80 per barrel, markets react as if the real price of oil has risen. Oil users cut back their consumption, while producers undertake new investment to increase supply. Profits of oil companies increase, returns on capital increase, and more capital is directed to the oil business. It makes perfect sense if the rise in price represents a change in the supply and demand of oil. It makes no sense if the rise in price is due to a change in the value of the money. Changes in the value of money confuse the system of prices, interest rates, profit margins and returns on capital that guide all activity in the market economy. The result is chaos and confusion – the artificial boom and bust that people like Mervyn King and Danielle Booth complain about.

For centuries, gold has been the best-possible approximation of this ideal of Stable Value. In practice, it worked very well. The “rules-based policy” that formed the basis of Western Civilization and the Industrial Revolution was very simple: base your money on gold.

Perhaps someone could invent an even better representation of the Stable Money ideal. But, nobody ever has. Certainly, none of these “rules-based” propositions could ever do so. They aren’t even intended to. They are just another flavor of funny-money manipulation.

Most governments today have no interest in domestic monetary manipulation. They just link their currency to an external standard of value, the dollar or euro, and enjoy all the benefits of fixed exchange rates. This works best if the dollar or euro itself is also linked to an external standard of value – gold. This was the basis of the Bretton Woods arrangement, 1944-1971. The dollar was linked to gold at $35/oz., and other currencies were linked to the dollar. It produced the most prosperous period for the world economy in the century since 1914.

Some things work, and some things don’t. We know what they are. Maybe economists will figure it out too, someday.