Last Friday’s Financial Times contained an article which suggested that the Republican Party is seriously thinking of returning the US to the gold standard, and that it will discuss this idea at the annual party convention in Tampa this week.
Many people will react to this radical idea by asking if the Republicans have learned anything at all from history. But do they actually have a point?
Surely anyone with a grasp of economic history knows that strict adherence to the gold standard, with the balanced budget mantra, at a time of asset price deflation in the early 1930s exacerbated the recession, which morphed into the Great Depression. But is the case as open and shut as that?
While the lessons of that era are reasonably well accepted, there are also those who will rightly point out that, whatever about the 1930s, anyone with a grasp of recent economic history can see that the massive quantitative easing of the past five years has had little or no effect, other than facilitating a massive increase in the US’s national debt.
This is the heart of the matter, and there are two legitimate sides to the argument.
On one side, you have Barack Obama and most moderate to slightly left-of-centre economists, led by Paul Krugman, who believe that the way to jolt the US economy back to life is with as much credit as possible. They contend that the economy is suffering from a liquidity trap, because the banks are not lending money.
Therefore, orthodox monetary policy, where you cut interest rates and the economy recovers on its own, can’t work.
This school of economics – to which I subscribe – sees the recession in the US as a balance-sheet recession, and believe those broken balance sheets are forcing the central banks into more unorthodox policies.
On the other side, you have those who believe that all this printing of money will lead to massive inflation in the US; that the bond market will collapse; and that the US will descend into hyper-inflation, driven by far too much paper money sloshing around the economy, which is the direct result of too much of it being printed in the first place.
By picking Paul Ryan (a budget hawk and admirer of Ayn Rand) as his running mate and paying homage to Ron Paul (an interesting thinker and a man who believes that the Federal Reserve is destroying the US by printing too much cash), Mitt Romney hopes to define the central debate of the US presidential election.
This debate will be over big government versus small government, and the gold standard is emerging as a central plank for the small government side.
The advocates of this side believe that linking the dollar in this way would prevent the government and the central bank from printing money to finance deficits.
This would stop the US budget deficit in its tracks and – they claim – put the US economy back on a solid footing.
How would it work? And what is meant by “returning to the gold standard”?
The gold standard was an exchange rate system that worked very well from 1860 to 1914. It tied all major currencies to gold. If gold reserves began to fall, the country would have to raise interest rates and deflate, with wages and prices falling in order to get gold flowing back into the country, attracted by the high real interest rates.
The currency parity was maintained, but the entire adjustment fell on workers’ wages. As long as workers’ wages were flexible downwards, a country that was experiencing an outflow of gold could rectify itself.
So if a country was experiencing a boom, and its people were buying imports, the amount of gold in the country’s reserves would fall. This would have to be replaced quickly by offering investors a higher interest rate. The higher interest rate would grind down wages, and the economy would deflate.
As long as inflation wasn’t too different between the countries, and workers had few rights, this all worked. But when the big powers went to war with each other, the central banks (to varying degrees) started printing money to pay for guns, and all countries came off the gold standard.
Then, after the First World War, inflation rates were massively different in many countries, so going back to old exchange rates meant huge deflation in countries. This obviously drove up unemployment.
After the crash of 1929 – triggered by an increase in US interest rates – all countries that wanted to stay on the gold standard had to deflate their own economies in the face of collapsing demand. Obviously, wages would only fall if trade unions (which had largely been absent in the period 1860-1914) allowed this to happen. However, they wouldn’t, as they wanted to maintain the wages of their members. The result was that unemployment rose rapidly.
As it went on, deflation fed on itself, while the policy of letting the banks go to the wall caused the amount of credit to fall further, reinforcing this.
Without the government stepping in and boosting demand, the countries of first Europe, then Latin America and then ultimately the US, contracted further. The gold standard, because it implied that you could only increase the money supply if you increased actual gold in the vaults, prevented any reflation.
Ultimately, all countries, when faced with deep recessions, abandoned the gold standard. The US, the last to ditch it, came off gold in 1933. Now Mitt Romney’s team want it to go back to gold, to force the Fed to stop printing money without a corresponding infusion of gold.
The implications of this would, I believe, be a massive recession in the US and massive deflation with it. The gold standard advocates dispute this, though. They say there is no bond crisis on the horizon, and point to the fact that bond yields have never been lower – indicative of a demand for US government paper.
In fact, with yields so low, the gold standards advocates claim that there is no value in US bonds, particularly if the Federal Reserve keeps printing more and more money to finance more and more government programmes.
This is not an academic debate, and it is not going away. For now, the ones in power are those who believe that reflation – via the government and the central bank, using fiat money or created money – is the logical way to go (because there is a balance sheet recession, a liquidity trap and the economy is still very weak). But that might not last.
The US presidential election looks set to pit two big ideologies against each other, and there can only be one winner.