Supply-Side University Economics Lesson #13
Memo To: Website Supply-Side Students
From: Jude Wanniski
Re: Gold Standard Mechanisms
I’d planned to devote this week to answering a collection of questions that have been asked during the last several sessions, but one “bundle” of questions from Michael Darda, a staff member of the Wisconsin State Legislature, made me think I should deal with them right away. Those SSU students who are coming in the middle of the semester can read through this without feeling dumb because the question comes from a student who has been with us from the beginning of the year. It does not hurt one bit to try to grapple with this, but you will get much more out of it if you curl up with the earlier lessons and hit this one in its appropriate time. When we are discussing gold standard monetary mechanisms, we are quite a way beyond supply-side ABC’s.
Q. Could you please explain to me the fundamental difference between the pre-WWI gold standard and the gold standard thereafter? I know that, in essence, it is a distinction between direct convertibility with no central bank, and a central bank adjusting the money supply around price signals provided by gold. In your view, which one is superior, and, could you explain the operating mechanisms to me? Also, when I explain your lessons to friends, I frequently get asked, “If the gold standard was so good, why was it abandoned?” What would you say?
A. First, we should get it straight that there may be dozens of different kinds of mechanisms that could be designed to make a gold standard work, but the mechanism itself is not the standard. A gold standard is one in which the national money is defined as a specific weight of gold. When today’s academics insist the gold standard ended in 1913, what they really mean is that the mechanism changed, but the definition remained. When President Roosevelt in 1933 was persuaded to devalue the dollar against gold and to make it illegal for U.S. citizens to own gold bullion, the mechanism changed again, but the dollar was still defined as a specific weight of gold. The dollar had been defined as 0.0483% of an ounce of pure gold. FDR changed it himself, without any consultation, to 0.0285% of an ounce. That is, where it took only $20.67 to buy an ounce, Roosevelt said it now would take $35. It was still a gold standard, but at a new price, and with a mechanism that did not allow ordinary citizens to exchange dollars for gold. In 1944, at the Bretton Woods conference, the U.S. government and its allies formalized this monetary system, which permitted only foreign central banks to convert dollars they acquired into gold, at $35 per ounce. Mechanisms can be changed to support the national monetary unit defined as a gold weight, but as long as the final objective is to preserve and guarantee the dollar/gold definition, it is a gold standard.
Which kind of mechanism is best? The kinds we had in the past were suitable to their times, but broke down under pressures of depression or war. A monetary standard is not a cure-all for economic distress. It is only good for eliminating monetary distress in an economic system, the kind of distress that occurs when the value of paper money can change every day relative to things that are real and palpable.
Prior to World War I, before the Federal Reserve was created as the nation’s central bank, the nation acquired its liquid money from the Treasury Department. Citizens brought gold to the Treasury and in exchange received currency at the specified definition, $20.67 for every ounce. The private banks used Treasury debt as circulating media alongside gold coins and gold certificates that could be redeemable at Treasury for gold. The system became cumbersome during the dramatic expansion of the economy in the latter part of the 19th century, with the Treasury forced to manage its relationships with the chartered national banks with increasingly archaic methods of asset management. It was not the gold standard that failed, but the mechanics of dealing with rapid economic change, sectional and seasonal. The Federal Reserve was established in 1913 to centralize national banking and permit management of the gold standard with an elastic currency, one that could respond quickly to sectional and seasonal demands. Its distinguishing feature was its ability to monetize debt through open-market operations in the 12 Federal Reserve districts -- buying or selling government bonds from its portfolio of debt to meet the demands for sectional and seasonal liquidity, but always within the constraints of the dollar’s definition as a specific weight of gold. The markets would understand that an increase in liquidity before Christmas would be followed by a draining of liquidity after the holidays, and that additions to liquidity would precede farmbelt harvests and be drained after harvest.
The private Bank of England had maintained the gold standard from 1717 to 1931, with time out during major wars. The threat to a monetary standard that guarantees the value of government debt is not the standard, but the viability of the government. In retrospect, the Lincoln Administration probably did not have to “go off gold” in 1862 in order to finance the war with greenbacks; if it held out until the Union army won a few battles, it could have financed the whole expense with bonds. Wesley Mitchell, a prominent academic economist early in this century, made this argument, and his influence may have helped persuade the U.S. government to preserve the gold standard throughout WWII -- enabling the colossal bond debt to be financed at 2%.
The 1944 Bretton Woods system maintained gold’s central role in the international monetary mechanism, but carried forward the flaw built into the Roosevelt mechanism -- which prohibited ordinary citizens from converting dollars into gold at the Treasury. The reason FDR did this was to prevent citizens from taking the surplus liquidity the Fed was trying to inject into the economy, by buying bonds, and coming to the Treasury to buy gold. The government wanted the public to spend the surplus liquidity instead of saving it in bonds or gold. All that was accomplished was that the public sold their gold to the Treasury for $35 an ounce and bought other bonds. The Depression actually deepened in 1937-38 as a result of the FDR tax increases.
The breakdown of the Bretton Woods gold standard was the result of several intellectual strands of thought running through American politics in the 1960s and 1970s, thoughts inconsistent with a gold standard. Because of the Crash of ’29 and the Depression, the demand-side economic theoreticians came forward -- Keynesians and monetarists -- with policy prescriptions that required manipulation of the monetary unit. Still and all, if Americans could have turned the surplus liquidity that resulted from these manipulations into gold at the Treasury department, the Keynesians and monetarists would have been foiled at the start, and it would have been impossible for the dollar gold price to rise from $35 in 1967 to as high as $850 in early 1980, and swing to and fro ever since. This is what Alexander Hamilton told Congress in 1791 -- that with a gold guarantee, government could not steal resources from the people by printing more money, because an extra dollar would immediately come back to the bank, either demanding gold or a bond paying an appropriate interest rate to compensate for risk. With a dollar as good as gold, the government would be forced to raise taxes if it wanted to get out of a problem it had either created or fallen into.
If the gold standard was so good, why was it abandoned? I hope the above review helps answer that question. The fact that we now do not have a gold standard for our national monetary unit is a source of financial volatility and economic distress around the world. The question our student poses is a key one in that it assumes a gold standard is optimal, but with what mechanism to make it work?
1. Flexibility. We know it has to have the kind of flexibility that only a government central bank can provide. The idea of dissolving the Federal Reserve system and throwing the economy into the briar patches of the 19th century is preposterous, and those monetarists or libertarians who seriously talk about it should not be taken seriously. History does misstep again and again in a trial and error process that moves civilization forward, but it did not misstep in centralizing national banking.
2. Optimum Price. The price of gold that is set as the national monetary unit is fairly critical. If it is set too low or too high, it will be subject to the angry political forces that are short-changed -- creditors if it is set too high, debtors if it is set too low. The price of gold is now at $282, its lowest price in 18 years, which means to me that if we were to fix at this level, the debtor class would soon find political venues to pull it apart. Because over the past decade the price has more or less fluctuated around $350, I can be confident that the political forces on either side will be content. By fixing the price at $350, those who want $400 will be unhappy about the price, but happier about being in a world without currency risk. Those who want $250 or $275 will be unhappy, but will be more certain that the debtor class will be able to pay its debts and not pull the system apart again.
3. It must be a SIGNAL. David Ricardo in 1823 said it best when he argued that money is working at the peak of efficiency when the central bank need hold no gold. By that he meant if the market totally believed the bank would not depart from the price commitment, the bank would not have to keep physical resources in reserve, but could lend them as well. Modern supply-siders, whether Mundellians or Lafferians (who have differences of opinion on the correct mechanisms of a gold standard), agree that the most important function of gold is as a signal. It is a price that is determined by all of humanity, in the sense that anyone can demand gold or supply gold, the same way anyone can demand or supply bread or cheese. A gold standard is democratic, while fiat money is elitist. When everyone can participate in setting the gold price by demanding and supplying in relation to the supply of dollars, it is more likely that mass will find the optimum price than if Alan Greenspan and his colleagues make decision behind closed doors.
4. Universal convertibility. Ordinary people everywhere must be able to convert the dollar into gold or gold into the dollar at the specified exchange rate. Where Alexander Hamilton only envisioned Americans being able to convert a surplus dollar into gold at Treasury or a national bank, we now must acknowledge the dollar is the dominant unit of account for the entire world. Under a fixed dollar/gold system, the mechanism has to recognize that anyone in the world can present a dollar for gold, and we have to supply it. Of course, if the central bank does its part in maintaining the supply and demand for liquidity by buying and selling government bonds, we could be sure nobody anywhere would prefer gold to a dollar as good as gold.