The Currency "Trilemma"


June 2, 2011

(This item originally appeared in Forbes.com on June 2, 2011.)

http://www.forbes.com/2011/06/02/fixed-floating-currencies.html


Technically, pegging a currency to gold--via some automatic mechanism like a currency board--is no different than pegging it to the euro or dollar. There's nothing inherently difficult about it. Eventually, one might conclude that gold is a better thing to peg to than the euro or dollar. Just read the newspapers and see what Ben Bernanke or the ECB are doing with their floating fiat currencies. Who wants to be a part of that?

The Keynesians, at first, will typically try to insist that this is not possible at all. They insinuate that currencies are naturally free-floating, and that to manage them amounts to "market manipulation," which is inevitably doomed to failure.

This is nonsense, of course, so when the Keynesians are pressed on the matter--when they see that they aren't going to get by so easily with these sorts of rhetorical tricks--they admit that fixing a currency is entirely possible. However, you would have to give up "sovereign monetary policy." This the Keynesians would never do, because it is the core of their entire soft-money religion.

For example, here's Paul Krugman explaining the "impossible trinity."

http://krugman.blogs.nytimes.com/2011/05/09/currency-wars-and-the-impossible-trinity-wonkish/?src=twrhp

Actually, there isn't a "trilemma" as some describe. One of the combinations--sovereign monetary policy, fixed exchange rate and controlled capital flows--is not inherently stable. The controlled capital flows would allow a government to maintain this unstable condition for longer than it would otherwise, but eventually something would give.

During the Bretton Woods period in the 1950s and 1960s, the U.S. attempted to have both a gold standard system ("fixed exchange rate" with gold) and a certain amount of Keynesian "sovereign monetary policy." This caused chronic problems, and various forms of capital controls were attempted to help keep the fundamental inconsistency intact. This allowed the system to persist longer than it would have otherwise, but it still collapsed.

Thus, there are really only two options: "Sovereign monetary policy," and some sort of automatic system, without discretionary input, which is most typically a "fixed exchange rate." It could be a fixed exchange rate with another currency, or a currency basket, some sort of statistical hodgepodge, or gold. You could even link your currency to the phases of the moon--possible, but I wouldn't recommend it.

Thus, the hard money advocate simply gives up any "sovereign monetary policy." Ultimately, fooling with the currency can only be destructive. The best currency is a stable currency. The best way to attain a stable currency, in an imperfect world, is to link it to gold. We have been doing this a long, long time--thousands of years, actually--so we already know the answers to these questions.

What happens when you give up "sovereign monetary policy"? Many countries have already done this, typically with a currency board with some major currency. There are now twelve currencies pegged to the euro, including 26 countries. Twenty-two countries peg their currencies to the dollar. Three peg to the British pound. Brunei pegs to the Singapore dollar and Macau pegs to the Hong Kong dollar (which is in turn pegged to the U.S. dollar). Another ten countries use the U.S. dollar officially, and an additional twelve countries use it unofficially. There are now seventeen official members of the eurozone, using euros, an additional seven official euro users, and four unofficial users.

My informal count shows ninety-nine countries today that have given up "sovereign monetary policy" and have adopted a "fixed exchange rate," either by using a major international currency itself or a peg to a major international currency. I'm sure I've missed many others. During the gold standard years of the 1950s or 1890s, this was typically the case as well: most countries pegged to a major international currency, which was in turn pegged to gold.

So you see, this is not exactly hypothetical. The only question is: does it make more sense to peg to a fluctuating dollar or euro, or to stable gold? For a major currency, the question is: Does it make more sense to have a "fixed exchange rate" with gold, or cross our fingers and hope that Ben Bernanke gets lucky with his "sovereign monetary policy"?

These questions have been around a long time. In a 1928 book called The Intelligent Woman's Guide to Socialism and Capitalism, George Bernard Shaw said:

"The most important thing about money is to maintain its stability ... You have to choose between trusting the natural stability of gold and the honesty and intelligence of members of the government. With due respect for these gentlemen, I advise you, as long as the capitalist system lasts, to vote for gold."

In 1928 intelligent women were expected to understand these things. Today, you should understand these things. Make your decision: fixed or floating?