Philadelphia Reflections

Gold Standard Substitutes

Bretton Woods conference in 1944

Make-shift proposals to address international monetary crises after 2007, particularly confiscation of bank deposits suggested briefly in 2013 for the Mediterranean island of Cyprus, stimulated a search for a better monetary system. A gold standard sufficed for thousands of years, but the Industrial Revolution increased world economies faster than gold metal was discovered, constantly driving prices downward. It became increasingly difficult to manage the rapid growth of debt, as happens in wartime. The crisis which led to the 1944 Bretton Woods Conference was the inability to accommodate the massive national debt rearrangements of the Second World War. With the United States owning two-thirds of the world gold supply, international trade was seriously impaired.

Bretton Woods created the International Monetary Fund and the World Bank, which can be ignored for present purposes. It established the United States dollar as a "reserve currency", alone able to be exchanged for gold. Other nations were allowed to exchange their money for United States dollars. Supplemented at the Bretton Woods conference in 1944 by this gold-standard-once-removed (the U.S. dollar as a "reserve currency"), this expedient only prospered as long as the United States could maintain a positive trade balance. After 1960, the outflow of gold from Fort Knox was relentless, and in 1971 the United States was forced to abandon its buffering between gold and the world's banking systems. After 1971 the world's currencies would supposedly trust their central banks to be "lenders of last resort", but in the financial crises after 2007 many could not sustain that obligation. What they could do was devalue their currency, and even that expedient was blocked by the rules of the eurozone. Put to the test, the European Central Bank became uncertain it wanted the role of lender of last resort. At one time, the gold standard had provided the one backing for a currency which was independent of all governments' temptation to inflate away their debts. The U.S. reserve-currency buffer extended the system for several more decades, but after President Nixon cut the link to gold, the post-1971 system only provided a promise of a government rescue, without the universal ability of governments to live up to the promise. In a sense, governments backed their currency with a mortgage on the nation, and many mortgages were already overextended. For those nations, variants of the gold standard had been replaced by no standard at all. Since governments which had historically been the cause of inflation were now expected to be the source of its restraint, the private sector urgently needed to devise a new system to force the public sector to accept a new and unwelcome role.

Money on a gold standard was formerly both a storehouse of value and a means of exchange. The world supply of gold was unable to keep pace with the world's increasing wealth for more than a century, so prices were driven down, disrupting long term debts. Rising prices were just as bad; what commerce needed was price stability. What was devised for the 1971 disruption was inflation targeting. The Federal Reserve and to some extent the other major central banks, issued or withdrew currency to achieve a 2% inflation rate, thus hoping to maintain stable prices with a 2% growth rate. Skipping over the details of central banking, the Federal Reserve could safely count on the government to promote inflation at almost all times; the need was to restrain it to 2%. Unfortunately, contraction at 2% takes about as long as expansion at 2%, frustrating the hope of the public to have booms last as long as possible and depressions to be over as soon as possible. Periodic episodes of deflation are a problem. From time to time the economy expands its production capacity faster than consumption can grow, and the inevitable resulting panic not only impairs the ability of banks to lend but frightens the public away from borrowing. Without a gold standard, prices then fall even farther and faster than with gold support because money no longer has any intrinsic value. Our problem thus reduces itself to two requirements.

Without a gold or other monetary standard, and seeking to preserve the inflation-targeting system, how can we induce prices not to fall in a depression? And, how can we induce a booming economy not to increase its production capacity beyond what it can consume or sell, so that every boom period stops being followed by an uncontrollable crash? That is, much of the problem of keeping production from falling, is to prevent it from going so high it has to fall. That's not so easy in a democracy; if you stand in the way of making money when making money is easy, you will very likely be voted out of office. Price controls, by the way, have been tried many times; they always fail. The practical problem is thus pressed into the mode of forcing savings into some sort of escrow fund, during boom times. Meanwhile, the practical politician must persuade a suffering public that, once you overbuild capacity, it will probably only wear out at the same 2% rate that it took to grow so big. These are not new sentiments; the public must learn self-restraint during booms, something it has repeatedly resisted.

Fort Knox, KY

Features particularly irritating to the private sector about the Cyprus proposal had several sources, all of them heightened by annoyance that the bureaucracy would immediately try to force the private sector to pay for administrative design blunders. A gold standard permits international trade in defiance of government wishes; a currency without a physical store of value cannot exist without workable rules for international trade. If satisfactory rules cannot be made, voices will demand a return to the gold standard. No one said the Greeks and the Turks should love each other; no one said the Russians must respect private property. What is stated is if workable rules are not forthcoming, private alternatives will arise.

Ben Bernanke is not only the chairman of the U.S. Federal Reserve, but he is also one of the recognized academic experts on managing depression. He has spent his life studying this particular problem and occupies the most powerful position among the group charged with doing something about it. His innovation in the management of a financial crash is QE, quantitative easing. Essentially, this amounts to the creation of a fund managed by the Federal Reserve, generated by purchasing bonds with money created by the Fed. The content, size, and purpose of the fund have varied in the past few years, to the point where it amounts to a gigantic fund at his disposal, as needed, Initially, it injected funds into markets frozen with fear, and successfully unfroze them, making a profit for the Treasury along the way. He next used the fund to manage a gigantic Keynesian effort to stimulate the private economy with a federal fund. While it is possible this stimulus averted some worse disasters, the net effect was not outstanding and is generally regarded as a failure. His current effort, titled QE3, amounts to an enormous effort at what is termed "good bank, bad bank" in financial jargon. Because so many good bonds are undervalued in a recession, it is believed they will return to true market value if the truly bad bonds are removed from the market place. In Victorian days, this was accomplished by bankruptcy, but it is thought to be more humane to buy up and remove them temporarily from the marketplace. The humane approach, of course, has the disadvantage that the bad bonds may reappear later, and some critics say it is only a variant of "kicking the can down the road." It seems to have worked well for the Scandinavians however, and the final verdict cannot yet be issued. For the purposes of the present discussion, the essential point is that a three-trillion dollar discretionary fund has been put in the hands of the most powerful and most knowledgable person involved in international finance. At the moment, the fund contains most of the dubious bonds in circulation, but there are signs that Bernanke plans to replace them with U.S. Treasury bonds, thought to be the safest investment available. He can essentially do anything he pleases with this fund, subject only to the approval of the rest of the Board.

It must have occurred to Bernanke, that this multi-trillion dollar fund of the safest investments on earth would make a highly suitable substitute for gold, if it ever becomes clear that the world needs to return to some tangible commodity to back its currency, or become the new lender of last resort, if we choose to put it that way. Mr. Bernanke essentially needs no one's permission to create this fund, but to use it in some novel way would require the permission of politicians, acting in some way identifiable as the will of the American public. If it should come to that, a few suggested limitations immediately come to mind.

In the first place, one of the main purposes of imposing a gold standard on spendthrift Kings was to keep the King from spending it and substituting his own worthless paper money. Three variants of this threat, inflation, devaluation and confiscation, all amount to the same thing, which would get us back to our present predicament quite quickly, indeed. Mr. Bernanke must realize that our Constitution was written by Founding Fathers who were intensely fearful of entrusting as much power to one person as Mr. Bernanke would likely possess if this idea moved to implementation. To put it bluntly, the first action after it is done should be to surrender the ability to do it. To take another lesson from Constitutional history, it might be remembered that the functions of the Legislative Branch were established in six months, those of the Presidency evolved in the first five years of George Washington's office, and those of the Supreme Court required forty years to evolve. During all of that time, the ability to destroy the Constitution's main purposes had to be shielded from unbelievers, and an apparently unnecessary Bill of Rights had to be appended to reassure the remaining doubters. The main risk to this technical monetary reconfiguration is not monetary, but political.

Financial Crisis

But there are technical issues, as well. Because they are technical, it is more difficult to depend on wise public opinion, and thus it enhances feasibility when technical issues can be translated into political speech. Because events have demonstrated it is much more difficult to reverse a depression than a bubble, thought should be given to devising ways to use this new vehicle to reverse depression. Obviously, it should be used to unfreeze a frozen market; that's an important lesson from the success of 2009. Furthermore, the revenue from three trillion dollars of bonds is appreciable and should be used to finance tax reductions in a recession. More importantly, it should be withheld from government treasuries to restrain a developing bubble, more or less forcing governments to raise taxes during a bubble. Perhaps standards are necessary for expansion and contraction of the fund itself to supplement the use of the fund's income in those extreme situations. Indeed, to forbid the use of principal for those end-purposes might leverage the effectiveness of changing the fund balance, because it would force larger swings of principal to be adjusted. Most of these considerations come into play when a bubble is being restrained because it is easier to restrain a growing bubble than to repair the damage once it bursts. Restraining a growing bubble is not easy, and picking the right time is still less easy. Better to make most of it automatic, and related to defined market benchmarks. Benchmarks may be inaccurately chosen, but at least something is learned for the next time.

Mr. Bernanke's QE fund is not the only one which could take the place of gold in a new monetary standard. Commodities of various sorts would not be much different from gold and might soften the volatility of the mining supply. Land could be used, or fresh water, or petroleum; perhaps we could divide up the ocean in some way. Among the more attractive candidates would be world index funds of stocks or bonds; bonds seem perhaps more suitable, perhaps not. But at the moment, no one seems to be exploring any substitute monetary standard other than gold or the QE fund. Perhaps the disadvantages of each would cancel out in a basket of all the suggested standards. Perhaps inflation targeting can be improved, and no other benchmark is needed; perhaps international branch banking could cover the requirements. And perhaps it is all an academic exercise, but it would still seem helpful if academia would explore a little further, just in case we need them.

Originally published: Saturday, March 23, 2013; most-recently modified: Sunday, July 21, 2019