A State-Level Gold Standard?

Barry Eichengreen provides \”A Critique of Pure Gold\” in the September/October issue of the National Interest. He speaks for most economists in referring to the idea of a return to the gold standard as \”an oddball proposal,\” and explains why in some detail. What caught my eye is that apparently some states have been considering requiring payments in the form of gold–a sort of mini-gold standard. Eichengreen writes:

\”A Montana measure voted down by a narrow margin of fifty-two to forty-eight in March would have required wholesalers to pay state tobacco taxes in gold. A proposal introduced in the Georgia legislature would have called for the state to accept only gold and silver for all payments, including taxes, and to use the metals when making payments on the state’s debt.
In May, Utah became the first state to actually adopt such a policy. Gold and silver coins minted by the U.S. government were made legal tender under a measure signed into law by Governor Gary Herbert. Given the difficulty of paying for a tank of gas with a $50 American eagle coin worth some $1,500 at current market prices, entrepreneurs then floated the idea of establishing private depositories that would hold the coin and issue debit cards loaded up with its current dollar value. It is unlikely this will appeal to the average motorist contemplating a trip to the gas station since the dollar value of the balance would fluctuate along with the current market price of gold. It would be the equivalent of holding one’s savings in the form of volatile gold-mining stocks.

Historically, societies attracted to using gold as legal tender have dealt with this problem by empowering their governments to fix its price in domestic-currency terms (in the U.S. case, in dollars).\”

 It is odd, to say the least, than many of those who favor a gold standard have also been investing in gold hoping to see its price rise. But as Eichengreen notes, in a gold standard, the price of gold would typically be set at a fixed level–historically, often a level below what would otherwise have been the market price. When President Richard Nixon officially ended what remained of the gold standard in 1971, gold was only used to pay debts to foreign governments holding U.S. dollars, and at a fixed price of $35/ounce.

Eichengreen traces how the idea of a gold standard has re-entered public discourse, championed by Ron Paul, who in turn refers to the work of Friedrich Hayek. But as Eichengreen reminds us, while Hayek was a fierce critic of central banking, and argued that central bankers needed to be controlled lest they conduct monetary policy in a way that feeds cycles of boom and bust in the economy, Hayek did not support a gold standard. In Eichengreen\’s words, summing up Hayek\’s standard arguments against a gold standard:

\”At the end of The Denationalization of Money, Hayek concludes that the gold standard is no solution to the world’s monetary problems. There could be violent fluctuations in the price of gold were it to again become the principal means of payment and store of value, since the demand for it might change dramatically, whether owing to shifts in the state of confidence or general economic conditions. Alternatively, if the price of gold were fixed by law, as under gold standards past, its purchasing power (that is, the general price level) would fluctuate violently. And even if the quantity of money were fixed, the supply of credit by the banking system might still be strongly procyclical, subjecting the economy to destabilizing oscillations, as was not infrequently the case under the gold standard of the late nineteenth and early twentieth centuries.\”

Hayek\’s answer to the problems of unrestricted central bankers was to allow the rise of private sources of money. Eichengreen continues:

\”For a solution to this instability, Hayek himself ultimately looked not to the gold standard but to the rise of private monies that might compete with the government’s own. Private issuers, he argued, would have an interest in keeping the purchasing power of their monies stable, for otherwise there would be no market for them. The central bank would then have no option but to do likewise, since private parties now had alternatives guaranteed to hold their value.\”

More on Teaching Monetary Policy After the Recession and Crisis

John C. Williams of the San Francisco Fed discusses “Economics Instruction and the Brave New World of Monetary Policy.” I blogged a couple of weeks ago with some of my own thoughts about how to teach monetary policy after the events of the last few years. Here are some thoughts from John: 
“Today the Board of Governors web site lists 12 monetary policy tools. Nine of them didn’t exist four years ago. The good news is that six of those tools are no longer in existence, reflecting the improvement in financial conditions.”
“Now, there’s no question that Keynes, Friedman, and Tobin were among the greatest monetary theorists of all time. Their theories are elegant statements of fundamental economic principles. As such, they deserve to be taught for a long time to come. But viewing them as definitive in today’s world is like thinking that rock and roll stopped with Elvis Presley. The evolution of money and banking since the 1950s is at least as dramatic as what’s happened with popular music—not that I want to compare the Fed with Lady Gaga.”
“The Federal Reserve has added $1.5 trillion to the quantity of reserves in the banking system since December 2007. Despite a 200 percent increase in the monetary base—that is, reserves plus currency—measures of the money supply have grown only moderately. Over this period, M1 increased 38 percent, while M2 increased merely 19 percent. In other words, the money multiplier has declined dramatically. Indeed, despite all the headlines proclaiming that the Fed is printing huge amounts of money, since the end of 2007 M2 has grown at a 5½ percent annual rate on average. That’s only slightly above the 5 percent growth rate of the preceding 20 years.”
“But now banks earn interest on their reserves at the Fed and the Fed can periodically change that interest rate. This fundamental change in the nature of reserves is not yet addressed in our textbook models of money supply and the money multiplier. Let’s think this through. At zero interest, bankers feel considerable pressure to lend out excess reserves. But, if the interest rate paid on bank reserves is high enough, then banks no longer feel such a pressing need to “put  those reserves to work.” In fact, banks could be happy to hold those reserves as a risk-free interest-bearing asset, essentially a perfect substitute for holding a Treasury security. If banks are happy to hold excess reserves as an interest-bearing asset, then the marginal money multiplier on those reserves can be close to zero. In other words, in a world where the Fed pays interest on bank reserves, traditional theories that tell of a mechanical link between reserves, money supply, and ultimately inflation no longer hold.”
“Instead, the Fed provided additional stimulus by purchasing longer-term securities, another policy tool absent from standard textbooks. From late 2008 through March 2010, the Fed bought $1.7 trillion in such instruments. Then, in November 2010, we announced we would purchase an additional $600 billion in longer-term Treasury securities by the end of June 2011. … I estimate that these longer-term securities purchase programs will raise the level of GDP by about 3 percent and add about 3 million jobs by the second half of 2012. This stimulus also probably prevented the U.S. economy from falling into deflation.

Teaching Intro-level Monetary Policy After the 2007-2009 Recession

Andrew T. Hill (Temple University and the Philadelphia Fed) and William C. Wood (James Madison University) offer a thoughtful discussion of how the teaching of monetary economics at the intro level needs to evolve in \”It\’s Not Your Mother and Father\’s Monetary Policy Anymore: The Federal Reserve and Financial Crisis Relief.\”

As I see it, Fed actions during the crisis can be summed up in two main categories: 1) Providing liquidity to financial markets in crisis; and 2) Direct Fed purchases of financial securities, both Treasury debt and mortgage-backed securities. In teaching, the issue is to convey these two themes to students, but not get bogged down in institutional details. As Hill and Wood write, \”it\’s very easy to get drawn into the details of the Fed\’s programs and over teach.\”

Most intro econ courses already have some discussion of the lender-of-last-resort function for central banks, and of using the discount rate as a tool of monetary policy. It\’s fairly straightforward to build on these themes to discuss how the Fed extended vast amounts of credit during the worst of the financial crisis: that is, to fulfill its lender-of-last-resort obligations in a complex modern financial economy, the Fed needed to go beyond lending to banks, and extend short-term credit to lots of other market players. A slightly deeper point is that the Fed also figured out ways to extend this credit so that the recipient firms could remain anonymous to the financial market–and thus they didn\’t need to worry that getting credit from the Fed would send a bad signal about their future prospects. 

Hill and Wood provide a table that may be useful for many instructors listing the new monetary policy tools created during the last few years: Term Auction Facility (TAF), Term Securities Lending Facility (TSLF), Primary Dealer Credit Facility (PDCF), Commercial Paper Funding Facility (CPFF), Term Asset-Backed Seucurities Loan Facility (TALF), and others.  But intro teaching should skip this alphabet soup. All of these agencies were closed by mid-2010; in general, the Fed\’s short-term lender-of-last-resort was finished by then.

In teaching about the direct Fed purchases of financial securities, this quantitative easing should be presented as a fourth possible tool of monetary policy, along with the standard triumvirate of reserve requirements, discount rate, and open market operations. Some teachers may try here to present the Fed balance sheet to their classes to show this change, and for those who want to take this approach, Hill and Wood present four illustrative and simplified balance sheets at different points in time.

But for intro purposes, I\’m not sure much is gained by presenting explicit Fed balance sheets. Instead, this material can be presented pretty clearly at an intuitive level by saying that the Fed feared that financial markets wouldn\’t absorb these securities without more disruption, so the Fed took them on. In the short run, this probably helped smooth out the crisis. But the Fed can\’t print money to buy securities continually.So it needs to decide when to stop. It also will need to decide how to wind down the $2 trillion or so in financial securities that it currently owns, either by gradually selling them off or by holding at least some of them to maturity.

One other change that may be important in the next few years is that the Fed traditionally did not pay any interest on bank reserves that it held. As of 2008, the Fed can pay interest. Thus, if it seems like a bank lending boom is getting underway and higher inflation is threatened, the Fed could raise the interest rate that it pays on bank reserves, and limit banks\’ willingness to lend in this way. This tool doesn\’t matter much in a world of near-zero interest rates and low inflation, but if inflation beckons, it will be interesting to see how the Fed uses this new power.