Right Reason

Forbes on the Gold Standard

Over at Forbes, the eponymous editor-in-chief has recently provided the second most convincing argument for the gold standard:

In order to work properly and productively markets need a reliable pricing mechanism. By manipulating interest rates on such an unprecedented scale the Federal Reserve has effectively destroyed the ability of our credit markets to genuinely price the borrowing and lending of money. Does anyone really believe a 10-year Treasury should yield little more than 1.5% or a 30-year government bond just under 3%?

This point is critical: The Fed’s forced suppression of organic interest rates has made the pricing of credit impossible to figure. And guess what? If you can’t determine the real prices of products and services, you get less–or none–of them. It’s Soviet-style economics.

Say we had market-determined interest rates again. Banks might then have to pay 3% or more on your deposits. Unable to get virtually free money, banks would more actively seek customers for loans. And regulators, who in their current bout of unreasonableness have also suppressed lending impulses, would be more vigorously resisted.

A problem with how Mr. Forbes phrases the argument is his focus on the rate of interest payed to deposit accounts. How much the Fed actually affects the rate of interest that banks in the market pay on deposits is an easier question to ask than answer. A handy, though slightly dated guide to this issue has been published by the St. Louis Federal Reserve here. However, with the Bernank throwing everything he's got to get spending back up, I would expect that the effect of the market rate of interest on deposits has been higher than normal. Still, Mr. Forbes should have focused more on the market for Treasuries rather than wandering off on a point that is far more questionable.

 

This brings me to the best argument for the Gold Standard. The best argument is that would prevent the money supply from being manipulated in order to provide perverse incentives to the government. What do I mean by this? An example would be best: Just last yeas, as a part of Operation Twist, the Federal Reserve bought 61% of the United States debt, and as such have been subsidizing the massive deficit that the United States has been running (an article from the Wall Street Journal on the issue is here). In Europe the ECB now intends to directly buy sovereign bonds in order to indirectly bail-out the countries teetering on the edge of crisis. These policies directly provide incentives for governments to continue to live beyond their means and to continue to pile up debt for other people to deal with. If we want a constitutional arrangement that provides incentives for governments to guard the public purse and the soundness of their balance sheets, then there must be an institutional arrangement that prevents actions like these in the economy. By limiting the amount of money in existence and limiting the extent of central bank's actions by the amount of gold held in reserve, a gold standard would help provide that institutional arrangement.

 

Of course, all of these arguments for the gold standard assume that central banks will actually obey the rules of the gold standard, which they did not after 1929, as Milton Friedman and Anna Schartz note in The Great Contraction:

The international effects (of the rise in the U.S. gold stock in the two years after the 1929 crash) were severe and the transmission rapid, not only because the gold-exchange standard has rendered the international financial markets more vulnerable to disturbances, but because the United States did not follow gold-standard rules. We did not permit the inflow of gold to expand the U.S. Monetary stock. We not only sterilized it, we went mcuh further. Our money stock moved perversely, going down as the gold stock went up. In August 1929, our money stock was 10.6 times our gold stock; by August 1931, it was 8.3 times the gold stock. (Friedman and Schwarz, pg. 109)

When the costs of not obeying the rules are negligible, then they will not be obeyed. Just as Greece, Spain, Portugal and Italy continued to run massive deficits despite being obligated by the rules of the Euro not to, we ought to expect governments to do the same. And then when crisis approaches and the rules seem to determine that events must go that way, politicians and central bankers will simply get rid of the rules. Worked for them in 1931, 1971, and in 2010, so why expect events to go differently in the future? Promises to do better?

Words are wind. When betting on either incentives that tempt or promises that hold true, my bet will be on the former. So, even though I do believe that it is a good thing that the gold standard is in the news if for no other reason it provides a foil for our current system, I do not think that the gold standard will accomplish what its advocates desire.

That is why I would much prefer we do away with the government's monopoly over money and let the free decisions of individuals decide the dominant currency (just as the free market decided on gold rather than silver being the dominant currency in the 18th century).

Monetary Policy: A Matter of Institutions

Will the Federal Reserve, or any Western central bank for that matter, be able to provide monetary stimulus to the economy? No, for a reason why, look to the recent post from Professor John Crochrane's blog, “The Grumpy Economist”:

The deep, intractable problem with this idea is commitment. This occupies the bulk of Mike's analysis, but I don't think he, or others advocating these policies, successfully solves it.

Every day I promise that tomorrow I'm not going to have dessert. Every tomorrow I change my mind. Because I can. Tomorrow, if inflation breaks out, the Fed will want to raise rates sharply.

How can the Fed promise today to do something it will very much regret tomorrow, and get people to believe that promise?  More deeply, how does the Fed commit to allowing "just a bit" of inflation in the future, and not starting down the path of the 1970s again?

Simply put, no informed person will actually believe that a central bank would be willing to actually grab the inflation tiger by the tail and risk another '70s scenario.

Central banks may roar as loud as they can, they can do all of the open-mouth operations they want and announce that they are willing to see some mild inflation to get spending back up to the historical NGDP baseline. However, no one will, or should for that matter, listen. After all, no central bank within the Occident would now be willing to commit to taking on the great political costs such a policy would have and without commitment those words are little more than exhaled breath.

If central banks want to get more spending, expectations are what matter. For monetary stimulus to work, they have to convince all of the companies and banks now sitting on cash that they have better start spending it if they don't want to see a good portion of the assets of their balance sheets. The point shouldn't be to blind-side the economy with a flood of new money and money-substitutes, but to gently prod savers into spending their held assets. However, if the central bank wanted to create expectations of inflation, open-mouth operations would not be enough, it would have to prove its mettle first. That exercise of power would almost necessitate unleashing unexpected inflation. 

Turning back to why those open-mouth operations are so impotent, the reason has to do with the institutional evolution especially over the past half decade, though certainly acting on previous precedents, of central banks involving themselves more and more with politics outside of the regulation of the rate of interest and monetary aggregates. What we see today are central banks that are becoming more and more institutions that are an active part of their respective government's economic policies. Take two examples: the Federal Reserve and the European Central Bank. After the Dodd-Frank Act, the Federal Reserve Chairman now sits on a regulatory council, the Financial Stability Oversight Council, (the loss of independence was implicitly accepted by the bill when it included a partial audit of the Fed). This was after the sitting Chairman overstep his explicit authority by bailing out companies and even urging on the Federal government to pass TARP. This, though, doesn't come close to matching the statecraft that is now being practiced by the decision-makers within the ECB who are using all tools within their disposal in order to salvage the European Union.

When central banks are so tied to the political workings of their nations, as the Fed and the ECB are now, they are vulnerable to shifts in public opinion. The very same shifts that unexpected inflation would doubtlessly cause. Those shifts of public opinion would effect not only the means that the central banks have adopted, but also the ends that they now strive after. Why would the Federal Reserve risk its future ability to pursue polices independent of Congress by stirring up more anti-Fed sentiment within the United States. Why would the ECB risk their attempts to help the EU survive the ongoing Euro Crisis by the undermining the current German government and reinforcing anti-EU sentiment within nations like Finland, the Netherlands, and the UK already teetering on leaving the Eurozone?

Yes, one could argue that they do so by betraying any hope of swift economic recovery, but I still find it hard to believe it is still not in their long-term interest to follow those strategies. And when it is within their interest to do so, open-mouth policies will not provide any monetary stimulus for they would not be willing to shoulder the costs of following through with those announcements.