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The Road to Monetary Stability

by David Beckworth

Money, Gold, and History, by Lewis E. Lehrman (Lehrman Institute, 251 pp., $9.95)

In 2013, the Federal Reserve celebrated its 100th anniversary. During that century, the U.S. economy was subjected to numerous boom-and-bust cycles, the sharpest economic contractions in its history, and one decade of record-high inflation. Since these developments occurred on the Federal Reserve’s watch, many observers conclude that the Federal Reserve is to blame. Lewis E. Lehrman, however, says: Not so fast. In his latest book, Lehrman argues that the culprit was not the central bank, but the gradual decline of the gold standard. The slow shift from the hard constraint of an international gold standard to a world of floating exchange rates is, in his view, the real source of the macroeconomic instability. This is not a new argument for Lehrman: He has been making this point since the 1970s, when the United States left the gold standard. This new book is a compilation of his work since then.

Lehrman argues that not only is the gold standard the best way to maintain monetary stability, but it was pivotal to the formation of modern civilization. He argues that the British and American industrial revolution could not have happened without it. Its widespread adoption, he holds, was crucial to the first wave of globalization in the latter half of the 19th century. It created an environment of price stability that facilitated trade and made it easier for firms and households to make long-run economic plans. This monetary system reached its pinnacle with the international gold standard of 1879–1913. World War I shattered it, and since then the international monetary system has been on a downward trend toward greater instability.

For Lehrman, the current system of floating exchange rates and reserve currencies is a serious malady, and the cure is the gold standard — which would impose fixed exchange rates on countries that adopted it. Lehrman likes this approach because, if followed properly, it has a natural equilibrating process. Imagine the U.S. and the U.K. on the gold standard: Dollars and pounds would both be defined in terms of a certain amount of gold. If the U.S. money supply grew too rapidly and pushed up U.S. prices, Americans would start buying more of the cheaper U.K. goods. This shift to U.K. goods would require buying more pounds, since U.K. goods are priced in pounds; this would involve converting dollars into gold and sending the gold to the U.K. for the pounds. The flow of gold from the U.S. to the U.K. would decrease the money supply and price level in the U.S. but increase them in the U.K. The excessive U.S. money growth, therefore, would be automatically corrected, and prices between the two countries would converge. This process is called the “price-specie flow mechanism.”

Lehrman does not see a similar adjusting mechanism in the current world of floating exchange rates and reserve currencies. Consequently, he wants the U.S. to call a major international conference that would establish gold convertibility for the major currencies. He even wants the U.S. to go it alone on the gold standard, if necessary.

So is Lehrman right? Is an international gold standard the correct path to improved monetary stability and increased global economic growth? I wish I could say yes and share Lehrman’s certainty. The reason I cannot is that the history of the gold standard, the reason it worked, and the world we live in all seem far more complicated to me than their portrayal in Money, Gold, and History.

Consider, first, the history of the gold standard. Though Lehrman claims that the gold standard is “the historic common currency of civilization” and the “proven guarantor of one hundred years of price stability,” the history of gold is much more nuanced. Silver actually was the dominant metallic standard for hundreds of years before gold. The main reason it was displaced by gold is not that gold was inherently better, but that important countries, including the U.K. and the U.S., introduced bimetallism — legally minting silver and gold into money — and did so at exchange rates that inadvertently led to the undervaluation of silver. This undervaluation eventually drove silver out of circulation as money. Gold became the money standard largely by accident.

In the U.S., bimetallism was introduced in 1792. Soon afterward, changing market prices led to an overvaluation of silver at the mint and a de facto silver standard that lasted until 1834. Congress then changed the mint ratio and, in an instant, gold became overvalued, and it would serve as the monetary standard from 1834 to 1861. This change was part of President Andrew Jackson’s famous war on the Second Bank of the United States, whose bills were backed by silver. There was nothing market-driven or natural about this switch from a silver standard to a gold standard. It was pure politics.

That gold was an accident of history is further evident in the contentious debate over a gold standard versus a bimetallic standard after the Civil War. Convertibility of dollars into metals had ended with the Civil War, and Congress had set 1879 as the year it would resume. Congress, however, failed to authorize the further coinage of silver. This meant that dollars would be convertible only into gold. Had silver still been coined at the mint, it would have become, by 1879, the de facto money standard, given market prices. This shift to gold irritated many, particularly those who thought gold was too deflationary; this was such a concern that it became the defining issue of the 1896 presidential election. Only with the Gold Standard Act of 1900 was the possibility of monetizing silver permanently put to rest. If gold was the “currency of civilization” for centuries, as Lehrman claims, why was its success an accident, and why has the U.S. money standard always been so contentious?

Lehrman also claims that politicians cannot manipulate a gold standard as they can fiat currency, because the gold supply depends on real-world gold production. But the above examples and others (such as the suspension of convertibility during the Civil War and FDR’s confiscation of gold in 1933) clearly show that even the gold standard is susceptible to manipulation.

That the U.S. gold standard was an accident of history and that its longest unchallenged, continuous run was only a quarter of a century suggests the question: Was it the gold standard, per se, that created the long-run price stability of the 18th and 19th centuries, or was it a deeper political and institutional commitment to price stability? Lehrman attributes the price stability to the price-specie flow mechanism, but the mechanism’s success was dependent on the commitment of the government to allow the gold standard to work.

The same is true for the current international monetary system. Though Lehrman sees it as fundamentally flawed, it too has an adjustment mechanism that can work reasonably well if managed properly. While the gold standard kept exchange rates fixed and forced adjustment through changes in the price level, the current system allows the exchange rates to bear most of the adjustment. That adjustment, if allowed to work (in conjunction with a central bank’s aiming at price stability), should not be any more destabilizing than the gold standard.

If anything, one could argue that the current international monetary system could be more stabilizing, since it forces the adjustment on one price — the exchange rate — rather than on thousands of prices, as is the case with the gold standard. The euro-zone crisis offers a good example of how this might work. The euro-zone effectively sets up fixed exchange rates among countries in the currency union. While they have deep structural problems, the severe business cycle they are now experiencing is being worked out by painful deflation in the periphery countries. An alternative approach would be to abandon the euro, adopt domestic currencies, and let their exchange rates bear some of the adjustment.

The key point is that both fixed- and floating-exchange-rate regimes have adjustment mechanisms that work if used correctly. The interesting question, then, is: Why have these mechanisms not worked properly over the past century?

The answer, in my view, is that governments have become increasingly concerned with stabilizing their domestic economies and, consequently, more interventionist in monetary matters. The breakdown of the inter-war gold exchange standard, the end of the Bretton Woods system, and the high inflation of the 1970s were all the result of U.S. officials’ attempting — and failing — to manage the business cycle. Prior to this era, there was less concern about swings in economic activity, and the sometimes painful discipline of the gold standard could therefore be tolerated.

Barry Eichengreen, in his 1992 book Golden Fetters, argued that indifference to the business cycle began to wane in the 20th century because people started demanding more from their elected officials. This meant more government intervention in the economy, and therefore an increase in monetary instability. The gradual abandonment of the gold standard over the 20th century was a symptom of these developments, not their cause.

There is no turning back the clock on this changed political dynamic — and that’s why it’s unlikely that any country will ever go back to the gold standard. Moreover, there is a better path to restoring monetary stability. As Lehrman notes, the key to restoring stability is to create an environment where money supply equals money demand. The supply of money is created mostly by banks and other financial firms. The demand for money is shaped by the needs of households and firms. Both are difficult to measure and individually beyond the direct control of the Federal Reserve. The product of the two, however, can be meaningfully influenced by the central bank. It is called total dollar spending, and its stabilization should be the objective of monetary policy.

The Federal Reserve can do this by managing expectations of future total-dollar-spending growth. Here’s how: The Federal Reserve credibly commits to doing whatever it takes to keep total dollar spending growing at a constant rate over time. The public would come to understand that, if total dollar spending went above or below this target growth rate, the Fed would correct it. This belief would become a self-fulfilling expectation, requiring minimal action by the central bank.

The key issue is whether there will ever be enough political support to adopt a monetary regime such as this. Though the history of the 20th century does not offer much hope, Federal Reserve chairman Paul Volcker showed us that it is not impossible for policymakers to make tough choices. My hope is that, one day, all policymakers will come to see the importance of monetary stability. Implementing a total-dollar-spending target for the Federal Reserve would be a great start.

– Mr. Beckworth, formerly an economist with the U.S. Department of the Treasury, is an assistant professor of economics at Western Kentucky University and the editor of Boom and Bust Banking: The Causes and Cures of the Great Recession.

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