Wednesday, April 9, 2014

Focus on the Fed, III: Banking and Reserve Currency

As we saw yesterday, a stable and standard currency is of the utmost importance to maintain a stable economic and political situation.  The problem we look at today is how to maintain a stable and standard currency, especially when there are many different types of money in an economy.

The oldest known coin in the west was found in the ruins of the temple of Artemis of the Ephesians
If the money supply consisted exclusively of currency issued by the regulatory authority, and if the regulatory authority maintained the standard without alteration, stability and uniformity of the currency would not be a problem; the currency would have a stable value in terms of whatever standard was used, e.g., $35.00 per ounce of gold.

There would, however, in a rapidly growing or industrializing economy be continual problems with inflation and deflation, and thus periods of “boom” and “bust,” as a result of the money supply not matching the needs of the economy, but that is a different issue.

Consistent with Say’s Law, however, the money supply consists not only of currency, but of all contracts that are used in commerce.  Historically, from a transactions perspective, currency has been the smallest and least important component of the money supply.

Converting money an important business service.
The problem, then, is how to ensure that all contracts denominated in terms of the standard have the same value and that there are sufficient media of exchange to carry out commerce.  The solution is to 1) have the option of converting any and all contracts into the standard, 2) backed by the word of a trustworthy authority, 3) to deliver asset-backed reserve currency on demand.

This is the role of the commercial bank.  A commercial bank trades contracts issued by individuals and other institutions (mortgages and bills of exchange) for contracts issued by the bank (promissory notes).  The bank’s promissory notes either circulate directly as currency (banknotes) or are used to back demand deposits (checking accounts).

Because not everyone who receives the bank’s banknotes or accepts checks drawn on the bank is indebted to the bank, holders of the bank’s obligations (banknotes and checks) must have the right to exchange or “convert” the bank’s obligations they hold into the official reserve currency.

Assuming that the reserve currency itself is sound, this gives the public confidence that the bank’s obligations are worth in terms of the reserve currency what it states on the face of the obligation.  This is why, whatever backs all other forms of money in an economy, the reserve currency must be asset-backed.

Inelastic Reserve Currency


The need for the reserve currency to be asset-backed is a pillar of the banking principle, and thus of a sound economy.  The problem is that the traditional assets used as reserve currencies, the precious metals, are “inelastic,” that is, the amount of reserve currency does not vary directly with the present value of existing and future marketable goods and services in the economy.  Except by chance, there is always either too much or too little money in circulation, adversely affecting the ability of people to engage in commerce.

Gold and silver are inadequate for monetary purposes.
The failure of a specie reserve currency to expand or contract directly with the needs of the economy causes inflation and deflation.  Backing all or a portion of the reserve currency with government debt does not solve the problem, and causes other problems.

One, government debt is not an asset of the issuer, but a liability of the issuer.  This violates the first principle of reserve currencies that they must be asset-backed.

Two, if the amount of government debt is fixed, there is no more practical advantage to backing the reserve currency with government debt than there is to backing it with gold or silver.

Three, implementing an elastic debt-backed reserve currency does not solve the problems associated with an inelastic debt-backed reserve currency.  If a debt-backed reserve currency is well managed, it is still only by chance that the amount of money in circulation is the amount needed to facilitate commerce and maintain a stable value.

If not well managed, that is, if politicians succumb to the lure of “free money” and the temptation to finance government operations or stimulate economic growth without recourse to direct taxation, a debt-backed reserve currency seriously erodes both economic and political stability.  In extreme cases, this can lead to loss of national sovereignty as well as hyperinflation.

This is why the rally at the Fed this coming Friday is so important, and you may want to consider attending if you're in DC on April 11, 2014.  Go to the Federal Reserve Board of Governors Building from 11:00 am to 1:30 pm, and look for the people demanding a reform of the Fed instead of ending it.


No comments: