The Global Two-percent Inflation Standard -- How Will It End?

The “global 2% inflation standard” has already been around for almost 20 years – longer than the effective life of the Bretton Woods system (from the general launch of convertibility for current payments in 1959 to the freeing of the gold price for non-official transactions in 1968). The US and Europe already joined the standard in the late 1990s. Japan “signed up” a few years ago. Under the rules of this “standard” each member central bank aims at perpetual inflation of 2% p.a. (equivalent to 3-4% p.a. if inflation were measured as in the 1950s and earlier without hedonic price adjustment to take account of quality improvements). Currencies are freely floating (no official intervention).

The timing of monetary policy actions in each country towards meeting the 2% inflation target are wholly at the discretion of the respective national authority. The IMF acts as the referee of the standard, nodding its approval to central banks as they experiment with a range of non-conventional tools (quantitative easing, negative interest rates) in their striving to achieve the target and on occasion hailing their “courage” in “fighting deflation”. When that courage extends to launching a currency war offensive (always without official declaration), the IMF is strangely silent, even though the founders of that institution saw as one of its principal purposes the avoidance of this scourge of the 1930s global economy.

For those looking beyond the hubris of the officials who administer the 2% inflation standard disturbing evidence accumulates about its power to spread asset price inflation disease and foster cycles of mal-investment all at the expense of economic prosperity. The evidence stems from several distinct business cycles. In the present one (starting around mid-2009) the “natural rhythm of prices” has been downwards for some considerable time creating a particularly challenging environment for the central bankers seeking to pursue perpetual 2% inflation.. At a moment of their choosing each national monetary authority decides to utilize (or start talking about possible utilization) a barrage of measures so as to lift a “too feeble inflation rate” back to target which has the immediate impact of depreciating the national currency.

Yet there is no groundswell of discontent about this monetary standard, in part because the central bankers and their political enablers are adroit at transferring any blame to the barons of the financial industry. There is no general recognition by the economics profession of asset price inflation disease, albeit that it has long been studied by the so-called “Austrian School” (see Brown 2015). A familiar refrain is that the disease is hard to measure and its prognosis at any point is highly uncertain. Such real difficulties though do not stand in the way of the disease being deadly to the economic system. In the early stages of the asset price inflation disease which the standard fosters, the monetary regime enjoys considerable popularity. The critics of the standard have a tough task in rallying any broad popular movement against the status quo given the economic sophistication required to understand their arguments.

There are plausible scenarios in which the case for abandoning the 2% inflation standard, emphasizing both domestic and international considerations, would gain political momentum, most importantly in the US. One could also imagine the crumbling of the 2% inflation standard starting in Germany or Japan.

In considering the example of the US or a smaller country exiting the 2% inflation standard key questions include the replacement standard and what would be the repercussions for the global monetary environment. In this paper the assumption is that the momentum for replacement would be in the direction of “sound money” (see Ebeling 1992) – meaning roughly the aim of conserving monetary purchasing power over the very long-run though avoiding short or medium term price level targets and allowing full scope for prices to fluctuate inter-temporarily consistent with the invisible hand doing its job efficiently (there would be periods when prices declined and others when they rose).

Sound money requires financial sector liberalization. Suppose this came into reality in the US – the most likely candidate country for monetary and financial reform. What would be the implications for the rest of the world and in particular would the 2% inflation standard crumble to be replaced by a global dollar standard or even a gold-dollar standard? That is the destination question of this paper, in the pursuance of which there is a first section reviewing the origins of the global 2% inflation standard; a second section follows on its now evident failures. The narrative then shifts to how the standard might start to fall apart, the nature of the accompanying monetary reforms, and the implications for international monetary arrangements.

How did the global 2% inflation standard begin?

Transcripts of FOMC meetings reveal that in July 1996 Chairman Greenspan led a discussion on whether now that inflation had fallen to 1-2% whether that should be regarded as consistent with price stability or whether policy should continue to bear down on inflation until it reached zero (see Brown 2015). Then Governor Yellen was invited to present a paper in favour of the first option. Her argument turned on first, the presence of “money illusion” which meant that real wages would be more flexible with positive inflation; second, the possibility of a zero rate bound meaning that rates could not fall to neutral level if that was negative as in a weak phase of the business cycle; and third, a hypothesis that hedonic price adjustment (taking account of quality improvements) by the official statisticians was not yet fully adequate. There was remarkably little counterargument in the meeting. In fact the main reservation came from a member who thought that Congress should be consulted first as to whether perpetual 2% inflation was indeed consistent with legislation which specified price stability as the aim which the Federal Reserve should pursue (see Pollock, 2015). No consultation of course occurred and even once Congress had grounds to suspect that the Fed has shifted its goal post to targeting perpetual inflation rather than “price stability” it raised no challenge.

In Europe, the launch of the European Monetary Union at the end of 1998 was the decisive event along the way to Europe joining the 2% inflation standard. In the Summer of that year Professor Issuing (the ex Bundesbank chief economist who became the eminence grise in the ECB council during the early years) and his committee of experts resolved the details for the ECB’s monetary framework. The Maastricht Treaty had specified the aim of price stability, but the Issing Committee interpreted this as 2% p.a. inflation, albeit denying that it had adopted a version of inflation targeting.

In Spring 2003 Professor Issing announced a refinement of the framework whereby the ECB would strive as assiduously to prevent inflation falling below 2% p.a. as rising above. And around the same time the Greenspan Fed took the unprecedented step of easing policy so as to breathe inflation back into the economy (on the view that inflation had fallen too low). Professor Bernanke had been appointed (by President Bush) a Governor of the Fed the year before and became a powerful voice within the FOMC for inflation targeting and “fighting deflation” (see Brown, 2014). At the IMF, Chief Economist Rogoff was highlighting global “deflation danger”, especially in Germany, in the prolonged aftermath of the IT boom and bust (featuring in particular the NASDAQ bubble of 1999-2000).

Japan continued to be outside the 2% inflation standard. The official long-term aim of the Bank of Japan was to hold the rise of prices to less than 1% p.a. and to be quite content with the outcome of stable prices. It was not until early 2013 when the Abe government came to power that Japan joined the 2% inflation standard The new prime minister’s clear intention was that the vast currency appreciation of the preceding years due to Japan being outside the standard whilst the US aggressively pursued 2% inflation should be reversed. The new governor appointed at the Bank of Japan by PM Abe embarked on a massive programme of quantitative and qualitative easing, supplemented eventually by negative interest rates.

What is remarkable about this passage of the world on the 2% inflation standard is how little if any of the process came under parliamentary or congressional scrutiny. The central bankers ordained the standard even though they were subsequently to describe the aim of 2% inflation as a mandate they were obliged to follow. Yes, the central bankers were appointed by governments or presidents well aware of their views and likely policy stance. And in the respective parliaments there had been opponents of those appointments. Yet in general (some exceptions in US Congress though their critique did not fall within the mainstream of the Republican agenda for Federal Reserve reform) the opponents did not pick out the 2% inflation standard for criticism. If there had been any real scrutiny and debate by the legislature what would have been the points raised, perhaps by panels of experts selected for that purpose by overseeing committees?

The traditional Keynesian assumptions about money illusion and labour market frictions could certainly have been questioned. In the age of the micro-computer and Amazon and more generally progress in information technology are we to believe that individuals in general do not have a very good idea about what is happening to wages and prices in real time? In negotiating a nominal wage rate cut with the employer the employee immediately can gauge whether this is happening generally throughout the industry or economy and how this translates into real purchasing power given a likely simultaneous fall in many prices.

More generally in a well-functioning capitalist economy under conditions of sound money we should not expect prices to be stable or on a stable path over short and medium periods of time in contrast to the very long-run. Fluctuations in prices of goods and services on average over time, both down and up, are essential to the invisible hand doing its work of continuously restoring economic equilibrium through time.

For example under a monetary regime where prices are expected to be on a flat trend over the very long run, these would fall to a low-point during a phase of cyclical weakness and rise during the subsequent economic expansion. Indeed the expectation of such pro-cyclical fluctuation in prices would mean that real interest rates would be negative in the weak phase of the cycle and conversely – no need for unconventional policy tools to achieve the result with all their associate hazards including in particular asset price inflation.

Similarly during periods of above normal productivity growth prices would tend to decline whilst the neutral level of interest rates in real terms would be abnormally high (and conversely during periods of below average productivity growth). At times when real wages across much of the labour market are falling in equilibrium terms one might expect nominal wage growth to be feeble or even negative, imparting a downward jolt to prices. Attempts of monetary authorities to over-ride this natural rhythm in prices, by steering market interest rates away from neutral, lead to the generation of asset price inflation and deflation.

An enlightened central banker could respond to such criticisms by arguing that a regime of permanent inflation at 2% p.a. should not be interpreted as steady inflation throughout at that level. Instead there would be fluctuations in the rate of increase below and above that trend, just as around a flat trend under the aim of long-run stable prices. The problem here is how to convince households and businesses about a man-made rule of 2% p.a. for the long-run – not founded in long tradition or long history and metallic fact (as under the gold standard).

Moreover there is the question of incentives. Yes, business people and households may bring spending forward during a recession when prices observed are lower than usual and there are anticipations of higher prices into a subsequent expansion. But who is taking out their micro-computer to estimate whether they should buy now because prices now increasing at a slower pace than usual are likely to rise at a faster pace in the future meaning that the real interest rate on monetary assets averaged throughout could be quite negative?

In practice the central bankers and their political enablers have not had to confront such questions and they have found deflation phobic rhetoric to be effective for their purposes.. And in Japan’s case a powerful narrative circulated inside and outside the country about the perils of “permanent deflation” and the non-ending “lost decade” which seemed to justify joining the 2% inflation standard (as in early 2013). Japanese experience through 1990-2010 also was a critical component of the historical folklore as told by the architects and advocates in Europe and the US of inflation targeting and later of the Great Monetary Experiment. In fact there had been no deflation and no lost decade (see Borio 2015 and Brown (2015).

In the aftermath of the Great Recession (2008-9) there had been a very powerful appreciation of the yen wrought by the Federal Reserve’s aggressive monetary experimentation. Joining the 2% inflation standard could be a powerful tool towards reversing that unwelcome appreciation of the yen and towards producing a big rise of Japanese equities in terms of devalued yen. Shinzo Abe won a landslide election victory for the LDP in December 2012 on the basis of just such a program capitalizing also on anger against the previous DPJ government (which had broadly been sympathetic to a strong yen and to Japan pursuing its own objective of price stability, staying outside the 2% inflation standard) for its widely perceived incompetence In the wake of the March 2011 triple disasters (earthquake, tsunami and nuclear accident).

Asset Price Inflation and Currency Wars under the 2% inflation standard

The evidence from the almost two decades of the global 2% inflation standard suggest that it has fermented bouts of asset price inflation disease and also currency warfare. Let’s take these two phenomena in turn.

When central banks are seeking to lower interest rates well below mainstream estimations of neutral level (these can be heterogeneous and made with very low confidence) so as to over-ride the natural fluctuation downward in prices a likely result is to strengthen the forces of irrationality in the market-place especially those described as “yield-seeking behaviour” and cause the spread of asset price inflation. Rates below neutral produce widespread patterns of capital gains which in turn seem to justify various speculative stories (for example limit oil, China and emerging market miracle, wonders of European integration) in specific asset classes which under normal monetary conditions would be met with considerable scepticism on the part of investors. The so-called irrational feedback loops which figure in the behavioural finance literature become operative. (For example a sequence of capital gains makes the speculative hypothesis seem highly plausible). Rates which are below neutral may also be low in absolute terms – further encouraging irrational striving for yield in higher risk assets (a key part of this is the dropping of scepticism towards what would normally be regarded as dubious speculative stories). Also relevant could be anxiety about potential future inflation shock albeit in the far distance meaning possible severe erosion of monetary wealth in real terms. .

At the time that the Greenspan Fed took the US on to the 2% inflation standard (July 1996), the economy was in an episode of rapid productivity growth in the midst of the IT revolution. The neutral level of interest rates would correspondingly have been abnormally high. And the natural rhythm of prices would have been downwards (or below long-run trend if this were positive). Instead the Federal Reserve took its cue from inflation being below its unannounced target to delay any substantial tightening of monetary policy in line with rapid growth. The result was growing asset price inflation of which symptoms included the Asian/emerging market bubble and bust and subsequently the IT/telecommunications bubble and bust (Brown 2015).

As the full extent of the bust emerged the Greenspan Fed became growingly concerned about the danger of “deflation” and these concerns were shared by the IMF and European Central Bank. Inflation targeting central bankers had no patience with arguments that the natural rhythm of prices coming out of recession should be weaker than during strong phases of the cycle. In early Spring 2003 the Fed concluded that inflation had fallen “too low” and announced an easing of policy designed to breathe inflation back into the economy. Even once the Fed resolved on a tightening of monetary policy it practised a degree of forward guidance unknown in previous cycles, promising that the rate rise would be gradual. Long-term interest rates were at abnormally low levels relative to previous cyclical experience. Puzzled Fed officials blamed this on an Asian savings surplus. But the alternative more plausible explanation was that the Fed’s forward guidance on short-term interest rates coupled with desperation for yield were distorting the long-term interest rate market..

Corresponding to the Fed’s efforts to breathe in inflation the dollar was weak in foreign exchange markets. From the viewpoint of Fed officials, including the new Governor from Princeton (Ben Bernanke) dollar devaluation would help push up prices and stimulate the economy (see Bernanke 2013). In turn the decline of the dollar would be the transmission mechanism which would spread the US monetary stance to Europe and Japan. Even though the ECB had embarked on a very similar monetary course to the US in early 2003 it had been more halting and the euro climbed.

The ECB decided against tightening in late 2004 (see Brown 2014) even though there were concerns expressed around its policy making table about symptoms of excess speculation in various asset markets and accelerating broad money supply growth. In effect if Europe was not to be a loser in the currency war which had started with the Fed’s breathing in inflation offensive it would have to follow keep monetary conditions very easy. That is what happened. Interest rates in Europe as in the US were most likely well below neutral level and also low in absolute terms – fuelling a process of asset price inflation which in the European theatre included sovereign debt in the periphery zone countries, Real estate markets in Southern Europe, subordinated debt issuance of the banks, amongst others.

European investors desperate for yield were also ready to play the US high yield markets such as in the sub-prime mortgage arena, hedging the currency risk as required. In the same vein income-famine US investors entered the European credit markets in the search for yield (usually hedging out any currency risk). There were also spill overs in the equity markets with US investors chasing the story that European financial integration meant that equities in banks in Europe would perform well – and similarly European investors embraced the US financial equity boom. The speculative temperature in the private equity “industry” on both side of the Atlantic soared to high fever levels as the combination of high-priced junk bonds and rising equity markets seemed to generate perpetual high returns in this field.

Japan, even though not yet a member of the global 2% inflation standard, was very much affected by the global asset price inflation disease of 2003-7 with its original source in the Fed and ECB. The strong yen in the years 2002-4 encouraged the Bank of Japan to stick with its experiment of quantitative easing which it did not wrap up until 2005 and even then held rates artificially low (see Momma 2014 ). Japanese investors searching for yield became big players in global credit markets and the so-called yen carry trade ballooned – the borrowers of yen to buy high coupon foreign currencies unduly credulous about speculative stories that justified that strategy. And a sequence of high profits from the trade seemed to justify their speculation. As the yen eventually tumbled under the weight of capital outflows the Japanese export sector boomed amidst what was to prove later to be much mal-investment.

The Great Monetary Experiment

Fast forward to the asset price inflation which followed the Great Recession having its origins in the Federal Reserve’s Great Monetary Experiment (quantitative easing and long-term interest rate manipulation all presented by its architects as in accordance with the principles of the 2% inflation standard). As in the early 200Os, there was an undeclared currency offensive by the US.

Ben Bernanke, the then Fed Chief, had said that dollar devaluation was a legitimate means of reflation as the rest of the world would benefit ultimately (see Bernanke 2002). The dollar fell sharply against the yen. During the Great Recession and its immediate aftermath it is highly plausible that the natural rhythm of prices as determined by cyclical forces was downwards (coupled with expectations of price rebound into a subsequent economic expansion). The nature of technological change which brought severe downward pressure on equilibrium wage-rates for many white-collared workers surely reinforced that rhythm. And so the Bernanke Fed in striving to reach 2% inflation in effect got to that result via dollar devaluation and the (in part related) jump in commodity prices, especially oil (which should be seen as part of the asset price inflation phenomenon, being led by powerful speculative stories - including insatiable Chinese demand - amidst desperation for yield).

Against the euro the force of the Great Monetary Experiment (GME) as a weapon of currency war was checked by the onset of the European sovereign debt crisis. The euro eventually staged a rise during 2012/13 as the crisis passed, triggering Europe’s own journey into a GME. By late 2012 Japan was no longer ready to be a victim of US currency warfare.

Everyone and their dog knew that the Fed was deliberately creating asset price inflation. Indeed the widespread anxiety about the ugly end phase of this disease helps to explain why its overall stimulus to business spending inside the US was so disappointing, albeit that there were areas of considerable strength related to particular speculative stories which were chased by yield hungry investors and fired by the booming private equity industry which thrived on high leverage and over-priced risky debt. For many, including Fed officials, the phenomenon of asset price inflation did not extend beyond the US equity market and the high-yield credit markets. In fact asset price inflation was much broader than that. It included the giant carry trade into the emerging markets the core of which was the China and also high-interest currencies of economies riding on the China boom (for example Brazil), Australia, South Africa). The carry traders were enthusiastic consumers of speculative stories such as the emerging market economies being in a multi-decade miracle.

The biggest speculative story of all, besides China and the emerging markets, and in some ways related to these, was commodities and especially oil. The energy industry to the present cycle of boom and bust has many similarities with the railroad industry in some 19th century cycles. Yes, many were better off because of the transformational technology coupled with entrepreneurship which meant lower cost of transport or energy but the unstable monetary background made for boom and bust along the way. In this cycle Income famine investors were prepared to believe the limit oil hypothesis – an insatiable demand for energy and other commodities from the People’s Republic and more generally the emerging market economies. The private equity industry boomed again on the back of over-priced high-yield debt and rising equity markets and became major players in the shale oil and gas sector in the US, the sub-prime auto finance industry, and the aircraft leasing business, and apartment-to-rent construction.

It is too early to know how all this will end even though Ben Bernanke has been on his book tour marketing his “The Courage to Act” and claiming that the Great Monetary Experiment (GME) has been a big success – and likewise present Fed Chief Yellen History of previous asset price inflations provides some clues but not definite predictions. For example the asset price inflation of 1934-6 fed by the equivalent of Fed quantitative easing and negative rates culminated in the 1937 Crash and Roosevelt recession. The Great Asset Price Inflation of the mid-1920s with its origins in the “price stabilization” efforts of the Benjamin Strong Fed (which steered interest rates below neutral at a time of rapid productivity growth reflected in a natural rhythm of prices which was downwards) featured a giant speculative carry trade into the world’s then number 2 economy Germany. That country was apparently experiencing an economic miracle after war and hyperinflation. The carry trade boom turned to bust when the German stock and real estate booms burst from 1927 onwards with catastrophic consequences culminating in the 1931 global financial crisis. Some parallels can be drawn with the boom of the carry trade in the present cycle into China.

Both Bernanke and Yellen have testified about the success of the GME to Congress and faced little real push-back from their ultimate masters there. Already we can suspect that there has been huge mal-investment due to their policies in the energy and commodity sectors. If money disequilibrium had not got in the way with its unleashing of irrational forces there would have been less of a hectic application of the new technologies in travel or energy extraction (and energy conservation) and more utilization of capital elsewhere in the global economy. Possible mal-investment is obvious in the export sector (related to emerging market economies), within the emerging market world itself (including over-investment in real estate), the automobile sector and even rental apartments – and the possible list goes on to include the sky-high temperatures in Silicon Valley, with its basis including a range of highly speculative stories, including the Eldorado of the Cloud or of mobile advertising.

The collapse in the commodity prices, especially oil, and sharp rise in the US dollar through 2013-15 which gathered pace as speculation on a start to Fed “normalization” gained ground meant that the props to goods and services inflation in the early post- recession period broke. But meanwhile a strong rise in real estate prices and apartment rents in the US had got under way, which meant that so-called core CPI rates were close to target. In addition there were big increases in the cost of health services including insurance related to the introduction of Obama-care.

The wider point here concerns the cumulative cost of asset price inflations both for the US and global economies. These costs come in two main forms. First there is the cumulative cost of mal-investment across a sequence of business cycles. Ultimately much of this investment becomes economically obsolescent. Second there is the increase in risk aversion on the part of investors who so often experiencing the devastation of the end phase of the asset price inflation disease require a higher return than otherwise to justify risk-investment. Yes it is possible that in the next asset price inflation episode even wilder monetary experimentation will make investors even bigger suckers for a range of incredible speculative hypotheses (meaning that with their rose coloured spectacles on they perceive very high returns) and so strong investment spending will be generated somewhere in the global economy. But the extent of mal-investment would also increase.

How will the 2% inflation standard crack up?

Could all the ill consequences described of the asset price inflation disease and currency warfare as engendered by the 2% inflation standard and the Great Monetary Experiment bring about a popular revulsion which would cause a crack-up?

The problem for monetary reformers who would like this to happen is that asset price inflation disease is a complex phenomenon, hard to diagnose, and little understood. Moreover the central bankers who are responsible for the origins and spread of the disease in many cases do not admit its existence and are adroit at deflecting criticism for bad outcomes to a range of unpopular targets including barons on Wall Street, greedy financial intermediaries, “the speculators”, and so on. Even so, if the present asset price inflation disease were to end very badly (in terms of economic and wealth effects) it is plausible that a political movement for reform in the direction of sound money could become powerful. This is perhaps easiest to imagine in the case of the USA, Germany and Japan.

In the US there has been a long established anti-Fed political force based in the libertarian right which would like to return the US to some form of gold standard. Within the mainstream, however, of the Republican Party a vision of monetary reform in the direction of sound money has failed to form in any coherent fashion. At present the Congressional Republicans in so far as they focus on monetary reform have an agenda of “auditing the Fed” and mandating that the Fed apply the so-called Taylor rule (itself based on neo-Keynesian discretionary monetary policy-making). Even some of those Congress members who distance themselves from the Taylor rule have not made any demand for scrapping of the 2% inflation target and they seem to think that the asset price inflation disease can be halted by instructing that the Fed monitor symptoms rather than tackling underlying causes. All this could change, but it is difficult to see how without the fortuitous circumstances of a wise prince choosing a talented adviser (in modern terms a new President appointing a talented monetary revolutionary – perhaps in disguise at first – as chief economic adviser; in fact before this stage the presidential candidate would have had a skilful campaign adviser who could find a way to package anti-Fed populism to win votes)

In the case of Germany, a campaign for the return to hard money (like the Deutsche mark) would inevitably have at its core anti-ECB and anti-euro rhetoric. To win the argument in terms of election outcomes the campaigners would have to find on their side those who object to the potentially huge hand-outs that German taxpayers have become committed to under monetary union as well as rallying all those discontented small savers who detest zero or negative rates imposed for the sake of the weak member countries. The boom and possible bust in the German real estate sector could be another vote gatherer amongst those “left behind”. It is not outside the range of mainstream scenarios that a future German chancellor whose support came from such a coalition of voters would be able to insist that continued membership in EMU would turn on the ECB reforming its monetary framework in the direction of hard money, abandoning in particular the 2% inflation target and ending the use of the ECB to make easy loans through its back door to delinquent debtor members. And if the other member countries did not agree, then Germany would exit EMU, or possibly form a new mini-monetary union with like-minded fellow countries.

As regards Japan, considerable discontent is now (early 2016) evident about its joining the 2% inflation standard (albeit that so far 2% has not been achieved). Popular surveys reveal nostalgia for stable or even falling prices. Asset price inflation has enriched a thin layer of the population in yen terms (in dollars the outcome is ambiguous or negative). Devaluation has added to the problems of poverty and many households resent the apparent related squeeze on their real incomes. Stock ownership is not as widespread as in the US or Europe. And there has been widespread scepticism of the Abe program of generating wealth inflation via mega money printing and currency devaluation. If the experiment turns out badly – meaning another early recession, a more widely perceived problem of poverty, and serious setbacks in the efforts of ageing population to provide for their retirement, and no economic renaissance, then we could imagine a political backlash. In Japan’s virtual one-party democracy the discontent would manifest itself along factional lines within the ruling party and within the powerful bureaucracy.

There are important asymmetries which would handicap the emergence of monetary reform (away from the 2% inflation standard) starting in Germany or Japan rather than in the US. If Japan or Germany (together with some other or all other EMU members) unilaterally abandoned the 2% inflation standard they would experience steep appreciations of their currency inflicting considerable pain on their export sectors. Their international muscle to bring about reform elsewhere which would mitigate this appreciation is small. Neither the Japanese nor European exit on its own would significantly influence of US political scene or Federal Reserve policy-making. And the governments in these countries could not realistically raise the threat of trade protection were the US not to go along with a similar monetary agenda.

By contrast, were the US to go down the road of monetary reform (in the direction of sound money) that in itself would strengthen political forces in Germany or Japan And were Europe and Japan to persevere with a 2% inflation standard once the US had left and experienced big currency devaluations in consequence, Washington could fire warning shots of action against unfair trade. Moreover the likely size of that devaluation in effective exchange rate terms (for the yen or euro) would be considerably greater than for the dollar in reverse circumstances given that so much of the world takes monetary policy action so as to limit fluctuation in the national money against the greenback.

The US also has the power to attack the global architecture of the 2% inflation standard – in particular insisting that the IMF abandon its support for this. A reformist White House and Congress could weigh on the IMF to no longer condone the unleashing of currency offensives by Europe or Japan under the guise of anti-deflation rhetoric or else that organization could find itself blocked from further US funding. The implementation of negative interest rate regimes would be viewed as indicative of likely camouflaged currency warfare. And indeed QE and other non-conventional tools of monetary policy including the payment of interest on reserves (which facilitates official manipulation in interest rate markets) could be seen as indicative of intent to wage currency war at some point. The US, having abandoned the 2% inflation standard, would be a potential victim of other countries using their continuing adherence to that standard to wage currency war. US currency diplomats would do well to draw up a check list of foreign monetary policies which would be deemed as grounds for suspicion in that regard. Ultimately many foreign countries might find that the most peaceful course of action would be to follow the US in breaking with the 2% inflation standard.

There is another source of asymmetry – the ability of each of these three countries or blocs (as Europe) to build monetary stability on an exit from the 2% inflation standard. Real reform in the direction of sound money would not be a matter of replacing a 2% inflation target with a 1% or 0% target, all else the same. Instead it would involve a radical overhaul in which monetary base was again put back at the pivot of the monetary system, the central bank abandoned all efforts at rate pegging and rate manipulation leaving these to free market determination, and the acceptance of considerable short and medium term fluctuations in the price level consistent with a flat trend for prices in the very long run. The larger the country or the currency bloc the greater the scope to build sound money order pivoted on monetary base. In a small or medium size country demand for monetary base under any practical regime might be inherently unstable and the extent of exchange rate volatility accompanying this unbearable politically.

Any effort to make demand for monetary base more stable by for example re-integrating gold into the system is only practical for a country which has huge gold reserves to hand – meaning practically the US, but also Germany and some other Continental European countries (especially France). Moreover were the US to launch monetary reform as described it would find a growing cluster of countries in the world choosing to join the dollar standard (by pegging their exchange rates against the dollar). That would reduce the cost to the US in terms of potential exchange rate volatility. By contrast we could not imagine a similar expansion of the euro standard or yen standard based on monetary reform by the respective lead country.

Re-building the international monetary system after US abandons inflation

The re-pivoting of the US monetary system on monetary base requires several conditions to be met. In particular there must be a large and stable demand for monetary base which should be a highly distinct asset (not a virtually perfect substitute for a range of very similar instruments). There must be no interest paid (positive or negative) on monetary base and so shifting demand for monetary base is manifested directly in fluctuations of interest rates. (See Brown 2016) (indeed in the first 60 years following the final end of the gold standard in the mid-1930s, monetary base paid no interest whether in Europe, US or Japan. The “innovation” of interest on reserves started with the ECB in 1998 and then the US and Japan in 2008). And the supply of monetary base must grow along a path which is consistent with stable prices in the very long run.

These conditions were to a considerable degree met under the gold standard, but with some definite short-comings. In the US and Europe the banking systems did not operate under a benign regime of competition in which demand for reserves by the banks and for cash and gold by the public would evolve in a stable manner. Rather regulations in the US as regards reserves to be held by various tiers of banks (whether money centre, or regional or local) seemed to provide grounds for false confidence in permanent financial stability when times were good.

Depositors and other creditors of the banks were not on constant watch. The same point could be made about the false confidence provided by the Bank of England’s lender of last resort role in Britain. The suppression of “free banking” in the US (in the mid 19th century) and in the UK much earlier meant there were no good real time market indicators about whether banks were becoming overextended such as would occur if their banknotes were to start slipping to a discount or there were to be a bulge in those being presented to the bank of issuance (which would force a cut-back in that bank’s expansion). In principle an interbank market for deposits could achieve the same purpose or a well-functioning bank equity market in bank stocks, but these in the main did not exist.

Under the historic gold standard the supply of monetary base (aggregated across all countries on the standard) was largely regulated by conditions in the gold mining industry. But gold or gold coin was not the only form of monetary base. There were also banknotes and gold certificates. And in Britain and other European countries there was a market in Treasury bills which functioned as near-reserves given the central banks operations there. And so there could be periods of significant acceleration or deceleration of monetary base growth brought about by action of national authorities, albeit that ultimately these constrained by pledges of convertibility of paper into gold.

In a monetary system where monetary base is the pivot and interest rates are freely determined (not subject to various types of pegging and manipulation) divergences can still open up between market rates and unknown neutral level. Markets use all available information in the estimation of the neutral level but these can prove to be wrong. There is a continuing process of discovery including the learning from mistakes. In principle we could say that the deviations between market and neutral should be smaller and less persistent than in a regime of discretionary policy-making by central bankers especially those prone to wild experimentation, but nonetheless these divergences can exist, and be the source of episodes of asset price inflation disease. Similarly shortfalls of growth in demand for monetary base behind the actual path of supply (whether determined by gold mining conditions or by monetary authorities) can be the source of asset price inflation.

How could the US re-pivot its monetary system on a monetary base aggregate? The first challenge is to create the conditions where there would be a large genuine demand for monetary base which was stable over time and for which there were no close substitute assets. High legal reserve requirements on the banks are not the way forward to this as these create so many perverse incentives. Instead the roll back of deposit insurance and too big to fail and of lender of last resort function would create the conditions where banks had to hold large reserves to satisfy deposit clients that these (deposits) were instantly convertible always into cash. Yes, different banks could market different quality of deposits in terms of the credibility of the convertibility pledge. At one end of the spectrum there would be the warehouses which virtually maintained 100% reserves to money market funds at the other end which could be expected sometimes to suspend convertibility Alongside anti-trust action would be enforced vigorously to remove advantages that credit card companies might secure from retailers which unfairly disadvantage cash payments in the economy.

A big issue to be considered by the monetary reformers would be whether to introduce gold convertibility. The advantage is the distinctiveness of gold as an asset means that a demand for monetary base would be more strongly anchored than otherwise. Also in principle the supply of monetary base would be unhinged from discretionary policy makers subject to political pressure. In practice, though, that unhinging would take a long time in view of the “re-entry” problem. No one knows how much the rest of the world would convert gold into dollars under the new monetary regime. And of course the reforms of the US financial system accompanying the monetary reform would not occur all in one day. Given huge uncertainty at first about the equilibrium demand for monetary base and its potential supply in the form of gold, discretion in the management of the supply of non-metallic dollar base would be unavoidable.

With the US monetary system again pivoted to monetary base and the dollar convertible into gold, many countries around the world would peg their own currencies to the dollar rather than experience considerable exchange rate volatility. And a dollar link under such a system would offer a good prospect of monetary stability for all countries that joined it, in contrast to the situation under a global 2% inflation standard (including the US), where a dollar link intensifies the exposure to risk of asset price inflation disease. Some countries with large gold reserves could opt to join the dollar area via introducing direct gold convertibility for their own currencies (rather than via a dollar peg). Demand for monetary base across a gold bloc extending well beyond the US should be inherently more stable and predictable and supply less subject to policy discretion than one just consisting of the US.

Alternatively US monetary reform could go down the road of ersatz gold, with no formal role for the yellow metal. The supply of monetary base would be determined be a set of constitutional-embedded rules designed to keep this in line with demand with goods and services prices on a flat trend from a very long-run perspective. The success of endeavour would depend on whether a simple rule such as x% expansion of the monetary base subject to certain over-rides as specified in a constitutional legal framework could be successful practically. Success would depend on there being a large stable demand for the monetary base, for which the financial reforms discussed above would be important. Again, the adoption of this monetary reform would go along with an expansion of the dollar zone in the global economy, though plausibly not to the same extent as one in which the US currency were convertible into gold.


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