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For R e l e a s e on D e l i v e r y
6 P.M. C . D . T . (7 P.M. E . D . T . )
April 6, 1989


H. R o b e r t H e ! 1 e r
M e m b e r , Board of G o v e r n o r s of the Federal R e s e r v e S y s t e m

Homer Jones Memorial Lecture
U n i v e r s i t y of M i s s o u r i , St. Louis
April 6, 1989


I am very honored to have been invited to deliver the annual
Homer Jones memorial lecture.

In deference to his memory I

believe it is appropriate that this lecture be concerned
with some of the enduring themes that pervade thinking about

Many distinguished economists have pondered the role of
money and prices and the question of whether it is better to
organize our monetary affairs along national lines or
whether an international monetary standard is more

In arriving at an answer, important aspects of

freedom, liberty, and constitutional sovereignty have been

The complexity of the topic is attested to by the fact that
the debate is still not settled definitively.

As a matter

of fact, the current debate about the desirability of a
common European monetary standard and the formation of a
European central bank have rejuvenated many of the old

My central theme today will be the role of money and
monetary stability and the question of whether it is more
appropriate to rely upon a national monetary standard or an
international one.

There is also a personal reason why I have chosen this

It has troubled me for many years that some of my

friends and colleagues view themselves as monetarists and
analyze domestic policy from that perspective, while another
group of my friends maintain that fixed exchange rates are
the glue that holds the world economy together.

From their

perspective, the world would be a better place in which to
live if we would only adopt a gold standard.

This reminds me of the time when I set out on my first trip
to Latin America.

As I was leaving, an expert on the region

told me: "Young man, as you travel from country to country
in Latin America, you cannot fail to notice that half of the
central bankers you encounter will advocate fixed exchange
rates, while the other half see flexible exchange rates as
the only solution to their country's problems.

Pretty soon

you will also learn that virtually all of them attended the
University of Chicago.

As far as I can tell, the only

reason for their different convictions is that the first
group studied in Chicago in a year when Harry Johnson and
Robert Mundell taught the Monetary Workshop, while the
second group took the course in a year when Milton Friedman
was teaching it."


Eventually, I learned that the views of both groups could be
reconciled on the global level because the different
conceptual and behavioral assumptions underlying the two
approaches converge on the global level.

If there were to

be only one world economic and financial system, the debate
about fixed versus flexible exchange rates would not have
been enjoined in the first place.

Unfortunately, that is

not the world we live in.

But even for the world that we live in, there is a
surprisingly close association between the global level of
international reserves (or the global monetary base), the
world money supply, and the world price level.

But that

finding does not answer the question of whether financial
stability is better achieved by having individual nations
manage their own monetary affairs in an independent,
decentralized manner; whether a global monetary constraint
should be relied upon bring about national monetary
discipline; or whether there exists a workable compromise
that we can all live with.

Clearly, I will not be able to do justice to all the
complexities and nuances of the topic in such a limited span
of time.

Hopefully, brevity will allow me to crystallize

some of the arguments and to bring some of the issues
sharply into focus.


I will first consider the role of money in the economy and
then discuss some of the problems of defining monetary

I will then turn to the role of freedom in

determining the ideal monetary system and finally present
what I would consider to be the rudiments of a workable
compromise system in our imperfect world.

The Roles of Money

Money enhances economic freedom.

In the absence of money,

we would still be free to make choices, but these choices
would be more costly, cumbersome, and constrained.

To see how money enhances economic freedom it is useful to
remind ourselves that money fulfills several distinct roles:
it serves as a unit of account, a medium of exchange, and a
store of value.

As a unit of account, money enhances freedom of choice by
permitting price comparisons to be carried out more readily.
It lowers information costs and thereby improves the choices

As a medium of exchange, money lowers transaction costs and
allows individuals to exercise their freedom to acquire
goods and services through transactions.

Without money,

there would still be the possibility to engage in barter

exchange, but this process would certainly be more
cumbersome and costly.

As a store of value, money makes it possible to exercise
intertemporal choices.

By allowing people to accumulate

funds and to spend them later, it enhances their freedom of
choice over time.

One may even argue that money increases political freedom.
Not only does money offer greater independence and freedom
of decision making, but a generally acceptable means of
payment and store of value enables the individual to turn
his back upon one political system and to take one's life
savings to live somewhere else under a different political

Thus, it is not surprising that politically repressive
regimes tend to provide their citizens only with a money
that has little or no international acceptability.
Furthermore, they tend to punish those who try to enhance
their freedom of choice and scope for independence by
accumulating foreign currencies.

It is also not surprising

that in times of extreme political suppression, gold has
often become an increasingly important treasure.


Money and the Price Level

We have discussed the various roles of money.

Money can

fulfill these tasks in an optimal fashion only if it is a
stable unit of account, a stable means of exchange, and a
stable store of value.

In other words: money should provide

a consistent yardstick, and that is synonymous with a noninflationary environment.

Unfortunately, the measurement of inflation itself poses not
only certain philosophical, but also important practical

If money itself is the yardstick, how can its

value be defined in terms of something else?

If the

monetary unit, say the dollar, were to be defined in terms
of gold, isn't it then true that gold is the yardstick?


that case, gold will at least assume the unit of account
function, while the dollar may serve as the means of
exchange and the store of value.

The value of a national currency may also be defined or
measured in terms of other national currencies.


obviously this cannot be true for all currencies as this
would involve circularity of reasoning.
ultimate yardstick.

There must be an

The Bretton Woods system solved this

problem by defining the value of all currencies in terms of
the dollar, while the dollar was defined in terms of gold.


In a national economy the measuring rod for the value of
money is typically provided by the price level.


the definition of the price level is not as unambiguous as
it may seem at first sight.

Most customary measures of the price level rely upon
weighted averages for transaction prices of current goods
and services.

These are the familiar indices of producer

prices, consumer prices, and the GNP deflator.


instance, the GNP deflator measures the value of the stock
of money, a

concept which has meaning only at a given point

in time, in terms of the prices of goods that are produced
during a certain period of time, that is, a flow variable.

But how about the prices of assets, such as commodities and
real estate?

Aren't these prices relevant when it comes to

judging whether we are in an inflationary or deflationary

One may well argue that it is more appropriate

to measure the value of money in term's of other assets
because money itself is an asset.

While there are good

arguments to be made for the consideration of tangible asset
prices in assessing the value of money, matters become
increasingly complex as we broaden the spectrum to financial
assets as well.

One may also argue that stock prices

are a convenient proxy for real asset values.

But other

influences, such as a change in management, may also
influence the value of a stock.


Matters become even more complicated in the case of bonds.
While they are an asset on one individual's balance sheet,
they are also a liability on someone else's balance sheet.
Their value is also directly influenced by monetary policy,
and it is easy to get into circular reasoning in that

While bond prices do give useful information,

it is probably better to consider that information
separately from information conveyed by changes in real
asset prices.

I would conclude from this discussion that if we are
interested in the stability of money as a unit of account,
store of value, and means of transaction, the appropriate
indices for determining changes in the value of money should
incorporate prices which reflect these functions.

That is,

asset prices, commodity prices, intermediate as well as
final goods prices might be given appropriate attention in
defining and measuring price stability and the value of

Gold as a Monetary Standard

Given the complexities of measuring the price level itself
and of defining the value of money, it is therefore not
surprising that over the centuries people have sought refuge
in simplicity and expediency and focused on gold as a
universal constant that provided a practical unit of

account, a medium of exchange, and a store of value.

More so than any other commodity, gold has combined the
various monetary attributes and has done so over centuries
of human history.

Moreover, a large and distinguished

number of economists has advocated a gold standard at some
point in their professional lives.

But many of them have

subsequently abandoned their beliefs that gold can serve as
a national, and indeed global, money and advocated
alternative systems.

I argued earlier that money plays an important role in
maintaining and enhancing economic and political freedom.
In my mind, gold fails to meet this crucial test for a
monetary standard.

The two largest gold producing countries

in the world are the Soviet Union and South Africa.

Due to

their position as key suppliers they wield considerable
influence over the market price of gold.

I view neither one

of them as an economically or politically reliable and
stable supplier.

Thus, I would not entrust them with the

degree of influence over our economic, financial, and,
indeed, political affairs that a move to a gold standard
would entail.

I find this objection so fundamental that I

see a further debate of the pros and cons of a gold standard
as essentially unproductive and pointless.

There is simply

no reason why free and democratic nations should cede an
important part of their sovereignty into uncertain hands.


Of course, everyone should be free to make his or her own
choices whether they wish to hold gold, use it as a store of
value, or as a medium of transaction among willing

Government should neither fix the price of

gold, nor impede its private use.

Freedom and the Monetary System

Choosing an international monetary system involves many
profound constitutional questions that affect a nation's

The deep desire to protect and foster human freedom unites
both the advocates of a national monetary rule and the
proponents of an overarching international monetary
standard. For simplicity's sake I will refer to them as the
monetarists and the internationalists.

The two groups also

distinguish themselves by advocating an international
monetary system that relies upon flexible and fixed exchange
rates respectively.

Both the monetarists and the internationalists hold the view
that government should serve the people and that the role of
government should be strictly limited.

In the economic

realm, both groups believe in price stability as the key
objective of monetary policy.

They also want to limit the

role of government, and therefore advocate the adoption of

"monetary constitutions" or predetermined rules according to
which policy is to be carried out.

In that they are united against the interventionist view,
which holds that active governmental decision making is a
positive force that is needed to bring about economic
stability, efficiency, and welfare maximization.

But national and international monetarists adhere to
different philosophical concepts and notions about which
monetary arrangements best protect human freedom.
Monetarists believe that human freedom is best protected if
governmental authority is exercised at the most
decentralized level of government;

the internationalists

believe that a global monetary rule would take monetary
decision making powers out of the hands of national
governments and thereby minimize the chance of inappropriate
interference by national governments.

Thus, monetarists and

internationalists tend to differ in their prescriptions as
to how best to organize the monetary system.

In addition,

there are certain empirical judgments about the way the
world works that underlie the two approaches.

Let me

explore these differences in some detail.

Monetarists tend to argue that in order to preserve
individual freedom, the power of the state should be
limited. They claim that the only consistent way to

accomplish this objective is to disperse governmental power
through decentralization.

Thus, governmental functions

should be exercised on the most decentralized governmental
level possible.

The national government should exercise

only those powers that cannot be delegated to regional or
local governmental units.

While the power to create money and regulate the value
thereof should be exercised at the national level,
monetarists believe that the authorities should be
constrained by a domestic rule as to monetary growth.

From this it also follows that the government should not be
externally constrained.

Preserving that international

independence is therefore a key requirement of any
international monetary system.

Consequently, the

international monetary system should be constructed in such
a way that monetary decisions are taken at the most
decentralized level possible:

namely, the nation.


exchange rates are therefore advocated by the monetarists as
a means of preserving the political and economic
independence of the country.

Under such a system,

international policy coordination is not only unnecessary,
but even undesirable as it will inevitably infringe upon the
freedom of the nation state.

Instead, flexible exchange

rates are advocated as an insulating buffer among countries.


In contrast, internationalists tend to argue that individual
economic freedom can best be attained in a system where one
common international currency is used in the entire world.
In such a system, individuals are free from national
economic and financial constraints and can maximize their
welfare unfettered and unhampered by national boundaries and
political intrusions.

They are at liberty to engage in

transactions with anybody else in the entire world.

In the

views of many internationalists, such a system is provided
by an international gold standard, where gold serves as the
actual medium of exchange.

Under such a system, the

uncertainty of exchange rate fluctuations is also eliminated
and global welfare maximization therefore becomes a true

The true internationalist sees the nation state largely as a
political construct that has only limited economic

A common global monetary standard will allow

individuals to maximize their economic and also their
political welfare.

Both sides are united in their view that the preservation
and enhancement of individual freedom and liberty is the
ultimate and overarching goal of any social order.
the ideal.

That is

They both wish to attain that ideal by

minimizing the political and economic power of the state.
Furthermore, they assume that competitive forces will bring

about economic adjustment in a speedy and efficient manner.

The question is whether this ideal view of the world is
realistic, or whether the imperfections still existing in
the world call for a compromise that may well fall short of
the idealistic systems represented by pure monetarism or

A Pragmatic Approach

I believe that the world is still an imperfect place.
Economic conditions vary widely around the globe.


most important of all, the degree of economic integration
also varies widely.

Few truly global markets exist.

Instead, we have a series of national and regional markets
that are linked with varying degrees of perfection.

In other words, the economic and financial world is a
patchwork quilt rather than a homogenous entity.

Some would

argue that this makes the world even more interesting or
beautiful —

and in a world with positive information costs,

it may be just as efficient.

The problem confronting us is therefore one of constrained
optimization and the development of a set of rules that will
permit the maximum degree of freedom in the economic and
political realm while taking into account the need for

collective decision making in certain areas.

Nowhere is that more apparent than in the monetary sphere.
Just like a separate money issued by each individual person
would lose its usefulness, so does a global monetary
standard not necessarily serve everyone best.

The debate

about the advantages and disadvantages associated with a
common monetary standard and a central bank for Europe shows
the problems and the issues involved.

Let me set out what I consider to be some relevant
considerations that should guide us in the decision as to
what monetary system might serve us best.

First of all, the goal of monetary policy should be to
provide a stable financial environment so that private
decision makers can maximize their welfare.

A stable

monetary standard will help to minimize transaction costs
and aid in rational economic decision making.

Stability in

this sense can be defined as the absence of any bias in
decision making that would be induced by a tendency for the
price level to vary in a systematic fashion.

This state of

affairs will be reached when the change in the general price
level is close enough to zero so that it will be ignored by
the economic agents in their decision making process.


Second, the value of money should not only be measured in
terms of output prices of items sold, but also in terms of
asset prices.

Third, price stability can be achieved only in an
economically and financially integrated area.

The world we

live in does not yet represent such a fully integrated
market area.

National borders, artificial or informal

barriers to economic and financial flows, information
barriers, and the like, all contribute to a compartmentalization of the world economy.

Fourth, a common indicator, such as a global commodity
basket, can provide a useful reference point for national
and international policy makers.

Such a reference point is

not only helpful in the formulation of domestic policy that
introduces sensitive asset prices into the decision making
process, but it also gives important information about the
development of global inflationary or deflationary

Indeed, the use of such a commodity price

indicator was agreed upon at the Toronto Summit meeting of
the industrialized nations.

Fifth, more or less homogeneous economic and financial zones
constitute the optimal domains for various monies or
monetary standards.

As economic and financial integration

progresses and the barriers among different economic regions

are being reduced, the natural monetary domain is also

At the present time, such progress is

particularly pronounced in Europe, which is rapidly moving
toward becoming an integrated economic and financial entity*
As a consequence, the European discussion about monetary
integration is nowadays more than theoretical speculation
and may well move into the realm of reality in the not too
distant future.

Sixth, it should be recognized that monetary integration has
not only economic, but also political significance.


it is not necessary that each sovereign country has its own
monetary unit, there must be a sufficient degree of
political consensus to permit the use of a common monetary

This common monetary standard can be established

through the formation of a joint political decision making
body, the delegation of the monetary decisions to a common
central bank, adoption of a commodity or gold standard, or
the formal or informal acceptance of a standard represented
by another monetary authority.

In the latter case, the

political underpinnings of that decision making body must be
sufficiently similar to their own political beliefs and
priorities to assure that no substantive conflicts arise.

As the global integration of economic and financial markets
proceeds, and as political interdependence increases, it
therefore stands to reason that monetary integration will
1 7

increase as well.

In that connection it is important that progress in one area
is accompanied by progress in the other areas.

Just as it

would be unrealistic to expect rapid political integration,
it is also unrealistic to see monetary integration as
getting out too far in front.

Time for adjustment and

consensus formation must be permitted.

But as confidence in ever increasing economic and financial
integration increases and as political cooperation becomes
an enduring reality, progress toward greater monetary
integration will be made as well.

That is, the monetary

domains will tend to expand and over time we will move
closer to a global monetary standard.

What does all that imply for the real world that we live in?

In that connection it is good not to forget important
lessons of history.

Soon after the establishment of a

government for the United States, the First Bank of the
United States was founded in 1789.

Its charter was not

renewed and it was succeeded by the Second Bank of the
United States, which ceased to exist in 1836.



because there was not yet enough of an economic and
political consensus in the young nation to support a uniform
monetary policy.

The interests of the merchants and traders

of the East could not yet be reconciled with the priorities
of the farmers and settlers of the South and West.


the United States had to do without a central bank until the
formation of the Federal Reserve System only 75 years ago.
And even then, the Federal Reserve System was designed to
assure representation of the views of the various regions of
the country, as well as a balanced representation of the
banking, commercial, industrial, agricultural, and public

Looking beyond our borders, we already see an ever
increasing integration in the economic and financial affairs
of the United States and Canada.

The U.S. dollar is used

widely in Canadian capital markets.

It is also used as a

medium of exchange and a store of value in much of Latin

But clearly there is no political base for

monetary integration among the various countries of the
American continent.

Matters have proceeded further in Europe, where the economic
integration movement has also been accompanied by the
establishment of common administrative and political

This sets the stage for the important debate

about the desirability of establishing a central bank for
Europe, which could issue a common currency and administer a
common monetary policy.


It is instructive to trace the development of the European
Community because it illustrates the interdependence between
economic, monetary, and political integration.

An economic

beginning was made by the original six signatories to the
Treaty of Rome that established the European Economic

Gradually other nations entered the economic


In the monetary sphere, Belgium and Luxembourg have long had
a common currency.

The common monetary arrangements of the

European snake constituted essentially a period of
experimentation and experience gathering, but taught
important lessons that were then incorporated in the more
formal European Monetary System.

While the original members

of the European Economic Community are now all participants
in the European Monetary System, some of the countries that
joined the Community later have not yet taken this step.
Overall, progress has been gradual and not devoid of
disappointments and setbacks.

All this has been accompanied by the establishment of common
European political institutions and an administrative
apparatus that has progressed from what amounted to
coordinating functions to an important decision making role.
Thus, an ever increasing economic and political consensus is
formed that may in due course represent a sufficient
foundation for the establishment of a common European


currency and monetary policy.

I have previously advocated the establishment of unitary
exchange rates as an intermediate step that might be taken
by Europeans.

Under such an arrangement, all currency

exchange rates would be aligned such that one German mark
would equal one French franc, one British pound, and so on.
The institutional arrangements of the current EMS system
wou"1''. be maintained.

Under such an arrangement, the various

currencies would soon become accepted across the continent,
and in effect a uniform means of exchange for the continent
would be created.

If successful, a full monetary union and

European central bank might follow in due course.

The formation of such a European currency area would
undoubtedly have implications that would transcend European

Already quite a few African countries peg their

currencies to those of European countries, and it can be
expected that these and possibly others would want to peg to
a common European currency as well.


What may we conclude from this discussion?

One, the choice of a monetary standard and a monetary system
involves important political choices and is rooted in basic

notions about how best to protect and preserve human

Two, a certain congruence among economic, financial,
political, and monetary arrangements is needed for their
public acceptance and to assure their viability.

Three, as the world becomes more integrated, progress toward
the establishment of ever larger ^monetary domains can also
be made.

But by necessity, that progress is slow and


I believe that we are privileged to live in a time where we
are witness to considerable progress on all fronts and are
able to participate in building a more integrated world,
where economic and political decisions can be made with
increasing freedom for all people.