Monday, November 10, 2014

Is a Commodity Reserve Standard with a Fixed Reserve Ratio More Tractable than a Nominal Income Target?

Formulating the blueprints of a commodity reserve standard with a fixed reserve ratio has proven to be more difficult to detail than I first imagined. In spite of that, I believed I have worked out the most important details. 
1) The central bank holds a bundle of commodities as a part of its reserves. The fraction of central bank notes and credits that these reserves represent must stay constant. 
2) The central bank also hold short-term securities for its remaining reserves. 
3) (Here’s the important part!) The central bank must hold constant its nominal value of reserves comprised by the commodity basket and its reserves comprised of credit. When interest rates fall, the central bank will sell securities, when they rise the central bank will buy securities. Likewise, when the price of the bundle falls, the government will buy shares of the bundle.
    a. The government does not buy the physical commodities, only promises to them.
That is the plan in a nutshell. Other details are, of course, important. For example, as I mentioned previously, the government should purchase from a variety of dealers so as to minimize Cantillon effects.

The core of good macroeconomics lies behind the proposal. Theoretically, it relies on Say’s principle, the equation of exchange, and expectations. Briefly, when prices fail to fully adjust there is a fall in output. If this was a one-time phenomenon, then it might be worth living with, but often the process is dragged out due to a high degree of deflationary expectations. It is not uncommon for bad policy to be the culprit in all of this. Given that monetary policy is not disappearing in the near future, the best policy makes the monetary base responsive to changes in demand for money.

So far you might be asking, why not just stick with nominal income targeting? Nominal income targeting does share the characteristics that I am describing, but I believe that providing good information may be a problem. How thick does the betting market need to be in order for information to be accurate and for the market not to be swallowed in volatility? Is NGDP the best indicator for monetary policy? Difficulty arises because in targeting macroeconomic variables, there will always be errors and transactions unaccounted for in the estimates. These problems are complicated which may be why the profession has not voiced widespread support for the proposal. (There are of course other reasons including bias, ignorance, gold-buggery, etc…) A commodity reserve currency with a fixed reserve ratio nominal value for the central bank's asset side of the ledger lacks these problems.

The policy makes money responsive to prices. Market prices already exist and they are reliable indicators concerning the demands of consumers relative to the supply of available goods and services. One problem that I have been confronting with nominal income targeting is that the immediate change in the money supply may distort prices too much as all changes in demand for money will be fully and immediately compensated by changes in the base money stock. There may be good reasons that agents have increased demand their demand to hold money. A commodity reserve currency with a fixed reserve ratio would allow agents to exercise this preference and let it be reflected in prices. It simply prevents a deflationary spiral that may arise because of policy uncertainty or institutional collapse. Finally, a last advantage of the policy is that it not only constrains the central bank by a rule, but it makes the central bank act as a storehouse. By holding a stock of commodities during a bust and releasing them during a boom, the policy would alleviate, but not eliminate, price volatility. It would serve the same role for credit, preventing credit markets from seizing when liquidity dries up.

Perhaps the most attractive feature of the policy is that it does not need any more information than is already available. There is no need for policymakers to try to guess the future or to target a particular interest rate or price level. In fact, there is no need for policy makers once the rule is implemented. The rule is the only policy necessary. Prices and interests rates move and the base money stock responds. It is as simple as that.

**Thanks to Justin Merill, editor of the facebook groups freebanking and Emergent Society, for discussing this with me**

Late Thoughts: The purchase of commodities should also channel expansion into labor markets during the downturn. It therefore can be a replacement for discretionary fiscal stimulus.

**Edited 11/20/2014

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