I hear a lot of people saying that the root problem of the financial crisis is fiat currency. There is no restriction on creating paper money so too much gets printed, they opine. Their conclusion is that paper money needs to be backed by gold. So buy the precious metal because when the dust settles, we’ll be on a gold standard.
I disagree. The problem hasn’t been that the fiat currency now in existence didn’t have an anchor. It has had one since the early 1980s: Price stability rules followed by the central banks. Those rules required central banks to keep the inflation rate close to 2% a year, and this constraint placed restrictions on the amount of money that could be printed.
However, the way the price-stability rule was implemented had a flaw. If this flaw is fixed, then I believe we have a much better shot at a return to an era of sustained prosperity than under a gold standard.
A standard based on a properly implemented price-stability rule promises a much better way to limit paper currencies than gold because it imposes discipline in a sustainable way. The supply of money can be varied to keep price deflation and depression from occurring. Gold, on the other hand, is not elastic. It’s fixed in supply; the history of the gold standard is full of deep and prolonged depressions.
Gold’s severe economic dislocations gave rise to populist movements bitterly opposed to hard currency (see, for example, William Jennings Bryan’s Cross of Gold speech in 1896). Moreover, history books show that in the face of such opposition, governments rarely ever did adhere to the standard. Over time, they ended up printing more money anyway.
So what’s the flaw to correct in the price-stability-rule monetary system? It’s the definition of price stability. It included only prices for consumption goods and services. Prices for assets were excluded. When the latter began taking off, starting with tech stocks in the 1990s and then real estate prices in the 2000s, the central banks said it was not their concern.
This was the mistake. A target of 2% for the CPI was still too easy because it pumped out enough liquidity to create asset bubbles that went pop. That’s what events are telling us now. If monetary policy had also been set with reference to asset prices, these bubbles could have been kept from becoming large enough to destabilize the U.S. financial system and economy.
So a more appropriate definition of price stability would include asset prices. This may result in negative growth rates in the CPI at times, but it need not entail a deflationary spiral because of the elasticity of the money supply, as I wrote a year ago in a column entitled Ensuring financial stability.