In Friday’s Wall Street Journal, Lewis Lehrman and John Mueller argue for replacing the dollar as the world’s reserve currency with gold. I don’t know Lewis Lehrman, but almost 30 years ago, when I was writing my book Free Banking and Monetary Reform, which opposed restoring the gold standard, I received financial support from the Lehrman Institute where I gave a series of seminars discussing several chapters of my book. A couple of those seminars were attended by John Mueller, who was then a staffer for Congressman Jack Kemp. But despite my friendly feelings for Lehrman and Mueller, I am afraid that they badly misunderstand how the gold standard worked and what went wrong with the gold standard in the 1920s. Not surprisingly, that misunderstanding carries over into their comments on current monetary arrangements.
Lehrman and Mueller begin by discussing the 1922 Genoa Conference, a conference largely inspired by the analysis of Ralph Hawtrey and Gustav Cassel of post-World War I monetary conditions, and by their proposals for restoring an international gold standard without triggering a disastrous deflation in the process of doing so, the international price level in terms of gold having just about doubled relative to the pre-War price level.
The 1922 Genoa conference, which was intended to supervise Europe’s post-World War I financial reconstruction, recommended “some means of economizing the use of gold by maintaining reserves in the form of foreign balances”—initially pound-sterling and dollar IOUs. This established the interwar “gold exchange standard.”
Lehrman and Mueller then cite the view of the gold exchange standard expressed by the famous French economist Jacques Rueff, of whom Lehrman is a fervent admirer.
A decade later Jacques Rueff, an influential French economist, explained the result of this profound change from the classical gold standard. When a foreign monetary authority accepts claims denominated in dollars to settle its balance-of-payments deficits instead of gold, purchasing power “has simply been duplicated.” If the Banque de France counts among its reserves dollar claims (and not just gold and French francs)—for example a Banque de France deposit in a New York bank—this increases the money supply in France but without reducing the money supply of the U.S. So both countries can use these dollar assets to grant credit. “As a result,” Rueff said, “the gold-exchange standard was one of the major causes of the wave of speculation that culminated in the September 1929 crisis.” A vast expansion of dollar reserves had inflated the prices of stocks and commodities; their contraction deflated both.
This is astonishing. Lehrman and Mueller do not identify the publication of Rueff that they are citing, but I don’t doubt the accuracy of the quotation. What Rueff is calling for is a 100% marginal reserve requirement. Now it is true that under the Bank Charter Act of 1844, Great Britain had a 100% marginal reserve requirement on Bank of England notes, but throughout the nineteenth century, there was an shift from banknotes to bank deposits, so the English money supply was expanding far more rapidly than English gold reserves. The kind of monetary system that Rueff was talking about, in which the quantity of money in circulation, could not increase by more than the supply of gold, never existed. Money was being created under the gold standard without an equal amount of gold being held in reserve.
The point of the gold exchange standard, after World War I, was to economize on the amount of gold held by central banks as they rejoined the gold standard to prevent a deflation back to the pre-War price level. Gold had been demonetized over the course of World War I as countries used gold to pay for imports, much of it winding up in the US before the US entered the war. If all the demonetized gold was remonetized, the result would be a huge rise in the value of gold, in other words, a huge, catastrophic, deflation.
Nor does the notion that the gold-exchange standard was the cause of speculation that culminated in the 1929 crisis have any theoretical or evidentiary basis. Interest rates in the 1920s were higher than they ever were during the heyday of the classical gold standard from about 1880 to 1914. Prices were not rising faster in the 1920s than they did for most of the gold standard era, so there is no basis for thinking that speculation was triggered by monetary causes. Indeed, there is no basis for thinking that there was any speculative bubble in the 1920s, or that even if there was such a bubble it was triggered by monetary expansion. What caused the 1929 crash was not the bursting of a speculative bubble, as taught by the popular mythology of the crash, it was caused by the sudden increase in the demand for gold in 1928 and 1929 resulting from the insane policy of the Bank of France and the clueless policy of the Federal Reserve after ill health forced Benjamin Strong to resign as President of the New York Fed.
Lehrman and Mueller go on to criticize the Bretton Woods system.
The gold-exchange standard’s demand-duplicating feature, based on the dollar’s reserve-currency role, was again enshrined in the 1944 Bretton Woods agreement. What ensued was an unprecedented expansion of official dollar reserves, and the consumer price level in the U.S. and elsewhere roughly doubled. Foreign governments holding dollars increasingly demanded gold before the U.S. finally suspended gold payments in 1971.
The gold-exchange standard of the 1920s was a real gold standard, but one designed to minimize the monetary demand for gold by central banks. In the 1920s, the US and Great Britain were under a binding obligation to convert dollars or pound sterling on demand into gold bullion, so there was a tight correspondence between the value of gold and the price level in any country maintaining a fixed exchange rate against the dollar or pound sterling. Under Bretton Woods, only the US was obligated to convert dollars into gold, but the obligation was largely a fiction, so the tight correspondence between the value of gold and the price level no longer obtained.
The economic crisis of 2008-09 was similar to the crisis that triggered the Great Depression. This time, foreign monetary authorities had purchased trillions of dollars in U.S. public debt, including nearly $1 trillion in mortgage-backed securities issued by two government-sponsored enterprises, Fannie Mae and Freddie Mac. The foreign holdings of dollars were promptly returned to the dollar market, an example of demand duplication. This helped fuel a boom-and-bust in foreign markets and U.S. housing prices. The global excess credit creation also spilled over to commodity markets, in particular causing the world price of crude oil (which is denominated in dollars) to spike to $150 a barrel.
There were indeed similarities between the 1929 crisis and the 2008 crisis. In both cases, the world financial system was made vulnerable because there was a lot of bad debt out there. In 2008, it was subprime mortgages, in 1929 it was reckless borrowing by German local governments and the debt sold to refinance German reparations obligations under the Treaty of Versailles. But in neither episode did the existence of bad debt have anything to do with monetary policy; in both cases tight monetary policy precipitated a crisis that made a default on the bad debt unavoidable.
Lehrman and Mueller go on to argue, as do some Keynesians like Jared Bernstein, that the US would be better off if the dollar were not a reserve currency. There may be disadvantages associated with having a reserve currency – disadvantages like those associated with having a large endowment of an exportable natural resource, AKA the Dutch disease – but the only way for the US to stop having a reserve currency would be to take a leaf out of the Zimbabwe hyperinflation playbook. Short of a Zimbabwean hyperinflation, the network externalities internalized by using the dollar as a reserve currency are so great, that the dollar is likely to remain the world’s reserve currency for at least a millennium. Of course, the flip side of the Dutch disease is at that there is a wealth transfer from the rest of the world to the US – AKA seignorage — in exchange for using the dollar.
Lehrman and Mueller are aware of the seignorage accruing to the supplier of a reserve currency, but confuse the collection of seignorage with the benefit to the world as a whole of minimizing the use of gold as the reserve currency. This leads them to misunderstand the purpose of the Genoa agreement, which they mistakenly attribute to Keynes, who actually criticized the agreement in his Tract on Monetary Reform.
This was exactly what Keynes and other British monetary experts promoted in the 1922 Genoa agreement: a means by which to finance systemic balance-of-payments deficits, forestall their settlement or repayment and put off demands for repayment in gold of Britain’s enormous debts resulting from financing World War I on central bank and foreign credit. Similarly, the dollar’s “exorbitant privilege” enabled the U.S. to finance government deficit spending more cheaply.
But we have since learned a great deal that Keynes did not take into consideration. As Robert Mundell noted in “Monetary Theory” (1971), “The Keynesian model is a short run model of a closed economy, dominated by pessimistic expectations and rigid wages,” a model not relevant to modern economies. In working out a “more general theory of interest, inflation, and growth of the world economy,” Mr. Mundell and others learned a great deal from Rueff, who was the master and professor of the monetary approach to the balance of payments.
The benefit from supplying the resource that functions as the world’s reserve currency will accrue to someone, that is the “exorbitant privilege” to which Lehrman and Mueller refer. But It is not clear why it would be better if the privilege accrued to owners of gold instead of to the US Treasury. On the contrary, the potential for havoc associated with reinstating gold as the world’s reserve currency dwarfs the “exorbitant privilege.” Nor is the reference to Keynes relevant to the discussion, the Keynesian model described by Mundell being the model of the General Theory, which was certainly not the model that Keynes was working with at the time of the Genoa agreement in which Keynes’s only involvement was as an outside critic.
As for Rueff, staunch defender of the insane policy of the Bank of France in 1932, he was an estimable scholar, but, luckily, his influence was much less than Lehrman and Mueller suggest.
Uneasy Money 