The World Bank boss Robert Zoellick claims that we should all return to the Gold Standard to restore economic stability in the World economy. He is crazy. Sorry! The G-20 meeting in Seoul this week will obviously be concentrating on side issues such as the impact of the latest US quantitative easing plans on world inflation and the international currency system which many commentators are now claiming is in turmoil. Zoellick’s proposal will be added to the agenda which will reinforce what a waste of time these meetings are turning out to be. Zoellick’s call for a gold standard is just another one of these conservative smokescreens that attempt to solve the problem by denying it. They are all just expressions of obsessive and moribund fear of fiscal policy and the erroneous allegation that budget deficits cause inflation. So we will get a G-20 communiqué in a few days calling for more international cooperation in trade and currency settings and more fiscal consolidation and the need for on-going discussions about the creation of a new international reserve currency (perhaps a gold standard). But all these words will be in spite of the real policy agenda that is required – more public spending. What will they come up with next?
In a recent Op-ed (November 8, 2010) – The G20 must look beyond Bretton Woods – Zoellick said among other things that:
… the G20 should … build a co-operative monetary system that reflects emerging economic conditions. This new system is likely to need to involve the dollar, the euro, the yen, the pound and a renminbi that moves towards internationalisation and then an open capital account.
The system should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values. Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today.
Why would a return to the Gold Standard be crazy?
Remember as you read on to keep reminding yourself of the obvious – a sovereign nation with a flexible exchange rate can also use fiscal policy to maximise domestic outcomes if they desire notwithstanding external constraints (and domestic constraints like lack of food!).
Zoellick’s proposal is just one of a long line of proposals that get oxygen because governments are scared to use the tools that they already have and which work best when there is an floating exchange rate.
So we get Ireland destroying itself because it gave up both its currency sovereignty and its capacity to float a sovereign currency when it joined the Euro. You might like to read the latest insights from Irish academic Morgan Kelly who presents a dire update on the situation in the nation that the Euro bosses held out as the demonstration state both in the lead up to the crisis and subsequently in embracing austerity the earliest. The nation will collapse before long.
You also see central banks trying once again to revive their flagging economies with quantitative easing – again. This is despite the fact that banks do not lend reserves; US corporations are cashed up to the hilt; and US households are embracing a new period of frugality because they have huge debt overhangs that they know have to be extinguished. As I explained in yesterday’s blog – Religious persecution continues – quantitative easing will not be the silver bullet. So why are they doing it again? Answer: because the US government refuses to implement the appropriate fiscal stimulus.
All the talk about quantitative easing flooding the world with US dollars and creating an inevitable inflation are just hot air.
And that segues in to the largely irrelevant debate about the need to rebalance global trade patterns from which the call for some return to a fixed exchange rate system materialises. If you want to see how a fixed exchange rate system kills nations you just have to look at what is happening in Greece, Ireland and Spain at present.
Trade imbalances (deficits) have to addressed via domestic contraction which biased most economies to permanent states of stagnation – high unemployment and flagging living standards.
So it is just another part of the anti-fiscal policy agenda that has resurfaced and gathering pace even when the effects of too little fiscal intervention are staring us in the face and have been doing so for nearly 3 years now.
In part, the anti-fiscal policy agenda is sourced in a deep anxiety about inflation. The contradictions in this stance are stark but that never stops the proponents pushing it. Spending equals income whether it is private or public. The composition of the output that creates the income might be different but you need spending to create income.
Too much spending whether it be public or private will be inflationary. There is not something magical about public spending that makes its more prone to generating inflation. Further, as I have explained before it is the act of spending which introduces an inflation risk (depending on the state of capacity utilisation) and the monetary operations that accompany the spending (for example, debt-issuance) do not alter that risk.
Mainstream macroeconomics is mired in the flawed belief that the government has three sources of funding: (a) taxes; (b) debt-issuance; and (c) printing money. Students rote learn that the degree of expansion is in order of these options and that printing money is “so expansionary” because it also reduces interest rates (in their models) as well as directly impacts on demand that it is inflationary.
Not only do sovereign government not have to “fund” their spending, the government budget constraint (GBC) framework which is the pedagogical device that students learn this nonsense within is deeply flawed.
Students learn that the printing money option – called monetisation – involves the government running a deficit with no external debt issued to “pay for it”. What a nonsensical description of the options facing a sovereign government. When the government spends the recipient receives a credit (say a deposit at a bank) at the same time the government credits the reserve accounts that the particular commercial bank maintains with the central bank. There is nothing more to it than that.
So bank deposits and reserves rise by an equal amount and the recipient expresses the increase in their net financial position (wealth) in the form of an increased deposit at the bank.
The banks now have excess reserves because they can always rely on the central bank to provide them with reserves should they be short. The central bank may offer a support rate on these reserves (as Australia has done for year – 25 basis points below the target rate; or as the US has done since 2008).
If there is no support rate, then the overnight inter-bank interest rate will drop to zero as a result of the desire of banks to seek some overnight return on these reserves. The reality is that these transactions among banks net to zero which means they cannot eliminate a system-wide surplus. Assuming the central bank has a non-zero target rate then it has to “drain” these excess reserves (a liquidity management operation) to prevent the competition among banks to lend their excess reserves.
How does it do this? Answer: sell government bonds. What does this mean for the textbook version of “monetisation”? Answer: it means the mainstream textbook rendition is wrong. The central bank has no choice but to sell debt in this situation or else it has to be prepared to run a zero interest rate regime (as in Japan for two decades).
In the current period, where the central bank offers to target rate to banks holding overnight reserves, these liquidity management operations are no longer required. This means that the central bank can ignore the impacts of the deficit on bank reserves and maintain control over the interest rate by ensuring it pays the same rate on overnight excess reserves as it announces as its policy rate. There are no further complications with this approach.
The national government does not have to issue debt to net spend (that is, run a deficit). So wouldn’t this be more inflationary than if it issued debt? Answer: not at all. The inflation risk is in the spending not the monetary operation.
To understand this one has to come to terms with the stock impacts of the deficit flows. Government deficits increase non-government sector net savings by increasing national income. The stock manifestation of this net saving flow manifests as increased net financial assets (wealth) held by the non-government sector initially as bank deposits.
What if the government issues debt as described above? Answer: the portfolio of the net financial assets held by the banks is changed. The bank debits its reserve account (at the central bank) by the sum of the payment for the government bonds and it now holds paper instead of reserves on its balance sheet. The reserves are “drained” from the system by the monetary operation.
Have the deposits held by the initial recipient (which was the expression of the rise in net financial assets due to the deficit) disappeared? Answer: No, they are still there.
What if the government issues debt to the public? Answer: Bank reserves still decline because the holders of deposits at the bank pay for the bonds via a reduction in their deposit balances. The improved net financial asset position of the non-government is now expressed by the holding of the government debt by the public (not banks) rather than bank deposits. The public have just converted their non-interest bearing wealth into interest-bearing wealth.
Has there been any difference in the change in aggregate demand as a result of these different options? Answer: none, aggregate demand went up by the same amount equal to the net government spending plus the multiplied induced consumption. Please read my blog – Spending multipliers – for more discussion on this point.
So you can see the fallacy in the theories that distinguish between “printing money” and “issuing bonds” and conclude that one is more inflationary than the other. There is no difference for aggregate demand. To understand this you need to also appreciate that banks do not lend reserves.
Bank reserves are an essential part of the clearing or payments or settlements system (different terminology is used in different countries to denote the same mechanism). Accordingly, the funds are used to settle the myriad of transactions that implicate each of the banks each day. Having excess reserves doesn’t increase the capacity of the banks to lend.
In a fiat monetary system, the banks can lend whenever they choose. Their loans create deposits and are not dependent on the existence of “excess” reserves. Banks will lend to anyone who they can make a profit on. If they didn’t have the required reserves at the end of the day then the central bank provides them.
So there is no sense in the logic that holdings of excess reserves are inflationary. Bank reserves are not a component of aggregate demand.
What about the argument that if the non-government sector has bonds they are less likely to spend these “savings”? Answer: If the holders of either form of net wealth (bank deposits or bonds) wanted to dis-save they could easily do that. In this instance, the budget deficit would fall anyway as the automatic stabilisers increased tax revenue and welfare spending fell. If the automatic stabilisers didn’t reduce government demand enough – that is, nominal demand growth was outstripping the real capacity of the economy to produce more goods and services then further fine-tuning of discretionary fiscal policy would be required to avoid inflation.
The point is that public and private spending works in more or less the same way. Both add to demand and command real resources and both can be excessive in relation to each other and the real capacity of the economy to produce goods and services.
Please read Scott Fullwiler’s excellent coverage of this issue – HERE – for more detail in the US context.
So these deep anxieties about inflation and deficits are ill-founded and should not lead to the policy debate being derailed into sideshows like debates about the merits of a return to a Gold Standard.
Brief review – How did a Gold Standard work?
Please read my blog – Gold standard and fixed exchange rates – myths that still prevail – for an introduction to this topic.
I won’t repeat that blog and the nuances of pure commodity currency systems and convertible currency systems backed by gold are explained there.
Zoellick is thinking of a return to a paper currency system where paper money issued by a central bank is backed by gold. So the currency’s value can be expressed in terms of a specified unit of gold. To make this work there has to be convertibility which means that someone who possesses a paper dollar will be able to swap it (convert it) for the relevant amount of gold.
In the early versions of the Gold Standard, central banks would set their currency against the gold parity. As an example, say the Australian Pound was worth 30 grains of gold and the USD was worth 15 grains, then the 2 USDs would be required for every AUD in trading exchanges.
The central banks would maintain the “mint price” of gold fixed by buying or selling gold to meet any supply or demand imbalance as a result of trade between nations. Further, the central bank had to maintain stores of gold sufficient to back the circulating currency (at the agreed convertibility rate).
Gold was also considered to be the principle method of making international payments. Accordingly, as trade unfolded, imbalances in trade (imports and exports) arose and this necessitated that gold be transferred between nations (in boats) to fund these imbalances. Trade deficit countries had to ship gold to trade surplus countries.
So trade surplus nations could expand their domestic money supplies (issue more notes) because they had more gold to back the currency. This expansion was in strict proportion to the set value of the local currency in terms of grains of gold. The rising money supply would push against the inflation barrier (given no increase in the real capacity of the economy) which would ultimately render exports less attractive to foreigners and the external deficit would decline.
For the deficit nations, the loss of gold reserves forced their governments to withdraw paper currency which was deflationary – leading to rising unemployment and falling output and prices. The latter improved the competitiveness of their economy which also helped resolve the trade imbalance. But it remains that the deficit nations were forced to bear rising unemployment and vice versa as the trade imbalances resolved.
The political costs of this imbalance in domestic fortunes ultimately led to the system being abandoned (in an evolved form) in 1971.
The proponents of the gold standard focus on the way it prevents the government from issuing paper currency as a means of stimulating their economies. Under the gold standard, the government could not expand base money if the economy was in trade deficit. It was considered that the gold standard acted as a means to control the money supply and generate price levels in different trading countries which were consistent with trade balance. The domestic economy however was forced to make the adjustments to the trade imbalances.
Monetary policy became captive to the amount of gold that a country possessed (principally derived from trade). Variations in the gold production levels also influenced the price levels of countries.
In practical terms, the adjustments to trade that were necessary to resolve imbalances were slow. In the meantime, deficit nations had to endure domestic recessions and entrenched unemployment. So a gold standard introduces a recessionary bias to economies with the burden always falling on countries with weaker currencies (typically as a consequence of trade deficits). This inflexibility prevented governments from introducing policies that generated the best outcomes for their domestic economies (high employment).
Ultimately the monetary authority would not be able to resist the demands of the population for higher employment.
After World War 2, the IMF was created to supersede the gold standard and the so-called gold exchange standard emerged. It is this sort of system that Zoellick is proposing.
Convertibility to gold was abandoned and replaced by convertibility into the USD (although Zoellick would like a broader basket of reserve currencies), reflecting the dominance of the US in world trade (and the fact that they won the war!). This new system was built on the agreement that the US government would convert a USD into gold at $USD35 per ounce of gold. This provided the nominal anchor for the exchange rate system.
The Bretton Woods System was introduced in 1946 and created the fixed exchange rates system. Governments could now sell gold to the United States treasury at the price of $USD35 per ounce. So now a country would build up USD reserves and if they were running a trade deficit they could swap their own currency for USD (drawing from their reserves) and then for their own currency and stimulate the economy (to increase imports and reduce the trade deficit).
The fixed exchange rate system however restricted fiscal policy (which goldies consider an advantage) because monetary policy had to target the exchange parity. If the exchange rate was under attack (perhaps because of a balance of payments deficit) which would manifest as an excess supply of the currency in the foreign exchange markets, then the central bank had to intervene and buy up the local currency with its reserves of foreign currency (principally $USDs).
This meant that the domestic economy would contract (as the money supply fell) and unemployment would rise. Further, the stock of $USD reserves held by any particular bank was finite and so countries with weak trading positions were always subject to a recessionary bias in order to defend the agreed exchange parities. The system was politically difficult to maintain because of the social instability arising from unemployment.
So if fiscal policy was used too aggressively to reduce unemployment, it would invoke a monetary contraction to defend the exchange rate as imports rose in response to the rising national income levels engendered by the fiscal expansion. Ultimately, the primacy of monetary policy ruled because countries were bound by the Bretton Woods agreement to maintain the exchange rate parities. They could revalue or devalue (once off realignments) but this was frowned upon and not common.
Whichever system we want to talk off – pure gold standard or USD-convertible system backed by gold – the constraints on government were obvious.
The gold standard as applied domestically meant that existing gold reserves controlled the domestic money supply. Given gold was in finite supply (and no new discoveries had been made for years), it was considered to provide a stable monetary system. But when the supply of gold changed (a new field discovered) then this would create inflation.
So gold reserves restricted the expansion of bank reserves and the supply of high powered money (government currency). The central bank thus could not expand their liabilities beyond their gold reserves (although it is a bit more complex than that). In operational terms this means that once the threshold was reached, then the monetary authority could not buy any government debt or provide loans to its member banks.
As a consequence, bank reserves were limited and if the public wanted to hold more currency then the reserves would contract. This state defined the money supply threshold.
The concept of (and the term) monetisation (as discussed above) comes from this period. When the government acquired new gold (say by purchasing some from a gold mining firm) they could create new money. The process was that the government would order some gold and sign a cheque for the delivery. This cheque is deposited by the miner in their bank. The bank then would exchange this cheque with the central bank in return for added reserves. The central bank then accounts for this by reducing the government account at the bank. So the government’s loss is the commercial banks reserve gain.
The other implication of this system is that the national government can only increase the money supply by acquiring more gold. Any other expenditure that the government makes would have to be “financed” by taxation or by debt issuance. The government cannot just credit a commercial bank account under this system to expand its net spending independent of its source of finance. As a consequence, whenever the government spent it would require offsetting revenue in the form of taxes or borrowed funds.
Ultimately, Bretton Woods collapsed in 1971. It was under pressure in the 1960s with a series of “competitive devaluations” by the UK and other countries who were facing chronically high unemployment due to persistent trading problems. Ultimately, the system collapsed because Nixon’s prosecution of the Vietnam war forced him to suspend USD convertibility to allow him to net spend more. This was the final break in the links between a commodity that had intrinsic value and the nominal currencies. From this point in, most governments used fiat currency as the basis of the monetary system.
So would a return to a Gold Standard alter any of this?
Answer: No! We would return to the same problems that led to the system’s downfall. In a sense, the Eurozone is running a version of the Gold Standard – in the form of a fixed exchange rate system (with no prospect even of re- or devaluation). The only way that a Eurozone nation can adjust to a persistent external deficit is to implement a harsh domestic deflation to increase competitiveness. It is a path to falling living standards and ultimately political and social instability.
There are claims that the international currency system is in a state of near collapse.
The UK Guardian economics correspondent Larry Elliott wrote (November 8, 2010) that:
… without doubt, a return to gold has some attractions. The international currency system is in turmoil; countries are adopting beggar-my-neighbour devaluations; the gold price has soared to just shy of $1,400 (£868) an ounce and this week’s G20 meeting in South Korea is shaping up to be an ill-tempered affair.
The devaluations (or managed rates) are also manifestations of the destructive effects of the neo-liberal era exemplified by the IMF and World Bank obsession with export-led growth. The underpinning agenda of this approach can be traced back to a anti-fiscal policy obsession. Export-led growth strategies are not reliable and deprive the citizens of access to the fiscal capacity of their government and the use of their own resources.
Please read my blog – Export-led growth strategies will fail – for more discussion on this point.
Each government can make its own decision about whether they choose to hold USD reserves or diversify, say into Euro. But they would be far better advised to stop seeking to net export as a policy position and instead use their fiscal capacity to stimulate domestic demand. That would solve this “alleged” international currency system turmoil pretty quickly.
I also find it amazing that nations like China and Germany are now lecturing the Americans for “living beyond their means” and demanding the US government cuts back on US demand. If the US did cut back on demand for imports then where are these export goliaths going to make their money from? Answer: this posturing is total hypocrisy.
Elliot does make there good reasons why a return to the gold standard would be disastrous. He said:
Firstly, the world supply of gold is too small to support a global economy with an annual output of $50tn a year. Secondly, the global economy is a lot more diverse than it was in the 19th century, when the scene was dominated by a handful of European nations plus America. Thirdly, pegging currencies to gold would almost certainly prove to be deflationary. Here, the lesson of Britain is apposite, since the 1925 decision by Churchill to return to the gold standard at the pre-war parity following pressure from the Bank of England governor Montagu Norman was one of the great economic blunders of the 20th century. Within six years, deflationary pressure had forced Britain to abandon gold.
All those sovereign nations running current account deficits take note! If they support a return to a gold standard at the current G-20 meeting then they are also signalling they support government policy deliberately creating unemployment and poverty and deflation.
The problem is that the proponents of these mad schemes don’t make that connection. If it was their job at stake maybe they would.
For the Euro nations – they should abandon their monetary union and by floating their reintroduced currencies start improving the living standards of their citizens and eschewing the destructive path they are on at present. Either way the path forward is now going to hurt these nations but in the medium- to long-term these nations will be far better off abandoning the Euro, placing a moratorium on debt, protecting their housing markets and getting people back into work and spending locally.
To move forward the world leaders have to abandon all these neo-liberals manias and see that spending equals income. In normal times, public spending can be moderated by private spending growth to ensure that inflation is contained and employment growth is high. But these are not normal times and there is little to suggest that private demand growth in most of the advanced nations is going to become very robust anytime soon.
In that context, given spending equals income, the only show in town is to expand fiscal policy. By sidetracking into these non-issues – quantitative easing; export-led growth; gold standards etc the leaders are just going to make things worse.
I liked Brad Delong’s conclusion – Zoellick “really may be the Stupidest Man Alive”.
That is enough for today!