In 1943, disillusioned by the failure of an international gold standard managed by poorly coordinated central banks, F.A. Hayek wrote “A Commodity Reserve Currency,” in which he detailed the functioning of a commodity-backed reserve currency whose operation would be subject to rules. Hayek’s article followed the suggestion of Benjamin Graham and Frank D. Graham, who, in Hayek’s words, both followed a proposal “by the Dutch economist, Professor J. Goudrian [sic], in a pamphlet, How to Stop Deflation.”
Hayek’s proposal argued that monetary authorities should designate a basket of commodities as reserves. The authorities would target the price of the basket, such that when the basket is below the target price, the monetary authority increases its holdings of commodities in the basket through purchases enabled by expanding the money stock. When the price of the basket is above the target, the monetary authority sells its holdings of the basket of commodities. With a sufficiently broad basket of commodities, this would allow the relative prices of these commodities to fluctuate while overall demand for the basket is sustained. The benefits of such a standard are as follows: (1) monetary policy ceases to be discretionary; (2) monetary policy promotes a relatively stable and predictable price level; (3) monetary policy is countercyclical.
Consider how monetary policy is devised within the United States. The Federal Reserve has a dual mandate. It is expected to maintain price stability and maximum employment of labor. To maintain price stability is to limit the rate of monetary expansion. The price-stability mandate also includes moderating long-term interest rates.
The second mandate, to maintain maximum employment, might be thought of by Keynesians in terms of the Phillips curve, which posits an inverse relationship between unexpected inflation and the unemployment rate. The relationship between these cannot be exploited by monetary authorities in the long run, because laborers adjust their expectations for wages as they become aware of inflation, which reduces their wealth. As Milton Friedman points out in his now-famous speech “The Role of Monetary Policy,”
The monetary authority controls nominal quantities – directly the quantity of its own liabilities.… It cannot use its control over nominal quantities to peg a real [inflation adjusted] quantity – the real rate of interest, the rate of unemployment, the level of real national income, the real quantity of money, the rate of growth of real national income, or the rate of growth of the real quantity of money.
It is efficient for the unemployment rate to be greater than zero. Some unemployment must exist as individuals search for jobs that suit their preferences and skill sets while others invest time to adapt to a rapidly changing market by learning new skills. The natural rate of unemployment measures such unemployment. Monetary authorities cannot sustainably push the rate of unemployment below this natural rate in the long run.
Friedman built his analysis upon the rational-expectations hypothesis. This revolutionary hypothesis had an especially significant implication for monetary policy. Since investor expectations inevitably adjust to changing policy, monetary policy ought to be predictable so as not to increase uncertainty for investors. In light of rational expectations, the best a monetary authority can do to maintain the maximum level of employment is to be transparent concerning plans for future policy.
Hayek’s rule fits that policy and theoretical criterion. Most importantly, by constraining monetary policy with a rule, it is no longer dependent upon the whims of policy makers. Once the rule is settled, the job of the monetary authority is to respond to the changing value of the commodity basket by purchasing or selling the basket. Since the prices of goods, especially commodities, tend to be countercyclical, a commodity reserve currency of the form Hayek proposed would tend to mitigate some of the volatility in total expenditures due to the business cycle. As the basket’s price index falls below the policy target, as occurs in the depths of a recession, the monetary authority expands the money stock. As the economy recovers and moves into a boom, a rising price index leads the monetary authority to sell the commodity basket, thus preventing an unsustainable boom driven by monetary expansion. Thus, Hayek’s policy would promote price stability and, along with market forces, help guide the observed rate of unemployment in the direction of the natural rate.
Hayek’s commodity reserve standard would automatically serve to stabilize prices and output. In our discussion of rule-based monetary policy and sound money, the mechanics and principles guiding Hayek’s proposal deserve careful consideration.