The new monetary economics revisited.

• Author: Cronin, David
• Position: Essay

This article revisits the key conceptual aspects of the New Monetary Economies (NME) by examining the idea of "monetary separation" and objections raised against it. So long as a dominant role for base money in exchange exists, using it to provide the unit of account remains advantageous and is likely to outweigh any mooted benefits of separation. Recent quantitative analysis, however, shows the transaction demand for government base money to be falling, a development that can be expected to continue in the years ahead. The passage of time thus seems to be weakening the principal basis on which monetary separation has been criticized--namely, the superiority of base money in payments. That development fits into the history of money told by Austrian economists, which emphasises payment practices evolving over time in response to technological improvements and market forces.

The New Monetary Economics

The "New Monetary Economics" is a term that was first used by Hall (1982a). It refers to a body of literature, epitomized in articles by Black (1970), Fama (1980), Hall (1982b), and Greenfield and Yeager (1983), which proposes that monetary arrangements could be improved by liberalizing the supply of media of exchange within the economy and by requiring that prices no longer be quoted in terms of government-supplied flat base money.

To ensure a determinate price level, the government has only to provide a unit of account and require that prices are quoted in terms of it. The unit of account would be defined in terms of a commodity, or a bundle of commodities, not used to settle payments. A state of monetary separation would then exist with the medium of account (the medium in units of which prices are expressed) and the medium of exchange differing from one another. More than one medium of exchange could operate within the economy and transactions could be effected using accounting-based transfer methods. There would be no justification for government intervention in money and banking since there would be nothing special about the issue of media of exchange, whose equilibrium quantity would be determined by the same demand and supply forces that operate in other markets.

The payment system would differ from the current fiat money system, in which a unit of the settlement medium, government base money, provides the unit of account. It would also differ from a directly convertible payment system in which there is an obligation on the issuer to convert a unit of the medium of exchange into a predefined quantity of some medium of redemption, a unit of which acts as the generally accepted unit of account. Examples of this type of system are historical gold standards. In contrast, with monetary separation, only indirect convertibility arises. In such systems, the redemption medium, or media, and the bundle defining the unit of account are different.

The principal argument put forward by White (1984) and O'Driscoll (1985, 1986) against monetary separation proposals is that having the unit of account be a unit of a general medium of exchange is a part of the natural evolution of monetary arrangements and brings advantages to trade which monetary separation could not achieve. (1) Those authors draw on monetary history, in particular Menger's (1892) historical account of the evolution of money, in giving reasons why a unit of a generally accepted medium of exchange should, and does, provide the economy's unit of account. (2) That history also indicates, they claim, a continuing demand for currency, and base money more generally, in exchange. As such, base money will remain the medium of account as well. Monetary separation is thus seen as inefficient and unlikely to emerge on an unfettered path of monetary development.

Criticisms of monetary separation rely heavily on the claim that there will be a continuing demand for base money in payments. Today's base money is issued by the central bank. Recent quantitative analysis shows the transaction demand for currency to be falling, in both absolute and relative terms, in many developed economies in response to technological change, a trend that is forecast to continue in the years ahead. The demand for settlement balances held at the central bank is being impacted by computer algorithms designed to economize on the amount of liquidity required to settle interbank payments and by the substitution of commercial bank money for central bank money in settling many large-value payments. The passage of time thus seems to be undermining the principal basis on which monetary separation has been criticized.

Proposals for Monetary Separation

Unlike Black (1970), who has relatively little to say about the unit of account in his payment system, Fama (1980) makes monetary separation a prominent feature of his contribution to the NME. In Iris payment system, transactions involve book-entry of debits and credits on bank accounts. The value of account balances, from which payments are made, fluctuate in line with the market values of the portfolios they are held against. With no entity with a fixed nominal value being utilized in transactions, there is no exchange medium to define the unit of account. Any tangible commodity could act as a medium of account: "It could be tons of fresh cut beef or barrels of crude oil" (Fama 1980: 43). Defining the unit of account using such a medium would be credible and appropriate as the real numeraire good would have a determinate price relative to all other goods.

Hall (1982b) and Greenfield and Yeager (1983) express unhappiness with the prevailing monetary standard in which base money serves as both the general medium of exchange and the medium of account and contend that monetary arrangements could be improved by separating the medium of account from the medium of exchange. The ANCAP and BFH schemes are their respective proposals for achieving separation. Both schemes involve government defining the unit of account physically, in terms of a number of commodities, and not in terms of any medium of exchange.

In the ANCAP scheme, Hall advocates a commodity standard (or what he calls a resource unit) whereby fixed weights of ammonium nitrate, copper, aluminium, and plywood make up the dollar. (3) A selection of commodities would be preferable to one based on a single commodity, such as the gold standard, as offsetting fluctuations in the four ANCAP...