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Three Proposals for Price Stability

Candidate Ramaswamy wants to reform the Fed. Many of his arguments do not withstand scrutiny. However, there is one that deserves closer attention: his call to “stabilize the dollar…in terms of commodities.”

We can think about commodity-based dollar stabilization in three ways. First, the Fed could use its existing monetary policy tools to keep the dollar price of a commodities basket constant. Second, the Fed could commit to buying and selling the basket at a constant dollar price. Third, the Fed could restrict itself to defining the unit of account in terms of the basket, allowing financial markets to take over the money creation process.

All three options are an indirect way of targeting the price level. Keeping the price level steady (alternatively, stabilizing the purchasing power of the dollar) works well to offset demand-side shocks. There are, of course, potential supply problems. Any price-level stabilization policy compels the Fed to loosen monetary conditions when prices fall for supply-side reasons and tighten monetary conditions when prices rise for supply-side reasons.

If shocks to real commodity production change the prices of commodities relative to prices of goods and services, all three proposals would require monetary policy to become too tight (negative supply shock) or too loose (positive supply shock) in order to keep the basket fixed in dollars. All forms of price level targeting have this problem (and it’s the main reason I prefer NGDP targeting). Nevertheless, in a world of second-best policy options, they are worth considering.

Option one keeps the Fed’s operating framework mostly as-is. Instead of pursuing full employment and stable prices, the Fed uses interest on reserves, open-market operations, and other policy levers to ensure a pre-chosen commodity basket is always worth the same number of dollars.

The problem with option one relative to the others is that it retains a high degree of discretion. As we’ve learned (the hard way), central bankers make mistakes, even when their goals are concrete.

What if we could outsource policy implementation to a much larger and wiser group — namely, financial markets as a whole? Option two binds the Fed more tightly. If the central bank pre-committed to buying or selling the commodity basket at a fixed dollar value for all counterparties, we could harness market mechanisms to maintain the peg.

Any time the market value of the commodity basket diverged from the fixed Fed purchase price, financiers would earn pure economic profits by arbitraging away the difference. Suppose the market price of the commodity basket, in dollars, was higher than the Fed’s exchange peg. Then arbitrageurs would buy the basket from the Fed in exchange for dollars and then use those dollars to buy even more of the commodity basket than they started with. Pure profit! The Fed would take the dollars it received in exchange and retire them from circulation. The dollar price of the commodity basket would fall. This process would continue until the market price equaled the pegged price.

It works the same in reverse, of course: a lower market price of the commodity basket impels arbitrageurs to sell the basket to the Fed, gaining in return enough money to purchase more than the starting amount of commodities. The Fed thereby injects dollars into the economy, raising the market price of the basket until it returns to the peg price.

The genius of this mechanism is that it harnesses financiers’ relentless search for profits as a mechanism for executing monetary policy. Why rely on bureaucracies when we can use markets?

Option three is the most extreme. Indeed, there wouldn’t really be a central bank or monetary authority at all. The Fed would define the dollar in terms of the commodity basket and then get out of the way. So long as Uncle Sam conducts all its public business in terms of the new commodity-dollar, the network effect will likely prompt financial markets to adopt it as well.

Option three would essentially privatize the money creation process. Financial intermediation is now responsible for all money creation, as opposed to the broader monetary aggregates, as under the current system. Banks would still offer checking accounts, savings accounts, certificates of deposit, money market mutual funds, and a host of other savings and liquidity instruments. The difference lies mostly in redemption. It would be too difficult for a bank to meet customer redemption demands by giving everyone who shows up to the teller’s window physical commodities. Likely the bank would pre-specify a medium of redemption, such as gold, that customers would receive based on its market price (its relative price to the commodity basket).

Notice that this system severs the monetary base from the medium of exchange. The commodity basket is the monetary base, whereas the liquid financial instruments banks issue are exchange media. Also, by decoupling the medium of redemption (whatever banks promise to use to price withdrawals) from the medium of exchange and unit of account (commodity-dollars), it makes banks much more flexible in response to changes in liability demand. Hence it fosters a money supply that is elastic to the needs of commerce. That’s a highly desirable feature both in terms of aggregate demand stability and financial stability.

As a “dark horse” candidate, Ramaswamy has a greater burden of proof before the electorate. He needs to prove his policy proposals are a cut above his rivals’. So far, his suggestion to focus the Fed on commodity price stability is too vague to evaluate. He should pick a framework centered around one of the three above approaches and pitch it to the American people. Let’s see in much greater detail how he means to eliminate monetary mischief and financial folly.

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