To Prevent Financial Shocks, Build a Suspension System for the Gold Wagon

By: John_Newman

When I drive down the road and hit a pothole, my car's suspension system absorbs the shock. Engineers design suspension systems to reconcile our driving habits automatically to the realities of hard pavement. So it should be with our monetary system.

In his article (“To Prevent Bubbles, Restrain the Fed”, WSJ, Nov. 17, 2008), Mr. O'Driscoll quite properly criticizes our monetary policy as being too discretionary, non-transparent and political. He suggests a return to a commodity standard (e.g., gold) to instill needed discipline. I would like to embrace Mr. O'Driscoll's plan, and extend it one step further by addressing a major weakness of the gold standard.

We know from history that linking money supply to commodity prices would instill discipline. But just as a car without a suspension system cannot handle potholes, bolting money directly to commodities (or other externality) makes us vulnerable to jarring financial shocks. Just ask Argentina.

We also know from our own history the risk of un-coordinated fiscal and monetary policy. Just think back to 1982, when fiscal stimulus had to be countered by strong monetary discipline to prevent runaway inflation. Couldn't better fiscal policy coordination in 1981 have avoided strong monetary discipline a year later?

What's missing from the Gold Wagon is an independent suspension system that maintains a “flexible automatic linkage” between money supply and commodity prices. That suspension system should be rules-based and administered by an international body.

Can we design an independent suspension system for the Gold Wagon? Let's try.

In 1986, I presented a tax policy proposal to Bob Packwood's Senate Finance Committee for a bank clearance fee to pay for a flat-rate income tax system. That proposal entailed an automated clearance fee on funds transferred through the payment system. At a half basis point, the rate equals a couple hours' foregone interest. See Tax Notes Magazine, October 14, 1985, page 191-201 (explains why such a system meets the criteria of good tax policy).

An automated funds clearance fee administered by an international body might provide a fiscal policy counterweight to excessive monetary policy and provide a suspension system to the Gold Wagon. As commodity prices increase in a country's local currency, that price signal would trigger a pre-programmed increase in the clearance fee on bank funds transfers in that country.

Proceeds from the clearance fee would be held by the international agency in a “spendthrift trust” account for that country's benefit. This would help neutralize politically-driven increases in the money supply and instill discipline.

Calibrated rules-based clearance fees would remove liquid money in circulation from the country, keeping interest rates lower, while building a rainy day fund against future shocks to that country's system. Funds could also pay for pre-programmed commodity or currency market transactions to counter that country's inflationary tendencies.

Coordinating monetary and fiscal policy at the international level in a rules-based fiscal enforcement system linked flexibly to commodity prices might help stabilize wild currency swings that distort economic choices and defeat comparative advantage. Stable currencies would help smooth out financial market volatility and business risk.

Most importantly, a rules-based automated suspension system may allow participants to hitch their economies back to the Gold Wagon. This could help restore discipline, credibility and stability to fiat currencies, while buffering economic shocks.

Countries joining this voluntary international system would bolster their financial credibility, while departing countries would exacerbate their position. To guard against the law of unintended consequences, the plan should have a sunset provision, set up initially with a zero rate, modeled and beta tested incrementally and studied carefully.

My question for the program trading experts is this: Is it possible to devise a rules-based system that administers a clearance fee and trust accounts in a manner that provides an automatic suspension system to the Gold Wagon? Perhaps someone with financial engineering expertise will extend this theoretical discussion one step further….

By John Newman

John Newman has an LLM in Tax from Georgetown, has published tax policy articles cited by the U.S. Supreme Court and is CEO of Invisible Hand Software, LLC, operator of the QuickForms.com legal expert system. He can be reached at legal@aol.com.

© 2008 Copyright John Newman- All Rights Reserved
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