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Tuesday, June 22, 2010

Two-level currency system

Let me first confess that I was a proponent of single global currency system. The quantum of trades in FX was so huge that I thought it must serve no important purpose as the cost indicate. However, over the past two years my view is now leaning towards a two-level currency system. To understand this let us first understand few short points that I have already made in my book "Subverting Capitalism & Democracy".

Two functions of currency
A currency system needs to have two critical functions. First, it should reliably communicate price information. Second, it should facilitate the transactions in the economy and not hinder it. Given these two functions, a high or loose money supply distorts price information but allows enough money for transactions. A constrained money supply does not allow transactions to happen thus possibly limiting growth. Thus, the increase in money supply should account for the following:

  1. The increase in the economic value being created in the economy. The higher money supply should support the exchange of these new goods, new services etc. (Simplistically let us assume 3 units growth was achieved)
  2. The decrease (or increase) in the need for money because of efficiency in transaction creating additional velocity. This refers to structural increase in velocity rather than cyclical changes (let us assume velocity grew accounting for 2 units increase in money supply)
  3. The increase in money inventory (locked up money) as activity increases (let us say 1 units)

So the net increase in money supply should be +3-2+1 = 2 units. Now each of this is difficult to determine as it is. So I think Milton Friedman implied that the actual increase in money supply should be a little higher than 2 say 2.2 units. This leads to inflation but that is better than deflation (separate debate). 

Further, we need reliable mechanisms to measure each of the three. If there is no confidence on the measurement we do not have a monetary policy. This is the problem with Euro. Fudging of sovereign balance sheets and finances have impaled the confidence in the monetary system.

Two-level currency system
An ideal system, I think, may be a two level currency system. A currency at the national level should signal the relative prices of goods and services in the economy. An international currency should signal the confidence in the judgement exercised in national currency. The international currency therefore decides the relative prices of currencies and thus of everything.

In pre-Bretton-Woods  era we had gold as an international currency while Bretton-Woods established US Dollar in that role. The system, however, leaves the world vulnerable to US monetary policy misgivings. The world does not have a mechanism to communicate the confidence in US monetary policy.

In sum
When we evaluate US monetary policy, I believe, we should do it in relation to world GDP growth, interest rates rather than simply to US growth and interest rates.

A currency without the legal charter to measure other economic variable does not make sense. Thus, community-level currencies (some experiments are being conducted in the UK) do not make sense unless they are deflationary by design.

We need a extra-national currency to signal confidence in national monetary policies. The money supply, in this case, should grow at the pace of world growth.

Over time as confidence in global measurements of economic activity grows, we can move to a single currency albeit accompanied by a single global monetary policy. Till such time a two-level system may be better.

My book "Subverting Capitalism & Democracy" is available on Amazon.