Returning to gold

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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]

8 Responses to "Returning to gold"
  1. Mark, you are contradicting yourself.

    You were some time back advocating austerity policies because they would prove expansionary to the economy.

    We find now in chapter 3 of the latest outlook they do not.
    Quite the opposite in fact.
    No Mea Culpa though!

    If you remain firm in your strange beliefs then the Gold Standard would enable austerity poicies par excellence

  2. KB you’re a bit confused. A gold standard does not imply contractionary fiscal policy. It implies RANDOM monetary policy. Random policy is rarely good. Random in the sense that the money supply and interest rates will be determined largely by discoveries of gold. As far as fiscal policy goes, a gold standard when it is adhered to implies that governments cannot monetise debts. So deficits and debt have to be financed by bond issuance. The problem with the gold standard leading up to the depression was that policies in some countries to acquire gold led to a reduction in money supplies and tight monetary policy right through the late 1920s and early 1930s. Money, trade protection AND fiscal policy played a role at the start of the depression, and bank failures in the US lengthened it. Australia during the depression that had serious public debt problems. Keynes arguments might have been applicable to the US and UK, in that they could afford to loosen fiscal policy, but Australia was in a similar position to the US or UK today – we just couldn’t afford to spend our way out of trouble. We could  default, as the NSW Premier urged, but issuing further debt when debt was heading well over 100% of GDP was not likely to have worked.
    KB just maybe the great Keynes was not always the answer. Sometimes fiscal policy works, sometimes not. You are a slave to a defunct economist.

  3. We never had the opportunity to delve into the gold standard topic in class but I’ve long wondered why there is such an emphasis on gold (although I think I might have just worked it out). What I mean is why not oil?
    After all, wouldn’t oil be of greater true value than that shiny stuff that goes into jewellery and electronics?
     
     

  4. Good question. There is no reason whatsoever. Why not bananas? Well they have a bit of a problem with longevity. There was a tobacco standard in some US colonies, but that runs the risk of fires. Silver works pretty well…in the end people will always search for a “pure” source of value, but unfortunately there really is little such thing. The real source of value is whatever people think is valuable… whatever that might be. Land…maybe. Gold, why not. Stone rings… sounds good. In the end, put your faith in whatever everyone else is about to put their faith in, and I’m afraid that’s as good as it gets.

  5. I am afraid Peter Temin and Barry eichengreen disagree with you in terms of whether a gold Standard exacerbates contractionary policies.

    no country started to expand until they got off the Gold Standard.

    interest rates were raised because of the need to be seen to remaining on the gold Standard. Simply a variation of the bond vigilantes.

    Well we know when fiscal policy works from the IMF and I am afraid it is at severe odds with your strange theories.

    • ? KB are you reading what I wrote. I say exactly what Temin and Eichengreen say. Policy was contractionary from late 1920s on, which was not desirable. I’m not that interested in revisiting the debate over whether fiscal policy will work in highly indebted countries right now. I had my say on this and the simple Keynesians have their simple views, I prefer to take a more case by case approach. It looks like we’ll have some good evidence on this. Ireland may default (which is probably sensible), the US will continue to spend and head towards default, while the UK will tighten…plus other countries in between. But not much point writing if you’re not reading it, and not sure why you’re writing if you’re not thinking beforehand.

  6. Mark, the problem of the gold Standard was the increase in interest rates to ‘protect’ the standard. interest rates fall everywhere after each Country left the gold Standard The evidence is in. Chapter 3 of the latest world Bank report has all the evidence you need and it doesn’t support your simple theory at all. Indeed there never was evidence in the first place only a theory which we know doesn’t work. Keynes proved correct again.

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