Reform the Monetary System?

by Andreas Hoffmann*

Most economists agree that the latest crisis was caused by risk-taking incentives (competition for profits, wrong ratings, false policies, moral hazard) along with financial innovations that allowed banks to lend excessively. While monetary policy prevented, for better or worse, a collapse of the financial system, an increasing number of economists also agree that it is not possible to safeguard the financial system over and over again. There are limits to intervention. Therefore we have to find a way to deal with the very causes of the crisis.

Currently the only policy solution seriously discussed is regulation of financial markets or certain instruments. Success of regulation is questionable due to two reasons: First, financial innovation is a process that does not stop after regulators finished the job. Excessive credit lending is still possible given the current monetary system. Second, risk-taking incentives remain unsolved. Regulation does not address moral hazard due to lender of last resort and bail-out expectations.

To solve these problems serious thought must be given to reforming the current monetary system. There are two ways to tackle this issue:

First, one can try to solve the problems within the current monetary framework. Central banks would need a new policy rule. They could e.g. have to counter-cyclically react towards credit expansion by ‘leaning against the wind’ when asset prices skyrocket and credit aggregates explode (link). If they communicate their intention to do so, the incentives for risk-taking may be limited in the first place. This solution assumes the central bank’s ability and will to act accordingly.

Second, alternative monetary regimes should be discussed. In this respect, a commodity standard could limit credit expansion via financial innovation (link). Free banking may further promote self regulation and could restrict bank’s risk-taking when the lender of last resort is absent (link). Alternatively a world fixed real exchange rate regime might improve international financial stability (link).

Surprisingly most economists do not seriously consider reforms of the monetary system. In the recent gold standard discussion many economists quickly dismissed and ridiculed the idea with reference to the experiences of the Great Depression. Had the current system proven to be more stable and less crisis prone, this would be understandable!

*University of Leipzig and New York University.

24 thoughts on “Reform the Monetary System?

  1. A nice post.

    I agree on the need for moentary reform and Andreas sets forth alternatives. As it happens, Jim Grant has an op ed in today’s NYT, which makes the case for gold.

    It will take a serious examination of the Fed’s actual performance relative to the classical gold standard and national banking system to change minds. The Selgin-Lastrapes-White paper linked to at Coordination Problem is a good start.

    To be fair, one must mention a monetary rule like the Taylor Rule. Also, there are the advocates of 100% banking.

  2. This suggested approach is also the most profound lesson we can learn from constitutional economics if we apply it to monetary institutional economics. Thank you for this piece, Andreas.

  3. Thanks for the comments. I like Jim Grants’s piece.

    Certainly research is needed to test whether any of the abolished systems would have brought about better outcomes than the current one, including something like BW or a gold standard.

    I think there should be an open discussion about all kinds of possibilities to stabilize our unstable monetary system. Maybe this has to be done internationally. This would not be an easy task as interests of countries may differ. We might need a new Machlupian ‘Bellagio group’ to come to an agreement 🙂

  4. This piece seems to refute itself in part.

    It first refers to the inherent futility of regulation and then, in the first of the two resolutions posited, suggests restructuring … the regulations! Maybe I’m putting too broad a brush into the writer’s hand.

    I’m also frustrated by the diffident, tentative choice of words: “discuss” alternative monetary structures? This is merely a stylistic, emotional complaint on my part, but it nonetheless informs my reaction. “Consider?” Better.

    Better still: “select,” or even “move to.” Sounding precipitous, here? Well, if so, that’s YOUR stylistic, emotional reaction.

  5. N.Joseph Potts,

    thanks for your critique. But I disagree a bit with your interpretation.

    Maybe the difference I make between new monetary policy rules and regulation in the market is not clear here:

    Regulation of the financial industry – such as banning derivatives or so – is not the same as changing the rules of the monetary framework.

    Proposing ‘leaning against the wind policies’ is more than simply banning an instrument because it changes the monetary policy rules – and, as proposed by e.g. Borio and White or Roubini, restricts banks from overexpansion when asset markets hike. Currently central banks are not supposed to restrict lending as long as cpi increases remain at low levels.

    This may not be a perfect solution. Fine!! But it could improve the outcome. So it should be considered, especially as it is the easiest change to implement.

    For the wording:

    I do not want to anticipate results. In my opinion ‘select’ or ‘move to’ is inappropriate at this stage. Proclaiming a different system without serious comparison of the merits would suffer from pretence of knowledge.

  6. What about everyone just doing the RIGHT thing! Follow the Golden Rule and be honest. The love of money gained by dishonest people has corrupted our monetary system and are entire way of life.

  7. “Machlupian Bellagio Group.” I like it. It’s actually something we should think about. We need a group committed to monetary reform. Beyond that, no preconditions.

    Cato’s annual monetary conference is being held this Thursday and can be viewed online. I’m up on the first panel: “Does Monetary Policy Cause Asset Bubbles?” I don’t how much we will get into monetary reform. My paper does so a bit at the end, but I have only 12 minutes to summarize it.

  8. Nice comment about “leaning against the wind” policy. I don’t have a link, but Trichet has said that ECB should restrict money growth and “lean against the wind”, so maybe at least ECB is reforming its policy. Thus, I totally agree with your suggestion.

    But, I think history tells us that free banking just does not work as we might assume. I think banks were more or less free “back in the days”. Was is not the panic of 1907 after which Fed was created? As we very well know, the panic ended to intervention of J.P. Morgan. Now the panic ended to massive government bail-out. It also dead certain that banks would have created these financial innovations regardless (or lack) of regulation. So, I do not think that putting blame on too much regulation is the right conclusion about the crisis. I do not think that data or even theory supports it (see for example: Akerlof ja Romer (1993), “Looting: The Economic Underworld of Bankruptcy for Profit”,
    Brookings papers on Economic Activity
    2:1–73). It is likely that the only policy decision that really contributed to the crisis was the creation of Fannie and Freddie, i.e. government intervention to housing market.

    And last but not least, tying money to some commodity is not a good idea. In general, economic theory does not seem to have a very good understanding of what money is. Like I allready wrote on the fb discussion, money should not be tied to production process, because it controls/transforms/guides the production process. It’s sole purpose is to transform the value of certain production process to an other (and sustain value). If you think of it this way, tying money to some part of production makes no sense.

  9. Jerry,

    The conference schedule looks very promising.


    I have a link for “leaning against the wind” in the post.

    I do not understand your last comment: In my reading – as you put it – money’s “sole purpose is to transform the value of certain production process to an other (and sustain value)” makes the case for a commodity standard. Maybe I misunderstand this paragraph.

    I think we agree that the current system failed in providing a stable framework. We also do not know if it provides a more stable framework than previous regimes.

    Therefore considering options, which include free banking, should be natural. It is possible that free banking had its flaws. Maybe they are even worse. This needs to be further investigated.

  10. We certainly did not have free banking in the US in 1907. It was the National Bnaking System, which had many limitations and restrictions. Arguably, however, it performed as well or better as the Fed era. Likewise the gold standard + BOE in the 19th century wasn’t half-bad compared to modern experience.

    What is called free banking in the US ended with the National Banking Act. The US free banking system differed from the Scottish. All this is explained at length by Selgin and White.

  11. Yes, we should remove the central bank! The federal reserve is a private company that is designed to efficiently extract wealth from the middle class and hoard it. It IS the fundamental problem. This corporation does not work for the best interests of the many, only the few. It also creates fiat money out of thin air thus causing inflation at real rates far higher than reported.

  12. I agree with Jerry. There were eras of free banking that seemed very stable.

    But it is hard to compare performance of different systems in different historical context (with financial deepening having increased as it has).

    But this goes both ways! Therefore we have a lot of alternatives on the table to think about.

  13. The discussion is more specifically about reforming the monetary government apparatus. Dodd-Frank in the US and various new rules in Europe added more regulation on top of a dysfunctional system rather than restructuring it.

    As Andreas says, reform has received little attention.

  14. I think it was Axel Weber, the Bundesbank president, who first articulated and promoted, despite a rather skeptical Trichet and opposition from other ECB Board members, the idea of using monetary policy “to lean against the wind”.

  15. History repeats itself, “first as tragedy, then as farce.” But, Marx should have added, “once again as tragedy,” or so it would with a return to the gold standard.

    What was the lesson of the 1930s? The sooner a country abandoned the gold standard, the quicker its economy recovered; the longer a country held onto the gold standard, the more it was plagued deflation, bankruptcies, and unemployment.

  16. Yeah, that might be right, but back then there were no asset bubbles 🙂 Weber said in a speech that he wants to include this “lean against the wind” policy in the ECB mandate, which is limited to price stability.

  17. “Most economists agree that the latest crisis was caused by risk-taking incentives”

    And yet most regulation seems to focus not on changing those incentives, but on controlling the behavior of actors who face those incentives. Seems kinda dumb to treat the symptom and not the illness. Why not more focus on replacing incentives that produce bad outcomes with incentives that produce good outcomes?

  18. @Robert Johnson

    “most regulation seems to focus not on changing those incentives, but on controlling the behavior of actors who face those incentives. Seems kinda dumb to treat the symptom and not the illness. Why not more focus on replacing incentives that produce bad outcomes with incentives that produce good outcomes?”

    Yes, but what kind of regulation do you see that would counteract risk-taking incentives and is different from a change in the monetary framework?

  19. I like the article and agree that there is a need for monetary reform. My question is the following: When it comes to monetary reform, what is your opinion on a demurrage currency?
    Wouldn’t this be another alternative to be considered as well?

  20. Yes, why not. I am not sure if it is possible. You could simply trade the currency against some non-demurraged asset. And it is likely that people would do that with the money they want save for later. So you end up with some sort of commodity standard.

  21. Thanks for your answer. I see your point, but I do not think that this necessarily has to be a problem. If the demurrage money is still the fiat legal tender money and has to be used for payment of taxes and so forth, than people could either spend the money to avoid the demurrage or save it in non-demurraged tangibles as you described it or lend it to other people that would pay their demurrage fees for them. This could be more practical than holding commodities because it is leading to the same result (no gains) if the bank pays your demurrage. I see a rush to commodities mainly in the case when monetary policy gets out of hand (maybe like we see it today?). So rather as a controlling mechanism.
    So while this might not seem like a major improvement on the first look, if we look closer we see that it could lead to the elimination of ever increasing credit/debt due to compounding interest. So wouldn’t this simply be a different machanism of luring the money back into the economy, which does not have the negative effect of exponential growth of money and debt like we currently have?
    Please comment if I am mistaken here.

    (PS: The question might also be, why don’t we have a commodity standart right now, when real interest rates are negative?)

  22. Chris,

    I have to admit that I have not given much thought to this possibility since I always had the impression it would not work.

    Maybe I am wrong here. I would have to think of it. The idea reminds me of Gesell’s free money, which I have not studied in detail.

    But what would happen to the interest rate as a signal for time preference to coordinate saving and investment? I do not know, to be honest.

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