(This item originally appeared at Forbes.com on March 27, 2020.)
For most of the 182 years between 1789 and 1971, the United States embraced the principle of a dollar linked to gold — at first, at $20.67/oz., and then, after 1933, $35/oz. Nearly every economist today will tell you that was a terrible policy. We can tell it was a disaster because, during that time, the United States became the wealthiest and most prosperous country in the history of the world.
This is economist logic.
But, even if some economists might agree with the general principle, they might be particularly hesitant to apply such monetary discipline right now, in the midst of economic and financial turmoil. This kind of event is the whole reason why we put up with all the chronic difficulties of floating currencies, and economic manipulation by central banks. Isn’t it?
So, let’s ask: What if we were on a gold standard system, right now? Or, to be a little more specific, what if we had been on a gold standard system for the last ten years, and continued on one right now, in the midst of the COVID-19 panic and economic turmoil?
In the end, a gold standard system is just a fixed-value system. The International Monetary Fund tells us that more than half the countries in the world, today, have some kind of fixed-value system — they link the value of their currency to some external standard, typically the dollar, euro, or some other international currency. They have fixed exchange rates, compared to this external benchmark. The best of these systems are currency boards, such as is used by Hong Kong vs. the U.S. dollar, or Bulgaria vs. the euro.
If you think of a gold standard as just a “currency board linked to gold,” you would have the general idea. These currency boards are functioning right now to keep monetary stability in the midst of a lot of other turmoil. If you had all the problems of today, plus additional monetary instability as Russia or Turkey or Korea has been experiencing (or the euro …), it just piles more problems on top of each other.
Actually, it would probably be easier to link to gold than the dollar or euro, because gold’s value tends to be stable, while the floating fiat dollar and euro obviously have floating values, by design. If you are going to link your currency to something, it is easier to link it to something that moves little, rather than something that moves a lot. Big dollar moves, such as in 1982, 1985, 1997-98 and 2008, tend to be accompanied by currency turmoil around the world.
But, even within the discipline of a gold standard system, you could still have a fair amount of leeway regarding central bank activity, and also various financial supports that arise via the Treasury and Congress.
Basically, you could do just about anything that is compatible with keeping the value of the dollar stable vs. gold.
In the pre-1914 era, there was a suite of policies to this effect, generally known as the “lender of last resort,” and described in Walter Bagehot’s book Lombard Street (1873). This framework resolved the Overend and Guerney crisis of 1866, which became the foundation of Bagehot’s book. It was used again in the Barings crisis of 1890, and the financial turmoil that surrounded the “free coinage of silver” debates in the U.S. and other countries, during the 1890s. Another set of solutions resolved the Panic of 1907, without ever leaving the gold standard. The Federal Reserve was explicitly designed to operate on a gold standard system; and mostly did so for the first 58 years of its existence, until 1971. Others have argued that a functional “free banking” system, as Canada had in the pre-1914 era, would allow private banks to take on a lot of these functions, without the need for a central bank to do so.
What could the Federal Reserve do today, while still adhering to the gold standard?
First: It could expand the monetary base, by any amount necessary, that meets an increase in demand to hold cash (base money). Quite commonly, when things get dicey, people want to hold more cash. Individuals might withdraw banknotes from banks. Banks themselves tend to hold more “bank reserves” (deposits) at the Federal Reserve — the banker’s equivalent of a safe full of banknotes. This has happened, for example, during every major war. During the Great Depression, the Federal Reserve expanded its balance sheet by a huge amount, as banks increased their bank reserve holdings in the face of uncertainty. Nevertheless, the dollar’s value remained at its $35/oz. parity.
Second: The Federal Reserve could extend loans to certain entities — banks, or corporations — as long as this lending is consistent with the maintenance of the currency’s value at its gold parity. In the pre-1914 era, this was done via the “discount window.” One way this could come about is by swapping government debt for direct lending. For example, the Federal Reserve could extend $1.0 trillion of loans to banks and corporations, and also reduce its Treasury bond holdings by $1.0 trillion. This would not expand the monetary base. But, it might do a lot to help corporations with funding issues.
What the Federal Reserve would not be able to do is: expand the “money supply” (monetary base) to an excessive amount — an amount that tended to cause the currency’s value to fall due to oversupply, compared to its gold parity.
Now we come to a wide variety of actions that are not really related to the Federal Reserve, but rather, to the Treasury and Congress.
In 1933, a big change was Deposit Insurance. The Federal Government insured bank accounts. It helped stop a banking panic at the time. This is a controversial policy even today, and some think it exacerbated the Savings and Loan Crisis of the 1980s, not to mention more issues in 2008. But, nevertheless, it didn’t have anything to do with the Federal Reserve.
In 2009, the stock market bottomed when there was a rule change that allowed banks to “mark to model” rather than “mark to market.” Banks could just say: “We are solvent, we promise.” It worked.
Today, Congress has been making funds available to guarantee business lending, and for a wide variety of purposes that should help maintain financial calm. Whether this is a good idea or not will be debated for a long time I am sure. But, it has nothing to do with the Federal Reserve. All of these actions are entirely compatible with the gold standard.
What about interest rates? Don’t we want the Federal Reserve to cut rates when things get iffy? In the 1930s, interest rates were set by market forces. Given the economic turmoil of the time, government bond rates, and especially bill rates, were very low. The yield on government bills spent nearly the whole decade of the 1930s near 0%. Markets lower “risk-free” rates automatically, during times of economic distress, when you just allow them to function without molestation. Every bond trader already knows this.