There are some pretty crazy ideas floating around in the lead up to the G20 meetings. World Bank President Zoellick has proposed a return to gold, while Tim Geithner is suggesting that current account deficits/surpluses be restricted to +/- 4 percent. The Chinese have suggested that these policies are too communist even for them! Zoellick’s precise words were that “consideration should be given to employing gold as an international reference for market expectations regarding inflation, deflation and future currency values”. This is pretty vague, but the basic workings of a gold standard system are pretty straightforward. My 500 word version in the AFR today is below…[DDET Read more]
In recent days World Bank President Robert Zoellick has written that gold should form the basis of the international monetary system, suggesting a possible return to an international gold standard system.
Under a gold standard issuance of notes by central banks is limited by holdings of gold. So if central banks are acquiring gold they are able to issue more notes, while if they are losing gold they have to contract the note issue. Gold is hard to find, so growth in the note issue tends to be low and so does inflation. The biggest sustained increase in supplies of gold occurred during the sixteenth century, when gold holdings in Europe increased dramatically after Spain discovered South America. But even then, inflation averaged only 1 percent during that century.
A gold standard system rules out active monetary policy. Quantitative easing, such as is occurring in the United States, is not possible under a gold standard. But more generally since the money supply is determined by a country’s supply of gold, interest rates will also be determined by gold flows, rather than central bank discretion.
Internationally a gold standard system forces countries to balance their international accounts. A country that cannot finance a current account deficit with sufficient inflows of foreign capital will automatically give up gold to its trading partners. The result will be a tightening of monetary policy. This should lead to falling prices and improved competitiveness, ultimately bringing the international accounts back into balance.
In a country such as China, which is currently acquiring US dollar reserves, the gold standard system would lead to an inflow of gold. According to the normal rules of a gold standard system, this would lead to increases in the money supply and inflation in China, a loss of competitiveness and eventually a rebalancing of trade.
The problem with the gold standard system is that we have found much better ways to control inflation and international accounts. The RBA has been very successful in keeping inflation in the 2-3 percent target band since this target was introduced in the early 1990s. A gold standard would force inflation to be too low, and run the risk that deflation would occur at precisely the wrong time. This is what occurred during the Great Depression, and explains why most countries abandoned the gold standard at that time.
As for the international rebalancing, a gold standard system keeps exchange rates fixed, so that adjustment comes slowly through the mechanism described above. But it is much quicker to have exchange rates adjust to effect changes in competitiveness.
Apart from the theoretical arguments against a gold standard the practical problems are significant. Most central banks have sold most of their gold holdings, and even in those that have not holdings of gold are nowhere near sufficient to back the note issue. A gold standard would be great for Australia’s gold producers, but would be of little use to the rest of us. [/DDET]