THE NATIONAL CONSTITUTION PROTOTYPE PROJECT

National Currency Management

Many have debated how best to manage a nation's currency. Up until the 1970s, the US dollar was backed by gold. The belief up to that time was that a currency needed to be backed by gold or silver as a way to "guarantee" its value. By tying a currency to gold or silver, it imposed a limit on the amount of currency that a nation could issue, and such restriction would, in theory, then prevent a government from printing so much currency that the nation's currency would become worthless.

However, there is a huge problem with that idea. And perhaps the best way to explain the problem is by way of analogy.

Imagine a nation's economy as a living creature and the quantity of blood cells circulating throughout the creature's body as representing the nation's currency in circulation. Note that each blood cell can only deliver a finite amount of oxygen to the creature's body, so the total number of blood cells circulating in the creature's blood vessels sets a limit on the total amount of energy that can be delivered at any given time to the creature's body. Note that the implication of that energy limit is that the creature cannot grow beyond a certain size. If it grows too big, its blood supply will not be able to keep up.

To be clear, many nations get around such a bottleneck by issuing bonds. Bonds allow a government to "suck up" currency in circulation and then pump the currency back into the economy. Such bonds expand the effective money supply beyond the amount of currency in circulation. But there's a catch. The total value of the bonds outstanding can greatly exceed the amount of currency in circulation and, thus, also the amount of gold or silver backing the currency. Consequently, the total debt of a nation could be far greater than its gold or silver reserves could ever possibly repay.

But then, that is only a problem if everyone queues up to exchange their bonds and bills for gold all at once. And as long as that doesn't happen, everyone is happy. Right?

In the 1970s, the US President (Richard Nixon) shocked the nation when he took the unusually step of taking the dollar off the "gold standard". Since then, the value of the dollar has been effectively determined by the government's ability to create demand for the dollar through its ability to tax. To put it simply, if someone owes the government a dollar, the government is fairly confident the debtor or taxpayer will do whatever is necessary to acquire the dollar that they owe the government. Of course, in practice, the "demand creation" process is a bit more complicated than that; but one simply needs to understand that, if the government can control both the demand for and supply of its currency, it can control its currency's value.

Of course, there remains the potential problem of hyperinflation (the rapid devaluation of a nation's currency). At times, it can be very tempting for a government to allow the value of its currency to slip by cutting taxes and increasing spending. And when the amount of inflation cannot be reasonably predicted, financial markets tend to react very negatively.

So how can a nation put constraints on the government's ability to devalue its currency while still allowing the money supply to expand as the economy expands?

One solution is to create an institution that is independent of the government that is responsible for regulating the amount of currency in circulation. In the US, that institution is called the Federal Reserve. And the effectiveness of the Federal Reserve to regulate the currency largely depends on the wisdom and objectives of its head (the Chairperson of the Federal Reserve Board).

However, there is another approach that perhaps should be considered. And it is one that can potentially eliminate much of the uncertainty that still lingers in the currency management system in operation in the US.

Electrical power is a vital resource for modern economies. Electrical power generation tends to scale extremely closely with an economy. And, just like gold, a kilowatt of power does not decay in value over time. A nation can, if it chooses, define its currency's value in terms of a unit of electric power (and its fuel-related equivalents). A nation can even build in a deflation factor in its currency's definition that provides a highly predictable deflation rate (which can, for various reasons, be extremely beneficial).

Sounds a bit nuts? Perhaps. But, if we are to be perfectly honest, is it any crazier than the system that is currently in operation today in the US where the value of the currency has no defined value at all?