A gold-based currency board, please

According to the author of this article, gold should return back to its formal role in international money. Nobelist Robert Mundell even predicted that "Gold will be apart of the structure of the international monetary system in the twenty-first century."

By Steve Hanke
Real Clear Markets

Until early in the 20th century, gold played a central role in the world of money. Gold had an incredible run – almost three thousand years. And why not? Afer all, Professor Roy Jastram convincingly documents in Te Golden Constant just how gold maintains its purchasing power over long periods of time.

But, since President Richard Nixon closed the gold window in August 1971, gold has not played a formal role in the international monetary regime Today, the “regime” is characterized by many as a chaotic non-system.

In the past decade, gold prices have surged and there have been noises in some quarters that gold’s formal role should be re-established in the sphere of international money. Nobelist Robert Mundell has gone so far as to predict that “Gold will be part of the structure of the international monetary system in the twenty-frst century.”

Automatic Currency Boards versus Central Banks

Gold-based currency boards could transform Professor Mundell’s prediction into a reality. Currency boards have existed in more than 70 countries and a number are still in operation today. Countries with such monetary institutions have experienced more fscal discipline, superior price stability, and higher growth rates than comparable countries with central banks.

An orthodox currency board is a monetary institution that issues notes and coins (some currency boards have, however, also accepted deposits). Its monetary liabilities are freely convertible into a reserve currency (also called the anchor currency) at a fxed rate on demand. The reserve currency is a convertible foreign currency or a commodity chosen for its expected stability. For reserves, such a currency board holds low-risk, interest-earning securities and other assets payable in the reserve currency. Its reserves equal 100 percent or slightly more of its notes and coins in circulation, as set by law.

An orthodox currency board has no active role in determining the monetary base. A fxed exchange rate with the reserve currency and the requirement that the currency board hold foreign reserves equal to 100 percent of the monetary base prevents it from increasing or decreasing the monetary base at its own discretion. Nor does a typical currency board infuence the relationship between the monetary base and the money supply by imposing reserve ratios or otherwise regulating commercial banks. An orthodox currency board system is passive and is characterized by automaticity. Regardless of the metric used, the money supply in a typical currency board system, therefore, is determined entirely by market forces—that is, the demands of money users who bring reserve currency to swap for local currency determine the amount of notes and coins that the currency board supplies.

In a currency board system and in a central banking system alike, commercial banks are entrepreneurs of credit. A commercial bank cannot lend more to borrowers than it can borrow from depositors (or credit markets), in the form of deposits held instead of spent. If a commercial bank lends excessively, the borrowers spend the excess, for instance, by writing cheques. In the payments system, more funds fow out of the bank than fow into the bank. To prevent the outfow from bankrupting it, a commercial bank holds reserves. Te loans of commercial banks are limited by their need to maintain sufcient reserves to enable depositors to convert deposits into cash (or reserves) on demand and to withstand outfows of reserves through the payments system.

A typical central bank, in contrast, can at its discretion increase or decrease the monetary base. It can lend to commercial banks, creating reserves for them, even if its foreign reserves are decreasing. More reserves tend to enable commercial banks to make more loans, which they do by creating deposits for borrowers. Te money supply then increases. Decreasing the monetary base tends to have the opposite efect. Besides changing the monetary base, a typical central bank can also infuence the supply of commercial bank loans by changing the reserve requirements for commercial banks.

Despite the inability of an orthodox currency board to create reserves for commercial banks at its own discretion, the money supply in a typical currency board system is quite elastic (responsive) to changes in demand, because the system can acquire foreign reserves. Te rules governing a currency board merely prevent it from creating reserves for commercial banks in an infationary manner, as a central bank can. Other sources of elasticity in the money supply are variability in commercial banks’ ratio of reserves to deposits, the pooling of reserves among branches of commercial banks in the currency board country and the reserve country, interbank lending, and variability in the public’s deposit-to-cash ratio.

In the past, currency boards have issued monetary liabilities that were fully backed by gold and were fully convertible into gold at a fxed rate on demand. Te following gold-based currency board law is presented to indicate how a modern, independent, gold-based currency board could be established and would operate. As drafed, the law would allow for the creation of a publically-owned entity. But, with slight amendments, the draf law could support the establishment of a purely private currency board.

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