Month: October 2015

A Word Against the Gold Standard

Now that we’re now warming up for another GOP and democrat debate in the US, I thought it was time to expound some more economic consensus. Namely, discussion over the Gold Standard.

To be honest, I find it surprising that the Gold Bug continues to consume many fringe elements of the political spectrum given what we’ve observed in Europe since 2009. Economically, Europe’s problems are almost wholly due to the difficulties of holding a fixed exchange rate over sub-optimal currency zones. The Gold Standard, in light of this, has all the features of such a fixed exchange rate with the added inflexibility of weakened central banks. Is this what the world needs in the future? The contention of most economists is that it is not; that it is a ‘barbarous relic belonging to the dustbin of history’. This is insisted for the following reasons:

  • Capital flow Bias.
    As suggested by Peter Temin, a fundamental structural flaw of the Gold Standard was the asymmetry of price-specie flows between surplus and deficit countries. In theory, the Gold Standard should have corrected trade imbalances since a country with trade surpluses (deficits) would receive capital inflows (outflows) in the form of gold. These specie inflows in turn would expand (contract) the money supply and raise (dampen) the price level. Thus, correcting the imbalance of competitiveness between countries and balancing trade. In practice however, it was very easy for trade surplus nations to sterilise inflows whilst deficit nations were forced to contract the domestic money supply in an effort to ‘catch-up’. Overall this had the effect of pronouncing the demand-side impact of trade imbalances rather than alleviating them, in turn creating a deflationary bias.Sound familiar? This line of thought, whereby deficit nations are forced into internal devaluation as surplus nations sterilise the inflows, is the key issue underlying Europe’s sovereign debt crisis.
  • Macroeconomic contagion.
    Picture what happens when an economy that forms part of the Gold Standard enters a recession. Wages and prices fall as per usual, and competitiveness is increased. This all happens under floating exchange rates as well. The difference in the Gold Standard however is that this fall in wages and prices, through the trade account, creates an inflow of specie domestically that must be matched by a global outflow. Thus, though the domestic money supply may be allowed to expand as per usual, overseas markets are forced into a contraction. In this sense, economic contraction in a few major markets has an added contagion effect that is wholly divorced from economic fundamentals; caused instead by monetary rigidities.
  • Short-Term Volatility.
    Whilst it is true that the under the Gold Standard the world witnessed a more stable long-run price level, in the short run there was far greater volatility. This came from the fact that the conduct of monetary policy would be subjected to supply-side concerns amounting from the industrial demand and supply of gold.  In addition, financial speculation on commodity prices would tangibly affect coverage ratios and thus monetary policy. Overall, this had the effect of destabilising commercial balance sheets and frustrating macroeconomic management.
  • Practicality
    According to recent estimates by the Federal Reserve, M2 in the U.S alone today is estimated at about $10.5 trillion, whilst the value of all gold ever mined amounts to around $8.2 trillion. If the Gold Standard were to be implemented today, it would require one of two things. In the first instance, central banks across the globe could contract the money supply by a huge quantity and inflate the price of gold past all industrial applications. Or, central bank reserve requirements could fall precipitously. The trade-off is most definitely between a calamitous recession on the one hand and a destabilisation of global finance on the other.
  • Speculative Attack.
    We’ve all seen what happens to central banks that can’t maintain their pegs, or fall victim of severe financial speculation. It has happened in both the developed and developing economies in the post-war era. When foreign reserves fall to levels that make effective coverage of the exchange rate impossible they fall victim to sharp and intense financial panics. The Gold Standard would entail a Global Return to policies that risk the same situation.

Finance Under Attack

As the topic of financial stability becomes increasingly important in the Australian political landscape I have increasingly found myself confronted by 2 indubitably populist arguments that claim to undermine the consensus in financial economics. The 2 claims that I have been confronted with go as follows:

  1. The crash of September 15, 2008 is a perfect counterexample to the efficient market hypothesis. Clearly, innovation creates an information asymmetry in finance since sellers can deceive buyers via the ‘complexification’ of products.
  2. Bailouts provide an implicit subsidy to institutions that desire to take on excessive risk.

First off, it is probably helpful to recognise that there is a vast amount of misinformation circulating with respect to TARP and the Federal Reserve’s emergency liquidity facilities. In many political circles I hear the claim that the response of the Fed in 2008 was an implicit subsidy to the financial sector at the expense of the taxpayer. This claim however, is dubious at best.

In fact, if one looks at the actual cash flows from the emergency loan facilities it is clear that the Fed has ostensibly profited off of the crisis. From October 2008 onwards Bernanke made it clear that the Fed would constrain credit support to illiquid institutions only, and would not fund insolvent corporations. I would also claim that the Treasury department’s TARP has delivered a substantial profit. Thus, the position that bailouts are everywhere and anywhere a phenomenon of corporatist greed is not tenable in my view.

Interestingly enough though, the conservatorship of Fannie Mae and Freddie Mac (prior to TARP), did indeed involve substantial transfers of losses from the private to the public sector. These losses on the whole could amount to over $300 billion if the worst forecasts are to be believed.

This opens the argument, is there an actual case for central bank and treasury intervention on behalf of insolvent institutions? On the surface, it appears difficult to justify such an action given that it would involve the creation of moral hazard to some extent.

But how does this moral hazard actually manifest? Moral hazard undoubtedly develops from the class of agents that are shielded from risk by public policy. In the vast majority of conservatorship arrangements these agents are the senior creditors. Equity holders and the managerial class classically get wiped out and as such, those who are directly insured are not those who are direct risk takers. Instead the implicit subsidy takes an ancillary form, where creditors will generally be inclined to lend to risky institutions at lower rates. The insensitivity of interest to risk thence creates a profit spread that is conducive to leverage and risky investments.

But notice the implicit assumptions here. In the real world it is not the sellers of derivatives that are insured, but rather a distant group of savers. To assume that these saver understand their government insurance policy we assume a kind of hyper-rationality. These creditors can not only perceive the levels of risk embedded in investment bank assets, but can also foresee the chance that the public will insure against any possible downside. Here, the level of moral hazard emanating from public policy is directly proportional to the informational efficiency of financial markets. In other words, a world in which the odd bailout can create huge moral hazard problems is also the world in which markets have high informational efficiency.

Hence, argument (1) is completely inconsistent with argument (2) unless one can make the claim that the makeup of CDOesque consumers is less sophisticated than the makeup of creditors. I am not going to come out in favour of any position on financial regulation here, but I encourage those who take issue with the whole paradigm of financial economics to reconsider their dogma.