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Walker Todd: Forget Bretton Woods II -- we need a new gold standard
By Walker Todd
The Christian Science Monitor, Boston
Monday, November 17, 2008
Too much credit and easy money. Those were the biggest culprits behind this financial crisis. Yet, apallingly, the government's rescue attempt is built on more credit and even easier money. That's like giving a procrastinator a deadline extension. By choosing this course, Washington has steered us on to the "road to Weimar" -- the road to runaway inflation.
It didn't have to come to this. And it still doesn't. But the proper remedy will take tremendous political courage: Bring back the gold standard. That, more than any byzantine regulations that emerge from the Bretton Woods II conference this weekend, would provide stability and safety for nations and individuals around the world.
Sadly, current policy seems to reflect a desire to weaken the dollar as quickly as possible.
The Federal Reserve's own data tells the story. The headline is the doubling of Federal Reserve credit, the main component of the US monetary base. Since Labor Day 2008 it has risen from $894 billion to $2.2 trillion.
That's the greatest monetary expansion in the Fed's 95-year history. How the Fed is doing it matters almost as much. It has nearly abandoned its traditional instrument for monetary policy, open-market operations, which involves the purchasing and selling of full-faith-and-credit US Treasury securities. With increasing frequency and amounts, it has relied primarily on "discount window operations" -- lending to specific institutions for specific purposes instead of general injections of funds into an open market -- since August 2007. This shift may weaken its ability to "tighten" monetary conditions should inflation reach dangerous levels.
A gold standard offers exactly the kind of discipline that's missing from the Fed. But its impact would be wider: Both in substance and in symbolism, gold provides integrity to the entire global financial system. Governments, however, have historically bridled at the constraint and accountability a gold standard brings. After all, when currency can be exchanged for gold, it's harder for governments to inflate the money supply, which they're tempted to do in order to spend beyond their means or cheat on their debts.
Before 1933 you could, generally speaking, trade a US dollar for a set amount of gold. That gave the dollar strength and stability. During World War I, when European governments abandoned gold and inflated their currencies to pay for the war effort, the US maintained its gold backing.
In 1933, however, to enable the Treasury to finance massive new government spending hailed as an economic recovery package -- sound familiar? -- President Roosevelt suspended domestic transactions in gold, and reduced the dollar's gold value. Finally, in 1971, President Nixon officially abandoned the gold standard. The dollar -- and inflation -- have fluctuated wildly ever since.
Today's Fed thus faces virtually no constraints. Were a gold standard in place, it could not possibly have doubled its balance sheet in only seven weeks without triggering a wholesale flight from the dollar analogous to the summer of 1971.
Weimar Germany experienced one of the greatest inflations in modern history in 1922 and 1923. Eventually the official exchange rate reached 4.2 trillion marks per dollar. Some Germans heated their homes by burning cash, since it was cheaper than buying wood. The inflation finally was tamed by government bonds promising repayment in gold, backed by land taxes also payable in gold.
Today, if the US price level responded directly with the Fed's current rate of expansion of its own credit, then the technical conditions for Weimar-style hyperinflation could be upon us. Fortunately, Fed credit expansion acts on the domestic price level with a significant time lag. But could it tighten monetary conditions if it had to, having shifted its reliance to the discount window and the specific projects being financed there?
That's why a conversation about a gold standard is needed. But could it realistically make a comeback? Anna J. Schwartz, who co-wrote with Milton Friedman the highly influential book, "A Monetary History of the United States: 1867-1960," suggested at a 2004 gold conference at the American Institute for Economic Research that only a crisis of sufficient depth and magnitude would provoke the public to demand the stability of gold or a gold-linked currency. Such a crisis, which appeared remote at the time, may soon be upon us.
There's another significant point that Ms. Schwartz raised in 2004: The size of government itself would have to shrink radically to permit a complete return to gold. Before 1933, the share of gross domestic product represented by government at all levels was about 10 percent. Today the national average of that share is about 35 percent. Any adjustment to economic shocks has to be absorbed by a proportionately much smaller private sector than was the case 75 years ago.
Some critics worry that a return to gold would make credit harder to come by. It's true that the kind of ultra-loose credit that fuels housing bubbles would be marginalized, but normal credit in a gold system would tend to be cheaper because concerns about the future value of repayments are diminished.
America faces a stark choice. The path back to a gold standard is rocky and uphill. The current inflationary path is slippery and downhill. One leads to integrity and stability. The other could lead to financial ruin. Which will we choose?
Walker Todd, an economic consultant with 20 years' experience at the Federal Reserve Banks of New York and Cleveland, is a research fellow and conference organizer for the American Institute for Economic Research in Great Barrington, Mass.
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