CURRENCY CONVERTIBILITY

The classical means of stabilizing the value of money was to guarantee its convertibility on demand into specified commodities. This system was uniquely successful over a period of centuries, and since its most recent abandonment in 1971 the world economy has suffered from unprecedented inflation and economic instability. In this book Patrick Collins argues that, on the basis of historical experience as well as on theoretical grounds, only the resumption of currency convertibility in some form offers a realistic prospect of eliminating inflation.

After critically reviewing a succession of proposals that have been made over the past century for the resumption of currency convertibility based on commodities other than gold, Patrick Collins concludes that there is only one genuinely practical policy proposal in this field. This is the unjustly neglected proposal of the Australian economist Leo St. Clare Grondona, which avoids the weaknesses of other proposals, and which individual governments could implement independently, without risk, in terms of their national currencies. Like the original gold standard (though without its rigidity) this extremely simple system of conditional currency convertibility would give market forces a greater role in the control of the money supply, and would tend to counteract both inflation and recession.

Although widely praised in the past, Grondona's system has suffered by association with other, overambitious proposals in this field. Due to the resulting misconceptions concerning both the substance and the economic implications of the Grondona system there has never been an official investigation of the potential benefits of resuming currency convertibility in this way. The re-examination of this highly practical policy proposal is particularly timely today, when the importance and the difficulty of achieving sound money are more widely understood. This book will be of interest to all those concerned to see a return to more stable economic and monetary conditions, particularly those in business.

Patrick Collins is Lecturer in Managerial Economics in the Department of Management Science at Imperial College of Science and Technology, London. After studying natural sciences and economics at Cambridge he undertook postgraduate research at Imperial College from 1977 to 1981. He has worked as a consultant to the European Space Agency and acted as part-time assistant to the late Leo St. Clare Grondona from 1976 to 1982, during which time he became an authority on Mr. Grondona's work.

CURRENCY CONVERTIBILITY

The Return to Sound Money

Patrick Collins

Palgrave Macmillan

ISBN 978-1-349-07060-2 ISBN 978-1-349-07058-9 (eBook) DOI 10.1007/978-1-349-07058-9

©Patrick Collins 1985 Softcover reprint of the hardcover 1st edition 1985 978-0-333-36381-2

All rights reserved. For information, write: St. Martin's Press, Inc., 175 Fifth Avenue, New York, NY 10010

Published in the United Kingdom by The Macmillan Press Ltd. First published in the United States of America in 1985

ISBN 978-0-312-17915-1

Library of Congress Cataloging in Publication Data Collins, Patrick, 1952-Currency convertibility.

Includes index. 1. Currency convertibility. 2. International finance. I. Title. HG3851. C65 1985 332. 4'5 84-18197 ISBN 978-0-312-17915-1

Dedicated to Leo St Clare Grondona (12 August 1890-19 October 1982),

and to the Prime Minister and Chancellor who have the vision and the wisdom to

resume the only policy that has ever preserved sound money, in the only

manner that is feasible today

Contents

List of Figures List of Tables Preface Acknowledgements List of Abbreviations

INTRODUCTION

POST-WARINTERNATIONALMONETARY ARRANGEMENTS 1.1 The Gold Exchange Standard and its Aftermath 1.2 Difficulties of Monetary Control Today

2 THE ORIGINS OF MONEY AND OF THE PRINCIPLE OF CURRENCY CONVERTIBILITY 2.1 The Origin of Currency Convertibility 2.2 The Mechanism of Currency Convertibility 2.3 Mistaken Criticisms of Currency Convertibility 2.4 Ascendancy of Currency Convertibility

3 VARIOUS PROPOSALS FOR THE RESUMPTION OF CURRENCY CONVERTIBILITY 3.1 Gold Convertibility 3.2 Currency Convertibility Based on Primary Commodities 3.3 Counter-Cyclical Influence of Systems of Currency

Convertibility 3.4 Requirements of a System of Currency Convertibility Based

on Primary Commodities 3.5 Proposals for Directly Stabilising the Real Value of Money

4 CONDITIONAL CURRENCY CONVERTIBILITY BASED ON PRIMARY COMMODITIES: THE GRONDONA SYSTEM 4.1 Principles of Operation 4.2 Additional Provisions

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X

xi xiii XV

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6 6 9

15 15 17 21 24

35 35 39

41

45 50

64 65 70

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4.3 Factors Relating to Scale of Implementation 73 4.4 Possible Scale of Operation by Different Countries 78 4.5 Objectives that are not those of the Grondona System 90 4.6 Practical Implementation of the Grondona System 97

5 ECONOMIC EFFECTS OF IMPLEMENTATION OF CONDITIONAL CURRENCY CONVERTIBILITY BASED ON PRIMARY COMMODITIES 101 5.1 Influence on Primary Commodity Industries 102 5.2 Effects on Inflation 112 5.3 Effects on Balance of Payments 115 5.4 Effects on Terms of Trade 117 5.5 Effects on Exchange Rates 117 5.6 Effects on Interest Rates 123 5.7 Effects on Level of Economic Activity 124

6 MONETARY EFFECTS 132 6.1 Direct Stabilisation of the Real Value of Money 132

Appendix 6.1 Influence of a Commodities Reserve Department on Commodity Prices and on the National Exchange Rate 137

6.2 Direct Effects of a Commodities Reserve Department's Functioning on the Money Supply 139

Appendix 6.2 Effects on Banks' Balance Sheets of the Operations of a Commodities Reserve Department, and of Offsetting Monetary Policy Measures 148

6.3 Interaction of a Commodities Reserve Department's Functioning with National Monetary Policy 162

7 INTERNATIONAL ECONOMIC EFFECTS 173 7.1 Stabilising Influence on International Trade 1 73 7.2 Stabilising Influence on International Economic Activity 180 7.3 Multi-national Implementation 183 7.4 Effects on International Monetary Arrangements 187 7.5 Relations with Existing International Trade Organisations

and Agreements 190

8 THE GRONDONA SYSTEM CONSIDERED IN DIFFERENT ECONOMIC CONTEXTS 199 8.1 The Business Environment 199 8.2 The Current Controversy in Economic Policy 201

Contents

8.3 International Economic Reform 8.4 World Economic Recovery 8.5 'There's No Such Thing as a Free Lunch'

EPILOGUE

Appendix A: Past Response to Grondona's Work Appendix B: Possible British Initiative References Index

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204 206 209

213

219 227 231 237

List of Figures

3.1 3.2(a) 3.2(b) 4.1

4.2

5.1

5.2 5.3

6.1(a)

6.1(b)

Price Index for South England over seven centuries Commodity prices and the business cycle Commodity prices and the business cycle Reserve price schedule of Commodities Reserve Department based on illustrative figures in Table 4.1(b) Effective reserve price schedule for several Commodities Reserve Departments expressed in sterling Influence of Commodities Reserve Department's operation on market price of a particular commodity Commodity prices and the business cycle Rates of growth of international trade of major OECD countries, 1965-83 Stabilising effect of CRD's functioning on real value of national currency; influence on commodity prices greater than on exchange rate Stabilising effect of CRD's functioning on real value of national currency; influence on exchange rates greater than on commodity prices

6.2-6.13 untitled 7.1 Multi-national operation of Commodities Reserve

Departments in respect of a particular commodity

X

37 42 43

68

79

106 128

130

140

141 150-8

186

List of Tables

4.1(a)

4.1(b)

4.2 4.3(a)

4.3(b)

4.3(c)

4.3(d)

4.3(e)

4.3(f)

4.4

Framework of Commodities Reserve Department's reserve price schedule for any commodity Illustrative price schedule for fictitious commodity with initial 'Index' price of £1000 per ton Raw material imports of six major OECD countries, 1980 Approximate scale of operation of US CRD based on unweighted average 1978-81 trade values, prices in 1982 dollars Approximate scale of operation of Japanese CRD based on unweighted average 1978-81 trade figures, prices in 1982 Yen Approximate scale of operation of West German CRD based on unweighted average 1978-81 trade figures, prices in 1982 Deutschmarks Approximate scale of operation of French CRD based on unweighted average 1978-81 trade figures, prices in 1982 French francs Approximate scale of operation of British CRD based on unweighted average 1978-81 trade figures, prices in 1982 sterling Approximate scale of operation of Italian CRD based on unweighted average 1978-81 trade figures, prices in 19821ire Approximate scale of Commodities Reserve Department operations in relation to national money supplies, 1982 figures

xi

67

67 75

81

82

83

84

85

86

88

Preface

This book is concerned primarily with a single aspect of monetary policy, namely the principle of maintaining 'currency convertibility', whereby the real value of a currency is preserved by guaranteeing to convert it on demand into specified commodities. This policy is not a part of con­temporary monetary arrangements, which are unprecedentedly inflationary, although the principle of currency convertibility has been supported throughout several centuries by leading economic and political thinkers as being the indispensable foundation of a sound monetary system.lt has been a feature of every monetary system that has succeeded in preventing infla­tion, and continues to be the only system that has ever preserved the real value of money over a timescale of generations. In doing so the system has succeeded both in providing the technical means to achieve this goal, and in maintaining the public support that is necessary in a democracy for the continued acceptance of sound monetary policy. It has achieved this in large part by increasing the role of market forces in the deter­mination of monetary policy, thereby removing it to that extent from the political arena.

Although there are many more or less specialised books which deal with different aspects of monetary systems, the policy of maintaining currency convertibility is not normally treated as a separate subject. (It is rare, for instance, for 'convertibility' even to appear in the index of economics texts.) It is more commonly treated as merely one aspect of the operation of the classical gold standard which was abandoned in its original form in 1914. However, the underlying principle of guaranteeing the convertibility of currency is more general and of wider significance than this particular case. It has important implications for a wide range of economic policy issues. These include control of inflation, stabilisation of the business cycle, instability of exchange rates and primary commodity prices, international trade fluctuations, and the debate over the relative importance of rules and discretion in the operation of monetary policy.

In the following chapters the origins of currency convertibility and the reasons for its universal acceptance in the past are examined. The potential benefits of reintroducing it in some form and the best means of obtaining

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xiv Preface

these benefits today are then considered, together with the economic implications of such a step for the various aspects of the economic system, both domestic and international. In order that it should be accessible to the widest possible audience, the book avoids the use of specialist vocabulary as far as possible.

London PATRICK COLLINS

Acknowledgements

I would like to thank Chris Burnham for kindly commenting on an earlier draft of the book, and my parents and Peter and Penny Grondona for their generosity and help.

P.C.

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List of Abbreviations

CAP CBI c.i.f. CRD DCE ECU EEC EMS GATT GNP ICA IMF OECD SDR T UNCTAD

Common Agricultural Policy Confederation of British Industry Cost, insurance and freight, or 'charged in full' Commodities Reserve Department (of Central Bank) Domestic Credit Expansion European Currency Unit European Economic Community European Monetary System General Agreement on Tariffs and Trade Gross National Product ~nternational Commodity Agreement International Monetary Fund Organisation for Economic Co-operation and Development Special Drawing Right Tonne United Nations Conference on Trade and Development

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