Editor's note.

AuthorDorn, J.A.
PositionOn global financial stability - Editorial

Part 2 of Restoring Global Financial Stability, based on the Cato Institute's 27th Annual Monetary Conference, held in Washington, D.C., on November 19, 2009, contrasts the current discretionary government fiat money regime with alternatives designed to improve global financial stability. (1) Those alternatives range from constraining the power of central banks by imposing some type of monetary rule to replacing them with private competing currencies convertible into one or more commodities. Even if it is unlikely that the Federal Reserve and other central banks would be abolished any time soon, it is useful to consider the properties of private, rule-based, market-friendly monetary regimes.

Financial stability rests squarely on monetary stability and predictability. Today the dollar has no defined value, as it did under the gold standard, and there is no monetary rule of law to reduce uncertainty about the dollar's future value. The Federal Reserve is tasked with meeting two objectives--full employment and price stability--but the Fed cannot alter employment and other real variables in the long run by manipulating the monetary base. Having two targets, therefore, detracts from what it can do--control currency and bank reserves to influence the path of money, credit, and prices.

Under current law, no official is penalized if the Fed fails to achieve long-run price stability; but if inflation occurs, citizens suffer a loss of value in their cash holdings. There is nothing to anchor the value of the dollar in a fiat money world except a belief in the U.S. government's promise to protect the value of money. With no link to gold and no monetary rule, that promise was broken long ago--and with record deficits and debt, the dollar's future value is even less certain.

The challenge, as Lawrence H. White notes, is not to make the Fed independent but to limit its discretion. Financial and monetary stability require limits on the quantity of money and credit. Under the gold standard, market forces brought the supply of money in line with the demand for real balances, and the long-run value of money was relatively stable. That predictability is absent today.

If there is no consensus to adopt a convertibility principle and institute a real gold standard, then at least the discretionary nature of monetary policy should be limited by adopting a monetary rule to reduce uncertainty. One can debate the merits of various rules, but the objective should be to...

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