The True Gold Standard (Second Edition)
Key Writings: White on the Gold Standard
Critics have raised a number of theoretical and historical objections to the gold standard. Some have called the gold standard a "crazy" idea.
The gold standard is not a flawless monetary system. Neither is the fiat money alternative. In light of historical evidence about the comparative magnitude of these flaws, however, the gold standard is a policy option that deserves serious consideration.
In a study covering many decades in a large sample of countries, Federal Reserve Bank economists found that "money growth and inflation are higher" under fiat standards than under gold and silver standards. Nor is the gold standard a source of harmful deflation. Alan Greenspan has testified before Congress that "a central bank properly functioning will endeavor to, in many cases, replicate what a gold standard would itself generate."
This study addresses the leading criticisms of the gold standard, relating to the costs of gold, the costs of transition, the dangers of speculation, and the need for a lender of last resort. One criticism is found to have some merit. The United States would not enjoy the benefits of being on an international gold standard if it were the first and only country whose currency was linked to gold.
A gold standard does not guarantee perfect steadiness in the growth of the money supply, but historical comparison shows that it has provided more moderate and steadier money growth in practice than the present-day alternative, politically empowering a central banking committee to determine growth in the stock of fiat money. From the perspective of limiting money growth appropriately, the gold standard is far from a crazy idea.
The Federal Reserve System is a major sponsor of monetary economics research by American economists. I provide some measures of the size of the Fed’s research program (both inputs and published outputs) and consider how the Fed’s sponsorship may directly and indirectly influence the character of academic research in monetary economics. In particular, I raise the issue of status quo bias in the Fed-sponsored research.
Barry Eichengreen (2011) writes:
Briefly, the classical conception of the “lender of last resort,” spelled out by the English journalist and banking historian Walter Bagehot (1871) during the classical international gold standard era, is an institution that lends reserves to illiquid (but solvent) commercial banks in a period of peak demand for currency or bank reserves, in the extreme during a period of bank runs. Its aims are to prevent regrettable bank insolvencies due to hasty asset liquidations, and to satisfy the public’s demand for currency or reserve money so that the runs cease and the market calms. This seems to be the notion that Eichengreen has in mind.
Assuming that the Federal Reserve exists and is the agency to which the role is assigned, Professor Eichengreen takes a true gold standard to imply that “it could provide additional credit only if it somehow came into possession of additional gold.” That is, the gold standard is not “true” unless it imposes a 100 percent gold marginal reserve requirement on central bank liabilities. This is a highly idiosyncratic understanding of a true gold standard. Peel’s Act of 1844 did impose a 100 percent marginal gold reserve requirement on expansion on the Bank of England’s note-issues, but the Bank could still provide additional credit by expanding its deposit liabilities. Indeed the Bank is generally understood to have acted as a lender of last resort during the Baring Crisis in 1890, while Peel’s Act was still in place.
A 100 percent gold marginal reserve requirement on all central bank liabilities would constrain last-resort lending. But imposing such a rule on the central bank is not required to have a true gold standard, and indeed having a central bank is not even required. A gold standard, again, is generically defined by gold serving as the medium of redemption and medium of account, not by any reserve requirement imposed on a central bank. The United States was on the classical gold standard without a central bank from 1879 to 1914. During that period, private clearinghouse associations acted as lenders of last resort to their member banks (Timberlake 1984). So a central bank is not even necessary to have a lender of last resort.
Eichengreen (2011) argues that “confidence problems are intrinsic to fractional-reserve banking and why an economy with a modern banking system needs a lender of last resort.” But as noted in Section 6 above, confidence problems are minimal if no legal restrictions prevent banks from adequately capitalizing and diversifying themselves.
The danger of setting the new gold parity too low (too few dollars per ounce of gold) is exemplified, as Selgin (2012) notes, by Great Britain’s choice in 1925 to restore the old parity. At discussed above, because the price level had risen sharply, a return to the old parity required a sharp deflation to return to the old price level. The danger of setting the parity too high is, conversely, a transition inflation to reach the new equilibrium price level. Eichengreen (2011) summarizes the problem this way:
To avoid transitional inflation or deflation, the new parity must be the one at which monetary gold supply and demand are equated at the current price level. If we could assume that the supply and demand for monetary gold were unaffected by the reinstatement of the gold standard, the solution would be easy: choose the current price of gold. But that is unlikely be exactly true. As I earlier argued, the demand for gold bullion and coins today is an inflation-hedging demand that would be absent under a gold standard. On the other hand, because a gold standard lowers the mean and medium-term variance of the inflation rate, the demand to hold currency and demand deposits for transaction purposes, against which banks would hold gold reserves, would rise. As Selgin (2012) notes:
Tyler Cowen (2008) cites the same problem: “One five or ten percent deflation is enough to crush the economy and indeed the whole gold standard idea. Given the socialist calculation debate, can we really know the right transition price?”
Choosing a new parity is indeed a problem. There are two approaches to estimating the new parity that would avoid transitional inflation or deflation. Note that new parities need to be chosen simultaneously by all participating currency areas in order to agree to return to the gold standard simultaneously so as to create the broadest possible international gold standard. The first, more conventional approach is to use econometric studies of recent inflation-hedging demand for gold, and of transactions demand for zero-yielding bank reserves at gold-standard-type expected inflation rates. The second approach, which calls for further study, is to derive guidance from market signals, in particular from the gold futures market or some new kinds of prediction market, in which market players put money on their own estimates of what the real purchasing power of gold will be following a return to the international gold standard.
In a world where prices and wages exhibit greater downward that upward stickiness, playing it safe in the choice of a new parity means erring on the side of a small transitional inflation rather than a deflation.
So as not to overstate the relative size of the problem, however, we should note that the same problem attends any significant change in the inflation path, or significant change in other policy (such as the rate of interest on reserves) under a fiat standard. The switch to a lower inflation rate target, for example, will cause the path of transactions demand to hold money relative to the volume of spending to jump upward (will shift the velocity of money downward). Underestimating the increased demand, and failing to offset it with a one-time increase in the stock of money, will cause the policy to create an excess demand for money and will thus create a recession with unsold inventories of goods and unemployed labor services. The Bernanke Fed’s switch from zero to positive interest on bank reserves in October 2008 sharply increased the banking system’s demand to hold reserves, swamping the money-supply-expanding effect of the accompanying “Quantitative Easing 1” expansion of reserves. The result was seven months in 2009 (March through September) in which the year-over-year inflation rate was negative. The downturn in real output already underway was amplified. Curiously this “bad” deflation – and the first deflation of either kind in more than five decades – occurred on the watch of an expressly deflation-averse Fed chairman.
Ezra Klein (2012) comments:
It is of course true that the urgency of adopting a gold standard to fight inflation is lower when the inflation rate is lower. If inflation were our exclusive concern, and we could trust the central bank to keep inflation as low under a fiat standard as it was under the classical gold standard, then it would be foolish to bear any cost to reinstitute a gold standard. Inflation today is certainly lower than it was in the 1970s and 1980s, but it is not true that inflation is as low today as it was under the classical gold standard. As noted above, the inflation rate was only 0.1 percent over Britain’s 93 years on the classical gold standard. Over the most recent ten years (August 2002 to August 2012) in the United States, the CPI-U price index rose 27.5 percent, for an annualized inflation rate of 2.5 percent. Over the last forty years (since August 1972, shortly after President Nixon closed the gold window), the rise has been 449.2 percent, and the annualized rate 4.4 percent. There remains a case for the gold standard based on inflation alone.
How low are market expectations of the inflation rate to come? According to the Financial Times (17 September 2012), the announcement of the Fed’s QE3 program pushed the market’s expectation of the US inflation rate over the next 10 years (derived from prices on the inflation-indexed bond market) to 2.73 percent per annum. Inflation expectations are not as low today as they were under the classical gold standard, and they are more volatile. There is no tangible institutional assurance that the US inflation rate will not return north of 4 percent or even 10 percent.
Of course, consumer price inflation is not our exclusive concern. The past decade has reminded us that, even with consumer inflation rates around 2.5 percent or lower, asset price bubbles and unsustainable credit booms are a serious danger under a central bank policy of artificially low interest rates. The ultralow Fed Funds rate policy of 1.25 percent or less from November 2002 through June 2004 helped fuel the housing bubble (White 2012b). Today’s rate policy has been holding the Fed Funds rate at 0.25 percent or less for more than 3.8 years (since December 2008), with the announced prospect of another three years of ultralow rates. Time will tell where a new bubble is now forming. More generally, the Fed’s track record for real economic stability under fiat money does not weigh in favor of fiat money (Selgin, Lastrapes, and White 2012).
BY LAWRENCE H. WHITE