Thursday, July 18, 2019

All that glitters is not gold

I wrote a Wall Street  Journal Oped on the gold standard, partly in response to last week's Oped by James Grant (whose "PhD standard" is a great quip) and Greg Yp's excellent column on Judy Shelton and gold.

Pegging the dollar to gold won't  stop inflation or deflation.  Inflation was already quite volatile in the 19th  century, and it would be worse today:
What determines the value of gold relative to all goods and services? In the 19th century, gold coins were used for many transactions. People and businesses had to keep an inventory of gold coins in proportion to their expenditures. If the value of gold rose relative to everything else (deflation), people gained an incentive to spend them, and thereby drive up the prices of everything else. If the value of gold fell (inflation), people needed more of it, so they spent less and drove down other prices. This crucial mechanism linked the price of gold to all other prices. 
That link is now completely gone. Other than jewelry and some minor industrial uses, there is nothing special about gold, and little linking the price of gold to all other prices. If the Fed pegged the price of gold today, the price of everything else would just wander away. The Fed might just as effectively peg the price of chewing gum. A monetary anchor is a good thing, but the anchor must be tied to the ship. Gold no longer is. 
Broader commodity standards face the same problem. Traded commodities are such a small part of the economy that the relative price of commodities can swing widely with little effect on inflation.
In particular, if the value of gold goes up, you have deflation, which many people are  worried about today. The gold standard did nothing to stop the sharp  deflation  of the 1930s.

Gold is not really a monetary promise, it's a fiscal promise:
If people demanded more gold from the government than it had in reserve, the government had to raise taxes or cut spending to buy more gold. More often, the government would borrow to get gold, but governments must credibly promise to raise taxes or cut spending to borrow. This fiscal commitment ultimately gave money its value, not the sometimes-empty promise to exchange money for gold. Taxes ultimately back all government money. The gold standard made this fiscal commitment visible and testable. 
It is possible, though, to answer gold standard advocates critiques of current affairs without a return to gold
..the U.S. could enact a policy today that emulates the good features of the gold standard. I call it the CPI standard. First, Congress and the Fed would agree that “price stability” in the Fed’s mandate means precisely that, not perpetual 2% inflation. The Fed’s mandate would be to keep the consumer-price index (or a suitably improved index) as close as possible to a stated value. 
Second, the CPI target would bind fiscal policy (Congress and the Treasury) as well as monetary policy (the Fed). Inflation would require automatic fiscal tightening and deflation would trigger loosening, just as a gold-standard government trying to defend its currency must tighten fiscally to raise its gold reserves. 
Third, the government would emulate the promise to trade gold for notes in modern financial markets. There are many ways to do this, but the simplest is to commit to trade regular debt for inflation-indexed debt at the same price. Under this system, inflation would cost the government money and force a fiscal tightening in the same way gold once did. And vice versa—the system would forestall deflation as well. 
 I conclude
Gold-standard advocates offer a cogent critique of current monetary policy, but a return to gold is unfeasible. A stable CPI, immune from both inflation and deflation, backed by the same fiscal commitments that underlay gold, is worth taking seriously.
As usual, I have to wait 30 days to post the whole thing.


  1. I think people who favor the gold standard might be critical of the following line of the piece: "Governments couldn’t issue more cash when needed. As a result, there were banking crises and cash was seasonally short around harvest time." Advocates of the gold standard often argue that the banking crises in the US were due to restrictions on banking in the US, the lack of branch banking most significantly. Granted, I think your argument for an elastic currency is a good one, but banking restrictions made the problem much worse. Canada, for instance, did not have nearly as many problems as the US during this time period.

  2. What about adverse supply shocks, John? Do you think it is a good idea for the Fed to shrink M to keep P from rising in response to those? More generally, why stabilize an output price index even when doing so must result in an unstable index of input prices, including nominal wage rates? Gunnar Myrdal 9for one) thought the central bank should target the stickier price index. Was he wrong?

  3. Is your analysis of how a "gold standard" works just a version of the quantity theory of money? And this is in the context of a "national currency"? Thus the international effects of how capital flows work still would be a flexible exchange rate, just as in today's commodity market "exchange rate (offer price)" for gold? How would government debt affect reserves, if government debt were always rolled over (or consoles)?

    1. In my view, above, gold had value previously because of a quantity theory of gold. Gold coins are limited in supply by the limited supply of gold, and are demanded to make transactions.

  4. I take the call for a return to gold more as a call to eliminate discretionary policy, especially countercyclical policies aimed at "full employment." Whether that is achieved by a gold standard or a CPI standard is secondary. I share your view on this, but I think it would take an act of Congress to remove the dual mandate from the Fed's charter. Or you can make the case that there is no tradeoff, that the best way to achieve stable full employment is with a stable price level.

  5. How about plywood? That is, isn't there some good or index of goods to which the dollar could be pegged that is representative of the entire economy?

    1. IIRC long before Greenspan was Fed Chairman, he was a private economist. Back then he advocated an index called PANAL which stood for plywood, ammonium nitrate, aluminum.

  6. We seriously considered gold price fixing at the Gold Commission in 1982. Anna Schwartz aided by Mike Bordo ran the commission at Treasury. I advised Fed govs Rice, Wallich and Partee who were on the commission. Anna was actually trying to make Milton's case for fixed money growth. Regardless, all of the stuff is in the report. We used my briefing notes to the governors to write a Flood& Garber paper for the JPE. It was just an ok paper, but the equilibrium concept - due to Steve Salant - was the model for lots of papers doubting the uniqueness of fixed-price rules that were not the government's first priority.

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  8. Treasury and Congress are not bound by anything, except re-election. Getting Congress to voluntary approve any kind of automatic price stability requires money, lots of it. You have to induce Congress to give up the right to coin we the Fed can d balanced banking.

    If the Fed wanted to lease the monopoly money license from Congress, what is the net value of that lease? I haven't found an economists yet that can answer the question, not even Fed economists. Nor have I found an economists that could engineer the deal, even if they could estimate the price. We waste time unless we are ready to name a price to pay off Congress.

  9. "The Fed might just as effectively peg the price of chewing gum"
    Well, there's a thought.

    1. chewing gum violates the rule of pecunia non olet (money does not stink) because it is organic and can rot.

    2. I liked targeting shoes, the median standard tennis shoe should be priced at $20, and the Fed can buy and sell Shoe futures.

  10. The current Fed system has two major flaws.

    First it is unconstitutional. Only congress has the power to coin money and regulate the value thereof, it has delegated that power to the Fed without standards.

    Second, the fed is a bunch of economists, giving them that much power is like giving whiskey and car keys to a bunch of teen age boys. Someday, maybe not today, something horrible will happen.

  11. Most nations on a gold standard abandoned it, not because the price of gold varied, but because the money-issuer became insolvent and couldn't pay its obligations in gold. The resulting bank run forced the issuer to suspend convertibility, i.e., to go off the gold standard

  12. If zero inflation is the goal of macroeconomic policies, then we should emulate Japan, which has obtained price stability through the assiduous application of large and chronic national budget deficits, prodigious amounts of QE, and by pegging interest rates at zero or lower.

    Looking at the trend lines, Europe is migrating to the Japan model, and perhaps even the US.

    One more recession, and I suspect the US will be Japanified.

    Japan, btw, per worker, has not done so badly in the last decade or two.

    Back to the US, we suffer a form of chronic negative supply shock due to skyrocketing housing prices borne of property zoning. To get to zero overall inflation in the face of ever-worsening housing shortages may require starving or even shrinking the rest of the economy, to counterbalance the measured inflation from housing.

    In conclusion, is zero inflation in the US a worthy goal if reaching for such a target results in less, and not more, prosperity?

    And if zero inflation is nevertheless a worthy goal, should we get there by large budget deficits, big QE and dropping the Fed funds rate and IOER to zero?

    Not in theory, but as a practical, proven course (see Japan)?

    In theory this should not happen. In reality, it has and is.

  13. The federal government did not issue paper money until the Civil War. State banks issued dollars to the congressional definition of 1792 set “to regulate the value thereof.” Oddly enough, a twenty-dollar-bill was exchangeable for a one-ounce, double eagle, gold coin ($20.67). That was when the private sector, the free market, issued and managed both money and credit. What’s that one-ounce coin worth now with the politically appointed Federal Reserve in charge—$1,400 or more?

    P.S. What was the dollar price of gold when Greenspan left?

  14. "A stable CPI, immune from both inflation and deflation,"

    A CPI standard is not immune from either. If the money issuer becomes insolvent, and if it maintains convertibility (into gold or a CPI basket), then a bank run will result, just as it always did under the gold standard.

  15. "little linking the price of gold to all other prices."

    It is unlikely that the price of gold could stray too far from the cost of mining gold for very long - that ties gold back ultimately to the price of fuel, machinery and labor.


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