Ben Bernanke went to George Washington University on Wednesday to give the first of four lectures on about the Federal Reserve System and the financial crisis. Wednesday’s lecture was entitled “Origins of the Federal Reserve: Economic Stability Concerns.” Most of the news coverage and commentary about the lecture seemed to be addressed to Bernanke’s discussion, about mid-way through the 75 minute lecture, of the gold standard and its shortcomings. Bernanke’s intentions were certainly admirable, inasmuch as a foolhardy attempt to restore the gold standard now, four score years after its slow, agonizing, disastrous demise in the early 1930s, would recklessly risk a repetition of that catastrophic episode. Unfortunately, Bernanke did not do a great job of explaining why we ought not give the gold standard one more shot.
Bernanke gave his lecture by going through a power-point presentation consisting of about 50 slides. He got to the gold standard on slide 22 on which he describes the gold standard as “an alternative to a central bank.” That is not quite correct, there having been central banks in existence, notably the Bank of England, under the gold standard. But we can let that pass, because modern-day advocates of the gold standard like to hold up the gold standard as an alternative to central banking. Bernanke provided a couple of further statements describing the workings of the gold standard.
- In a gold standard, the value of the currency is fixed in terms of a quantity of gold
- The gold standard sets the money supply and price level with limited central bank intervention
Now the first statement is perfectly fine. The gold standard is quintessentially a means by which a unit of account, say the dollar, is defined as a certain weight of gold. In the US from the late 19th century until 1933, the dollar was defined as a quantity of gold such that an ounce of gold would be worth $20.67. But the second statement is totally wrong. The gold standard, by defining what the value of a dollar is in terms of gold, does nothing to “set” the money supply. (Actually, I don’t know what it means to “set” the money supply, but I am assuming it means something like fixing a particular numerical limit on the number of dollars.) Under the gold standard, the number of dollars in existence depends on how many dollars the public wants to hold given the value of gold. Of course, the value of gold means more than the fixed conversion rate between gold and dollars; it means the purchasing power of gold in terms of all other goods. The more valuable gold is, the fewer dollars people will want to hold at a given conversion rate between the dollar and gold, but the amount of dollars that people will want to hold, not some numerical relationship between gold and dollars, is what determines how many dollars people actually do hold.
Things get even worse (much worse) on the next slide with the heading: “Problems with the gold standard.” Here is what Bernanke has to say about that:
- The strength of the gold standard is its greatest weakness too: Because the money supply is determined by the supply of gold, it cannot be adjusted in response to changing economic conditions.
Sorry, Professor Bernanke, you got that one wrong, too. The money supply is not determined, or set, by the supply of gold, so the money supply is perfectly capable of adjusting to changing economic conditions. What Bernanke probably had in mind was something like the following. Suppose people get nervous for whatever reason about the state of the economy. When they get nervous, they want to increase the amount of money they have on hand rather than tying up their wealth in illiquid form. In such situations, an effective central bank could increase the money supply, providing the public with the added liquidity that they want, thereby allowing the economy to keep functioning, without serious disruption, because the money supply was increased to match the increased demand to hold money. However, if the money supply is fixed, because under a gold standard the amount of money is determined or set by the supply of gold, the only way that the money supply can increase is by obtaining additional gold. But it takes a long time to mine more gold out of the ground, so in the meantime, people will have less money on hand than they want to hold, and the only way they can increase their cash holdings is to spend less. But in the aggregate people can’t increase their holdings of money by reducing their spending; they just reduce money income, forcing prices and output to fall. In other words the gold standard causes a recession.
So why is that wrong? It’s wrong, because under a gold standard, if people want to hold more dollars, more dollars can be created. Yes more dollars can be created out of thin air under a gold standard! The whole point is that any dollars created have to be convertible on demand into gold. Well if people want to hold more dollars, they can be created, and held, just as desired. Given that people want to hold the dollars, not spend them (remember that that was the assumption we just started with), creating additional dollars to be held will not cause an increase in the rate of dollars returned for redemption. So an increase in the demand for money need not cause a recession under the gold standard.
Well, in that case, so what exactly is the problem with the gold standard? There’s only a problem with the gold standard if the increase in the demand for money is associated with an increase in the demand for gold. An increase in the demand for gold over any short period of time implies an increase in the value of gold, because the amount of gold in existence is very large compared to the current rate of production. So an increase in the demand for gold necessarily increases the value of gold, implying that the prices of everything else in terms of gold start to fall. Suddenly falling prices – deflation — reduces money income and output, so there’s a recession. The recession is caused not because the money supply failed to rise — it did rise!–, but because the demand for gold increased.
Why would an increase in the demand for money cause an increase in the demand for gold? There are two possibilities. First, there could be legal reserve requirements, so that whenever the quantity of money is increased more gold has to be held as “backing.” Some (maybe most) people mistakenly believe that the reserve requirement is what constitutes a gold standard. But it’s not; the gold standard is defining the value of a monetary unit as a fixed weight of gold. That definition is consistent with any reserve requirement from zero to 100 percent. The second possibility is that the general feeling of uncertainty that causes people to want to increase their holdings of money also causes them to want to increase their holdings of gold, because they think that the money issued by governments or banks may have become more risky. This may be true under some circumstances, but not necessarily others.
The gold standard may be able to accommodate some increases in the demand for money, but not others. It depends. But historically some episodes in which the demand for money has increased have been associated with increases in the demand for gold. When that happens, watch out! Of course in the Great Depression, it was the demand for gold that increased, even before the demand for money increased, largely because of the monetary policy of the insane Bank of France in 1928-29.