Paul Davidson: Reforming the world’s international money

Paul Davidson is a leading academic scholar in the field of Economics with a large catalogue of publications of merit.  I would like to use this post to introduce you to him and a specific work of his that deserves more attention in the mainstream media.  This post may be a bit wonkish, but I hope you will appreciate the message.

First, Davidson has been a professor at a number of leading academic institutions for nearly fifty years where he most noted as a progenitor of the Post-Keynesian school of economics.  Here is how Wikipedia sums it up:

Paul Davidson (b. 1930, New York is an American macroeconomist who has been one of the leading spokesmen of the American branch of the Post Keynesian school in economics. He is a prolific writer and has actively intervened in important debates on economic policy (natural resources, international monetary system, developing countries’ debt) from a position that is very critical of mainstream economics.

Davidson did not originally choose economics as a profession. His primary training was in chemistry, for which he got a BSc from the University of Pennsylvania. In 1951 he worked in that same university as an instructor in physiology and chemistry. He soon switched to economics, receiving his MBA from the City University of New York in 1955, and completing his PhD at the University of Pennsylvania in 1959.

He has taught economics at University of Pennsylvania, Rutgers University, Bristol University, University of Cambridge, and the University of Tennessee. He is a Visiting Scholar at the Schwartz Center For Economic Policy Analysis at the New School for Social Research and is currently an Emeritus Holly Professor of Excellence at the University of Tennessee, Knoxville. He is especially known for promoting a Post Keynesian school of macroeconomics. He and Sidney Weintraub founded the Journal of Post Keynesian Economics in 1978. He is the Editor of the Journal of Post Keynesian Economics.

Now, the reason that Professor Davidson is relevant here has to do with the present economic crisis. Much of the panic from after the failure of Lehman Brothers has subsided. However, many challenges remain. In solving these challenges, our policy makers must take a log-term perspective in order to ensure that we do not have to face an epic downturn like this again. In my view, a true workout of our present economic ills necessitates the reform of our international monetary system.

Enter Paul Davidson. He has only just published a timely paper called “Reforming The World’s International Money.” In it he suggests that the fiat monetary regime that we have had since the end of Bretton Woods was always unsustainable and is now broken. A new international money is needed.

If we are to prevent a global Great Depression, it is time to restore Keynes’s vision of how the international payments system should work to permit each country to promote a national full employment policy without having to fear balance of payments problems or financial events occurring in other countries from infecting the domestic banking and financial system.

Edward here. You should note that Davidson is suggesting that a new monetary regime is in order now in 2009 in order to prevent a worst-case scenario. I have bolded the key parts of his argument below.

In The General Theory, Keynes argued that if an economy was operating at less than full employment, then the nation’s central bank, while maintaining the stability of financial markets, should focus on providing all the liquidity that the economy can absorb in order to reach full employment. For more than a quarter century after following World War II, the major central banks around the world tried to meet the role that Keynes had prescribed for them in his General Theory.

From the end of the war until the early 1970s most central banks tended to provide increases in the money supply in response to any domestic or international increase in demand for the nation’s money, while maintaining interest rates at historic lows for prosperous times. This endogenous increase in the money supply tended to support expansion of aggregate demand that resulted in a golden age of economic growth and development for both developed and less developed capitalist economies….

When, in 1973, the U.S. withdrew from the Bretton Woods Agreement, the last vestiges of Keynes’s enlightened monetary approach were lost, apparently without regret or regard as to

  • [a] why the Bretton Woods system had been developed in the first place and
  • [b] how well it had helped the free world to recover from a devastating war which had destroyed much of the productive stock of capital in Europe and Asia.

In the decades since the breakdown of Bretton Woods, the world’s economic performance has been unable to match what became almost routine economic success in the quarter century since the end of World War II in terms of low rates of global inflation accompanied by high rates of employment and real growth.

Since 1973, however, international economic problems have multiplied, while significantly high rates of unemployment in many nations has again become the norm.

Under any traditional international free trade system, any nation that attempts to improve its economic growth performance by pursuing Keynes’s policies for increasing domestic effective demand via easy monetary and fiscal policies will almost immediately face an international payments problem.

However, under a fiat currency regime as we have today that is not the case.  Davidson explains:

Since 1973, the conventional wisdom of economists and politicians is that nations should liberalize all financial markets to permit unfettered international capital flows to operate under a freely flexible exchange rate system. The current international financial market crisis is a result of permitting unconstrained international financial flows.

The question is what is the solution.  The Gold Standard is often offered up as a potential solution.  But, a true gold standard has not been in operation since 1914.  And the price of making gold the standard for money is too much to bear, especially in this deflationary environment.

Davidson offers an alternative system.  This system prevents a lack of demand (as under the gold standard). It automatically corrects imbalances like the U.S. current account deficit or the Chinese/Japanese surplus. And it provides a way to increase ‘dollars’ in circulation without debasing the currency.  In short, it is a very good system.

I recommend you read his paper in full.  The link is at the bottom of this post.  However, the guts of his proposal are cited here in his words.

In the 21st century interdependent global economy, a substantial degree of economic cooperation among trading nations is essential. The original Keynes Plan for reforming the international payments system called for the creation of a single Supranational Central Bank. The clearing union institution suggested infra is a more modest proposal than the Keynes Plan, although it operates under the same economic principles laid down by Keynes. Our proposal is aimed at obtaining an acceptable international agreement (given today’s political climate in most nations) that does not require surrendering national control of either local banking systems or domestic monetary and fiscal policies. Each nation will still be able to determine the economic destiny that is best for its citizens without fear of importing deflationary repercussions and financial disruptions from their trading partners. Each nation, however, will not be able to export any domestic inflationary forces to their international neighbors. What is required is a closed, double-entry bookkeeping clearing institution to keep the payments ‘score’ among the various trading nations plus some mutually agreed upon rules to create and reflux international liquidity while maintaining the purchasing power of the created international currency of the international clearing union. The eight provisions of the international clearing system suggested in this chapter meet the following criteria. The rules of the proposed system are designed

  1. to prevent a lack of global effective demand either due to a liquidity problem arising whenever any nation(s) holds either excessive idle reserves or drain reserves from the system, or a financial crisis occurring in any nation’s banking and asset marketing system spilling over to create liquidity and insolvency problems for residents and financial institutions in other nations.
  2. to provide an automatic mechanism for placing a major burden of correcting international payments imbalances on the surplus nations,
  3. to provide each nation with the ability to monitor and, if desired, to control international movements of funds to prevent contagion from financial problems occurring in other nations, tax evasion money movements, earnings from illegal activities, and even funds that finance terrorist operations, and finally
  4. to expand the quantity of the liquid asset used in settling international contracts (the asset of ultimate redemption) as global capacity warrants while protecting the purchasing power of this asset.

There are eight major provisions in this clearing system proposal. They are:

  1. The unit of account and ultimate reserve asset for international liquidity is the International Money Clearing Unit (IMCU). All IMCU’s can be held only by the central banks of nations that abide by the rules of the clearing union system. IMCUs are not available to be held by the public.
  2. Each nation’s central bank or, in the case of a common currency (e.g., the Euro) a currency union’s central bank, is committed to guarantee one way convertibility from IMCU deposits at the clearing union to its domestic money. Each central bank will set its own rules regarding making available foreign monies (through IMCU clearing transactions) to its own bankers and private sector residents…
  3. Contracts between private individuals in different nations will continue to be denominated into whatever domestic currency permitted by local laws and agreed upon by the contracting parties. Contracts to be settled in terms of a foreign currency will therefore require some publicly announced commitment from the central bank (through private sector bankers) of the availability of foreign funds to meet such private contractual obligations.
  4. The exchange rate between the domestic currency and the IMCU is set initially by each nation or currency union’s central bank– just as it would be if one instituted an international gold standard. Since private enterprises that are already engaged in trade have international contractual commitments that would span the changeover interval from the current system, then, as a practical matter, one would expect, but not demand, that the existing exchange rate structure (with perhaps minor modifications) would provide the basis for initial rate setting.
  5. An overdraft system should be built into the clearing union rules. Overdrafts should make available short-term unused creditor balances at the Clearing House to finance the productive international transactions of others who need short-term credit. The terms will be determined by the pro bono publico clearing union managers.
  6. A trigger mechanism to encourage any creditor nation to spend what is deemed (in advance) by agreement of the international community to be “excessive” credit balances accumulated by running current account surpluses…
  7. A system to stabilize the long-term purchasing power of the IMCU (in terms of each member nation’s domestically produced market basket of goods) can be developed. This requires a system of fixed exchange rates between the local currency and the IMCU that changes only to reflect permanent increases in efficiency wages…
  8. If a country is at full employment and still has a tendency toward persistent international deficits on its current account, then this is prima facie evidence that it does not possess the productive capacity to maintain its current standard of living. If the deficit nation is a poor one, then surely there is a case for the richer nations who are in surplus to transfer some of their excess credit balances to support the poor nation.

The hope is that this is something the new U.S. administration can take on.

Source “Reforming The World’s International Money“, (PDF) paper presented at conference on “Financial Crisis, the US Economy, and International Security in The New Administration”, New York, November 2008 – University of Tennessee website

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Originally published at Credit Writedowns and reproduced here with the author’s permission.