Wednesday, September 21, 2016

A Mechanism For Ridding Ourselves of the Federal Reserve

A fascinating paper by Kevin Dowd and Martin Hutchinson, "Learning the Right Lessons From the Financial Crisis", looks at the mess that has been created in the global economy since late 2007 and how the Federal Reserve has pretty much been incapable of truly fixing the problems in the economy as would have been expected.  For the purposes of this posting, I am going to focus on one aspect of their paper; the mechanism that could be used to rid us of the Federal Reserve.  Here is a summary of their rather interesting suggestions.

Let's start by looking at a few key elements of the economy and how they have changed since 2007:

These graphs give us a sense of the futility of the Federal Reserve's actions and the monetary corner that it has painted itself into since the Great Recession took hold of the economy in late 2007.  It also gives us a good idea of how families have suffered over the last nine years and how the federal government is setting itself up for severe problems once monetary policies "renormalize".

The authors of the paper believe that there are several actions that must be taken if the malaise in the economy since the Great Recession is to be defeated.  Among those, their first suggested reform is to recommoditize the the dollar.  This is a "fancy" way of suggesting that the dollar needs to be reconnected to the gold standard that was abandoned in 1971 by the Nixon Administration.

Here's a quote from the paper:

"The key to monetary reform at the most fundamental level is to establish a robust monetary constitution that would have no place for institutions with the power to undermine the currency; thus, there would be no central bank. However, before we can end the Fed, we must first put the U.S. dollar on a firm footing. The natural way to do that is to recommoditize it—that is, anchor the value of the dollar to a commodity or commodity bundle."

In the Gold Standard Act of 1900, the dollar was defined as:

"twenty-five and eight-tenths grains of gold nine-tenths fine"

This is roughly equivalent to 1.5 grams of gold and fixed a gold price of roughly $20.67 per troy ounce.  The authors note that a gold standard is commendable because it prevents "monetary meddlers" (i.e. central bankers) from issuing endless supplies of currency.  The problem with a gold standard is that the price level is hostage to the gold market; if demand for gold rises, the price of gold will rise and this will push up the price of gold against goods and services whose prices must fall (i.e. deflation).  If the demand for gold falls or the supply rises, the price of gold drops and price levels of goods and services must rise (i.e. inflation).  History shows that while the price of goods and services was somewhat volatile over the short-term, it was much more stable over the long-term than prices have been since the end of the gold standard. 

So what can be done to alleviate the problems with the traditional gold standard?  The authors suggest that the most promising proposal is known as the "fixed value of bullion standard" which was proposed by Aneurin Williams, a British politician  in 1892.  Here is a quote from his paper:

"In a country having a circulation . . . made up of paper, and where the government was always prepared to buy or sell bullion for notes at a price, the standard of value might be kept constant by varying from time to time this price, since this would be in effect to vary the number of grains of gold in the standard unit of money. . . . If gold appreciated [relative to the price level], the number of grains given or taken for a unit of paper money would be reduced: the mint-price of gold bullion raised. If gold depreciated, the number of grains given or taken for the note would be increased: the mint- price of gold bullion lowered."

By changing the gold content of a unit of currency (i.e. a dollar), its purchasing power will be kept steady.  Williams suggested that a price index would have to be prepared frequently and that the mint price of gold would be raised or lowered in proportion to any rise or fall in prices above or below the par value.  Basically, the gold content of a unit of currency becomes the shock absorber.

Once currency is convertible to gold, the Federal Reserve's right to issue currency would be terminated.  Commercial banks would be allowed to issue their own currency based on their gold holdings.  Commercial banks would be free to issue notes denominated in U.S. dollars but the value of a U.S. dollar would be legally defined as a given amount of gold no matter who the issuer  of the currency would be.  

While a return to a commodity-based standard for the dollar would require a mechanism that is beyond the scope of this simple posting, it is increasingly apparent that the Federal Reserve/central bank model is not working.  The economy is subject to significant cyclic fluctuations that the Fed is powerless to stop and our experience since the so-called end of the Great Recession shows us that both traditional and experimental monetary policies have been more-or-less ineffective at restoring the economy to its pre-recession vigour.  It is obvious that a change is in order and the next recession may prove how badly that change is needed.


  1. The FED model is not working? Really? I guess the U.S. being an economic powerhouse is just an illusion - just like paper money, right?

  2. The comparison between the two is rather profound, isn't it?

  3. What a stupid idea. Why do we need centrally controlled currency? Why can't we have a free market for currencies? So people would use one that suits them most for their business? One would use free floating national currency, other currency pegged to a basket of commodities, third one Bitcoin and gold etc... The only way to fo it right - is to allow free market to sort it out.