For political and legal reasons, Hamilton had to address the loaded question of paper money. The Constitution outlawed the issue of paper money by the states; everybody remembered the worthless Continentals printed by Congress during the Revolution. Should the federal government now issue paper money? Fearing an inflationary peril, Hamilton scotched the idea: "The stamping of paper is an operation so much easier than the laying of taxes that a government in the practice of paper emissions would rarely fail in any such emergency to indulge itself too far." As an alternative, Hamilton touted a central bank that could issue paper currency in the form of banknotes redeemable for coins. This would set in motion a self-correcting system. If the bank issued too much paper, holders would question its value and exchange it for gold and silver; this would then force the bank to curtail its supply of paper, restoring its value.
Hamilton saw clearly that the system needed negative feedback to be what Chernow calls "self-correcting."
What is the source of negative feedback to our currency system now? Since 1971 the dollar has not been redeemable against precious metals.
Some people might answer the Federal Reserve, which indeed can adjust interest rates. But what's to stop the Federal Reserve from doing exactly what Hamilton feared -- i.e., lowering interest rates faster than taxes can be levied? We all know the answer to that question today. Let's not forget it.
A better answer might be currency derivatives, such as credit default swaps. These indeed can slow inflation -- if enough are traded and accurately priced. This hints at a somewhat subtle aspect of the kind of "self-correcting system" envisioned by Hamilton: the holders that are likely to exchange paper for gold and silver early when the currency is overvalued will do much, much better than the people who try to exchange it last. And so it is with derivatives. The effectiveness of derivatives as a correcting force depends on the information available and information processing capacity of the average market participant. So long as valuations are independent, but identically distributed, a central limit theorem will apply, forcing transactions toward a set of "rational" prices. But valuations are neither independent nor identically distributed in a crisis; they're highly correlated and indeterminately distributed.
The best answer is other currencies. The economy is global, and if the dollar gets overvalued relative to the yen or euro, then people will start trading dollars for yen or euros until they're matched. Foreign currencies are to the dollar today what gold and silver were in Hamilton's time. In Hamilton's day, there were planters in the south who exchanged tobacco warehouse bills as a currency. Some even bartered. It's not impossible to imagine that people in the United States might some day be paid in Euros or yen rather than dollars. It partly depends, as Hamilton understood, on how much our government can collect in taxes.
The case of the Chinese yuan is interesting because it is pegged to the dollar. What effect does that have on the negative feedback? The effect seems to be damping -- i.e., if our government's credit improves faster than China's, then the peg will nonetheless slow deflation. Conversely, if our government's credit degrades faster than China's (the scenario that for now seems more likely), then the peg will slow inflation.
"Deflation" and "inflation" here mean deflation and inflation relative to other foreign currencies. Another effect of the peg -- perhaps the most important over the past ten years -- has been the lack of any negative feedback to appreciation in Chinese credit or depreciation in U.S. credit relative to each other. In effect, the dollar is not the dollar anymore, but the dollar/yuan. Whereas without the peg, Chinese would at some point have demanded more currency from American businesses in exchange for their goods, with the peg in place, that point has been delayed while the Chinese government has accumulated larger and larger sums of dollars. Today, China's central bank has a currency reserve of U.S. dollars roughly equal to the excess dollars in circulation in the U.S. banking system ($1 trillion).
Let's say the peg was removed. The immediate consequence would be worldwide scramble to exchange dollars for yuan. The Chinese government, with its huge position, would be a big loser over the short run since it has no practical way to exchange that sum. The United States economy would be an even bigger loser, since runaway inflation would likely put the financial system back into cardiac arrest, destroying the confidence and credibility needed for trade to continue and the economy to function.
But longer term, we'd both recover. The Chinese would take a notional hit to their credit, but they have a solid infrastructure in place now, and could replenish their losses with taxes on their new middle class. The United States, in turn, would take longer to recover since we'd have to go back to making things that we've been importing for over ten years before the government would have revenue to tax.
The Chinese government cannot accumulate dollars indefinitely. The peg must be removed at some point. American real estate looks like a great bet in view of that contingency, despite its ugly state at the moment.
UPDATE: Well I guess I won't have to wait as long as I thought to find out whether any of this is correct. See here.
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