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.
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.