In recent months, we have witnessed fierce arguments between, on the one side, those who defend the current system of “fiat money,” in which, as John Maynard Keynes stated, money “is created and issued by the State, but is not convertible by law into anything other than itself, and has no fixed value in terms of an objective standard,” and, on the other, those who support a return to the gold standard or even privatized money.
It is important to remember that monetary policy reflects the state’s choice to prioritize one set of economic possibilities (e.g., long-term monetary stability) over other options (e.g., the government’s ability to use its money-supply monopoly to bolster employment during recessions). These trade-offs, however, don’t just involve technical economic arguments. They also come down to questions of principle.
The case, for example, for fiat money managed by modern central banks is linked to the conviction that the state’s control of the money-supply should be used to realize particular goals. This helps to explain why part of the Federal Reserve’s charter includes the objective of “maximum employment.” The underlying principle is that economic justice requires the state to go beyond maintaining the rule of law, promoting monetary stability, enforcing contracts, protecting private property, and preserving minimal safety nets.
What, then, are the principles underlying the gold standard? To grasp these, we should recall how the classical gold standard worked in its heyday between 1870 and 1914. During this period, the gold standard gradually linked the different currencies of major trading powers such as Germany, America, Britain and France insofar as all notes and coins of countries adhering to the gold standard were underwritten by and redeemable in specific weights of gold.
The effects were twofold. First, the gold standard facilitated an unprecedented stabilization of prices. Thus, as noted by Lewis E. Lehrman and John D. Mueller, “between 1879 to 1914, average annual CPI inflation [in America] was 0.2 percent, with average annual volatility (up or down) of only 2.2 percent. No other standard comes close in combining low average inflation with low volatility.” A second effect was that each unit of the currency circulating in a country could be equally used for payments in other countries. A common and stable universal currency was therefore created without any need for an international monetary authority.
Apart from generating monetary stability, the gold standard also automatically adjusted balance-of-payment deficits. If a country overextended itself by importing more than it exported, gold left the deficit country to cover the imbalance of payments against nations with surpluses. The money supply in the deficit country subsequently fell, thus reducing demand and providing a brake against inflation. The fall in demand also forced deficit countries to become more competitive. In surplus countries, the gold imports increased the money supply, augmented demand, reduced competitiveness, and thus gradually diminished the original causes of the gold inflows.
Central banks played a critical role in this process. Indeed the entire system relied on close cooperation between the world’s central banks. In surplus countries, the gold standard required central banks to lower the discount interest rate charged to members of the domestic money system in order to reduce the gold inflow. This resulted in gold flowing back to deficit countries. Conversely, central banks in deficit countries would raise the discount interest rate, thereby reducing demand, and averting potential inflation.
Consequently, under the pre-1914 gold standard, modern China could not have built up and maintained its presently large currency reserves. Similarly, neither the Bush nor Obama Administrations would have been able to run huge deficits. Nor would it have been as easy for American consumers to acquire such irresponsibly high personal debt levels.
There were several economic advantages to the gold standard. For one thing, its workings were driven by known rules. Monetary decisions by central banks could therefore be foreseen to a certain extent and were thus more predictable. One downside to the gold standard was the slowness with which the gold supply adjusted to real changes in demand. This impaired gold’s ability to function as a regulating mechanism. Ironically, however, it was soon realized that the gold standard’s regulating effects could be accelerated by measures that removed impediments to the ability of economies to adjust quickly to change. The gold standard therefore created incentives for trade liberalization, competition, and entrepreneurship.
A number of principled considerations were, however, also operative. The gold standard placed a high premium on economic security by reducing the uncertainty and risk that flows from fluctuations in the value of money that have nothing to do with the relative valuation of different goods and services. Constant oscillations in the value of currencies undermine our ability to discern what we find marginally preferable to what is marginally inferior.
Another commitment at stake was the conviction that stable money meant greater economic prosperity for increasing numbers of people. Greater monetary certainty spurred productivity and investment, not least because many long-term contracts benefited from a confidence that prices would remain relatively constant over time. Then there were the ways in which the gold standard bolstered the economic well-being of particular marginalized groups. Monetary stability helps, for example, those who lack the financial sophistication to navigate the shoals of inflation, or who are on fixed incomes (e.g., the elderly and disabled).
At the same time the gold standard also encouraged governments to promote the common good instead of narrow sectional interests. Within nation-states, for instance, the gold standard diminished opportunities for the state to manipulate monetary policy in order to favor those with an interest in inflationist policies.
Likewise, the gold standard also generated a commitment on the part of governments to promoting the international common good. As the German economist Wilhelm Röpke once wrote, the gold standard relied upon the unwritten agreement of central banks and governments “to behave in matters of monetary and credit policy in such a way that this fixed and free coupling remained an undisputed permanent institution, irrespective of trade fluctuations.” This required central banks and governments to prioritize the global economy’s long-terms needs over the short-term exigencies of national economies. It also entailed a willingness to resist popular pressures to revert to a type of monetary nationalism in the face of the fluctuations in employment and growth sometimes generated by the gold standard’s adjustment mechanisms.
We should wonder, though, whether the gold standard demanded too much from governments. As the economist and financial historian Michael D. Bordo pointed out in 1981, most countries on the classical gold standard did not follow the rules of the game. During economic downturns, governments were sorely tempted to escape those strictures of the gold standard that facilitated the process of downward correction that adjusted general living standards to the reality of a lower level of economic well-being. Even before 1914, governments knew that abandoning the gold standard would allow an expansion of credit and public spending not possible under the pre-1914 gold standard.
This situation was exacerbated by two factors. First, in the conditions of democracy, monetary authorities became more susceptible to popular pressures to use monetary policy to provide short-term fixes to immediate economic problems. Second, the rise of neo-Keynesian economic theories encouraged politicians and central bankers to adopt monetary policies and interventionist strategies that routinely violated the gold standard’s disciplinary boundaries. In his Tract on Monetary Reform (1923), Keynes demanded that Britain abandon the gold standard because, in his view, it required countries to pursue deflationary policies just when expansionary measures were needed to combat rising unemployment. On these grounds, Keynes dismissed the gold standard as a “barbarous relic.” Underlying Keynes’ argument was a political concern: that liberal democracies might falter under the impact of mass unemployment. Others, however, such as the distinguished French economist Jacques Rueff disagreed. Against Keynes, Rueff insisted that unless the gold standard was allowed to work its anti-inflationary magic, many people would turn to demagogues to save the social order from inflation’s destructive effects.
Is a restoration of something like the pre-1914 gold standard possible? The domestic opposition from those with vested interests in inflationist and interventionist policies would be formidable. Even if that was overcome, the gold standard’s reinstatement on an international level would require a nucleus of countries to agree to adhere to it—something which happened rather spontaneously in the nineteenth century through a series of unilateral decisions by individual countries. Once this had occurred, adherents of a re-established international gold standard would have to insist upon all members maintaining maximum monetary discipline as well as freedom and stability in foreign exchange markets. Countries unwilling to adhere to these rules could not be admitted to the club.
There is of course no such thing as a perfect monetary system. All involve trade-offs. Each has its disadvantages. Nor is something like the pre-1914 gold standard the only alternative to the present fiat money system. Today most politicians, central bankers, and economists regard the gold standard as neither desirable nor possible.
What cannot, however, be denied is that the case for the gold standard goes beyond efficiency arguments. It embodies an emphasis on limiting arbitrary state action, promotes the longer-term economic well-being of less powerful groups, encourages prudence and a concern for lasting stability over urges “to just do something” (however ineffective or counterproductive), and generates a concern for the national and international common good over more narrow sectional interests.
Such principles and commitments should surely be demanded of any monetary system.