Anybody who follows my blog will know that I am not a great fan of the gold standard or any other form of fixed exchange rate policy. However, I am a great fan of policy rules that reduce monetary policy discretion to an absolute minimum.
Central bankers’ discretionary powers should be constrained and I fundamentally share Milton Friedman’s ideal that the central bank should be replaced by a “computer” – an automatic monetary policy rule.
Admittedly, a gold standard or for that matter a currency board set-up, reduce monetary policy discretion to a minimum. However, the main problem in my view is that different variations of a fixed exchange rate regime tend to be pro-cyclical. Imagine for example that productivity growth picks up for whatever reason (for example deregulation or a wave of new innovations).
That would tend to push the country’s currency higher. However, as the central bank is keeping the currency pegged, a positive supply shock will cause the central bank to “automatically” increase the money base to offset the appreciation pressures (from the positive supply shock) on the currency.
Said another way, under any form of pegged exchange rate policy, a supply shock leads to an “automatic” demand shock. A gold standard will stabilize the currency, but might very well destabilize the economy.
Hence, the problem with a traditional gold standard is not that it is rule based, but that the rule is the wrong rule. We want a rule that provides nominal stability – not a rule which is pro-cyclical.
Merging Fisher and Hetzel
More than a 100 years ago Irving Fisher came up with a good alternative to the gold standard – his so-called Compensated Dollar Plan. Fisher’s idea was that the Federal Reserve – he was writing from a US perspective – basically should keep the US price level stable by devaluing/revaluing the dollar against the gold price dependent on whether the price level was above or below the targeted level. This would be a fully automatic rule and it would ensure nominal stability. The problem with the rule, however, is that it's not necessarily forward-looking.
I suggest that we can “correct” the problems with the Compensated Dollar Plan by learning a lesson from Bob Hetzel. Has I have explained in an earlier blog post, Bob Hetzel has suggested that the central bank should target market expectations for inflation based on inflation-linked bonds (in the US so-called TIPS).
Now imagine that we merge the ideas of Fisher and Hetzel. So our intermediate target is the gold price in dollars and our ultimate monetary policy goal is for example 2-year/2-year break-even inflation at for example 2%.
Under this Fisher-Hetzel Standard the Federal Reserve would announce that it would buy or sell gold in the open market to ensure that 2-year/2-year break-even inflation is always at 2%. If inflation expectations for some reason moves above 2%, the Fed would sell gold and buy dollars.
By buying dollars the Fed automatically reduces the money base (and import prices for that matter). This will ultimately lead to lower money supply growth and hence lower inflation. Similarly if inflation expectations drop below 2% the Fed would sell dollars (print more money), which would cause actual inflation to increase.
One could imagine that the Fed implemented this rule at every FOMC meeting and, instead of announcing a target for the Fed funds rate, would announce a target range for the dollar/gold price. The target range could for example be +/- 10% around a central parity. Within this target range the dollar (and the price of gold) would fluctuate freely. That would allow the market to do most of the lifting in terms of hitting the 2% (expected) inflation target.
Of course I would really like something different, but…
Obviously this is not my preferred monetary policy set-up and I much prefer NGDP level targeting to any form of inflation targeting.
Nonetheless a Fisher-Hetzel Standard would first of all seriously reduce monetary policy discretion. It would also provide a very high level of nominal stability – inflation expectations would basically always be 2%. And finally we would completely get rid of any talk about using interest rates as an instrument in monetary policy and therefore all talk of the liquidity trap would stop. And of course there would be no talk about the coming hyperinflation due to the expansion of the money base.
And no – we would not “manipulate” any market prices – at least not any more than in the traditional gold standard set-up.
Now I look forward to hearing why this would not work. Internet Austrians? Gold bugs? Keynesians?
PS: I should say that this post is not part of my series on Bob Hetzel’s work and Bob has never advocated this idea (as far as I know), but the post obviously has been inspired by thinking about monetary matters from a Hetzelian perspective – as most of my blog posts are.
PPS: Obviously you don’t have to implement the Fisher-Hetzel Standard with the gold price – you can use whatever commodity price or currency.