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Sound Money vs. Stable Money

Thursday, December 20, 2012

'Stable money' policy has not fulfilled its promises anywhere it has been implemented. It’s time to renew the debate.

Historically, there have been two contrasting monetary doctrines.

The first doctrine favors what it calls "sound money," defined as money that has a purchasing power determined by markets, independent of governments and political parties. A true gold standard is one example of money that has an intrinsic value determined by markets rather than governments. Note that, under a sound money doctrine's principles, a gold standard where the government sets a fixed price at which it is willing to exchange its currency for gold does not qualify. If the government sets the peg price, the market’s essential role does not occur. So the various “gold price” systems that have existed from time to time (most famously the Bretton Woods system) do not qualify as sound money systems.

The second doctrine favors what it calls "stable money," originally defined as money that is managed so its value does not change, but more recently redefined as money that is managed so its value changes at some fixed, predictable rate. The principles of this doctrine require some authority to "control" the supply of money so fluctuations in the value of money do not create financial disruptions, such as recessions, panics, and deflation. Candidates for the authority to exert this control are always limited to governmental bodies, typically either the finance ministry (the U.S. Treasury, for instance) or an "independent" central bank. The degree of actual independence to be exercised by the central bank is always somewhat ambiguous and frequently is subject to change as circumstances change, but the idea of some level of independence is almost always present.

Sound money advocates lost the intellectual battle in the early years of the 20th century, and now the principles of this doctrine have been largely forgotten.

Sound money advocates lost the intellectual battle in the early years of the 20th century, and now the principles of this doctrine have been largely forgotten. Even people who think of themselves as fiscal conservatives favor a "gold standard" where the government sets a price for which it is willing to exchange its currency for gold, rather than a currency whose value is set by market action. And almost all modern economic theories favor an "independent" central bank as the administrator of the stable money policy, including Keynesians, monetarists, and supply-side economists. Exceptions include Austrian School economists and Libertarians.

Stable money advocates almost always favor "fiat" money, or money with no intrinsic value, such as the paper dollar, since then there can be no market disruption of the policy of the entity whose task it is to establish a stable money regime. Further, stable money advocates usually distrust markets in two ways.

1. Stable market advocates sincerely believe that market-controlled money will periodically cause recessions, panics, and deflation, and that therefore markets must be replaced by government actions, the government being the only entity strong enough to act in the place of markets. 

2.    Stable market advocates also mostly believe that the private citizens who make up markets will sometimes "hoard" money with intrinsic value — gold coins, for instance — thereby causing insufficient money to be available to fuel economic expansion, thus causing recessions, panics, and deflation.

So in the interest of having stable money, the proponents of government-controlled money hope to avoid doing harm to human beings by keeping the money supply "under control."

How successful has the stable money doctrine been? 

One case where the stable money system is being applied in a forceful way is Japan, which has been battling recession and deflation since 1990, when the Japanese economy entered a malaise from which it has not yet recovered.

Two other notable cases where the stable money doctrine has been adopted are the eurozone and the United States. The eurozone is experiencing an ongoing debt crisis that threatens to bring about a monetary crisis and which appears to have originated in a misapplication of stable money principles. And the United States's long-standing stable money regime is still groping to find a mix of fiscal and monetary policies that will allow us to escape the malaise the U.S. economy entered in 2007.

The question is: Does stable money work?  

Stable money economies still experience recessions, panics, and deflation, despite their stable money regimes. Now their citizens are being told that to prevent deflation, they must risk increased debt and the threat of massive inflation as their money supplies are expanded. 

But deflation is not supposed to be possible in a stable money regime. The notion that markets create deflation but government entities would not was a major reason the stable money advocates won the original argument. If that notion is not true, many of the original arguments for stable money carry less weight.

History has demonstrated that the disadvantages sound money advocates predicted for any stable money regime are real: constant inflation and increased government size and power.

History has demonstrated that the disadvantages that sound money advocates predicted for any stable money regime are real: constant inflation and increased government size and power. The advantage of stable money was supposed to be a release from the cycle of recession, panic, and periodic deflation. But it now appears that such outcomes still occur regularly, despite a stable money policy. The stable money advocates' suggested solution: more government controls.

The modern version of stable money contains an additional flaw — the shift from a true stability goal to a consistent, predictable-change goal. The current stable money policy goal in the United States, Europe, and Japan is 2 percent inflation per year.

What happens under this policy is that the same goods and services that cost $1 today will cost $1.64 in 25 years, a reasonable retirement length, given our rising lifespans; $2.44 in 45 years, when someone who starts work today will retire; and $5.38 in 85 years, the potential lifespan of a baby born today.

This is the "stability" goal that most central banks are determined to achieve. In the United States, we have never achieved this “stability” goal. The U.S. Department of Labor’s Bureau of Labor Statistics website notes that $1 in 1913 — the year the Fed was created and the U.S. government became able to institute a "stable money" regime — would buy as many goods and services as it requires $23.37 to buy today. That's an average inflation rate of 3.23 percent per year.

So let's substitute 3.23 percent — the actual performance figure — for the 2 percent policy goal and see what happens.

What happens is that the same goods and services that cost $1 today will cost $2.22 in 25 years, $4.19 in 45 years, and $14.97 in 85 years.

The stable money policy has not fulfilled its promises anywhere it has been implemented. Not only has “stability” been replaced with “constant inflation,” but the stable money doctrine’s claimed benefits are now open to question as the crises it was supposed to prevent are occurring with great frequency, long duration, and severe consequences.

It’s time to reopen this debate.

Kenneth Gould is a retired banker, living in Lake Bluff, IL.

FURTHER READING: Gould also writes “The High Cost of College: An Economic Explanation” and “The Roosevelts Would Be Appalled.” John A. Allison and John L. Chapman say “It’s Time for Pro-Growth Monetary Reform.” John Steele Gordon asks “Good as Gold?” John H. Makin offers “All That Glitters: A Primer on the Gold Standard.”

Image by Dianna Ingram / Bergman Group

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