October 26th, 2012 | By Nick Sargen
For the past four decades the international monetary system has been characterized by floating exchange rates, in which national central banks are free to set monetary policies independent of balance of payments considerations. This arrangement, while far from perfect, has existed primarily for two reasons: (i) national governments are reluctant to cede their sovereignty in setting monetary policies; and (ii) global inflation has not been a problem – in fact, it has fallen steadily throughout this period.
In a recent commentary, John Makin notes that the debate about whether the United States should adopt a gold standard has heated up again in Republican Party circles owing to concerns about the Federal government's outsized budget deficits and the Federal Reserve's (the Fed) pursuit of unlimited quantitative easing. The Party's platform includes a proposal for a commission to consider "the feasibility of a metallic basis for the US currency," similar to one that was appointed shortly after the election of President Reagan. Whereas that commission advised against such a move, Makin asks whether it makes more sense to do so today.
Makin's conclusion is that a return to the gold standard is not something the United States can do unilaterally. If it is to occur it must be done as part of a new international financial system. In this regard, it's widely understood that a gold standard is not feasible in a deflationary environment such as the 1930s. But it is less evident why a gold standard was not a viable option for the United States in 1980, when President Reagan assumed office and inflation was at double digits.
Makin's explanation is that any government effort to set a price for gold in the 1980s would have meant that the government would have either had to acquire unlimited quantities of gold or sell unlimited quantities to establish a new official price. The need to do so was obviated, because the United States effectively went on a "Volcker Standard," in which the Fed Chairman simulated a gold standard by sharply reducing money supply growth. This policy change, in turn, ushered in a period of renewed central bank commitment to lower inflation that has lasted for three decades.
The case for considering a gold standard today, by comparison, is that the Fed's credibility and commitment to low inflation is being called into question given the tripling of the Fed's balance sheet since the 2008 financial crisis. Thus far, the rapid increase in the monetary base has not been associated with higher inflation, mainly because commercial bank lending (which is at the crux of the money multiplier process) has not expanded materially. However, advocates of a gold standard are worried that the introduction of unlimited quantitative easing increases the chance of higher US inflation.
Given the concerns about higher inflation, the question remains as to how a gold standard would work in current circumstances. Makin's assessment is that it would be difficult for the United States to engineer such a move unilaterally, and that it would require an international agreement to fix exchange rates in an era of huge international capital flows, which seems highly unlikely. Moreover, he contends now is not the time to contemplate such a change considering the risk of global deflation:
"Consider for a moment a thought experiment wherein the US government unilaterally decides to fix the dollar price of gold at a level that implies lower inflation…At such a level, private buyers would purchase the gold from the United States and experience a windfall gain. The US gold stock would fall, and the US money supply would fall as well, given a rigid gold standard rule. That kind of a deflationary shock would be disastrous in the current environment…"
Makin goes on to conclude that support for a new international monetary system that includes a mechanism to limit central banks' ability to accommodate large government borrowing could grow in a more inflationary environment. However, even in these circumstances, it would be difficult go see how a modern gold standard would evolve and function:
"The gold standards like those in place during the late nineteenth century can deliver relatively stable prices, and perhaps falling prices if the supply of gold does not rise rapidly enough. But it also delivers high volatility in real output and tends to be associated with financial crises. Like it or not, the modern world has grown used to central banks that aim at price stability and full employment and provide an elastic currency in an effort to achieve higher growth while avoiding financial crises."
By and large, I concur with Makin's assessment of the difficulty of returning to a gold standard in the current environment, especially where governments wish to retain independence of monetary policies. The breakdown of the Bretton Woods fixed exchange rate system in the early 1970s occurred against a backdrop of the reserve center – the United States – becoming a high inflation country. While the central banks in Europe and Japan sought to maintain their parties with the dollar through intervention in the currency markets, their efforts were overwhelmed by massive private capital flows. Once the parties with the dollar (and gold) were severed, it became impossible to re-establish them against a backdrop of global inflation.
The principal attempt to re-establish a fixed exchange rate system since then has been the creation of the euro-zone. While it was created amid considerable optimism, the experience in recent years has demonstrated how difficult it is to maintain a common currency when there is no central government to coordinate fiscal policies. Recognizing the problems Europe faces in coordinating policies, I believe it would be impossible to create an international monetary system today in which the major powers – the United States, Europe, Japan and China – would subordinate domestic policy objectives for the sake of the common good. Therefore, while there are likely to be increased calls for a gold standard, I believe they will go unheeded by policymakers in the major international financial centers.