One of my regular commenters J. P. Koning recently drew my attention to this post by Nick Rowe about the “identity” (to use a somewhat loaded term) between the gold standard and the CPI standard (aka inflation targeting). Nick poses the following question:
Is there any fundamental theoretical difference between how monetary policy worked under the gold standard and how monetary policy works today for a modern inflation-targeting central bank?
I will just note parenthetically that being a Canadian and therefore likely having been spared from listening to seemingly endless soundbites of Newt Gingrich pontificating about “fundamental this” and “fundamental that,” and “fundamentally this” and “fundamentally that,” Nick obviously has not developed the sort of allergic reaction to the mere sound or appearance of that now hopelessly hackneyed word with which many of his neighbors to the south are now incurably afflicted.
To attack the question, Nick starts with the most extreme version of the gold standard in which central bank notes are nothing but receipts for an equivalent amount of gold (given the official and unchangeable legal conversion rate between bank notes and gold. He then proceeds to relax the assumptions underlying the extreme version of the gold standard from which he starts, allowing central bank reserves to be less than its liabilities, then allowing reserves to be zero, but still maintaining a fixed conversion rate between central bank notes and gold. (Over 25 years ago, Fischer Black developed a theoretical model of a gold standard with (near) zero reserves. See his paper “The Gold Standard with Double Feedback and Near Zero Reserves” published as chapter 5 of his book Business Cycles and Equilibrium. Whether anyone else has explored the idea of a gold standard with zero reserves I don’t know. But I don’t dispute that a gold standard could function with zero reserves, but I think there may be doubt about the robustness of such a gold standard to various possible shocks.) From here Nick further relaxes the underlying assumptions to allow a continuous adjustment of the legal conversion rate between central bank notes and gold at say a 2% annual rate. Then he allows the actual conversion rate to fluctuate within a range of 1% above to 1% below the official rate. And then he allows the base to be changed while keeping any changes in the base unbiased so the expectation is always that the conversion rate will continue to rise at a 2% annual rate. Having reached this point, Nick starts to relax the assumption that gold is the sole standard, first adding silver to get a symmetallic standard, and then many goods and services to get a broad based standard from which a little addition and subtraction and appropriate weighting bring us to the CPI standard.
Having gone through this lengthy step-by-step transformation, Nick seems to think that he has shown an identity between the gold standard and a modern inflation-targeting central bank. To which my response is: not so fast, Nick.
What Nick seems to be missing is that a central bank under a gold standard is operating passively unless it changes its stock of gold reserves, and even if it does change its stock of gold reserves, the central bank is still effectively passive unless, by changing its holdings of reserves, it can alter the real value of gold. On the other hand, I don’t see how one could characterize an inflation-targeting central bank as acting passively unless there was a direct market mechanism by which the public forced the central bank to achieve its inflation target. If a central bank did not maintain the legal conversion rate between its bank notes and gold, it would be violating a precise legal obligation to engage in a specific set of transactions. Instead of buying and selling gold at $20.67 an ounce, it would be buying and selling at some other price. If an inflation-targeting central bank does not meet its inflation target, can anyone specify the specific transactions that it was obligated to make that it refused to make when called upon to do so by a member of the public? And this is aside from the fact that no one even knows whether an inflation targeting central bank is achieving or not achieving its target at the time that it is conducting whatever transactions it is conducting in pursuit of whatever goal it is pursuing.
In short, an inflation-targeting central bank cannot be said to be operating under the same or an analogous set of constraints as a central bank operating under a gold standard, at least not under any gold standard that I would recognize as such.