Thursday, April 12, 2012

Market Monetarism and the Monetary Constitution

A monetary constitution imposes restrictions on political control of the monetary order. It limits both the politicians in the legislative branch and those actually executing any monetary policy-- politicians from the executive branch or else some kind of appointed public officials.

In the context of the U.S., a monetary constitution would restrict the U.S. Congress in legislating regarding the Federal Reserve, as well as put limits on the Board of Governors and the FOMC. Of course, the U.S. already has a constitution, and it even has some monetary restrictions. Unfortunately, either the existing U.S. monetary regime is unconstitutional, or else, the monetary provisions of the U.S. Constitution are ineffective and irrelevant. (I lean to the second view.)

What would be appropriate provisions of a monetary constitution?

In my view, the first provision of the monetary constitution should be that the people will be free to utilize whatever media of exchange they choose. People should be free to issue, hold, earn, spend, and save alternative monies. Mostly, this would provide a last resort defense against a breakdown of the monetary constitution. However, it would also allow people to shift to the use of some money they find more useful, perhaps that issued by the monetary authority of a major trading partner.

However, most of the monetary constitution should be about the definition and regulation of the dollar.

First, the purpose of the monetary powers of the Federal government is to provide for the existence of a medium of exchange for the people to use in their commercial activities. Further, any changes in the quantity of money should accommodate changes in the amount of money people choose to hold.

Such a purpose for monetary powers could be clarified by provisions explaining what it is not. The purpose of the monetary power is not to create money for the government to spend or borrow. Nor is the purpose to help the government collect taxes, make expenditures, or borrow from other sources. Further the purpose is not to help the people obtain funds to borrow. And finally, the purpose is not to help Congress or the executive branch regulate commercial activity.

Again, the purpose of the monetary power is to he serve the welfare of the people by providing them a medium of exchange that will serve their purposes, which might include selling, spending, borrowing and lending. And the quantity of money created should adjust according to the amount people want to hold.

Unfortunately, while the general rule that the quantity of money remain equal to the demand to hold it is sound, this norm is not a complete specification. The demand to hold money depends on its purchasing power. Worse, deviations of the quantity of money away from the demand to hold it leads to market processes that cause changes in its purchasing power such that people choose to hold the existing quantity.

Superficially, this suggests that a requirement that money maintain a constant purchasing power is a necessary addition to the proposal that the quantity of money adjust to the demand to hold it. Further, it suggests it is a sufficient substitute. To keep the purchasing power of money stable requires that the quantity of money adjust to changes in the demand to hold it given its current and expected purchasing power. Further, a stable purchasing power for money prohibits changes in the quantity of money away from the demand to hold it.

However, a requirement that the price level in dollars remain stable would require excessive manipulation of the quantity of money. In place of such a requirement, the constitutional rule should require that dollar spending on output grow with growth in the long run productive capacity of the economy. Putting these two elements together, the purpose of the monetary power of the government is to provide for dollar-denominated media of exchange for the people's commercial activities. The quantity of the medium of exchange should adjust to meet the demand to hold it, so that expenditures on goods and services grows with the long run trend in productive capacity, having the effect of maintaining its purchasing power in the long run.

While this general purpose applies to any officials appointed to direct the monetary authority, it also applies to the elected officials in the legislative and executive branch. In particular, the constitution should specify that legislation determines what specific measure of spending on goods and services should be targeted, the initial level of that target, and the growth rate between the target levels.

Further, the constitution should specify that if Congress should change either what measure of spending is being used or the future levels of that measure, any change can only be implemented in the future, perhaps five years after the new legislation is passed. For example, if nominal GDP was being targeted on a 3 percent growth path, and Congress decided that final sales of domestic product should be used instead and grow at a 4 percent rate, then the target would remain the existing series of levels of nominal GDP for the next five years, and only at that point would there be a shift to a series of levels of Final Sales of Domestic Product growing at the new rate.

What of the monetary authority? The constitution should give Congress the power to appoint a commission to serve as monetary authority of the U.S. Some size should be specified, say from 7 to 15. The members should have some term, perhaps six years. The constitution would explain how they are appointed, presumably by the exectutive with approval by the legislature. For the U.S., that would be appointed by the President with the advice and consent of the Senate.

The key role of the monetary authority should be to see that the quantity of the medium (or media) of exchange is adjusted according to the demand hold it, so that the specific targets specified by Congress for spending on output are reached. While the monetary authority might advise Congress as to what growth rate or measure of spending are best, at any particular point in time, choosing the particular measure of spending and its growth path should not be the responsibility of the monetary authority.

While the monetary authority has discretion, subject to the target rule, the types of monetary instruments issued should be determined by the legislature. The monetary constitution should not be written in a way that assumes that the monetary authority will be issuing any type of monetary instrument, and particularly not zero-nominal interest, hand-to-hand currency. Any such "paper money," or deposit accounts that can be held by banks or the general public, should be specifically authorized by legislation.

The monetary constitution should specify that the monetary power of the government seeks to create a dollar such that the people will have a sound medium of exchange for their commercial activities. Whether or not the monetary authority actually issues any media of exchange itself would require legislative action. In particular, it should be possible for the legislature to allow the monetary authority to regulate privately-issued, dollar-denominated media of exchange.

Any monetary instruments issued by the monetary authority should be considered debt of the government. While the government could borrow in terms of other types of monies, such as foreign exchange preferred by the lenders, it could and probably would borrow largely in terms of money controlled by the monetary authority. The requirement that the monetary authority reduce any monetary instruments along with any decrease in the demand to hold it, even to the point of retiring all of it, makes any such issue of money a type of loan that must be repaid on demand. Rejecting the notion that this is a type of debt implicitly assumes that the quantity of money issued would remain unchanged in the face of a decrease in the demand to hold it, resulting in a loss of purchasing power. It is just such a scenario that the monetary constitution prohibits.

As a practical matter, the monetary authority could adjust the quantity of money it issues through open market operations. Looking at the monetary authority's balance sheet, it would be holding assets in the form of government bonds to match the monetary liabilities it issues. From the point of view of the government's consolidated balance sheet, open market operations would be shifts in the composition of the national debt between monetary and nonmonetary liabilities. An open market purchase would be more borrowing by the issue of monetary liabilities and less borrowing by the issue of nonmonetary liabilities. An open market sale would be less borrowing by the issue of monetary liabilities and more borrowing by the issue of nonmonetary liabilities.

If the monetary authority issues deposit type liabilities, it could adjust the interest rate it pays on them as well. Since any payment of interest on deposit liabilities would be an expenditure of public money, a simple rule placing a limit on the amount paid equal to interest rate on the government bonds securing the deposit would be appropriate. The monetary authority could pay the interest rate it is earning or less.

Finally, the monetary constitution should explain how these rules can be suspended in an emergency. If some emergency does develop, and there is no provision for suspending the ordinary rules, then the resulting constitution would be too brittle. The chains limiting the political system would simply break. It is much better to require that any suspension of these rules be made by the legislature, perhaps with a super majority.

However, some "emergency" provisions are more obvious and could be made subject to whatever rules apply to the constitution generally. For example, if monetary authority thought it was appropriate to pay higher interest on any monetary deposits it issues than is paid on the securing government debt, then it should be required to have authorization from the legislature. Further, if the demand for the monetary liabilities authorized by Congress is outstripping the national debt authorized by the legislature, then the monetary authority would need to ask legislature to authorize additional borrowing and somehow spend the money. This could involve the legislature providing loans to the private sector or else running operating deficits by cutting taxes or raising current expenditures.

An alternative solution to an emergency due to a shortage of money would be to suspend the issue of government hand-to-hand currency and solely issue deposit-type monetary liabilities. The interest rates paid on those could be reduced enough to keep the demand to hold money equal to the existing national debt.

In the unlikely event that the national debt were to be greatly reduced, approaching zero, then the issue of monetary liabilities by the monetary authority would also be greatly reduced, approaching zero. Even in this situation, it would be possible for the monetary authority to use regulation for the settlement of payments, particularly net clearings between banks, to keep the quantity of privately-issued dollar-denominated money adjusted to the demand to hold it so that spending on output grows according to the target determined by the legislature. Should such a scenario arise, then the legislature would develop the rules and the monetary authority implement them.

What role, if any, should nominal GDP futures convertibility play in a monetary constitution? I think that the legislature should be free to require such a system as a way to constrain and impose accountability on the monetary authority. While the monetary authority should be free to look at any private nominal GDP contracts that exist as an indicator of policy, creating such contract and requiring the monetary authority buy and sell them at a fixed price should be authorized by the legislature. At this time, I do not think such a system should be required by the monetary constitution.


  1. Lots of thoughtful and interesting commentary.

    However, for now, in a recession following/sparking a real estate bust, I think the Fed should print money until the walls are blistering in the press room, and the plates begin to melt.

    After that, and we have a full-on boom going on, and real estate have mostly reflated, then let's sit down and talk reasonably.

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