Should the U.S. adopt a Gold Standard?

The gold standard for the U.S. is not a serious issue in my view, but a few hundred people, including Ron Paul, think it is. FreedomFest staged a debate in Las Vegas July 10, 2008 on this subject. Gene Epstein, Economics Editor of Barron’s took the affirmative and I took the negative position.This is the paper I prepared for a debate.

July 10, 2008, FreedomFest, Las Vegas, Nevada

We live on here on earth with all of its marvels and challenges. Life on earth is full of opportunities and risks. All cultures and institutions are imperfect. Monetary arrangements are no different. There is no such thing as a perfect monetary system. The gold standard is one of the better ones with many virtues and many weaknesses. I will argue that it is not the best system for the United States today. I will begin by defining what a gold standard is then provide a quick review of its strengths and weaknesses.

The goal of the monetary regime or of the monetary policy of any country should be price stability with maximum economic growth and minimum fluctuations in output. In the long run, monetary policy can only determine the value of the central bank’s money (inflation). Economic growth (real GDP) is determined by real factors of technology, productivity, labor skills, and work effort. So monetary policy cannot increase real output in the long run other than through the benefits of providing money with stable value. However, it can affect output in the short run and this is where it tends to get into trouble. An important source of inflation results from central banks increasing the money supply to stimulate output in the short run. Historically, inflation of central bank money was generally the result of the central bank lending to government (printing money to finance government expenditures). All hyperinflations were of this sort.

What is a gold standard?

A gold standard is a monetary regime (policy) that fixes the price of currency to a physical quantity and purity of gold and supplies or redeems that currency at that price in response to market demand. Thus a gold standard is a monetary system or policy in which market demand determines the supply of money. The purchasing power of one dollar fixed to gold is determined by the purchasing power of gold, i.e. the price of things in general in gold.

Pros and Cons of a gold standard

Pros

• A gold standard is transparent, simple to administer, and has produced very stable prices over long periods. It reflects a strong commitment of the government not to resort to monetary finance (printing money) and may help reinforce such a commitment.

Cons

• It can produce more volatile prices in the short run.

“Between 1880 and 1914, the period when the United States was on the ‘classical gold standard,’ inflation averaged only 0.1 percent per year…. This compares with the post classical gold standard “period of 1946 to 1990 with an average of 4.2 percent.”[2] However, under the gold standard inflation has been quite volatile in the short run. “For the United States between 1879 and 1913, the coefficient [of variation of inflation] was 17.0, which is quite high. Between 1946 and 1990 it was only 0.8….[3]

• It precludes a monetary policy to soften or counter economic shocks resulting in more volatile business cycles.

In the United State, “The coefficient of variation for real output was 3.5 between 1879 and 1913, and only 1.5 between 1946 and 1990. Not coincidentally, since the government could not have discretion over monetary policy, unemployment was higher during the gold standard. It averaged 6.8 percent in the United States between 1879 and 1913 versus 5.6 percent between 1946 and 1990.”[4]

• The resource cost is very high (digging up and refining gold).

Milton Friedman estimated the cost for the U.S. at about 2.5% of GDP (or around $375 billion dollars per year today).

• It precludes a lender of last result to prevent bank runs

(though J.P Morgan was able to provide some of this from the private sector before the establishment of the Federal Reserve Banks).

The example of the Great Depression:

What should have been a “normal” business cycle recession starting in 1929 turned into the worst depression in U.S. history when the Federal Reserve raised interest rates in 1931 as required by gold standard rules to stem the outflow of gold and failed to provide lender of last support to hundreds of banks in the face of wide spread bank runs. By 1933, almost half of the 25,000 banks in the U.S. had failed. With normal credit sources severely disrupted, production plummeted. The introduction of trade restrictions worsened the situation and along with the gold standard helped spread the depression world wide. By 1932, U.S. manufacturing output had fallen to 54 percent of its 1929 level, and unemployment had risen to over 25 percent of the work force.

Britain restored gold convertibility in 1925 after its suspension during WWI at the prewar price. This is widely seen as a mistake that forced wide spread deflation on the British empire to reverse the war time increase in the price of gold. Speculative pressure forced the U.K to abandon gold convertibility September 20, 1931. In response to the speculative pressure on gold prices, the Federal Reserve, which hung on to its $20 dollars per ounce price and convertibility until 1933, raised interest rates in 1931 in an effort to stem the outflow of gold. The results were disastrous.

“· Countries that were not on the gold standard in 1929–or that quickly abandoned the gold standard–by and large escaped the Great Depression

· Countries that abandoned the gold standard in 1930 and 1931 suffered from the Great Depression, but escaped its worst ravages.

· Countries that held to the gold standard through 1933 (like the United States) or 1936 (like France) suffered the worst from the Great Depression.”[5]

Federal Reserve Chairman Bernanke is well aware of the risks of monetary contraction and deflation on the banking system and the real economy. [6] “Bernanke and James’ data for the average growth rate of industrial production for the countries [that abandoned gold] was positive in every year from 1932 on. Countries that stayed on gold, by contrast, experienced an average output decline of 15% in 1932. The U.S. abandoned gold in 1933, after which its dramatic recovery immediately began. The same happened after Italy dropped the gold standard in 1934, and for Belgium when it went off in 1935. On the other hand, the three countries that stuck with gold through 1936 (France, Netherlands, and Poland) saw a 6% drop in industrial production in 1935, while the rest of the world was experiencing solid growth.”[7]

What are the alternatives?

Flexible gold standard, Dollarization or currency board

Monetary regimes that fix the price of their currency to gold, another commodity, a basket of commodities, another currency, or basket of currencies (e.g. the SDR) and passively buy or sell their currency at that price are gold standard like regimes. However, gold would not be the best thing to fix the price of the currency to. Larry White has argued for a flexible application of such regimes in order to permit lender of last resort help to solvent banks experiencing runs. This would require temporarily lending to banks and there by increasing the monetary base beyond its gold backing. This could have avoided the problems leading to the Great Depression[8]

Inflation targeting

The major advantage of a gold standard is the commitment to long run price stability that it reflects. Inflation targeting reflects the same or even stronger commitment to price stability without the negative rigidities of a commodity standard. Inflation targeting holds the central bank accountable for achieving an explicit inflation target (generally 2%) two to three years in the future while leaving the central bank with full discretion over its monetary tools and their use for achieving the inflation target. Experience to date has been very good, reducing the variance of inflation without increasing real output volatility.

Is the price of gold more stable than other things?

Alan Greenspan has put monetary policy in historical context: “Although the gold standard could hardly be portrayed as having produced a period of price tranquility, it was the case that the price level in 1929 was not much different, on net, from what it had been in 1800. But, in the two decades following the abandonment of the gold standard in 1933, the consumer price index (CPI) in the United States nearly doubled. And, in the four decades after that, prices quintupled. Monetary policy unleashed from the constraint of domestic gold convertibility, had allowed a persistent overissuance of money. As recently as a decade ago, central bankers, having witnessed more than a half-century of chronic inflation, appeared to confirm that a fiat currency was inherently subject to excess.”[9]

If the Central Bank of Bosnia and Herzegovina, the currency board I helped establish, had fixed the exchange rate of its currency to an ounce of gold rather than to the Euro, what would have been the result for the purchasing power of its currency (the convertible markka–KM)? From 1999 to 2007 the inflation rate (CPI) in Bosnia averaged 2.7% compared with 2.0% in the EU and 2.5% in the U.S. On average over this period, as would be expected, the Bosnian inflation rate was similar to the European inflation rate. But what if it had been fixed to gold rather than the Euro?

The Euro price of gold rose from 8 Euro’s per gold gram in 1999 to 18.8 Euros at the end of 2007. If the KM had been fix to gold rather than the Euro, its value relative to the Euro would have more than doubled from 2 KM per Euro to 0.85 per Euro. Put the other way around, in 1999 one KM would buy one half Euro, while if its price had been fixed to gold in would have been able to buy almost 1.2 Euros at the end of last year, a 10% appreciation in value each year. Deducting the European inflation rate of 2.0% per year over that period, Bosnia would have had an 8% deflation in KM on average over this nine year period. On the other hand if the KM had been fixed to gold in 1997 (about 10 Euros per gram)[10] two years later it would have depreciated against the Euro (about 8 Euros per gram), implying over those two years about a 13% per year inflation rate (after adding the underlying 2.0% European inflation rate). In fact, gold prices of the USD and the EURO have varied dramatically and would have provided a very unstable and unsatisfactory anchor for the KM.

As an aside, real GDP growth over the 1999-2007 period averaged 5.7% in Bosnia and 1.8% in the EU. The money supply (M2) grew at the explosive seeming rate of 41% per year over that period in Bosnia and only 7.4% in the EU, indicating the difficulty of monetary targeting in transition economies or post conflict economies like Bosnia.

The enormous volatility of gold prices over the last 40 years makes it a very unstable anchor for most countries’ monetary policies. Its price rose from 35 dollars an ounce in 1971 to over $800 in 1981 to below $300 from 1998 to 2003 to $926 per ounce at noon yesterday. However, these swings reflect speculative shifts in demand that would surely be greatly moderated if the United States and the world as a whole adopted a gold standard.

Conclusion

The United States should not adopt a gold standard. Such a regime would have prevented the Federal Reserve from supplying the additional liquidity the banking system suddenly demanded this past year as part of the subprime mortgage crisis.[11] Without the injection of the additional liquidity, there would probably have been a financial sector meltdown and recession of hug proportions. Had the U.S. had a gold standard, it would not have survived such a financial crisis.

The United States should adopt inflation targeting. The Federal Reserve act should be amended to establish price stability as the primary objective of monetary policy, freeing the Fed from its statutory requirement to “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”[12]

---

[1] Warren Coats retired from the International Monetary Fund in 2003, where he led technical assistance missions to central banks in over twenty countries. He is currently Senior Monetary Policy Advisor to the Central Banks of Iraq and Afghanistan and a Director of the Cayman Islands Monetary Authority. His most recent book, One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina, was published in November 2007.

[2] Michael D Bordo, “Gold Standard” The Concise Encyclopedia of Economics

[3] Ibid.

[4] Ibid

[5] Brad DeLong, “Why Not the Gold Standard” 8/10/1996

[6] Ben Bernanke and Harold James, “The Gold Standard, Deflation, and Financial Crisis in the Great Depression: An International Comparison” NBER Working Paper No. 3488, Issued in October 1990.

[7] James D. Hamilton, Econbrowser blog December 12, 2005

[8] Lawrence H. White, “Is the Gold Standard Still the Gold Standard among Monetary Systems?” CATO Institute Briefing Papers, No.100, Feb 3, 2008

[9] Alan Greenspan, remarks before the Economic Club of New York, New York, December 19, 2002, p. 1.

[10] The Euro had not yet been introduced at that time and the KM was actually fixed one to one to the German mark, which in mid 1997 was 18.5 DM per gram of gold.

[11] Warren Coats, “The U.S. Mortgage Market: The Good, The Bad, and The Ugly,” Association of Banks in Jordan, June 22, 2008

[12] Federal Reserve Act, Section 2a.