‘As already noted, there is some logic in a ‘Taylor rule’ as a guide to the setting of interest rates, and the refinement of adding an asset inflation term is worth considering.

For a small open economy with a flexible exchange rate it will be more prudent to focus on the prices of property and other domestic assets, eg Tulips if in Holland in 1636, property if in Melbourne in the 1880s, and so on.  Share prices are the quintessential global product – with share prices everywhere heavily influenced by Wall Street.  It would be an act of futility for the central bank of small open economies like Australia or Sweden to focus on trying to stop share prices from rising if there was a boom in American share prices.  It would be far better to persuade the US Fed to lean into the boom and do everyone a favour.

This logic leads inexorably to some form of global monetary policy.  As China becomes more powerful, there is a steadily strengthening case for it to adopt a properly flexible exchange rate if the current monetary policy ‘architecture’ is retained.  When this is achieved, and as China’s capital market become more important, there will be a stronger and stronger case for coordination of Chinese and American fiscal and monetary policies. Agreed domestic inflation targets (including asset inflation) for both major economic superpowers would ultimately lead to similar monetary policies and this might also lead share prices to behave more sensibly.  But if it were felt by the central banks of China and the USA – meeting as the ‘Group of 2’ (G2) - that there was danger of a share price bubble developing in either Wall Street in New York or on the Bund in Shanghai, monetary policy in both places could be tightened somewhat more than the amount suggested by each nations’ goods and services inflation targeting regime.

But is there a better system than monetary policy based on inflation targeting via the instrument of ‘official’ cash rates in a myriad of individual countries, which is the current mainstream approach? One should at least consider a modern version of the gold standard. In place of a standard based on gold, one could imagine a commodity standard including pre-set weightings of gold, silver, platinum, copper, aluminium and even uranium.  There would be a preset annual growth (say 5 %) of the overall commodity bundle produced by an agency such as the International Monetary Fund (IMF).  The IMF would be responsible for acquiring the commodity bundles on a more or less continuous basis and feeding it to central banks in proportions based on each nations’ real GDP.  Whether such a commodity bundle would reside in the IMF’s vaults is an important technical matter that I will leave to those better qualified to answer.

This idea is not, of course, original, but rather is closely related to Keynes’ Bancor. Bancor is the name of the supranational currency that John Maynard Keynes proposed in the years 1940-42 and which the United Kingdom suggested for introduction after the Second World War. This ‘supranational currency’ would, Keynes argued, be used in international trade as a unit of account within a multilateral barter clearing system – the International Clearing Union – which would also have to be newly formed. This British proposal for a supranational currency could not prevail against the interests of the United States, which at the Bretton Woods conference established the U.S. dollar as the world’s key currency.

Since the outbreak of the Global Financial Crisis in 2007-08 Keynes' proposal is winning adherents: In a speech delivered in March 2009 entitled Reform the International Monetary System, Zhou Xiaochuan, the governor of the People's Bank of China called Keynes' BANCOR approach ‘farsighted’ and proposed the adoption of IMF SDRs as a global reserve currency. He argued that a national currency was unsuitable as a global reserve currency because of the difficulty faced by reserve currency issuers in trying to simultaneously achieve their domestic monetary policy goals and meet other countries' demand for reserve currency. (3) A similar analysis can be found in the Report of the United Nation's ‘Experts on reforms of the international monetary and financial system’ (4) as well as in a recent International Monetary Fund’s ‘Reserve Accumulation and International Monetary Stability’. (5)

There are two essential differences between current arrangements and a BANCOR system based on a bundle of commodities or SDRs.  Setting cash rates country by country, even by similar Taylor rules in pursuit of a common target for goods and services inflation, de-emphasises ‘quantity of money’ targets.  Setting and implementing a global ‘base money’ target would de-emphasise interest rate targets. It is not at this time possible to decide which system might prove most robust, but clearly both need to be analysed carefully.  Along with rules for containment of bank lending, either a quantity focus or an effective interest rate focus is needed if capitalism is to minimise unhelpful financial system instability.

My more conservative friends will fear a global quantity-based monetary system is a ‘socialist plot’, the same point they make about plans to control greenhouse gas emissions. While the head of the global central bank would wield considerable power, he would serve only at the pleasure of his political masters, although with a fixed term or terms.  He would have a clear mandate to control inflation.  The primary target would be goods and services inflation, with asset inflation as an important secondary target to be varied as the world gained experience of the proposed new system. Nations could retain their own currencies if they wished, although sensible leaders would link these currencies to the global currency.  Devaluation of national currencies would be possible, though serial devaluers would find it increasingly necessary to prepare contracts in a strong currency, which might increasingly be the global currency

The modern capitalist world is sitting uneasily between two radically different systems of monetary policy.  The ‘discretion’ allowed with flexible Taylor Rule methods of setting interest rates in each nation contributes to the ‘imbalances’ that so bedevil global economic development. Moving to a global system of base money control, administered by a global monetary authority independent of political government, is the logical alternative to the current system.  It may take a very damaging outbreak of inflationary global boom and bust for this idea to be taken seriously. (Pp 256 – 259)

The Bank of England in the nineteenth century

‘The Bank of England in the past manipulated its Bank Rate following the laws of the global gold standard to produce stability in an age of great innovation, with massive development of new lands and new industries. The gold standard as practiced in the nineteenth century was focussed on what economists called ‘external balance’, in practice as represented by the state of each nation’s gold reserves. One problem, as noted in Chapter 6, is the dependence of this standard on intermittent discoveries of gold.  Another is the fact that the stock of gold in a nation’s vaults is a lagging indicator. In principle, a gold standard or a broader commodity standard could work with inflation within a nation (or globally), as its principal target. Such an approach could allow for the fact that changes in the degree of tightness of monetary policy affects inflation with a lag and so it is future inflation (a ‘leading indicator’) that is an appropriate target for monetary policy. (P 278)

The way ahead

‘Global monetary policy must become more conservative and more coordinated. The currently conventional way to do this would be for the USA to restore a neutral monetary policy with official cash rates of a modest positive value, rather than the unsustainable near zero rates adopted during the panic phase of the current financial crisis.  In addition, China would adopt a fully flexible exchange rate, allowing it to run a sufficiently tight monetary policy to stop its rising inflationary problem.  Currently, China is suffering inflation that if not stopped will turn a low nominal exchange rate into a high ‘real’ exchange rate.

But, as I have argued in Chapter 12, management of global monetary policy requires a major rethink to decide whether what is needed is a global base money regime allowing steady growth of a new commodity standard or a greatly extended SDR standard administered by an independent global agency of some sort.  A reformed International Monetary Fund (IMF) might be given this task, but only when voting rights of its members are altered to more closely accord with the importance of major countries or groups of countries. With these and other reforms, the IMF would be given the task of liquidity management, including the possibility of intervention to provide funds for solvent financial institutions suffering in a general liquidity crisis.

Backed by this global base money standard, and provision for global liquidity management, individual national currencies might be made legal tender everywhere, achieving an old dream of serious competition in the provision of money. The US dollar is a de facto global currency but with the US economy in serious trouble and running loose monetary policy, the US has forfeited the right to own the global monetary policy regime. With a truly global base money regime, countries that used it to underpin their domestic monetary policy would gain the same sort of respect that is accorded nations that provide the rule of law, respect for property rights (including patent law) and a strong education for all children. (Pp 279 – 280)

The risk of policy instability

'The biggest threat to modern capitalism in my view is the possibility of instability caused by policy swings: expansion; recovery; asset inflation; goods inflation; policy tightens; economy falls back; recession starting the whole process anew. Such outcomes would destabilise the beliefs of the econocrats in major countries, as well as their political masters. It would also present a severe blow to the confidence of households and firms, and confidence is a vital part of the capitalist way.

Individual economies, and the global economy, need stable, well understood policies that are varied to a large extent by predictable rules and automatic changes in a stabilising direction.  This is not the present situation, and many changes are needed if we are to devise a more robust and sustainable system of global financial governance'. (P 285)

A modern version of the gold standard, along with other reforms suggested in the book, would greatly mitigate this major risk.

More on reform of modern capitalism here.

Henry's book Great Crises of Capitalism is now available at Amazon's Kindle store.  Here is the link.