Central bank activism under the gold standard can be typified by the Big Player problem. “Big players are privileged actors who disrupt markets (Koppl 2002).” They are capable of doing so because by virtue of their size, their immunity from market discipline, and their reliance on discretion:
They are big in the sense of that their actions influence the market. They are insensitive to the discipline of profit and loss. And, they are arbitrary in the sense that their actions are based on discretion rather than any set of rules. Big Players have power and use it. (Koppl 1996, 262)The Federal Reserve, or any other central bank, when not constrained by a rule, acts as a Big Player. From this logic, exchange rate stabilization was not just a policy that would have minimized price distortions if implemented. As a rule, it would have prevented the Big Player type distortions that result from uncertainty of future policy. Of concern is the effect of the Big Player on expectations. When Big Players intervene in markets without clear constraints on their actions, markets are unable to form clear expectations. Activist policy makers cannot be modeled by other economic agents as they lack stable parameters that guide their decisions (Koppl 2012, 123-24). As Big Players do not act consistently, a given state of reality can yield a variety of policy decisions (125). Market actors are left in a position where they must attempt to forecast the future given the possibility of very different policies being implemented. Divergent expectations can arise as some actors invest according to fundamental analysis – price is the discounted sum of the expected future revenue stream – while others bet on different possible states that can result from different policies. Expectations diverge and price and output volatility results. Increased randomness makes profitable investment more a function of luck then of accurate modeling. Markets thus lose information held by “fundamentals” investors and become more fragile as a result.
The modern international monetary system, comprised of independent central banks who issue fiat currency, is not subject to the same restrictions as a gold standard. This is not to suggest that a gold standard is without merit, only that any managed commodity standard with fixed exchange rates – stated simply, a fixed price for money – is inherently fragile, especially when policymakers act as Big Players. The Big Player problem has not disappeared. In the modern system, instead of holding gold, central banks expand the monetary base by purchasing debt. Many central banks hold primarily dollar denominated debt and target a specific exchange rate with the dollar. Such policies are reminiscent of the fixed exchange rates of the gold standard. Thus, the same problems related to discretion that plagued the gold standard are present in the modern system.
Assuming there is no radical regime change, these problems can at least be remedied in part by the implementation policy rules (Koppl 2012, 185). Unlike gold, whose quantity produced responds slowly to changes in demand, dollars can be issued by the Federal Reserve via the open market. If foreign or domestic demand for dollars increases, the Federal Reserve – the central bank at the center of the international monetary system – can change the volume of base money to offset the effect of increased demand on prices. The Federal Reserve can adopt a policy of nominal income level (MV) stabilization. Observed and expected changes in demand for dollars are automatically adjusted for under a nominal income target regime. Which measure of nominal income is most appropriate is a subject beyond the purview of this paper, but the policy can at least be analyzed theoretically.