Before it was unfairly blamed for causing the Great Depression, genocide, and world war, the gold standard was considered not only respectable but moral, according to informed opinion. These days, informed analysts seem to agree with much of the substance of the classical gold standard, but they prefer to talk about it in starkly different ways. Perhaps we should take their arguments to their logical conclusions.
Consider the euro.
Members of the single currency are forced to issue obligations in a currency none of them can print. They made the choice to sacrifice their monetary sovereignty in exchange for lower costs of trade and greater cross-border financial flows. For the many members hoping to piggyback off Germany’s postwar record of stability, joining the euro would also mean eliminating the risk premiums associated with excessive inflation and devaluation. These were the same arguments that were made about the virtues of the gold standard in the 19th century.
Ultimately, it was hoped, abandoning the peseta/lira/etc for the euro would promote integration with the wealthy northern core and convergence to higher living standards. (As it turns out, convergence was much more successful among the central and eastern European countries that didn’t join the euro.)
The risk of the strategy was that Spain/Italy/etc, by losing monetary sovereignty, would be vulnerable to the kinds of crises that had afflicted many poorer countries in the 1980s and 1990s. Euro area countries that grew accustomed to net inflows of capital would have to rely on debt restructuring and wage cuts if the financial account ever reversed.
Actually, euro area countries were more vulnerable than traditional EM crisis countries, because places such as Argentina and Korea at least had the option of breaking their pegs to the dollar and printing money to support their banks. Similarly, countries bound by the gold standard always had the option of de-linking and re-pegging. There is no comparably straightforward way to exit the strictures of the euro.
So were the advertised benefits of joining the euro — which never materialised — worth that risk?
Recent experience might make you think the answer is obviously no.
But as my colleague Martin Sandbu has repeatedly and elegantly argued, countries possess lots of policy flexibility even without monetary sovereignty. The problem for Europe, in his view, is that governments failed to make the most of the tools they had. As he wrote earlier this week:
The funding crisis that ensues for deficit-dependent governments was a key ingredient in the euro crisis, as was the concomitant tight or shrinking money and credit supply for the private sector. Minimising this risk with a fixed currency requires avoiding excessive debt finance.
As Guntram Wolff has shown, Bulgaria (with its currency pegged to the euro) relied more on foreign finance than Greece before the crisis, but came through in much better shape. One reason is that its capital inflows came in the form of direct investments (in factories and other productive capital) rather than debt, which could not be “called back”.
The same virtue belongs to equity finance, or even debt in the presence of effective frameworks and policies for restructuring in a crisis. Similarly, a restructuring-friendly policy framework for banks can help end the credit crunch involved in a financial crisis.
Substituting debt for equity allows asset prices to float even when exchange rates can’t. It also lets issuers reprice their obligations without needing to default. Even debt, which is often criticised for its rigidity, can be made more flexible, as Sandbu notes, with defaults and write-downs.
Meanwhile, the impact of currency depreciation can be replicated with wage cuts. That’s normally painful because cutting wages usually raises debt burdens. But if you’ve already replaced most debt financing with equity financing and made it easy to restructure bad debts, the drop in constant-currency wages can be offset with reduced obligations. Governments could also cut labour costs, as Sandbu has previously noted, by lowering income taxes and raising consumption taxes.
So it’s possible for governments to affect domestic financial conditions — replicating many of the benefits of monetary sovereignty — even if they no longer have their own money or central bank. All that’s needed is a sound financial system and extremely counter-cyclical fiscal policy.
At the same time, it’s important to remember that even countries with their own floating currencies and central banks are still vulnerable to global forces. Trying to tighten financial conditions by raising interest rates and letting the currency appreciate can end up encouraging locals to borrow in (temporarily) depreciating foreign currencies with lower interest rates. Not only do you end up with the debt boom you were trying to avoid, the debt is far more dangerous because it’s denominated in foreign money.
Similarly, the benefits of a floating currency on the trade balance may be overrated, especially for smaller economies integrated into global supply chains. Sandbu has even argued that fixed exchange rates boost productivity by wiping out businesses that benefit from devaluation, leaving only the best firms to survive. From this perspective, it makes sense for most countries that trade a lot with the euro area (including the UK!) to join the single currency.
The question is why these arguments don’t justify linking all the world’s major economies together into a single unified monetary system.
Instead of isolating the Europeans in their own bloc, Americans in the dollar zone, Chinese on the yuan, Japanese in yen, etc, why not put everyone onto the same common standard? And if there is going to be common standard, what better one to use than gold?
Replacing existing fiat money systems with a new currency managed by a World Central Bank would be politically challenging, if not impossible. What would the WCB target? Where would it be located? How could it set policy for the world when standards of data collection and definitions of things as basic as “unemployment” vary even across similar countries? Gold gets around all these problems because it is a lifeless shiny rock, rather than an institution designed and managed by people.
Getting interested countries to link their currencies to gold and maintain full convertibility would be difficult, but at least there is a precedent for it. Moreover, the expectations for countries keen on joining the standard wouldn’t be any more onerous than for countries interested in prospering within the euro area.
Consider that countries that anchored their monetary systems to gold in the time before World War I were expected to:
- Limit their spending
- Regulate their financial sector (or, in America’s case, tolerate regular banking panics)
- Allow prices and wages to move up and down, and
- Have robust mechanisms for restructuring bad debts
There were many benefits to joining the gold standard.
Countries in need of foreign capital had an easier time persuading investors to commit resources because it reduced the risk of inflation. World trade was overwhelmingly denominated in currencies backed by gold, so linking your currency to the international standard lowered the costs of transactions and boosted exports.
Gold was also valued as a constraint against excessive government spending, which meant it was an instrument of world peace and a bulwark against socialism. That’s one reason why the World War I belligerents abandoned gold to support their total war efforts. It’s also one reason why the return to gold in the early 1920s undid much of the gains made by labour movements during the War, as Adam Tooze masterfully explained. (Similarly, the military buildups in Japan and Germany in the 1930s wouldn’t have been possible had they not previously abandoned gold convertibility.)
Japan did particularly well from adopting gold in 1897, despite concerns from its business leaders that the inflexibility of the new currency regime would hit international competitiveness. Joining gold helped the Japanese government finance its 1904-5 war against Russia by borrowing relatively cheaply from American and British creditors.
Perhaps even more important, the majority of Japan’s trade was with the West, which was linked to gold, rather than with China and Korea, which were linked to silver, as Japan was before the monetary reforms. Increased transaction costs with its neighbours were more than offset with lower costs of trade with America and Europe. (And after a few years, Japan annexed Korea…)
As an American observer noted back in 1897:
If the gains of Japan are to be ascribed to silver, then why has not China prospered equally well on her silver standard? Indeed one is likely, in the plurality of causes operating upon a country’s general progress, to err, if the awakening commercial energy and intelligence be overlooked, and if emphasis be put solely upon such a matter as the media of exchange. If Japan can successfully compete with other nations by reason of a low cost of production, that fact will not be changed by using either silver or gold as a medium of exchange.
Scholars back then thought the exchange rate was only one influence on the trade balance, and probably a lot less important than other factors. This old-timey reasoning about gold sounds a lot like modern thinking about exchange rates.
The common argument against gold is that its supply is determined by nature. The total amount in existence does grow over time, but slowly and at unpredictable rates. Roughly, if the gold supply grows more slowly than the productive capacity of the global economy, you get deflation, and if the gold supply grows faster than the economy’s ability to produce, you get inflation. Basing your monetary system on gold therefore exposes you to a lot of unnecessary randomness. An inflation target, or a nominal output target, or any other target, in this view, would be better than gold.
This is fair, but it doesn’t actually imply gold would be worse for any European country, for example, than the euro. After all, Spain only represents about a tenth of the euro area’s economic output. Even Germany is less than 30 per cent of the bloc. So unless conditions are remarkably synchronised across the continent, there will be long periods when conditions set on the basis of the euro area average will be wildly inappropriate for individual countries, possibly every country.
For example, it wasn’t Spain’s fault that Germany was hit particularly badly by the tech bust and the end of the boom associated with spending on reunification. Nor would it be fair to blame the European Central Bank for responding to that bust with a monetary policy too tight for Germany and far too loose for Spain. The net effect, however, was a massive and unnecessary stimulus to credit conditions in a country that was already booming in the 2000s.
Similarly, it wasn’t Spain’s fault that many of the same Dutch and German investors that had loaded up on American subprime mortgage bonds had also gobbled up Spanish bank bonds, and decided to sell both at the same time. Even so, it meant that Spain was faced with a massive and unnecessary tightening of financial conditions at the same time the ECB was raising interest rates.
These shocks were extremely inconvenient for Spain, possibly worse than what Spain might have experienced under a gold standard. Writing in 1999 — before the global financial crisis — Christina Romer found that “real macroeconomic indicators have not become dramatically more stable between the pre-World War I and post-World War II eras, and recessions have become only slightly less severe”.
More importantly, if you believe the Spanish government had all the tools it needed to offset the massive swings in capital flows and credit conditions it actually experienced despite lacking its own currency and central bank, why would it matter if the random shocks came from German savers or gold mines? And if European countries can be expected to sacrifice their monetary independence to boost trade, promote cross-border investment, and (maybe) stabilise domestic inflation, why not expect the same of the rest of the world?
To be fair, there are some differences between the euro area and a restored classical gold standard. The ECB has the ability, even if it lacks the will, to stabilise credit spreads by committing to buy unlimited amounts of sovereign bonds in countries suffering from capital flight. It can lend theoretically unlimited amounts to troubled banks to replace frightened depositors as long as regulators convince themselves the banks are solvent. And the Target2 system is a lot simpler than shipping tonnes of gold across borders to settle payments.
On the other hand, the ECB’s willingness to intervene in markets and provide emergency lending seems highly contingent on political circumstances and the leadership of the ECB at any point in time. Mario Draghi may have saved the euro, but Jean-Claude Trichet nearly broke it. Who knows what future ECB presidents might do?
Besides, if you really believe that you can replicate the benefits of monetary sovereignty by writing down debt, regulating well, and aggressively adjusting the government’s budget, you don’t need your banks to have access to emergency lending and you don’t need to be included in a bond-buying programme. Simply wind down banks that run into liquidity trouble and default on debts you can’t pay. It might hurt at first but, presumably, people will get used to it and eventually be grateful for the longer-term benefits once (if?) they materialise. Gold or euro, it makes no difference.
So, for those who believe the euro was a good idea at the time and remains a good idea for prospective members, why would you oppose restoring the classical gold standard? Why should the benefits of integration and price stability be limited to Europe?
The euro was pointless — FT Alphaville
Economists agree: deflation is either good, or bad, or irrelevant — FT Alphaville
Explaining the pain in Spain — FT Alphaville