Tuesday, October 11, 2011

The Gold Standard Revisited

It has been nearly 40 years since Richard Nixon ended the direct convertibility of the U.S. dollar to gold, putting an end to the international gold-dollar standard established by the Bretton Woods Agreements following World War II. In the pinch of the current financial crisis, are we now left susceptible to the powerful moral hazards that this quasi gold standard was designed to prevent?

A gold standard is a monetary system in which the standard economic unit is a fixed weight of gold. It differs from the current monetary system of the United States and many other countries, which use fiat money that has no intrinsic value.

During the Great Depression, many countries left the gold standard because they needed to pump money into the economy to spur growth, and a gold standard did not allow them enough monetary flexibility. But there is also such a thing as too much monetary flexibility.

John Maynard Keynes, the famous British economist of the time, argued, "By a continuous process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some."

In other words, governments - no longer constrained by maintaining a certain amount of gold on hand - could now simply print money to pay off debts or fund budgets. Citizens would pay for this by having their currency holdings devalued. While some people who hold a lot of currency may be greatly harmed, people who hold other assets may be less affected or even benefit from such a policy.

Another moral hazard that such flexible monetary policy created was the manipulation of currency values to benefit a country's trade. By weakening its currency, a country can gain an advantage against other countries for its exports, because they will become relatively cheaper. Should countries begin to compete against each other in this manor, international trade and currency exchange could get out of control.

For many of these reasons, countries signed the Bretton Woods Agreement in 1944, creating the International Monetary Fund (IMF) and the international monetary system in which many currencies were fixed to the U.S. dollar, and the U.S. dollar was convertible to gold. The system had many of the benefits of a gold standard as well as some of the flexibility of full fiat money.

In 1971, Richard Nixon was under a lot of fiscal pressure due to the Vietnam War and ended the convertibility of the dollar to gold. This move created the floating exchange system that we have today.

As central banks combat the current financial crisis, however, will they now be tempted by the moral hazards that were prevalent during the Great Depression? Will they devalue currencies to gain a competitive advantage for exports? Will they inflate their currency to help pay off sovereign debt?

So far, governments and central banks have done a remarkable job of resisting these temptations. Perhaps the euro has helped in Europe's case. Faced with crippling debt, Greece and Spain might have sought to devalue their currency if it was still in their control. But how much longer can such temptations be resisted?

With populations under so much economic pressure, the political pressure to take drastic actions could prove too great. Could the euro zone break apart? Could currency wars ensue?

Another pressure that is somewhat unique to the current financial crisis is the widespread debt among many households. For households that are gainfully employed and carry a high level of debt - be it mortgages or credit cards - could benefit greatly from an inflationary environment. Inflation could result in higher nominal pay, yet the value of debt would remain fixed making it easier to pay it down.

Back in the 1870s and 1880s, the Greenback Party had this very idea in mind. They wanted to move back to the paper-based money system used during the Civil War - "greenbacks" - because it would allow for inflation. Such a move would help farmers get higher prices for their produce and pay down their debts more easily.

Could such a movement gain popularity today? Could highly-leveraged homeowners band together to support an inflationary agenda? The current political climate suggests that the chances are remote. Today, people seem more concerned about budget deficits and excessive government spending. In this regard, a return to the gold standard would be a quick way to reinstate stronger fiscal discipline.

Still, it is curious that more people have not suggested that inflation might be the natural way out of the economic downturn. After all, economists found that during the Great Depression a country's recovery could be directly tied to when it left the gold standard. Perhaps the aversion of many central banks towards inflation is what is truly slowing a global recovery - especially when the current downturn is so closely related to a bursting debt bubble.

Another factor that may be tempering the call for inflation is the high level of unemployment. It is the unemployed who would be the biggest casualty of an inflationary policy. With little income and lots of expenses, the unemployed would be squeezed even tighter by higher prices. But with a looser monetary policy, government could simply print money to finance more unemployment benefits, and if the economy ultimately recovers, unemployment could drop.

Returning to the gold standard or adopting an outright inflationary monetary policy may be extreme courses to take, but history suggests that premature belt-tightening could prolong the current downturn or cause a double dip.

Perhaps governments and the central banks are getting it about right after all. By coordinating many of their fiscal and monetary moves over the past couple years, they have avoided many of the beggar-thy-neighbor pitfalls that occurred during the Great Depression.

And despite all the concern about deficit spending and calls for fiscal restraint, the economic and political reality is that government will have to continue to fill the void until the private sector recovers. It is only a matter of time before the reality takes hold that inflation is the only possible result.

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