Monday, November 01, 2010

Is A Gold Standard Really Better?

Last Thursday's Wall Street Journal contained an editorial by Charles W. Kadlee, Gold vs. the Fed: The Record Is Clear, contending that a gold standard are associated with better US economic performance. His piece begins with this paragraph,

"When it meets next week, the Federal Open Market Committee (FOMC) is widely expected to signal its desire to increase the rate of inflation by providing additional monetary stimulus. This policy is based on a false—and dangerous—premise: that manipulating the dollar's buying power will lead to higher employment and economic growth. But the experience of the past 40 years points to the opposite conclusion: that guaranteeing a stable value for the dollar by restoring dollar-gold convertibility would be the surest way for the Federal Reserve to achieve its dual mandate of maximum employment and price stability."

Regardless of accepting, at least initially, Kadlee's assertion about gold, he paints the Fed's obviously economically unlikely hopes starkly. Whether it was once true, in today's world of copious data and information, nobody really believes simple currency devaluation will fool global investors.

Kadlee then lays out the empirical bases of his argument in these following passages,

"From 1947 through 1967, the year before the U.S. began to weasel out of its commitment to dollar-gold convertibility, unemployment averaged only 4.7% and never rose above 7%. Real growth averaged 4% a year. Low unemployment and high growth coincided with low inflation. During the 21 years ending in 1967, consumer-price inflation averaged just 1.9% a year. Interest rates, too, were low and stable—the yield on triple-A corporate bonds averaged less than 4% and never rose above 6%.

What's happened since 1971, when President Nixon formally broke the link between the dollar and gold? Higher average unemployment, slower growth, greater instability and a decline in the economy's resilience. For the period 1971 through 2009, unemployment averaged 6.2%, a full 1.5 percentage points above the 1947-67 average, and real growth rates averaged less than 3%. We have since experienced the three worst recessions since the end of World War II, with the unemployment rate averaging 8.5% in 1975, 9.7% in 1982, and above 9.5% for the past 14 months. During these 39 years in which the Fed was free to manipulate the value of the dollar, the consumer-price index rose, on average, 4.4% a year. That means that a dollar today buys only about one-sixth of the consumer goods it purchased in 1971.

Interest rates, too, have been high and highly volatile, with the yield on triple-A corporate bonds averaging more than 8% and, until 2003, never falling below 6%. High and highly volatile interest rates are symptomatic of the monetary uncertainty that has reduced the economy's ability to recover from external shocks and led directly to one financial crisis after another. During these four decades of discretionary monetary policies, the world suffered no fewer than 10 major financial crises, beginning with the oil crisis of 1973 and culminating in the financial crisis of 2008-09, and now the sovereign debt crisis and potential currency war of 2010. There were no world-wide financial crises of similar magnitude between 1947 and 1971."

Interesting data, but I can't help wondering why Kadlee leaves a four year gap, 1967-71, not assigned to the gold standard years. Isn't that the period during which US stagflation began? I recall it as when the stock market crashed from the Nifty Fifty go-go years, LBJ levied the income surtax of 10%, and the US tried a 'guns AND butter' approach to economics. All while still on the gold standard. My guess is Kadlee's gold standard-era economic performances look much worse if measured all the way through 1971, when Nixon closed the gold window.

As Kadlee presents the post-gold standard data, he mentions an innocuous detail. His gold standard data cover 20 years, while the post-gold standard era comprises 39 years. So when he declares that we've had the three worst post-1930s recessions in the non-gold standard era, right away, one should note that the chances of more bad recessions since 1971 could be doubled anyway, as a null hypothesis, simply because of the length of the era.

Still, his point is seductive, is it not? Because, gold standard or not, what is co-extensive with going off the gold standard is floating exchange rates. And, in a sense, the Fed's unconstrained ability to print money without worrying about losing all its gold as cheap dollars show up to take advantage of the bargain that only 35 of them would buy- an ounce of the precious yellow metal.

Kadlee continues his case by turning to exchange rates,

"And what of the seductive promise that a floating dollar would make American labor more competitive and improve the nation's trade balance? In 1967, one dollar could buy the equivalent of approximately 2.4 euros (based on the pre-euro German mark) and 362 yen. Over the succeeding 42 years, the dollar has been devalued by 72% against the euro and 75% against the yen. Yet net exports have fallen from a modest surplus in 1967 to a $390 billion deficit equivalent to 2.7% of GDP today."

Again, compelling. But also really the result of the post-gold standard floating exchange rates. And, once again, there's that troubling use of 1967, rather than, say, 1970, for the endpoint of the gold standard era. What difference would those 3-4 years have made? I don't know, and don't wish to engage in empirical research to find out. It simply bothers me when authors tailor time periods incorrectly for comparisons, and fail to disclose why.

There's no doubt, however, that the past 40 years of US deficit spending and dollar depreciation have eroded our purchasing power versus every other major currency. What is eye-opening for me, though, is his claim that  during the period, our net exports, which, in trade theory, should have boomed with the currency depreciation, have moved from surplus to large deficits of our GDP.

His summarizes his points thus,

"Economists and pundits may disagree on why the gold standard delivered such superior results compared to the recurrent crises, instability and overall inferior economic performance delivered by the current system. But the data are clear: A gold-based system delivers higher employment and more price stability. The time has come to begin the serious work of building a 21st-century gold standard for the benefit of American workers, investors and businesses."Again, Kadlee engages in some overstatement. Would we really say "a gold-based system delivers," or is it more correct to write, "a gold-based system is associated with,"

"higher employment and more price stability?"

And, as for "price stability," isn't that circular reasoning? Even a non-gold standard system of fixed exchange rates would have performed well. The problem, of course, is enforcement of such fixed rates in the absence of the natural punitive nature of the gold standard. That was the idea behind SDRs, but, with the abandonment of fixed rates, their replacement for gold in that role was obviated.

I think Kadlee's points are sensible and valid for an argument against floating rates, rather than for gold. Despite the troubling statistical legerdemain involving the missing 1967-71 data for comparisons, I'm quite willing to believe Kadlee's general thesis that some sort of enforced fixed exchange rate scheme would have constrained America's monetary profligacy over the last 39 years.

When I began studying economics in the mid-1970s, the warnings of excess American dollars and their inevitable effect on the US economy were already a decade old. But, back then, our trade deficits were still positive, as was our net foreign investment.

Nearly half a century of reckless deficits have reversed those two measures, and resulted in substantial loss of value in the dollar. You can't argue with that, gold standard or not.

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