With at least one upper-tier Republican candidate for President openly advocating the gold standard and pledging to re-establish it if he is elected President, more and more people are trying to figure out what going back on a gold standard would mean.
Tyler Cowen wrote about the gold standard on his blog the week before last, explaining why restoring the gold standard is a dangerous idea.
The most fundamental argument against a gold standard is that when the relative price of gold is go up, that creates deflationary pressures on the general price level, thereby harming output and employment. There is also the potential for radically high inflation through gold, though today that seems like less a problem than it was in the seventeenth century.
Why put your economy at the mercy of these essentially random forces? I believe the 19th century was a relatively good time to have had a gold standard, but the last twenty years, with their rising commodity prices, would have been an especially bad time. When it comes to the next twenty years, who knows?
Whether or not there is “enough gold,” and there always will be at some price, the transition to a gold standard still involves the likelihood of major price level shocks, if only because the transition itself involves a repricing of gold. A gold standard, by the way, is still compatible with plenty of state intervention.
Tyler’s short comment seems basically right to me, but some commenters were very critical.
Lars Christensen, commenting favorably on Tyler’s criticism of the gold standard, opened up his blog to a debate about the merits of the gold standard, and Blake Johnson, who registered sharp disagreement with Tyler’s take on the gold standard in a comment on Tyler’s post, submitted a more detailed criticism which Lars posted on his blog. Johnson makes some interesting arguments against Tyler, showing considerably more sophistication than your average gold bug, so I thought that it would be worthwhile to analyze Blake’s defense of the gold standard.
Blake begins by quibbling with Tyler’s statement that if the relative price of gold rises under a gold standard, the appreciation of gold is expressed in falling prices, reducing output and employment. Johnson points out that when prices are falling in proportion to increases in productivity deflation is not necessarily bad. That’s valid (but not necessarily conclusive) point, but I suspect that that is not the scenario that Tyler had in mind when he made his comment, as Johnson himself recognizes:
Cowen’s claim likely refers to the deflation that turned what may have been a very mild recession in the late 1920’s into the Great Depression. The question then is whether or not this deflation was a necessary result of the gold standard. Douglas Irwin’s recent paper “Did France cause the Great Depression” suggests that the deflation from 1928-1932 was largely the result of the actions of the US and French central banks, namely that they sterilized gold inflows and allowed their cover ratios to balloon to ludicrous levels. Thus, central bankers were not “playing by the rules” of the gold standard.
The plot thickens. The problem with Johnson’s comment is that he is presuming that there ever were any clearly articulated rules of the gold standard. The most ardent supporters of the gold standard at the time, people like von Mises and Hayek, Lionel Robbins, Jacques Rueff and Charles Rist in France, Benjamin Anderson in America, were all defending the Bank of France against criticism for its actions. (See this post about Hayek’s defense of the Bank of France.) I don’t think that they were correct in their interpretation of what the rules of the gold standard required, but it is clearly not possible to look up the relevant rules of how to play the gold-standard game, as one could look up, say, the rules of playing baseball. Central bankers were not playing by the rules of the gold standard, because the existence of such rules was a convenient myth, covering up the fact that central banks, especially the Bank of England, ran the gold standard in the late 19th and early 20th centuries and exercised considerable discretion in doing so. The gold standard was never a fully automatic self-regulating system.
Personally, I see this more as an indictment of central bank policy than of the gold standard. Peter Temin has claimed that the asymmetry in the ability of central banks to interfere with the price specie flow mechanism was the fundamental flaw in the inter-war gold standard. Central banks that wanted to inflate were eventually constrained by the process of adverse clearings when they attempted to cause the supply of their particular currency [to] exceed the demand for that currency. However, because they were funded via taxpayer money, they were insulated from the profit motive that generally caused private banks to economize on gold reserves, and refrain from the kind of deflation that would result from allowing your cover ratio to increase as drastically as the US and French central banks did.
Unfortunately, I cannot make any sense out of this. “Central banks that wanted to inflate” presumably refers to central banks keeping their lending rate at a level below the rates in other countries, thereby issuing an excess supply of banknotes that financed a balance of payments deficit and causing an outflow of gold (adverse clearings). Somehow Johnson transitions from the assumption of inflationary bias to the opposite one of deflationary bias in which, “funded via taxpayer money,” central banks were insulated from the profit motive that generally caused private banks to economize on gold reserves, thus refraining from the kind of deflation that would result from allowing your cover ratio to increase as drastically as the US and French central banks did. Sorry, but I don’t see how we get from point A to point B.
At any rate, Johnson seems to be suggesting — though this is just a guess – that central banks are more likely than private banks to hoard gold reserves. That may perhaps be true, but it might not be true if there are significant economies of scale in holding reserves. Under a gold standard with no central banks and no lender of last resort, the precautionary demand for gold reserves by individual banks might be so great that the aggregate monetary demand for gold by the banking system could be greater than the monetary demand of central banks for gold. We just don’t know. And the only way to find out is to make ourselves guinea pigs and see how a gold standard would work itself out with or without central banks. I personally am curious to see how it would turn out, but not curious enough to actually want to live through the experiment.
Johnson goes on:
I would further point out that if you believe Scott Sumner’s claim that the Fed has failed to supply enough currency, and that there is a monetary disequilibrium at the root of the Great Recession, it seems even more clear that central bankers don’t need the gold standard to help them fail to reach a state of monetary equilibrium. While we obviously haven’t seen anything like the kind of deflation that occurred in the Great Depression, this is partially due to the drastically different inflation expectations between the 1920’s and the 2000’s. The Fed still allowed NGDP to fall well below trend, which I firmly believe has exacerbated the current crisis.
What Johnson fails to consider is that inflation expectations are not totally arbitrary; inflation expectations in the 1930s plunged, because people understood that gold was appreciating toward its pre-World War I level. The only way to avoid that result for an individual country on the gold standard was to get off the gold standard, because the price level of any country on the gold standard is determined by the value of gold. That’s why FDR was able to initiate a recovery in March 1933 with the stroke of a pen by suspending the convertibility of the dollar into gold, allowing the dollar to depreciate against gold and gold-standard currencies, causing prices in dollar terms to start rising, thereby stimulating increased output and employment practically over night. The critical difference that Johnson is ignoring is that no country under a gold standard could stop deflating until it got off the gold standard. The FOMC is doing a terrible job, but all they have to do is figure out what needs to be done. They don’t have to get permission to do what is right from anyone else.
So how scary is the gold standard? Scarier than you think.