What if we reform the whole monetary system?

We could try to solve problems within the current monetary framework, or could discuss alternative monetary regimes.

Most economists agree that the latest crisis was caused by risk-taking incentives (competition for profits, wrong ratings, false policies, moral hazard) along with financial innovations that allowed banks to lend excessively. While monetary policy prevented, for better or worse, a collapse of the financial system, an increasing number of economists also agree that it is not possible to safeguard the financial system over and over again. There are limits to intervention. Therefore we have to find a way to deal with the very causes of the crisis.

Currently the only policy solution seriously discussed is regulation of financial markets or certain instruments. Success of regulation is questionable due to two reasons: First, financial innovation is a process that does not stop after regulators finished the job. Excessive credit lending is still possible given the current monetary system. Second, risk-taking incentives remain unsolved. Regulation does not address moral hazard due to lender of last resort and bail-out expectations.

To solve these problems serious thought must be given to reforming the current monetary system. There are two ways to tackle this issue:

First, one can try to solve the problems within the current monetary framework. Central banks would need a new policy rule. They could e.g. have to counter-cyclically react towards credit expansion by ‘leaning against the wind’ when asset prices skyrocket and credit aggregates explode (link). If they communicate their intention to do so, the incentives for risk-taking may be limited in the first place. This solution assumes the central bank’s ability and will to act accordingly.

Second, alternative monetary regimes should be discussed. In this respect, a commodity standard could limit credit expansion via financial innovation (link). Free banking may further promote self regulation and could restrict bank’s risk-taking when the lender of last resort is absent (link). Alternatively a world fixed real exchange rate regime might improve international financial stability (link).

Surprisingly most economists do not seriously consider reforms of the monetary system. In the recent gold standard discussion many economists quickly dismissed and ridiculed the idea with reference to the experiences of the Great Depression. Had the current system proven to be more stable and less crisis prone, this would be understandable!

*University of Leipzig and New York University.

Add/view comments on this post.

------------------------------

The Christian Science Monitor has assembled a diverse group of the best economy-related bloggers out there. Our guest bloggers are not employed or directed by the Monitor and the views expressed are the bloggers' own, as is responsibility for the content of their blogs. To contact us about a blogger, click here. To add or view a comment on a guest blog, please go to the blogger's own site by clicking on the link above.