Expansionary monetary policy, i।e., easy credit, created a boom, for example, dot-com bubble, sub-prime saga, and then the tightening of credit bursts the bubble. Again, whenever economy faces deflationary pressure, central banks concentrate on those deflationary forces for too long and reintroduce an asset boom of some kind. In addition, fiscal ‘stimulus’ in the form of tax rebate check or consumer bail-out could be another economic accelerant. If both the fiscal and money stimulus efforts kick in just as market forces also kick in, we will see another unsustainable boom that will be followed by a routine burst. What is not familiar is the scale of the devastation wrought in this boom-burst cycle.
At the bottom of the world financial crisis is international monetary disorder। Ever since the Bretton Woods system ended in 1971, it marked the end of a golden age of robust trade and unprecedented global economic growth। The Bretton Woods system derived its strength from a commitment by the US to redeem dollars for gold on demand। It is clear now that global financial regulators have failed at its most basic task, protecting the soundness of the international monetary system.
Never before had financial markets evolved such a multifaceted superstructure of interlinked securities, derivatives of all kinds, and special-purpose investment vehicles। As of June 2008, the total outstanding notional amount of financial derivatives, according to the Bank for International Settlements, is $684 trillion (i।e., about 75% of the whole derivative market) which is over 12 times the world’s nominal GDP. These financial derivatives derive their value from the unpredictable monetary policies of the central banks and the chaotic change of currencies. As this system evolved there was not a sufficient guard against systemic risk.
In addition, if we look at the timing of the previous boom-burst cycle, the cycle seems to be shortening। The next burst could come in next five or six years from now। To avoid next asset bubble from being inflated, central banks can impose a commodity standard on themselves। A commodity standard, for instance, a gold standard, imposes discipline on a central bank because it forces the central bank to acquire commodity reserves in order to increase the money supply in the market. Today the government can inflate asset bubbles without paying an expense for it because the currency isn’t linked to the price of a commodity.
Conversely, with a commodity standard in place, the government will also have price signals which will alert it to the formation of a bubble at the very beginning। Since, the price of the commodity will be continuously traded on spot and futures markets, and inappropriate policy by the central banks will be signalled by rising prices for the respective commodity। This way it will be clear to anyone observing spot markets whether a bubble is developing. Furthermore, if central bank officials ignore price signals, outflows of commodity reserves will compel them to act in opposition to the bubble.
Former US Federal Reserve Chairman Alan Greenspan once observed, ‘The abandonment of the gold standard made it possible for the welfare statists to use the banking system as a means to an unlimited expansion of credit… In the absence of the gold standard, there is no way to protect savings from confiscation through inflation (Gold and Economic Freedom, 1967)”। Paul Volcker, another former Fed chairman, noted that the inflationary forces which caused the US to go off the gold standard in the first place have only worsened.
Moreover, he also believes that floating rates undermine the fundamental idea of comparative advantage. Markets across the globe have already lost enough. It is the time to stabilise financial markets by instituting policies that foster economic growth and prevent the type of boom and bust cycle that has just wiped out a decade’s worth of asset accumulation. The idea is not to deflate asset bubbles but to avoid them in the first place. And if the world wants to have a ‘bubble’-free capitalism, imposing a commodity standard is a realistic response to the repeated failures of central banks to maintain sound money and financial stability.
*This article was published on the daily Independent in Bangladesh on December 1, 2008, and also on the daily New Age on November 29 & December 23, 2008.
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