FOREWORD
Money makes the world go round -- or so it has been said. We are all familiar with money, none of us admits to having enough of it, yet few of us know precisely what constitutes money. Indeed, even bankers and economists employ several different definitions of it.
Because it simplifies life enormously, we tend to express the prices of all goods and services in terms of some one or two things -- gold, silver, sea shells, rum, promises to pay later, the Australian dollar. This practice facilitates exchange and, so long as it is accepted, each measure of value is, for as long as it is widely accepted, "money". Goods and services change their relative prices to reflect changing demand and supply (each at the margin). So long as the average price of all goods and services remains near to constant, the value of the unit (money) in which they are expressed can be said to be stable.
If we should choose money that is itself subject to wild fluctuations of supply and demand, such as say rum, then the price system is not nearly so useful, contracts become unjust, there are windfall gains and losses of real wealth, we become subject to "money illusions" and so on. We suffer inflation (as in the 1970s and 1980s) or deflation (as at the beginning of the 1930s). The trick is to choose a medium of exchange that, on average, keeps its value -- whether because that is intrinsic to its nature (as adherents of the gold standard would have argued), or because it is administered with that being the sole objective (as the New Zealand dollar now claims to be). In short, we need honest, sound money.
This little booklet is about some of the ways of obtaining it. Several possibilities, including refinements to existing policy, are canvassed here -- and all of them found wanting. According to the authors, what we need is an approach that will rid us of inflation and its attendant costs, once and for all, rather than the interventionist tinkering by central planners and their political masters which has produced the endemic inflations of the modern world. In the view of both authors, the quickest, most credible and most lasting way to restore the health of our money would be to shift to a "commodity basket" unit of value -- that is, to define the Australian dollar in terms of a basket of goods so chosen as to provide a broad coverage of prices.
No doubt some will consider this a radical proposal, standing as it does in such stark contrast to current policy and the conventional wisdom on monetary matters. And it is true that some of the implications of the "commodity basket" approach -- an end to both the central planning and the monopoly supply of our money -- are certainly not conventional. But then, given the long-standing damage that has been done by unsound money, maybe a little unconventional thinking on the subject is not out of place. At the very least, the arguments marshalled here -- theoretical, historical and practical -- deserve to be widely read and discussed.
It is an easy "read" for the layman. I think that most who read it, even if they may not want to change the sort of money that makes their world go round, will nevertheless better understand the behaviour that retards rotation.
John Hyde
ACKNOWLEDGEMENTS
I have benefited greatly from discussions with monetary economists around the world, particularly Peter Bernholz, Kevin Dowd, John Greenwood, Steve Hanke, Alan Reynolds, George Selgin, Richard Timberlake, Alan Walters, Larry White and Leland Yeager. In Australia I have been particularly encouraged by Michael Porter and Peter Hartley. I should also like to thank the anonymous referee of an earlier draft of this essay. None of these professional economists, needless to say, is in any way responsible for my errors.
SOUND AND UNSOUND MONEY
The various necessities of life are not easily carried about, and hence men agreed to employ in their dealings with each other, something which was intrinsically useful and easily applicable to the purposes of life, for example, iron, silver and the like. Of this the value was first measured by size and weight, but in the process of time they put a stamp upon it, to save the trouble of weighing and to mark the value.
Aristotle
The textbooks tell us that money has three functions:
- to act as a medium of exchange;
- to provide a store of value;
- to give us a unit of account.
When analysing the role of money in our society it is important to keep track of these three different but essential properties.
MONEY AS A MEDIUM OF EXCHANGE
Money enables us to separate completely the act of buying from the act of selling. Most of us do not work for accommodation, a weekly ration of flour, tobacco, sugar, rum, a killer sheep, and occasional trips to town. We work for a money wage, let us for convenience say $50,000 per annum. With our earnings we buy what we need, for use or adornment. We exchange dollars and cents for food, clothing, shelter, transport, entertainment, objets d'art, etc, etc. We can divide our annual income into as small a fraction as one part in 5 million. (However, when the one cent and two cent coins are withdrawn this will become one part in one million).
A useful medium of exchange has to be portable, divisible into small parts, and readily acceptable amongst a large population and over a wide geographical area. The more instantly acceptable (geographically and in terms of population) a particular form of money is, the more useful it is. The question of acceptability is an interesting and complicated matter. During the period of free Scottish banking (1716-1844), Scottish banknotes were usually preferred to gold sovereigns. They were easier to carry, just as secure, and eventually gold sovereigns nearly vanished from Scotland, and were sometimes not accepted by tradespeople. It is noteworthy that in contemporary Australia, the one dollar and two dollar coins are unpopular, and the five dollar coin intensely unpopular, because of their inconvenience. The Treasurer has introduced them because they increase the profits from seigniorage, the cost of maintaining a note in circulation being significantly higher than the cost of maintaining a coin.
Australian banknotes are currently widely accepted, not only in Australia but also in most commercial centres around the world. However, the banknotes which today are most universally accepted are US dollar bills, which provide a medium of exchange for major transactions, and a store of value for hoarding purposes, in many South American countries, in the Middle East, and in Eastern Europe. The noted monetary economist Professor Lawrence White of the University of Georgia, has estimated that approximately 56 per cent of the US note issue is held outside the United States. A study conducted by the Federal Reserve, and discussed in their monthly Bulletin some three years ago, could only account for 20 per cent of the note issue within the United States.
MONEY AS A STORE OF VALUE
As people get older they usually build up their assets. They will own a home, car, furnishings, they may have some shares, and they will often hold part of their "portfolio" of assets as deposits in bank accounts of various kinds. We have long become accustomed to seeing the value of such assets decline with inflation. A bank account that has been maintained at a constant nominal level since the Hawke government first won office in March 1983, will reach half its March 1983 value some time during the next eighteen months.
Money such as the Australian dollar, which had (at September 1991) lost half its value since January 1981 (a half life of 10.8 years) does not, at first sight, appear to give us a major problem. However, money which loses its value at the rate of 50 per cent per annum would undoubtedly cause very significant problems. In the German inflation of 1922, money halved its value during the day, and halved it again the next day, and the next, and in this way inflation destroyed the whole fabric of German society, thus creating the social and political instability which facilitated Hitler's rise to power.
Money which retains its purchasing power, decade after decade, is of enormous benefit to the society which has it. It encourages saving, because saving becomes a relatively simple matter of finding some trustworthy banks who can be relied upon to honour their liabilities. Since the great bulk of the savings held as bank deposits in an economy comes from people on average incomes or less, ease of saving, and incentives to save, are of profound importance in economic development. The economic story of Japan, since the War, has been, in large measure, the story of successful saving.
Sound money is therefore, above all other things, money which does not lose its value, its purchasing power, from one year to the next, from one decade to the next. It is noteworthy that even the most respected of world currencies, the Deutschmark and the Swiss franc, declined in value over the thirty-year period 1950-1980 to 39.4 per cent and 38.5 per cent, respectively, of their 1950 values. These figures represent a half life of 22.3 and 21.7 years respectively. The Australian dollar has had a half-life of 9.8 years under Keating, 7 years under Fraser, and 4.5 years under Whitlam. In fairness to Sir Philip Lynch (Malcolm Fraser's Treasurer) it should be noted that the inflation which took place during 1976 and 1977 was, in large measure, due to the Whitlam government.
MONEY AS THE UNIT OF ACCOUNT
The most difficult aspect of money to understand is its function as a unit of account. In linear measurement we find the definition of a yard, or a metre, easy to accept. In former times these lengths were defined in terms of fine lines etched onto brass rods maintained in standards laboratories at constant temperatures. Money is much more difficult to define, however, because the value of anything is ultimately in the mind of the observer, and such values will change with time and circumstance.
Sir Isaac Newton, as Master of the Royal Mint, defined the pound sterling in 1717 as 113 grains of pure gold. This took Britain off silver and onto gold as defining the unit of account. The pound was 113 grains of pure gold, the shilling was one-twentieth of that, and the penny 1/240 of it.
By the end of the nineteenth century the gold standard had spread around most of the trading world, with the result that there was a single world money. It was called by different names in different countries, but all these supposedly different currencies were rigidly interconnected through their particular definition in terms of a quantity of gold.
In economic life the prices of different commodities and services are always changing with respect to each other. If the potato crop, for example, is ruined by frost or flood, then the price of potatoes will go up. The consequences of that particular price increase will be complex and unpredictable. Because of the high price of potatoes, prices of other things will decline, as demand for them declines. Similarly the argument that the Middle East crisis following the Iraqi annexation of Kuwait would, because of increased oil prices, have led to sustained general inflation is, although widely accepted, entirely without foundation. With sound money (money whose purchasing power does not decline over time) a sudden price shock in any one commodity will not lead to a general price increase, but to changes in relative prices throughout the economy. As oil increases, other goods and services will drop in price, and oil substitutes will rise in price, as the consequences of the oil price increase work their unpredictable and complex way through the economy.
The use of gold, during the days of the gold standard, as the unit of account meant that the price of all other commodities and services, would swing up and down with reference to the price of gold, which was fixed. If gold supplies diminished, as they did when the 1850s gold rushes in California and Australia petered out, then deflation (a general price level decrease) would set in. When new gold rushes followed in South Africa and again in Australia, in the 1880s and 1890s, the general price level increased, gently, around the world.
The key problem with our contemporary government fiat monopoly currencies is that their value is not defined; such value is entirely subject to the vagaries of political fortune. Their future value is unpredictable, depending as it does on political chance. In our economic calculations concerning the past we automatically convert incomes and expenditures to dollars of a particular year, using CPI deflators which are stored in our computers. When we perform economic calculations into the future we guess at inflation rates and feed them into our number crunching. Our guesses are entirely based on past experience. In Australia most current calculations assume an 8 per cent inflation rate, in perpetuity.
The great advantage of the nineteenth-century gold standard was not just that it defined the unit of account, but that it operated throughout almost the entire world. A price in England was the same as a price in Australia and in North America. Anthony Trollope tells us in his diaries about his Australian travels in 1872 that a pound of meat, selling in Australia for twopence, would have cost tenpence or even a shilling in the UK. It was this price difference which drove investment and effort into the development of shipboard refrigeration, and the opening up of major new markets for Australian meat, at great benefit to the British public.
Today we can determine price differences between countries by considering the exchange rate of the day. In twelve months' time, even a month's time, however, a totally different situation may prevail, and investments of time and money made on the basis of an opportunity at an exchange rate of the day, become completely wasted because of subsequent exchange rate movements.
The great advantage of having a single stable world money is that such money has very high information content. It tells people where to invest their time, energy and capital, all around the world, with much greater accuracy and predictability than would otherwise be possible.
THE PROBLEMS OF GOVERNMENT FIAT MONEY
We do not have what our grandparents and great-grandparents had: a stable, single, world money. We have government fiat currencies whose value is indeterminate except in the very short term. Many very clever people make very good livings from sharing, and spreading, the great risk and uncertainty tied up in the value of our dollars. The greater part of that risk is ultimately due to that discretion which is the essence of sovereignty.
Professor Leland Yeager summarised all these difficulties admirably in a recent paper:
It seems absurd to let so pervasively influential a price as a country's exchange rate jump around in response to investors' and speculators' changeable whims about their asset holdings. It seems absurd that changes in, and expectations and rumours about, monetary and fiscal policies, trade policies and market interventions should be allowed to exert such quick, magnified, and pervasive effects. But we should be clear about just what is absurd.
It is not the flexibility of exchange rates. It is not the alleged free-market determination of prices on the exchange markets. The absurdity consists, rather, in what those prices are the prices of. They are the prices of national fiat moneys expressed in each other, each lacking any defined value.
The value of each money depends on conjectures about the good intentions of the government issuing it and perceptions about its ability to carry through on its good intentions. These conjectures and perceptions are understandably subject to sharp change. (1)
Australia is a small country whose prosperity has always been based on supplying commodities to world markets. At the time when the international gold standard prevailed we were, with New Zealand, the richest country in the world. The importance to us of a single stable world money in those days, in providing information which accurately guided our investment decisions, cannot be over-estimated.
WHAT SHOULD AUSTRALIA DO ABOUT ITS MONEY?
Australia is currently suffering from acute monetary problems; high inflation, high interest rates, high exchange rates, high current account deficit. These things are all symptoms of unsound money. If governments seek to cure one symptom, without tackling the fundamental disease, other symptoms will suddenly appear. The real consequences of chronic unsound money are rapidly declining investment (particularly in the export sector), declining savings, and boom and bust in business life.
The response of the present Commonwealth Government to this situation has been to assert, very strongly, the efficacy of political control. The immortal words of Treasurer Keating, when speaking of the Reserve Bank, "They do what I say"; the failure of any member of the Reserve Bank board to tender resignation; and the appointment of the former Secretary of the Treasury, Bernie Fraser, to the Governorship of the Reserve Bank; all these underline the complete confidence of the Government (and its appointments to the Reserve Bank board), in a monetary regime operating according to the discretion of the Treasurer.
The response of the Opposition to these major problems is to flag what we can call a "Bundesbank" solution. The idea is a simple one. The German Bundesbank has been the second most successful central bank in the world. (The Singaporeans take first prize). It has a charter which gives it, at least in theory, independence from political interference, and a commitment to anti-inflationary policies. If Australia redesigns its Reserve Bank to give it independence and a new charter requiring overriding concern for a non-inflationary currency then, as in Germany, Australians will enjoy the benefits of sound money. That is the theory.
There are difficulties, however, with the Bundesbank solution. The fundamental pre-requisite for a successful Bundesbank is a 1922 German inflation. The people who established the Bundesbank after the war, under the leadership of Ludwig Erhardt, had all experienced the horrors of that inflation, and the catastrophe of Hitler and the War. Their sons, so to speak, now run the Bundesbank, but memories of 1922 have faded, and the inability of even the Bundesbank to resist powerful political pressures was brought out in a recent paper by Sir Alan Walters, (2) who cited the victory of Helmut Schmidt over the Bundesbank, when the then Chancellor foisted the European Monetary System (EMS) upon a highly antipathetic central bank. Much better known is the final subordination of the Bundesbank to Chancellor Kohl in the matter of the redemption rate for East German marks. In order to ensure rapid German reunification the one-for-one redemption was finally agreed to. This was a major defeat for the Bundesbank.
In mid-May 1991, the President of the Bundesbank, Dr Karl Otto Pöhl, resigned, five years before his eight-year term of office expired. Although it was denied, this resignation is clearly intended as a protest at the German Government's machinations concerning European Economic and Monetary Union.
One of the most damaging criticisms of central banks and their monthly, weekly, or even daily decision-making concerning the money supply is due to Axel Leijonhufvud, (3) who has described this process as a random walk. All around the world the governing boards of various central banks, with monopoly powers over money supply, meet (usually monthly) in circumstances of conjecture and uncertainty about the future, and decide on what each central bank should do about that unknown future. The result of their deliberations and decision making leads to a "random walk" monetary standard, a random walk, however, with a persistent inflationary bias.
As the persistent failure of monopoly supply and central planning of money becomes even more apparent, a number of leading monetary economists are advocating not a return to the gold standard of a century ago, but the development of a commodity standard as the unit of account. (4) Under this regime, the dollar would be defined as the sum of x mg of gold, plus y mg of silver, plus z gm of copper etc, etc. The composition of this basket of commodities is, and has been, the subject of much debate. If such a definition were to provide money free of political risk, there would have to be a credible degree of entrenchment built into the defining legislation. If such a unit of account were to develop as an international unit, then the commodities contained within the basket must be internationally and freely traded, so that an uncontrolled world market price exists for them. Precious metals, base metals, oil, specified grains, tea, coffee, cocoa, are clearly potential candidates for such a commodity basket, defined to establish a unit of account.
The relative prices of all these commodities, one against the other, will change from day to day. They will therefore also change against the unit of account, the dollar or whatever the unit of account might be called. But the sum of the prices of the particular amounts of the commodities specified in the definition of our unit of account would remain constant.
Australia has a window of opportunity in its present unhappy monetary state. The Australian dollar is internationally known as a high inflation currency, offering high interest rates and currently, little downside exchange rate risk. Australia is politically stable. Monetary reform, in which the Australian dollar was defined in terms of a large basket of internationally traded, well-defined commodities (the definition of which was well entrenched through legislation and preferably, eventually, through constitutional amendment), would enable Australia quickly to become a major international banking centre.
Once the unit of account is defined in this way, there is no need for a central bank to issue money. Indeed it is most important that the issue of money be de-monopolised. Private banks will issue money and through competition, the form of redeemability, and the type of notes and coins which the public prefers, will become readily apparent. The public will certainly want one dollar and two dollar notes. The current fifty cent coins will vanish.
The question of redeemability is much more difficult to predict. Gold may turn out to be what the public wants. If so, the bank notes will promise to pay, if not on demand, then within, say, a week, the amount of gold which that note will purchase on the date of redemption. That amount, of course, will vary from day to day, as will all the commodities used to define the invariant sum which defines the value of the dollar. The public, however, may not prefer gold but may seek redemption in other currencies such as US dollars. Only competition, and time, will determine the outcome.
A second-best solution, which politicians may find attractive, is to define the Australian dollar not in terms of a basket of commodities, but in terms of the major currency affecting our export trade, the US dollar. To tie the Australian dollar, without qualification, to the US dollar would mean accepting US interest rates and US inflation rates, and in this sense we would be giving up, in some sense, a measure of sovereignty. Australia could use the US dollar and at the same time assert its sovereignty by tying the Australian dollar to an inflation-adjusted US dollar.
Under this regime the Australian dollar would be defined on Day One at, say, 70 US cents.
Every quarter the US Bureau of Statistics issues CPI figures for the US dollar, and if, for ease of calculation, the quarterly figure was 1 per cent, then the Australian dollar would be automatically incremented in value, day by day, by one ninetieth of a percent. At the end of the quarter the Australian dollar would be worth 70.07 cents. In this way we assert our sovereignty, we obtain an inflation-free currency, and, at the same time, we free-ride on the universality of the US dollar.
As with a commodity-defined currency, we cannot have monetary stability if we have a monopoly supplier of money -- even if the notes issued are redeemable in gold or some other form of "outside money". Monopoly supply leads to monetary instability as the monetary history of nineteenth-century England demonstrates, and as George Selgin has predicted on theoretical grounds. We require competing money suppliers, and the functions of the central bank become those of prudential requirement supervision, and statistics gathering.
These matters are being discussed widely overseas. In Australia there seem to be only a few economists who are aware that the literature exists. Nobel Laureate James Buchanan, when puzzling recently over current public acceptance of institutions which have so clearly failed in their responsibilities to provide sound money, and of the indifference of the great bulk of professional and academic economists to one of the major economic problems of our times, asked
Why do we, as members of the body politic, put up with institutional arrangements that seem to keep us well within the frontier of potential value? Why do the professional economists, who are presumably competent to analyse alternative institutional structures, seem so reluctant to condemn the existing regime?
He answered his own question thus:
Many economists do not know what they are talking about, and, if economists do not know, how can they expect citizens to cut through massive intellectualised absurdity. (5)
It has taken many years to wean an influential profession away from the absurdities of High Keynesianism. As Kenneth Davidson reminds us almost every day in The Age, that process will only finally be accomplished with the passing of the current generation. It is to be devoutly hoped that it will take a much shorter time to persuade this profession that its ready acceptance of the post-war consensus on monetary regimes is similarly misplaced.
STOPPING INFLATION
INTRODUCTION
Inflation has ravaged the Australian economy for four decades. It has created so much uncertainty that sensible long-term planning is now virtually impossible. It pushed up interest rates, and high interest rates in the last couple of years have devastated the business community and destroyed many businesses and jobs. Though inflation and interest rates have fallen over the past year or so, the continuation of current monetary growth rates of 6-7 per cent can only mean that they will start to rise again, and the whole cycle will then repeat itself. Inflation has also impoverished many people who lost substantial parts of their savings, merely because they did not anticipate the effects that inflation would have on the assets in which they made their investments. At the same time, it has awarded large and often undeserved gains to those who were lucky or smart enough to load themselves up with debt that has subsequently lost its real value. These arbitrary redistributions of wealth have eroded both the security of property and the sense of fairness on which the market system depends if it is to function properly. Inflation also undermines the efficiency with which markets allocate resources. Markets start to malfunction because inflation injects noise into the signals about relative scarcities that market prices are supposed to provide. Inflation -- both here and abroad -- has also created a climate of exchange rate uncertainty that penalises those who engage in international trade, and makes us all worse off by restricting the international division of labour. Yet inflation provides no clearly established gains at all to set against these losses.
There is, therefore, a strong case that the elimination of inflation ought to be a major priority. However, not everyone agrees, and one continues to hear the argument that we should learn to live with inflation because reducing or eliminating it would be costly, and perhaps excessively so. The usual argument is that reducing inflation would involve an increase in unemployment or a fall in output, but this argument needs to be examined carefully. Back in the 1960s Keynesians told us that the Phillips curve represented a trade-off that the government should use to find the "right" mix of inflation and unemployment, and in practice that mix usually meant higher inflation and lower unemployment. Governments took their advice and the eventual result was soaring inflation in the early 1970s. Unemployment fell at first, but the "gains" in unemployment that these policies produced turned out to be merely transitory, and the end-result was both higher inflation and higher unemployment -- a combination of misfortunes that the Keynesian theory of the Phillips curve predicted would never occur. The experiences of the last twenty years have made it clear that our long-run choice is between higher inflation and lower inflation, period, and not between high inflation and high unemployment.
Some argue, nonetheless, that even if there is no long-run trade-off, the short-term costs of bringing inflation down are so high that we should think twice about trying to eliminate inflation outright, and this short-run Phillips curve theory still has many supporters. They argue that there is an "inertia" to the inflation process, and this inertia implies that we can only bring inflation down substantially by putting the economy through a painful and possibly quite long recession. The usual source of inertia is the sluggishness of inflationary expectations. Whatever the authorities do, it takes a while for private sector inflationary expectations to adjust. If the government tightened its monetary policy, inflationary expectations would still remain high for a while. But if the government persisted with its new policy, the private sector would eventually come to believe it and reduce its inflationary expectations, and only then would the recession begin to ease. Supporters of this view argue that this is exactly the kind of problem that governments face in practice -- that there is no "easy answer" to inflation -- and point to a number of recent cases where they claim governments have only been able to disinflate by putting the economy through a recession. A good case in point is said to be Britain in 1979-81 which went through a very severe recession after the Thatcher government tightened UK monetary policy in the months after it came into power in 1979.
The opposing position maintains that private sector expectations are fundamentally rational (that is, people try to avoid mistakes in their forecasts), and if it is rational for people to change their inflationary expectations quickly, then they will do so. The key point is credibility. If a government promises to get tough on inflation but those in the private sector have no reason to believe it, then they won't believe it and the government will only be able to change private-sector views by proving its determination the hard way -- in other words, by demonstrating a willingness to put the economy through a recession. According to this view, it was precisely because so many recent governments lacked credibility that they have had such difficulty bringing inflation down, and the UK recession of the early 1980s is a classic example. If the government has credibility, or can enact a set of measures that have credibility, then the private sector will believe it, inflationary expectations will fall, and inflation itself will fall without any significant unemployment side-effects. Put another way, the traditional argument that bringing inflation down quickly would produce large amounts of unemployment in its wake is only valid on an other-things-being-equal basis. But it is not valid here, because the key factor usually held equal -- inflationary expectations -- adjusts very quickly to the "right" change in policy regime, and the fall in inflationary expectations short-circuits the process that would produce the higher unemployment. The fact is that inflation can be reduced without major unemployment or lost output provided the reform package is credible.
A MONETARY REFORM TO ELIMINATE INFLATION
Once the decision is taken, there is a simple way to implement a credible monetary reform to eliminate inflation once and for all. The essential step is to redefine the Australian dollar in terms of a basket of goods which is chosen to keep prices stable. The reform would be straightforward to implement. The Government would announce that the law was to be amended to state that the dollar had a value equivalent to that of a specific basket of commodities. Anyone issuing dollars (for example, the Reserve Bank of Australia) would be legally compelled to buy them back on demand with assets of the same value as the commodity-basket that defines the dollar. The Bank could "buy back" its notes and deposits with financial instruments (such as shares), but which financial instruments it used for this purpose is not especially important, provided that the money-issuer cannot simply create those assets at will. (This stipulation is necessary to provide some discipline on the amount of currency the Bank can create.) Inflation would then end because the commodity-basket would be chosen to produce a stable price level.
Inflation would also be eliminated very rapidly indeed. It would be impossible for inflation to continue once the reform were implemented, because any "excess money" created would be returned to the issuer before it could push up prices. (At the moment, "excess money" leads to inflation precisely because there is no mechanism to retire it from circulation.) In addition, the private sector would realise that inflation was gone for good -- in other words, the reform would have credibility -- and inflationary expectations would consequently drop to zero. This fall in inflationary expectations would then short-circuit the Phillips curve mechanism, which might otherwise have pushed the economy into recession, and so any significant side-effects on unemployment should be avoided. The fall in inflationary expectations would also eliminate the inflationary premium that is currently built into interest rates, as lenders would no longer demand a premium to compensate them for inflation. Indeed, real interest rates -- that is, roughly speaking, interest rates adjusted for expected inflation -- would also fall. The new regime would eliminate a lot of current uncertainty about future market conditions, and thereby reduce the risk premia that lenders currently need to induce them to lend. These falls in real and nominal interest rates would then push up asset values (in other words, increase wealth). It is true, of course, that ending inflation would inflict losses on those who had "bet" on inflation continuing -- those who took short positions on T-bills, for example -- but the higher asset prices that would result from the reform imply that these losses would be more than offset by the gains.
This proposal would effectively restore a convertible currency, and lest we think that convertible currencies are somehow unusual, we should recall that they were the historical norm until the gold standard was abandoned earlier this century. Until 1914, the value of the currency was secured by its legal definition as a particular weight of gold and the right of the holder of a pound note to demand that an issuing bank exchange it, at any time he wanted, for gold at the legally specified rate of exchange between gold and notes. (This was what the legend "I promise to pay the bearer on demand the sum of one pound" actually meant. The pound was gold, and a "pound note" was only a claim to a pound.) A compelling attraction of convertibility is that it disciplines the issuer of money. If ever banks issued too much currency, the public returned any "excess" they did not want to the issuers, who were compelled to buy it back in exchange for gold. Another attraction of the gold standard was that the price level was comparatively stable (at least in the long run), because it was tied to the real value of gold. Banks stood ready to buy and sell pound notes for gold at a fixed rate of exchange, and that meant they were "fixing" the price of gold (in terms of pound notes). Whenever the price of gold outside the banks deviated from the banks' own fixed price, there were profits to be made buying gold from the banks or selling gold to them, and the process of making these profits caused the price of gold outside the banks to return to the banks' fixed price. The price of gold therefore tended to be uniform throughout the gold standard world. And since the price of gold was fixed, the general price level could alter only when there were changes in the relative price of gold, and such changes were relatively limited. Prices did fluctuate a certain amount from year to year, but movements in the price level tended to cancel each other out over the long term, and prices in 1914 were about the same as they had been a hundred years before. Moreover, interest rates under the gold standard were by modern standards both low and comparatively stable.
The proposal advanced here is similar in many respects to the old gold standard, but there is one important difference. The price level under the gold standard was tied to the real value of gold, and so prices tended to fluctuate whenever there were changes in conditions in the gold market (for instance, there was some inflation in the 1850s following the discovery of gold in California and Australia). If the currency were tied to a wider basket of goods, the price level would not fluctuate so much in respect to changes in the market conditions for any one good. A wider basket makes the price level more stable on a year-to-year basis, and we would choose the commodity-basket in such a way that there would be no significant price-level changes at all. The proposed currency reform is similar to the old gold standard in that it would discipline the issue of money and deliver long-run price stability as well as low and relatively stable interest rates, but it would improve on the gold standard by delivering price stability in the short run as well.
SOME HISTORICAL PRECEDENTS
The idea that one can stabilise prices almost immediately is not some untried academic speculation. Reforms like this one have been carried out in the past, and they have all been dramatic successes. The historical evidence indicates that credible monetary reforms to restore convertible currencies can eliminate inflation very quickly. Perhaps the most instructive examples occurred in Europe in the early 1920s. Hyperinflation was then rampant in much of eastern Europe, and a number of countries -- Germany, Austria, Hungary and Poland -- implemented radical monetary reforms which "stopped [their] drastic inflations dead in their tracks". (6) These reforms re-established the discipline of the gold standard, and reinforced that discipline by limiting or prohibiting the government's right to borrow from the banking system. In several cases the inflation ended virtually overnight, but in every case it was over well within a month. An earlier assessment of these experiences confirms this conclusion:
Whoever studies the recent economic history of Europe is struck by a most surprising fact: the rapid monetary restoration of some countries where for several years paper money had continuously depreciated [i.e., inflated]. In some cases the stabilization of the exchange was not obtained by a continuous effort, prolonged over a period of years, whose effects would show themselves slowly in the progressive economic and financial restoration of the country ... Instead, the passing from a period of tempestuous depreciation of the currency to an almost complete stabilization ... was very sudden. (7)
It is also interesting to note that these stabilisation packages were not accompanied by the massive rises in unemployment that the traditional Phillips curve analysis would predict. Unemployment rose in Austria, but it was already rising there before the stabilisation and one cannot tell whether all the post-stabilisation rise in unemployment was due to the stabilisation itself. There are no figures available for Hungary before price stabilisation, but the absence of any substantial rise in unemployment after stabilisation is certainly consistent with the view that there was no major unemployment "aftershock" to the stabilisation reform. In Poland unemployment actual fell for six months after the reform, and in Germany the stabilisation was accompanied by increases in output and employment and decreases in unemployment. (8)
One sometimes meets the reaction that these experiences are "so extreme and bizarre" that they have no relevance to contemporary countries. (9) However, as Sargent continues:
[I]t is precisely because the events were so extreme that they are relevant. The four incidents we have studied are akin to laboratory experiments in which the elemental forces that cause and can be used to stop inflation are easiest to spot ... these incidents are full of lessons about our own, less dramatic predicament with inflation, if only we interpret them correctly. (10)
One might add, however, that there is one important respect in which these experiences do differ from Australia's -- apart from the obvious difference that their inflations were much higher. In each of the hyperinflating countries, nominal interest rates lagged far behind the prevailing rate of inflation. The real interest rate was therefore substantially negative, and the restoration of sound money implied a considerable jump in real interest rates back to positive levels. Contemporary observers saw this hike in real interest rates as a major force making for greater unemployment. In Germany in particular, a large amount of investment had been undertaken on the basis of negative real interest rates which was no longer viable when real interest rates returned to more normal levels. A major capital restructuring then had to take place after the stabilisation which cost many German workers their jobs. In contemporary Australia, on the other hand, real interest rates are probably higher than their historical norm and they could be expected to fall if a price stabilisation package were implemented. (Real interest rates would fall, if only because the premiums they bear for future uncertainty would be reduced. Nominal interest rates would fall even more because of the elimination of the inflation premium they currently bear.) So the principal difference between the historical hyperinflationary experiences and Australia's now is that, in the former case real interest rates rose, while in Australia's case they would fall once the reform were carried out. The unemployment side-effects, to the extent that there were any, would have been more severe in the historical cases than they would be in Australia, and the fact that they were so small anyway gives us further reason to expect that Australia could implement a reform package like this without it producing a recession in the process.
In any case, the 1920s also saw two other episodes in which much more moderate inflations were ended by the same sort of radical monetary reform. One was the stabilisation of the French franc in July 1926. France had been in crisis for some years past. French governments had been relying on anticipated reparations receipts to meet their future debts, and government finances deteriorated as it became clear in 1924 that these receipts would not materialise on the expected scale. The government consequently resorted more and more to lending from the banking system (in other words, printing money) and the franc depreciated at an accelerating rate. Then Raymond Poincaré was appointed prime minister in July 1926, and the franc suddenly stabilised on the foreign exchange markets. Inflation stopped equally dramatically. It was widely known that Poincaré would restore the gold standard, and the franc stabilised even before the French legislature had time to enact his reform measures. In the following months he pursued a tight monetary policy, and the franc recovered ground against the dollar while domestic prices declined. The stabilisation of the franc appeared to have no serious ill-effects on output or employment, and was "followed by several years of high prosperity". (11) So once again, prices were stabilised with few or no harmful side-effects.
The other episode occurred in Czechoslovakia. When the Austro-Hungarian empire broke up at the end of the First World War, the new states that emerged from it inherited the old empire's inflation -- not to mention a mass of other chronic problems -- but Czechoslovakia alone among them took measures to stabilise the currency before it degenerated into hyperinflation. In February 1919, the National Assembly ordered the country's borders to be sealed and the foreign mail closed. Circulating Austro-Hungarian notes were then to be presented for stamping, and only stamped notes were to be recognised as Czech currency. Laws were also passed to limit government note circulation and prevent inflationary government finance. The effects of the reforms were clear and dramatic. The depreciation of the crown stopped, and the crown then began to appreciate against gold. The initial intention had been to restore the pre-War parity of the crown against gold, but it was later decided to stabilise the crown at its current value. No figures appear to be available about unemployment, but histories of the time do not suggest that there were any major unemployment side-effects.
COMMODITY STANDARD OR MONETARY TARGET?
A common objection to the kind of reform just proposed is that it is not necessary, and that much the same benefits can be achieved by the central bank adopting a monetary target that ensures that the money supply grows at a rate low enough to be compatible with stable prices. There are several basic objections to this argument. One objection is that the monetary target has room for error which the commodity-price rule does not. The experiences of monetary targeting over the last 15 years have well illustrated the difficulties, technical and otherwise, of central banks hitting their monetary targets. Financial innovation, the variable and unpredictable lags in the time it takes policy to take effect, and the limited and often unreliable information on which the monetary authorities have to work -- all undermine the effectiveness of traditional monetary targets. Monetary targets have also tended to be relatively easy to discard when the state of the economy changed and the relevant authorities -- the government or the central bank -- came to regard them as inconvenient obstacles to monetary stimulus. It is of course possible to legislate a monetary (or price-level) target, but then some mechanism needs to be found to ensure that the central bank's performance is adequate. The problem then is that the most obvious institution to assess the bank's performance is the central bank itself, and the scheme is still open to tampering by its supposed guardians. These problems undermine the credibility of the scheme and worsen the unemployment and lost output side-effects of implementing it. Even if the scheme were implemented and brought inflation down, it would not be expected to last. Inflationary expectations would remain relatively high, and worse still, the monetary target would almost certainly collapse in the end.
CONCLUSION
A reform to eradicate inflation is probably the single most important economic measure the Australian government could implement, and the foundations of the economy will never be secure without it. It is essential that the private sector have a stable and secure monetary framework within which to go about its business. A reform like this one would not only give the government a spectacular victory over inflation, but it would also reduce interest rates and probably produce higher output and lower unemployment as well. However, it requires that conventional ways of thinking be abandoned; and the authorities must be prepared to stop tinkering with the monetary system as they have been doing ever since the War ended. If the government really is serious about inflation, it must tackle the problem at its roots and commit itself to radical monetary reform. There is no alternative route to monetary stability.
ENDNOTES
1. Leland B. Yeager, "The Significance of Monetary Disequilibrium", Cato Journal, 6, Fall 1986.
2. Alan A. Walters, "Monetary Constitutions for Europe", a paper presented to the Munich meeting of the Mont Pelerin Society, September 1990.
3. Axel Leijonhufvud, "Inflation and Economic Performance", in Barry N. Seigel (ed.), Money in Crisis, (Cambridge, Mass., Ballinger for the Pacific Institute, 1984), Chapter 1.
4. For more detail about historical precedents, the consequences of shifting to a commodity standard, and an assessment of the political problems associated with such a move, see the companion essay below.
5. James M. Buchanan, "Reductionist Reflections on the Monetary Constitution" Cato Journal, Volume 9, Number 2, Fall 1989.
6. T.J. Sargent, Rational Expectations and Inflation, (New York, Harper and Row, 1981), page 115.
7. C. Bresciani-Turroni, The Economics of Inflation, (London, George Allen and Unwin, 1937), page 334.
8. Sargent, op. cit, chapter 3.
9. Ibid., page 101.
10. Loc. cit.
11. Ibid., page 119.
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