Thursday, April 21, 2016

Why a Central Bank: The Theoretical Solution


Yesterday we mentioned that there is always a solution, even to a mess like the banking system in Country Y, where the central bank doesn’t perform the function of a central bank (few do in any country, for that matter), and the commercial or mercantile banks can’t make loans to private sector businesses because people don’t trust private sector credit instruments (or the banks), and the currency is backed 100% with government debt.

So, what can be done in such a situation?
"Gresham's Law" operates when the same authority issues both bad and good money.
Believe it or not, similar situations have existed in the past.  Economies have been flooded with bad money, and good money ceases to circulate.  This is “Gresham’s Law,” usually stated as “bad money drives out good.”
That, however, is only the case when the same authority that issued the bad money also issued the good money.  When you have two or more different authorities issuing money in an economy, people quickly stop using the bad money in preference to the good money.
That’s why so many governments get so upset when foreign currency starts circulating where they presumably control everything.  When people use something other than the officially sanctioned currency to carry out transactions, government loses power in direct proportion to people gaining power.
As long as it's good, who cares where it's from?
If governments relied exclusively on taxation for revenue, of course, they wouldn’t care what currency was used, as long as it was sound.  When government relies on its own debt to finance operations, however, people refusing to accept or use the currency backed by that debt is a disaster . . . for the government.  If no one accepts the currency, then the government can’t finance operations.
The first step, then, is to set up a micro-financial system in Country Y (or any other country with the same problem) to run parallel to the government system.  Of course, this must be government-sanctioned.  For that, all that need be done is for the head of state or the legislature to grant quasi-legal tender status to the good money to be issued.
This is not as crazy as it sounds.  A number of places in the world have been implementing “community currencies.”  These would not be adequate as they now stand to function at anything other than the local level, but the phenomenon proves that it can be done.  The “crypto currency” (e.g., Bitcoin) phenomenon also demonstrates that a parallel currency can catch on throughout the world . . . although we do not accept the monetary theory that the Bitcoin and other crypto currency people employ.  Implemented in strict conformity with the Banking Principle, however, something similar to community currencies and crypto currencies would do the trick.
Gold: good, but inadequate
The parallel currency would have to be pegged to some objective standard of value, not to the national currency or even a global reserve currency.  Traditionally this has been silver, more recently (in historic terms, anyway), it has been gold.  Even more traditionally, it has been draft animals, usually cattle.
The problem is that when using a commodity as the standard of value for a currency, when the commodity is subject to speculative trading, the currency also has a speculative value, and the gamblers have a field day.  The authority holding reserves of the commodity also experience a drain on their reserves as people cash in the currency in preference to holding the commodity.
Energy is probably the soundest measure of value, as it is the most basic commodity apart from food, and less subject to speculative changes in value.  The problem is that in a place like Country Y, the educational level is very low, and most people might not grasp the fact that the standard of value is just what you measure the currency in terms of, not what backs the currency.
The standard of value may have to be a “basket of commodities,” determined by the market price of a list or index of basic commodities in Country Y — food, fuel, and fiber — somewhat analogous to the Dow Jones (formerly) Industrial Average.  X number of units of the parallel currency would always buy y units of the index of basic commodities.  Eventually, the food and fiber commodities could be taken out of the index, leaving fuel — energy — as the standard of value, but that change can be gradual.
Next week we’ll look at the practical application of this solution.
#30#

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