Without monetary reform things will become even more frightening than my little halloweenies
I was asked to respond to a scholarly article written by Wim Nusselder of “The Broker Online”. The article was titled “Licensed to print money: Can monetary reform prevent the next economic crisis” and it gave a broad overview of how our modern monetary system has developed and showed concern about whether it is fit for purpose. This concern involved:
- questioning the role of the Central Bank;
- considering the current debate over whether a monetary system where money is fractionally backed by legal tender from the Central Bank is better than a system where 100% of money is backed by legal tender;
- suggesting that we may have to embrace the new technologies that allowed bitcoin to establish and perhaps eventually replace the Central Banks role in money creation.
As my title suggests I would like to see a monetary system be efficient without a major overhaul and I can see solutions to our current monetary problems with just a little tinkering. For our monetary system to work efficiently we need to be confident that the money we use as a medium of exchange and unit of account can store value and be a standard for deferred payment.
The history of fiat money in all major economies suggests that the Central Banks have not done a good job and we need to consider briefly why this has occurred and here I am going to look specifically at the Bank of England, although the points I am going to make are applicable to all the main Central Banks. Also I am going to make a simple and important statement that will be used to confirm that monetary reform has been successful. It is that when inflation is low, stable and hitting its 2% target the Bank is doing a good job of managing monetary demand.
Starting in the 1960`s inflation was low and stable mainly because the Bank was forced, by the gold exchange standard and fixed exchange rates, to keep a tight control over monetary expansion. In the 70`s it did a really bad job allowing inflation to rise to just under 30%. This is because it was accommodating the, until then, untried and excessively expansionary Keynesian fiscal policies. In the 80`s and early 90`s it gradually pulled inflation back to its low target and between 1997 – 2005 it achieved its best period of monetary stability by hitting the inflation target. It was no coincidence that in 1997 the Bank had become independent and was charged with achieving a target for inflation. Obviously it would not have been asked and it would not have agreed to do this if it thought inflation was outside its control.
The financial crisis exposed another weakness in the Bank`s policy and it was its over-reliance on one instrument, namely interest rates, to control monetary demand. The Bank added QE to its armoury in 2009 and, not knowing the correct cash injection, over-compensated with £375b that caused inflation to rise to 6%. Since then it has pursued too tight a monetary policy and moved dangerously close to deflation at the time of writing. It has also used the wrong lever to control monetary demand and a 0.5% Bank Rate has done nothing other than fuel asset bubbles.
It is now time to set out the correct reform to strategy that will allow the Bank of England and other Central Banks to create monetary stability and achieve their inflation target of 2% (+/- 1%). There are five important points.
- The Monetary Policy Committee should have only one target for its monetary policy and that is the inflation target. It should be absolved of any other responsibility as it cannot and never could have any positive effect on employment and economic growth.
- Giving due attention to time lags the Bank should set a broad money aggregate target for growth which is several percentage points faster than the expected rate of growth for real output.
- Bank rate should be abandoned as an instrument for managing monetary demand and the average level of interest rates should be left to be determined by market forces.
- In order to control the growth of money supply and monetary demand the Bank should return to a cash ratio control (last used successfully in the 1960`s). This has two distinct advantages: firstly cash is the only thing that the Bank has total control over if we exclude counterfeiting and secondly the setting of a ratio should not be too onerous as they can almost choose any number close to what the main banks are currently holding: say 4%.
- Once a cash ratio has been set the Bank can go in and out of the National Debt, buying debt to return cash when target growth in monetary demand is too low and selling debt when target growth is too high. This can be done, as it always was, using open market operations (OMO`s) and be managed behind the scenes without any of the big destabilising announcements that have accompanied QE.
Hopefully you can see from the above that this reform has maximum control, a minimum amount of change and the Bank of England is not being asked to do anything it has not done before. I have no doubt that this can produce the best monetary conditions for the economy to grow at a faster and more sustainable rate with no risk of a domestically induced financial crisis and a greater resilience to crises originating in other parts of the world.
John Hearn 9/11/2015
My thanks to Wim Nusselder for his comments.