Calls for a return to the gold standard are in vogue these days. Tying the value of the dollar and other currencies to the precious metal is considered a monetary salve that will soothe the economic ills that harass us. It's an idea whose time has come…again, we're told. The World Bank's president last week suggested that the world should embrace, in part, a gold-based monetary system. And in yesterday's New York Times, financial writer James Grant eloquently pined for the gold standard of yore. "The classical gold standard, the one that was in place from 1880 to 1914, is what the world needs now," he writes.
Grant delivers a stirring brief for the precious metal as a monetary foundation. In advancing the agenda, he focuses on the benefits. But like so many gold bugs, Grant ignores the challenges. Those challenges are significant. Indeed, there are fundamental reasons why gold was abandoned as a monetary standard. Those reasons weren't trivial, nor would they be resolved in the 21st century. A gold standard, quite simply, is a wonderful thing…until it's not.
Every monetary system suffers tradeoffs. There is no ideal strategy for a) insuring price stability; b) minimizing economic volatility; and c) maximizing employment. Expecting gold will deliver will somehow dispense all three is expecting the impossible in the long run. True, anything's possible for a time, with or without gold. At times there's a virtuous circle of positive reinforcement in the business cycle that promotes that trio. One of those periods recently ended. The Great Moderation, as it's called, ran from roughly the mid-1980s through 2007, interrupted briefly in 2000-2002 with a severe stock market decline, albeit one that had relatively limited negative consequences for the real economy.
The Great Moderation was hardly perfect, but it was a potent run of employment growth, disinflation, and generally improving economic conditions in the U.S. and around the world. And in case you didn't notice, it all arrived without gold as a monetary standard. Fiat money has its problems, starting with the fact that it requires enlightened management. But it's not a hard-wired impediment to macroeconomic progress.
What, then, is behind the renewed urge to return to a gold standard? Like gold itself, the sentiment is an amalgam of allure and contradiction. Gold, after all, is first and foremost a prescription for putting a lid on inflation. But inflation is hardly a near and present danger. The economy's suffering from a severe bout of deleveraging, which is pushing the broad pricing trend lower. Yes, future inflation may be a threat in the years ahead, depending on what central bankers do, or don't do. But the macro priority du jour isn't looking for additional ways to reduce inflation, which is what a gold standard would impose. Rather, the principal task is arresting the fall in the inflation trend.
The annual rate of change in the core rate of consumer price inflation is running at roughly one-third the level these days compared with the 3% peak from two years ago. We can debate if that's accurate. But it's the trend that's troubling, not the specific level. Amazingly (for gold bugs), this disinflationary trend has come without a formal link to the world's favorite monetary metal. In a world of fiat money, gold bugs would have you believe, such a potent disinflation trend is impossible. Well, we now know different.
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A miracle? Hardly. The source of the disinflation, which conceivably could turn into deflation, is the blowback from deleveraging. Economies accumulated too much debt in the boom years of the Great Moderation; servicing that debt in times of weak growth is a burden. Predictably, spending is down and saving is up—exactly what you'd expect in a deleveraging crisis. Moving to a gold standard would only exacerbate the deleveraging process, perhaps to the point of creating a new recession, or perhaps a depression.
We've been here before. The Great Depression of the 1930s was also a period of deleveraging on a mass scale. Some of the catalysts were different, some the same vs. the current climate. One critical distinction between now and then: the gold standard. The U.S. was on a gold standard in the early 1930s; today we're not. That's a significant difference. But note that in both cases a deleveraging crisis arrived. Gold is no magical immunization that prevents financial crises. In fact, a gold standard may, at times, exacerbate those risks.
There's another distinction between now and then: the policy responses. Economists are in broad agreement that forcing "sound money" on an economy during a deleveraging crisis is the equivalent of taking away oxygen from a man who's having trouble breathing. The gold bugs always seem to overlook this point. Sure, if your only goal is maintaining the purchasing power of a currency, gold's your solution. But the body politic and most economists have a broader agenda during times of economic crisis. As such, gold is no help in periods of extreme macro stress.
Economic history is nothing if not clear on this point. Gold forced austerity on the world economies in the early 1930s at exactly the wrong time. To argue otherwise is to ignore a small library of research published over the decades. A few examples of how gold helped turn the economic troubles of the early 1930s into something far deeper can be found in Milton Friedman and Anna Schwartz's A Monetary History of the United States, 1867-1960, and the recent Lords of Finance: The Bankers Who Broke the World, by Liaquat Ahamed.
Yes, the gold standard as practiced was self regulating, a benefit that the gold bugs eagerly promote. True, but the dark side of that self-regulation is that gold supplies sometimes flow out of a country as a tool for adjusting trade imbalances. Sounds wonderful, except for the fact that a net outflow of gold is the equivalent of contracting the money supply. What's wrong with that? Nothing, most of the time. But during a severe financial crisis, such as the early 1930s or late-2008, a receding supply of money is akin to playing economic Russian roulette—with a fully loaded gun.
This wasn't widely understood as the 1930s began, but the message began to sink in…slowly. Countries abandoned the gold standard as the 1930s unfolded, with predictable results. As Barry Eichengreen's research shows, the earlier a nation left gold, the sooner its economy began to heal from the deleveraging crisis, as measures of industrial production clearly demonstrate in that period. Eichengreen advises in his 1992 article in Economic History Review that "the timing and extent of depreciation can explain much of the variation in the timing and extent of the economic recovery."
Did abandoning gold--a massive quantitative easing policy of its time--usher in a period of sharply higher inflation? Nope, not even close. There were many econonmic complaints in the post-gold standard world of the 1930s, but inflation wasn't one of them.
If there's a case for returning to a gold standard in the modern era, surely it was stronger back in, say, 2005 and 2006, when inflation was rising and monetary policy appeared to be delivering too much stimulus. Ah-ha! the gold bugs will cry--that's going on now as well. Actually, no. The Federal Reserve isn't trying to raise inflation so much as keep it from falling further. To the casual eye this looks like a misguided policy of trying to stimulate unhealthy increases in inflation. But as the first chart above reminds, the key goal now is simply arresting the disinflation trend. Ours is a crisis bound up with deleveraging, which renders the historical inflation threat null and void, albeit only temporarily.
Yes, the gold standard does of great job of maintaining a currency's value. Most of the time, that's a prudent goal. But sometimes there's a need for intervention in monetary management. The onset of the Great Depression was one of those times. So too was the 2008 financial crisis. Although criticizing the central bank is easy now, pundits are too quick to minimize what might have happened if the Fed didn't inject huge quantities of liquidity into the system in the fall of 2008. By contrast, a full-blown repeat of the Great Depression was more than a minor risk if the Fed had repeated the errors of the 1930s in late-2008. Sometimes an emphasis on austerity via holding tight to the gold standard or its equivalent threatens economic suicide.
Monetary flexibility also carries risks, of course, but so too does putting monetary policy into a straight jacket, a.k.a. adhering to a gold standard. There are no free lunches. And let's also recognize that re-imposing a gold standard today is sure to have zero political tolerance in the next financial crisis. Yes, variations of the gold standard ran for decades in the late-18th and early 20th centuries. But the masses in the 21st century won't tolerate the side effects of a gold standard, such as painful periods of deflation that arose in the 1880s and 1890s. There was a political backlash at the time, culminating in William Jennings Bryan's famous “Cross of Gold” speech at the 1896 Democratic convention. But it was hardly fatal for gold's supporters.
The deflationary runs triggered by the gold standard a century ago carried a small political price. A repeat performance isn't likely. Even if it was politically feasible, a gold standard isn't economically viable. There's a reason why the developed world deserted gold: in times of crisis, it squeezes the economy to a point that the masses suffer. They did so quietly a century ago, but no one will suffer in silence anymore.
Gold bugs like to argue that a gold standard would minimize if not eradicate financial crises. But history says otherwise. Financial crises were a recurring feature during the heyday of the gold standard. Suffice to say, whether we're on a gold standard or running fiat currencies, financial crises will remain a hardy perennial. The question is how central banks deal with those rare but inevitable crises?
Romanticizing the gold standard as an alternative to fiat money provides dramatic copy for pundits, but as a practical solution it's sure to be a dud. Been there, done that.