Monday, April 5, 2010

Why not a fixed money supply?


I asked this question in a macro-economics class at university once.  It seemed simple enough at the time, and seemed to me like a pretty simple and effective way to control a country’s monetary system. 

The question was side-stepped quite successfully.  So I went to my knowledgeable friend instead.

While there are some interesting conversations happening, I have yet to find a solid overview of the fixed money supply idea and the implications in practice. 

Thinking out loud here, as a general rule technological change and capital investment will enable a given society to produce more goods in future periods.  With a fixed money supply, that means that prices will decline over time – deflation.

So the relevant question becomes - how does an economy function with persistent deflation?  And my friend has a lot more to say on that.  (Just quietly, imagine you lived in a world with persistent deflation, you would be blogging about a how crazy it would be to propose a world with persistent inflation – how on Earth would it function with the value of money being destroyed each day?)


This interesting article outlines a number of tangible problems facing an economy with deflation, including sticky nominal wages and the inability for central bank to have a negative nominal interest rate.  However, past deflationary periods have not curtailed our passage of economic growth, nor do we often read about deflationary periods of prior to the Second World War.  The graph below shows the number proportion of inflationary and deflationary years pre and post WW2.  The ‘old fashioned’ long-run has almost equal periods of inflation and deflation - a time when money supply was far slower to grow than at present.

[Slide3.JPG]

One problem is that deflation rarely recovers to mild inflation but springs back to hyperinflation, as suggested here.  Because people hoard money during deflation, the government response is typically to increase the money supply, then, when deflation looks under control, these hoarded reserves come back into the flow of money, leading to rapid inflation.  With a fixed money supply, this effect should be dampened.

Maybe then the best thing for governments to do is live with a little deflation, rather than actively responding by increasing the money supply.  From the Austrian School we get these insights into money supply, and why a little inflation might still be a bad thing, and find this conclusion:

... to Mises even a monetary policy that would pursue a pre-determined rate of money supply expansion (as proposed for example by Milton Friedman's k-percent rule) for stabilizing a broadly defined price index would remain a potential source of crisis which, in turn, bears the risk of undermining the value of the currency. This explains why Mises, in an effort to reduce that very risk to the ideal of a free society, argued for stopping the expansion of the money supply, thereby arguing for a concept quite different from today's state-of-the-art monetary policy.

With a fixed quantity of money maybe we could end up with less volatile swings in the value of the currency because behaviour would not be influenced by expectations of monetary policy changes.  The expectation of a standing by the fixed money supply would lead less uncertainty, less hoarding, and potentially far more confidence in the currency.

However, we are still left with detailed questions about how debt or could work in this environment, whether people can perceive negative nominal gains as positive real gains (maybe there is a behavioural bias), and whether such a system provides a strong incentive for innovation and capital expansion.

I would appreciate thoughts on the matter as this is a bit of early brainstorming on the issue. 

8 comments:

  1. This is historically why gold has proved such a good form of money. As well as the typical properties that we associate with good money (easily divisible, does not corrode, etc.), it has two great properties:

    1) It's supply is not fixed. New gold is dug out of the ground. At the start of the 19th century, there was 3/4 of an ounce for every person on the planet. Fast forward 200 years, and there is still 3/4 of an ounce for every person. The supply of gold seems to follow population, thus helping to prevent continued deflation. The fact that gold cannot just be printed by a central authority means that it cannot be devalued quickly either.

    2) It is desirable as a consumer product as well as money. Furthermore, it is desirable as a *luxury* consumer item. This has a valuable effect. When everything is rosy, people (especially jewellers) will take gold coins (or trade their paper note for gold at a bank) and turn the gold into luxury items such as jewellery and trinkets. This has the effect of withdrawing money from the market, thus naturally helping to prevent the high inflation associated with booms. When boom turns to bust, the opposite happens: people turn the jewellery and trinkets back into money, thus helping to fight the deflation naturally by expanding the money supply.

    I believe that the main reason governments hate gold as money is that they hate to see the booms curbed. They want the party to continue, and fool themselves into thinking that monetary policy can be used to continue the boom without the following bust. However, as the current crisis shows, they help to exacerbate the bust by getting the policy wrong -- entire economies are just too complex to get such a decision right. Furthermore, even if they do get it right on occasions, the political pressure to continue the party is just too strong. Witness the Australian government's BS rhetoric regarding banks lifting their variable interest rates more than the RBA lift the OCR.

    Cheers,
    Tim

    p.s. I cannot see the image (slide3.jpg) in your post, Cameron. It seems to link to a google mail account.

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  2. Great points Tim. I will try and fix the image (it's working for me at the moment)

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  3. Fantasic points made by Tim, couldn't have said it better about all the advantages of gold-currency :)

    I'll just like to add that if anyone has the power to create money out of nothing then they'll keep doing it & robbing the people of their purchasing-power so a market-based standard would always be better than one that can be manipulated by a few people.

    TJ

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  4. In my opionion we need a fixed money supply system more than ever. The current fractional reserve system is now only being kept alive by quantitative easing i.e. the printing or creation of new money which devalues the purchasing power of the existing currency in circulation, whilst providing no increase in standard of living (no increase in production and corresponding drop in working hours). With a fixed money supply, deflation add infitum would not be an issue because the total amount of goods and services would does not constantly increase. Older good become worn out, depreciate, simply to be replaced by new ones. People would not need to save / hoard money excessively and a fixed money supply system would effectively be an economy in equilibrium with everyone's day to day needs. A fixed money supply would force people to agree prices in a fairer way than our present 'fractional reserve banking' system whereby the constant increase in money supply through lending pushes up prices. One means of implementing a fixed money supply would be for every one in a country to be issued with the same amount of new currency, but in a decent denominatio eg 10,000 units of the new currency. Everyone would be free to buy or sell each other's goods and services. This would encoureage people to work productively with each other, discourage scroungers. An even better idea would be to have a fixed money supply on some sort of 'standard'. For example, a fixed amount of money is in circulation is backed up by a three-year supply of the nation's natural resources, held in the central bank. These resources are sold to industry at a fixed price to convert into goods. At the end of their lifetimes, goods are recycled and the materials extracted could be sold back to the central bank for a slightly higher price. This would keep the fixed money supply in circulation at a rate determined by the lifetime of consumer goods, not a rate driven by excessive lending, as is the case with the current fractional reserve system. With such a new system there would be no need for lending or indeed excessive saving; banks would only be needed to securely store people's money. The system would effectively be hand-to-mouth, which is what human existance is all about, but peolple would always have the stability and knowledge that the price of staple items would remain stable for ever (in the absence of excessive population growth). If prices went up dramatically, that would simply be a manifestation of mass immigration (for example) and people would understand this readily from what is happening from the 'pound in their pocket' rather than thinking they just need to borrow some more money. In summary the money supply should be fixed to reference against the cake we share. The cake does not grow add infinitum, so the money supply should not grow. Lending should not be charged with interest. What we all own as individuals is what we all have and should be roughly stable in currecy units.

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  5. The problem with a fixed money supply is that the buying power of the currency would keep rising, which encourages people to not spend, as opposed to the current system of a depreciating buying power, which encourages spending.

    It would also concentrate economic power in the hands of the elderly in much the same way that property does now, except that the young can't buy into money in the same way they can buy into property.

    Wages would keep falling as currency unit purchasing power increased.

    You're right there is no body of work on this to my knowledge, but I do recall reading some comments by Chris Leithner. He might be worth chatting to.

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  6. Why not 0 inflation money supply? as suggested by some monetary reform economists.
    Today we see that the top percent holds 50% of the wealth, so obviously in a fixed money supply the situation would be worse, since it is a zero sum game, some people always earn more than they spend so in the long run they will hold most of the money! And the richer you are the less you have to spend.
    Even if prices go down still money will be scarce and the relative power the rich would have over the poor would be enormous.

    They way I see it there are two possible solutions:
    - 0 inflation currency (increases/decreases with the state of the economy)
    - fixed money supply with demurrage so the money is forced into circulation

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  7. I'm happy to see other people thinking about this. Most of the "problems" that people bring up about a fixed money supply relate to, "How will debt and credit work?" I suspect systemic debt is itself just a symptom of our improper land ownership paradigm. If that were fixed and debt were no longer seen as necessary or good, all of a sudden there aren't many arguments left against a fixed money supply.

    It's also interesting that Mises thought along these (anti-inflation) lines. I didn't know that.

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  8. I’m not an economist, but I remember reading Michael Lewis’ book ‘Liars Poker’. Lewis says that back in 1979 (presumably in an attempt to curb the overheated economy) Fed chairman Paul Volcker announced that the money supply would be fixed. It would cease to fluctuate with the business cycle and interest rates would float. What happened after that? Well for one thing, in less than a year interest rates in the United States almost doubled, reaching an all-time high of 20.00 percent in March of 1980.

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