Academic journal article Journal of Money, Credit & Banking

The Mechanics of Indirect Convertibility

Academic journal article Journal of Money, Credit & Banking

The Mechanics of Indirect Convertibility

Article excerpt

Decades of inflation have made economists far more skeptical than they used to be about fiat money, and there are many who now advocate a return to some form of convertible currency. It is natural that much of this renewed interest in convertible currencies should focus on the gold standard that used to exist before governments intervened to make the currency inconvertible, but the gold standard has drawbacks of its own, perhaps the most important of which is that it generated a certain amount of price-level instability itself. There has consequently been a considerable amount of research into alternative forms of convertibility that promise to avoid the weaknesses of the gold standard while still retaining its principal attraction, the discipline it offers against the over-issue of money. Much of this research links a system of convertibility to the pegging of the price of a "nearly comprehensive" basket of goods and services, the underlying idea being that if the basket is broad enough, it should have a stable relative price against any reasonable index of the price level, and so pegging its nominal price should ensure a relatively stable price level (for example, Greenfield and Yeager 1983, Yeager 1985a and b, Dowd 1989).

The idea that convertibility systems based on commodity baskets can offer a more stable price level than systems based on single commodities has long been recognized, but there was always the objection that basket-based systems required the issuer and sometimes the public to handle the baskets involved, and the problem was that handling costs could be very large, and for broad baskets effectively prohibitive. This objection, however, only applies to "directly convertible" systems in which the chosen basket is actually handled over the counter, as it were, and it can be avoided by adopting an "indirectly convertible" system in which the issuer(s) of currency undertake to convert their currency not into the nearly comprehensive basket as such, but into some medium of redemption (MOR) of the same value. A system of indirect convertibility based on a nearly comprehensive basket promises much the same discipline on the issuer as the gold standard, but it promises a much higher degree of price stability, and, perhaps, of general macroeconomic stability as well. Such a system might therefore provide the ideal set of operating rules for a central bank that sought to stabilize the price level whilst avoiding the handling costs of directly convertible systems.

Indirect convertibility is also of interest for another reason. If a central bank or other issuer of currency wishes to adopt a commodity-based rule to stabilize the price level, the rule usually suggested is what might be described as a "periodic adjustment rule" in which the issuer pegs the price of some MOR (for example, gold or Treasury bills), but periodically revises that price in a prespecified way whenever a chosen price index deviates from some target value, the underlying idea being to change the price of the MOR to steer the price index back toward its target. A well-known example is the "compensated dollar" of Irving Fisher (191 1), but more recent versions have been proposed by Hall (for example, Hall 1983). However, rules of this type have certain drawbacks. As explained in more detail below, they can generate considerable price-level instability - the price level can oscillate around its "long-run equilibrium" path, and the long-run path might itself be unstable. They can also create destabilizing speculative pressures analogous to the "crawling peg problem" that arises when central banks periodically alter the exchange rate, but do so in a predictable way that encourages private agents to speculate in anticipation of such changes. The issuer of currency would be open to speculative attack, and interest rates and other prices might also be destabilized. It is consequently doubtful how much price-level stability such rules would produce, and the crawling peg problem might render them unworkable in practice anyway. …

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