The True Gold Standard (Second Edition)
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.
The Federal Reserve System's James Narron and David Skeie, career officials with the Federal Reserve System, are two eminent historically erudite figures. Writing in the New York Federal Reserve Bank's online publication, Liberty Street Economics, they recently provided a continuation of their valuable historical "revue," Crisis Chronicles: The Collapse of the...
Jul 14, 2014
On July 6th, Nobel economics laureate and Princeton Professor launched, in the New York Times, one of his occasional polemics, entitled Conservative Delusions About Inflation, against proponents of the gold standard. Krugman Caricature under creative commons license from DonkeyHotey As usual, Prof. Krugman is, conveniently for the position he takes, beyond lopsided...
Jul 23, 2014
An article headline in Saturday’s Wall Street Journalread “Rate Talk Heats Up Within The Fed.” As Journalreporters Jon Hilsenrath and Michael Derby...
Jun 16, 1980
Key Monetary Writings
There is intellectual combat going on in Governor Reagan's camp. Some call it a struggle for Reagan's soul.
Why the Gold Standard?