Return to the Gold Standard? History Suggests Not To!

The Gold Standard: About to Return?

The financial crisis of 2008-9 has laid the foundation for intense debate about the future of the global financial system. In the US, depending on the outcome of the Presidential election, the Republicans have declared an intention to explore the viability of returning the dollar to some form of gold convertibility, including a possible return to the gold standard. The idea of some return to gold convertibility is not new: President Reagan established a Gold Commission in 1981. The Commission decided, however, that the prevailing fiat money system should be maintained. It was the Republican administration of President Nixon that suspended convertibility of dollars into gold in August 1971. The decision was unilateral: foreign central banks were not even consulted by the Nixon Administration.

The events of August 1971 had two consequences: firstly, it led to accusations that the Fed was capitulating to political pressure from the Nixon Administration; secondly, it effectively sealed the fate of the Bretton Woods system of fixed exchange rates that had prevailed since 1944, thereby ushering in an era of floating exchange rates. The collapse of Bretton Woods meant that countries could subsequently pursue independent monetary policies. Fiat money systems have been the norm since the early-1970’s in G7 countries. Could we see the return of dollar convertibility into gold? It partly depends on the election outcome.

Republican Backlash against Quantitative Easing

The Fed has enjoyed legal independence since its inception, although it periodically has endured uneasy relations with Congress. It appears that the decision to re-visit a potential role for dollar convertibility into gold is the result of the persistence of Congressman Ron Paul. The libertarian Congressman has been a fierce critic of the Fed since the financial crisis, particularly the adoption of quantitative easing.

Fed Chairman Bernanke’s current term expires in January 2014. The Romney-Ryan team have not yet seemingly endorsed another term should they win the election in November. This has not seemed to faze the Fed Chairman, who indicated last week that a third tranche of quantitative easing is likely to be invoked. Fed Chairman Bernanke clearly believes that asset purchases have been beneficial for the real economy. Contrary to the many critics of quantitative easing, inflation has not reared its ugly head, largely due to a significant decline in the velocity of circulation of money.

Returning to the Gold Standard: A Useful History Lesson

In order to appreciate some of the implications of the US solely returning to the gold standard, we need to briefly resort to the history books. The US has an interesting history of embracing the gold standard both domestically and internationally since the Fed’s inception in 1913. The US embraced a full gold standard between December 1914 and its entry into World War 1 in 1917. Gold exports were then partially suspended until 1919. The full gold standard was once again embraced by the US between 1919 and 1933.

The Fed quickly learned that maintaining a full gold standard without other countries being part of the same system incurred big costs in terms of discretionary management of the domestic economy. In 1920, the Fed was forced to engineer a significant tightening of monetary policy to defend its commitments to the gold standard, whereby banks had to maintain gold holdings equivalent to at least 35% of deposits and 40% of currency in circulation. The result was a depression that lasted 18 months, producing a -7% contraction in GDP while consumer prices fell -8%.

Despite the United Kingdom re-joining the gold standard in 1925, the international monetary system was unable to achieve economic and financial stability. The Roaring Twenties ended in the 1929 stock market crash, helping to usher in the Great Depression. In 1933, the US suspended the gold standard. The decision remains symbolic in that it established the principle that domestic policy objectives had primacy over the dictates of the gold standard.

A New Gold Standard Would Require International Agreement

The attempt by the US to unilaterally maintain the gold standard between 1919 and 1925 should provide enough of a warning to today’s policymakers. There would need to be an overhaul of the international monetary system for there to be a return to the gold standard. For example, foreign central banks would need to feel comfortable with the conversion rate. In 1971, the official conversion rate was just $35 per troy ounce. This compares to a London fixing price of $43 per troy ounce at the time. How would the new conversion rate be determined? London fixing prices have recently been trading around $1650 per troy ounce. Would the new conversion rate be acceptable to foreign central banks?

Governments like Flexible Exchange Rates

The biggest obstacle to the US returning to the gold standard is the drift away from fixed exchange rates since the demise of the Bretton Woods system and inception of the euro. Governments now recognise that floating exchange rates are useful for economic management. Countries with appreciating currencies will import deflation and export economic growth. Conversely, those countries with depreciating currencies will import economic growth and export deflation. Exchange rate management for domestic stabilisation purposes is not an option under the gold standard. Many governments would be unwilling to give up this option for engaging in policy discretion.

Gold Standard Implications for Capital Flows

Current account balances necessitate a one-way offsetting capital flow if exchange rate stability is to be maintained. In the case of the US, which has run a chronic current account deficit since 1982, there needs to be a sizeable appetite for dollar-denominated assets to preserve exchange rate stability. Under a floating exchange rate system, a lack of appetite for US dollar assets is transmitted via a weaker exchange rate. Would the situation change under the gold standard?

Under a full international gold standard, the rules of the game would change. Given that the US runs a chronic current account deficit, the Fed would be forced to shrink the money supply as dictated by the outflow of dollars and, ultimately, gold. Against this backdrop, US interest rates would rise, thereby choking aggregate demand in the economy. The chances are, however, that the increase in interest rates would also depress output and raise unemployment.

The Fed has been charged with a dual mandate since 1978, namely price stability and maximum sustainable employment. Under a gold standard, the Fed would be unable to pursue these dual policy objectives. A new Fed mandate would probably be required, involving an explicit commitment to preserve the official conversion rate to gold. Financial markets would potentially test the Fed’s commitment, particularly if it was felt that the political appetite for a gold standard was purely a fad.

The Gold Standard: An Anchor for Price Stability?

The main reason for the gold standard cited by its supporters is that it is an anchor for price stability. The historical evidence would, however, suggest otherwise. Under the gold standard, the variability of US consumer prices (CPI) was significant.  The irony is that the volatility of headline CPI under quantitative easing is far lower. This lower level of volatility is attributable to various factors, including excessive cash hoarding by the private sector and generally weak corporate pricing power.

The main problem that the world economy has historically faced under a gold standard is new discoveries. A rise in new discoveries of gold has resulted in higher prices in the long-run and faster economic growth in the short-run. Whenever the supply of gold has failed to match the growth of the world economy, prices fell in the long run and employment fell in the short-run.

The Gold Standard and US Equity Prices: Another History Lesson

While the US was under the gold standard between 1919 and 1933, there were four recessions. The volatility of economic growth and inflation was significant, along with similar behaviour for equity prices and corporate earnings. While a return to a gold standard need not result in four recessions in fourteen years, the variability to future output and prices could be more significant than commonly grasped. Under these circumstances, the predictability of corporate profits becomes much more difficult: investors would be justified in demanding a higher equity risk premium.

Summary and Conclusions

The Republican backlash against quantitative easing has resulted in renewed interest in restoring dollar convertibility into gold. Fiat money systems have become the norm since 1971. G7 countries have since been able to pursue their own independent monetary policies.

The Fed is seemingly poised to incept another tranche of quantitative easing. Inflation has remained subdued despite the expansion of the Fed’s balance sheet.

History suggests that the Fed cannot unilaterally operate a full international gold standard and engage in domestic discretionary demand management. Adoption of a gold standard would require international agreement on the conversion rate.

Governments have become accustomed to the policy flexibility that floating exchange rates provide. In contrast, under a gold standard, the Fed would be forced to shrink the money supply to counter the outflow of dollars due to the current account deficit. The Fed’s dual mandate would become inoperable under these circumstances.

There were four recessions between 1919 and 1933 under the previous gold standard.The variabilityof output, inflation and stock prices was high during this period. A return to the gold standard should prompt investors to demand a higher equity risk premium.







About Said Desaque

I'm a professional economist in financial services, with a keen interest in international relations, along with their implications for economic development.

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