The viability of an 'indirectly convertible' gold standard: comment.

• Author: Schnadt, Norbert
• Position: Response to Kevin Dowd, Southern Economic Journal, January 1991 - Includes reply

1. Introduction

   In a recent article in this journal, Dowd |1~ considers a monetary system which is a modification of the gold standard. In common with the gold standard, the value of currency is tied to that of gold at some given parity. But instead of undertaking to exchange its currency for gold, the currency issuing bank maintains the gold value of its issue by "indirect convertibility": redeeming its notes not into gold itself but into some other good known as a "redemption medium." The quantity of redemption medium offered for a unit of currency is equal in market value to the gold which would have been obtained in a direct conversion of a unit of currency at the given parity. The redemption medium could be any good other than gold and Dowd suggests that shares in some company might be convenient for this purpose.(1)

   The virtue of this arrangement, it is claimed, is that it overcomes the weakness of a direct gold standard, that the currency issuing bank's fractional gold reserves may be insufficient to sustain convertibility. An indirectly converting bank does not redeem into gold, so that it need not carry gold reserves. And exhaustion of reserves of redemption medium would not imply suspension of convertibility because the bank (provided that it was solvent) would apparently be able to purchase redemption medium as needed in the market. As a result, so Dowd argues, the indirectly convertible gold standard would be less prone to banking panics than the direct standard, and would also exhibit less volatile interest rates.

   In this paper we cast doubt on the viability of Dowd's scheme on the grounds that indirect convertibility could not be practiced by a bank whose currency is a medium of account for quoting prices of goods.(2)

2. Identification of the Medium of Account

   Dowd's description of his scheme implies that there are several banks whose private currencies simultaneously coexist as media of exchange. For the purposes of this appraisal, however, it is the identification of the medium of account which is of importance. What unit is commonly used for expressing prices of goods, in particular the price of gold?

   If indirect convertibility succeeds in tying the value of all currencies to gold, then any one of these currencies could be considered as the medium of account, as could gold itself. Our purpose here, however, is to investigate the viability of this method of ensuring the values of the currencies. This exercise requires that we allow the value of a currency to deviate from its chosen parity relative to gold, and then consider the dynamic process by which this deviation may be corrected. To assume that all currencies and gold are media of account would defeat this purpose.

   Addressing this question of the identification of the medium of account forces us to engage in some discussion of trading behavior. We shall make the plausible assumption that there is one "dominant" currency in which prices quoted by traders are understood to be measured. Prices are not understood as expressing amounts of gold, since gold is not a medium of exchange. The price tag put on an article by a trader refers to the quantity of paper dollars of this currency, or paper claims (checks) on this currency, which he would be prepared to accept in exchange for his article.(3) It is, moreover, this currency price of the article which the trader adjusts in the face of changed supply or demand for his article, and he does not adjust this price unless induced to do so by changed supply or demand.

   If some currency other than the dominant medium of account is tendered in exchange for an article, the traders' action is to convert the posted or contracted medium of account price at the moment of the transaction according to the observed market exchange rate between the currencies.

3. Indirect Convertibility for the Medium of Account

   Consider then the operation of indirect convertibility for the bank whose currency, according to our above discussion, is the medium of account. Quoted market prices of goods are expressed in this bank's currency, and henceforth we shall use the term "dollar" to denote this currency exclusively.

   Let the bank's chosen parity (the price of a unit of gold measured in its dollar currency) be |P*.sub.g$~. If the bank were practicing direct convertibility, it would offer conversion of each of its paper dollars into 1/|P*.sub.g$~ units of gold. Under indirect convertibility, the bank is committed to offer conversion of each of its paper dollars into an amount of redemption medium whose value, in the market, is equal to 1/|P*.sub.g$~ units of gold. Formally, this obliges the bank to observe the market price of redemption medium measured relative to gold, |P.sub.rg~, and to calculate its conversion rate of dollars to redemption medium |R.sub.r$~ as

   |R.sub.r$~ = |P*.sub.g$~ |center dot~ |P.sub.rg~. (1)

   The bank's dollar price of redemption medium, |R.sub.r$~, is thus its instrument which it adjusts continuously in order to compensate for observed changes in |P.sub.rg~.

   By assumption, however, market prices of goods including gold and redemption medium are expressed in dollars, hence the bank cannot make direct observation of the relative price |P.sub.rg~. The bank must rather derive this price from observations of the market dollar prices of gold |P.sub.g$~ and redemption medium |P.sub.r$~ as

   |P.sub.rg~ = |P.sub.r$~/|P.sub.g$~. (2)

   Substituting equation (2) into equation (1), the bank's operating rule is |R.sub.r$~ = |P.sub.r$~(|P*.sub.g$~/|P.sub.g$~). (3)

   Equation (3) shows that whenever the market dollar gold price |P.sub.g$~ deviates from the set parity |P*.sub.g$~, the dollar issuing bank sets its conversion price of redemption medium |R.sub.r$~ different from the market price of redemption medium |P.sub.r$~. To confirm that equation (3) correctly reflects indirect convertibility, suppose that |P.sub.g$~ has risen above |P*.sub.g$~, which implies that |R.sub.r$~ |is less than~ |P.sub.r$~. An agent could still buy gold indirectly at |P*.sub.g$~; he would do this by buying redemption medium (with his dollars) from the bank at |R.sub.r$~ then reselling the redemption medium at the higher market price |P.sub.r$~. The extra cash he receives in this way is exactly sufficient to compensate him for the price rise in |P.sub.g$~. Obviously, however, there is an opportunity for riskless arbitrage. An agent could multiply his stock of dollars by "round tripping" between the bank and the market for redemption medium.

   Any difference...