|Reviving the Gold Standard ?|
Implications for World Trade and Finance
The process of demonetization of gold as a means of payment and measure of value reached its completion when the United States in 1971 formally ended the last link between the dollar and gold, and when the IMF in 1978 adopted a new rule that currency values can no longer be set in terms of gold in the world monetary system. Under the new charter of agreement, one-sixth of the gold held by IMF has been sold on free markets and another one-sixth has been returned to the member countries. Thus, gold has been dethroned from its central position in the working of the U.S. and international monetary systems.
Gold, however, has not left the international financial system completely. It continues to play a role in collateralizing foreign loans. Central banks as well as individuals like to hold gold; more than 40 percent of the global stock of gold is still in the hands of governments, central banks, IMF, and other international institutions, constituting together about 45 percent of the total reserves of the IMF member countries. When the EC set up the European Monetary system (EMS) in 1978 as a means of stabilizing the European currencies against each other and the U.S. dollar, gold made up 20 percent of the reserve backing.
A significant move toward remonetization of gold, however, came recently from the United States when Reagan's supply-siders began to push for a return to the gold standard and when, in September 1981, Reagan appointed a 17-member commission to study whether the United States should go back to a gold standard. The motive behind this move is rather clear. After a long period of disruptive inflation with high interest rates, many American people lost confidence in the monetary management of their government-and in the dollar as a store of value. There has been growing opinion that the United States needs an institutional device with which to enforce some kind of automatic discipline on monetary management. In particular, the supply-siders might have been prompted by the fact that the Reagan administrations's package program-tax cuts, boosting military spending, and tight money-was not successful in lowering interest rates.
The key element in the gold standard is that the government sets two rules: First, it agrees to trade gold for dollars, or vice versa, at some fixed official price. Second, the government lets the stock of money be determined by the stock of gold that is held by the central bank. The gold advocates argue that the very fact of a dollar backed by gold on demand will have two effects: First, the federal government will lose the ability to create money at will, and secondly it will instill a new confidence in the future value of the dollar. Both of these will help to break inflationary expectations and lower interest rates in support of stable growth of the economy.
Well-intended as it is, the proposal for a gold standard naturally gives rise to heated controversy between the gold advocates and their critics. In this paper I would like to discuss some of the major issues involved in the proposal for returning to the gold standard and draw some implications with respect to the current world economic situation.
Fixing the Official Price of Gold
One of the major issues highlighted in the recent gold debate has been the problem of fixing a new official price of gold in dollar terms. In order to ensure the gold convertibility of the dollar, the government would have to set the official gold price at an appropriate level. If the price of gold is set too high, foreign governments and private citizens would flood the Treasury with gold, forcing an outflow of dollar currency that would cause inflation. If, on the other hand, the price of gold is set too low, the currency will flow into the Treasury to be redeemed in gold, generating a deflationary contraction of the money supply and economic recession.
A solution offered by the gold advocates to this problem is that the price of gold will only be established at a suitable time after the president announces his intention-say two years. This would make people realize that they are going to get a stable dollar once again and stop speculating on gold. When the market for gold stabilizes, the president will ask the Treasury to examine under the new condition the proper dollar price of gold.
Supposing that the "right" price has somehow been established, would it ensure that the price will remain "right" afterward-at least for a length of time? The critics' answer is generally negative. Wallich, for example, maintained that inflation abroad would eventually render the price too low or too high. Occasional adjustment of the price of gold might remedy this situation. But that, of course, would undermine the basic property and merits of the gold standard.
Indeed, experience with the gold standard since the early nineteenth century, particularly in the postwar period, amply illustrates how difficult it is to keep parity between the official price and market price of gold in terms of the dollar. In retrospect, it was tragic for the international monetary system and for the health of the world economy in the postwar period that the Bretton Woods System was established on the basis of an official price of gold in terms of the dollar that was well below the price in the free market. If the United States had selected the gold-dollar parity on the basis of the real purchasing power of the dollar in December 1946, the world would have been saved from much of the burden of later U.S. inflation.
At any rate, it should be noted that in the course of the more than 30 years-from 1946 to 1978-in which there existed an official price of gold set by the monetary authorities of the United States and other countries, only the 15-year period from 1954 to 1968 can be cited as a time in which the U.S. Treasury, together with monetary authorities of other major countries, succeeded in keeping the market price of gold close to the official price. This was done mostly by means of gradually selling off the gold held by the Treasury and central banks. In August 1971, however, accelerating inflation, the deteriorating balance of payments, and a collapse of confidence in the dollar owing to its sharp depreciation in world money markets led the United States to suspend the convertibility of the dollar into gold. This in turn precipitated the collapse of the Bretton Woods System of international monetary management.
Gold advocates usually derive a strong case for returning to the gold standard from the world's experience with a gold standard in the nineteenth century, particularly from 1879 to 1914-a period characterized by the secular trend of price stability and relatively low rates of interest. However, this should not obscure the fact that there have since been drastic changes in the general sociopolitical and economic environments in which the gold-based monetary system operated. Wallich pointed out, for example, that "there were special conditions that helped to make the gold standard work in the nineteenth century. Government economic policy was narrowly limited in scope. Maintenance of the national currency at a parity with gold was regarded as a paramount objective of the government, and all other considerations, such as full employment, were subordinated to it." On the other hand, the national and international monetary development under the Bretton Woods System had been fraught with various economic and noneconomic factors that made the gold-based monetary system difficult to work. These included downward rigidity of prices due to the strength of labor unions and big business, the acceptance of a tradeoff between inflation and employment, emergence of Eurodollars, the increasing role of multinationals in world trade and finance, and the Vietnam War.
Advocating the merits of the gold standard, Professor Reynolds argued that the monetary crises under the gold standard were due to sustained refusal to abide by the simple rule of the gold standard. "The same is true of the worldwide inflationary crisis since the mid-1960s," he remarked. His argument, however, does not seem to shed much light on the problem, as one can argue with equal strength that the paper standard failed because the government did not follow the policy norms of that standard. We know that some countries, such as Germany and Japan, fared better in monetary management in terms of the stability of prices and interest rates than other countries, especially France and the U.S.A., under the same paper standard in the 1970s. This indicates that the same institution may produce different results in different countries depending on how it is run.
Historically, annual gold production has averaged less than 2 percent of the existing stock. Professor Fellner and others have observed that the price of gold relative to goods in general rose very rapidly over the past decade, but gold output has been declining while the output of goods in general has been growing. For a gold standard to work well, the price of gold must be a good proxy for other prices. This condition is met if output is falling when the real price of gold is rising.
Given the inadequate gold output, a money supply tied to gold reserves of the central bank might be inadequate, having a deflationary impact on the economy. The central bank may choose either to reduce the gold reserves ratio against the note issue or devalue the currency against gold. Frequent alteration of the reserve ratio and devaluation, however, may cause inflation, while the expectation of further devaluation of the currency may lead to speculation in the money market.
The problems caused by the slow growth of the gold supply were recognized at various times during the gold standard era. For instance, in 1930 the League of Nations published a study concluding that the growth of the world's gold stock was too slow to finance world economic growth without putting serious deflationary pressures on prices. During the late 1950s, the IMF conducted a similar study also focusing on the problem of the long-run inadequacy of gold supplies. Later, this study formed the basis for the creation of SDRs-or "paper gold"-as a new international reserve asset that was not tied to gold.
Gold proponents, however, look at this problem quite differently. According to Reynolds, a gold standard would make postponing gold production less attractive as a hedge against inflation. Under a gold standard there would be more incentive to produce gold and less incentive to hoard it. The evidence after 1970 is therefore relevant only to the present monetary arrangements, not to a gold standard. Moreover, the supply of gold comes, he argued, not only from production but also from the existing stock. On the demand side, the supply-siders argue that making the U.S. dollar convertible into gold will create such a "quality dollar" that the public will find it unnecessary to hold gold.
There are no supporters of the standard who envisage a gold standard requiring a rigid gold cover with 100 percent reserve backing. Instead they argue that under a fractional reserve system, convertibility "is a self-limiting mechanism, requiring only a small buffer stock to meet unanticipated withdrawals" and that the monetary authority could easily compensate for erratic gold output. Regarding the more fundamental view on the relationship between the growth of money supply and that of output, Reynolds makes the rather surprising statement that "worriers about money growth being 'too slow' must first offer some tiny shred of evidence that more money means more production and employment. . . . In fact the evidence is that the (money) growth is at best unrelated to real growth."
The alleged long-run inadequacy of the global output or supply of gold may not be an insurmountable problem in the working of the gold standard. Nor should the concentration of gold output in South Africa and the Soviet Union be considered a serious problem, because the marginal addition by these countries to the global supply is almost insignificantly small-as the gold proponents plausibly contend. Looking at the past experience with the gold-dollar standard in the postwar period, the real problem in my view seems to lie in the utilization of gold by the monetary authorities of the key currency countries-for at least two reason. The first is that management of gold was always made difficult by the fact that the official price of gold was set below the market price for too long, and thus failed to reflect the long-term change in the purchasing power of the dollar. Specifically, over the period from 1934 to 1973, in which the official price of gold remained fixed at $35 an ounce, the U.S. consumer price index (CPI) rose over 400 percent. Under this situation, it is easy to see that the underlying excess demand for official gold tends to put an ever-increasing strain on the ability of central banks engaged to stabilize the market price of gold.
This was well illustrated by the experience with the so-called Gold Pool, which was formed in 1961 and lasted until 1968 with contributions of gold supplies from leading central banks. The Gold Pool was successful as long as gold from the Pool was sufficient to hold the market price of gold down to $35, but it collapsed in March 1968 when it could no longer stabilize the gold price with its limited supply of gold, giving way to a "two-tier" system in which the $35 price was maintained only for transactions among central banks. The "gold rush" that was touched off by the devaluation of the pound sterling in that year was of course directly responsible for the collapse of the Gold Pool, but it was also a culmination, among others, of the long-term imbalance between the official supply of and market demand for gold under too low an official price over a long period.
The gold price is all too sensitive not only to devaluation, wars, policy statements, rumors, and so on, but also to the speculators' expectations regarding the adequacy of central banks' gold stock that can be released, when needed, to stabilize the market price of gold. This consideration leads to the second point-that even though the Gold Pool was not successful in weathering out the gold rush, it is still important to realize that the collective or pooled use of gold stocks was found to be an effective way to strengthen the role of gold in the working of the gold standard. In this light, it is understandable that some economists recommended a pooling of national gold reserves into the IMF or into a hypothetical international central bank so that they could be used more efficiently, facilitating international financial settlements and adjustments.
Although the idea of the United States returning to the gold standard was taken up rather lightly by supply-siders mainly for domestic consideration, its far-reaching implications for the international monetary and trading system are difficult to fathom. What would happen, for example, if the United States unilaterally announced its plan to restore the gold standard? Gold exponents predict that international confidence in the U.S. economy and in the dollar would be enhanced so greatly that there would be heavy buying of the dollar, causing a drastic appreciation of the dollar or the depreciation of the paper currency. However, in their view, the buying frenzy would soon calm down because speculators, knowing that their profit potential after the official price is set will be nil, will no longer buy gold.
Apart from the speculation, Alan Reynolds predicts an inevitable shifting of the major countries from the paper to the gold standard. In his words, "there is no chance that most nations would not want to join the U.S. within one hour or two . . . because the alternative is to see their paper currencies sink against the dollar." There is still another prediction by the critics of the gold advocates, who argue that gold producers would stop selling and speculators would begin buying because they know their risk is limited: They would soon redeem gold for dollars at some level. Therefore, the price of gold would rise. However, some critics concede that after the price is fixed, it is likely that no future market would exist at all, bringing an end to a wild spree of gold speculation.
Although it is difficult to predict with any degree of certainty the consequences of a unilaterally established gold standard by the United States, it seems beyond doubt that such an announcement would cause the disruption of world money markets, entailing global realignment in interest rates, foreign exchange rates, and in the trade positions of countries involved. The burden of the adjustments may strain the capacity of the government to cope in a number of countries. This is to say that the United States cannot go along by itself toward a gold standard without risking severe dislocations in international economic relations and even threatening political stability in the free world. So if the United States is still determined to go alone, it should have an extensive and detailed plan involving the other countries concerned in order to successfully meet all possible contingencies.
Even if the United States succeeds, by skill or luck, in implementing a gold standard, it is still doubtful whether it would be able to sustain the original design and purpose of the new system if other major nations remain on the paper standard. The fluctuation in interest rates, foreign exchange rates, and price levels in the paper standard countries will be major determinants of the flow of gold to and from the United States. Under these circumstances, however, there is no guarantee that such flows of gold would necessarily be consistent with an optimum growth of the money supply in the United States. If the United States, faced with these external pressures, chose to make the link between gold and the money supply quite loose as it has been historically, the benefit of the gold standard would be lost. Wallich reminds us of the historical experience that "restraints imposed by the gold standard upon monetary policy were frequently set aside when they began to bite."
On the other hand, if we assume that major nations join, by chance or design, the United States in adopting the gold standard, then we are turning to the much larger issue of reforming the international monetary system. A return to the gold standard by major nations would require a return to the fixed exchange rate system, which of course calls for an agreement among member countries of the IMF. Some countries may prefer to remain on the current system of floating exchange rates, and this would require extensive multilateral negotiation among member countries of the IMF.
Implications for the World Economy
Discussions in detail of the problems involved in a return to a gold-based international monetary system are beyond the scope of this paper, nor is it deemed necessary at present as no country has yet proposed such a reform. However, a few remarks about the implications of returning to a gold standard with respect to the current world economic situation may be in order.
Since the beginning of this year, the world economy has begun to recover from the recent deep recession. In general, the economic outlook for the world as a whole seems quite good. The U.S. government predicts a 4.7 percent real GNP growth this year and a 4 percent growth next year in 1984. Particularly hopeful is the fact that the U.S. inflation rate in terms of consumer prices dropped sharply from 10.4 percent in 1981 to 6.1 percent in 1982, and fell further to -0.4 percent in the first quarter of 1983. This drop occurred largely because the U.S. money supply (M2) was very tight in 1982.
However, since 1981 the U.S. money supply has been increasing. One important factor is that the size of the large U.S. budget deficit is projected to increase to more than $200 billion in 1985. Therefore, the Americans are justifiably concerned about the rekindling of high inflation in the years to come. The American public feels that the financing of the burgeoning budget deficit will either crowd out private investment spending or expand the money supply in the years ahead. Thus, both real and nominal interest rates will probably remain very high.
The high real interest rates in the United States tend to discourage private investment, retarding a sustained recovery from the prolonged economic recession. They have also aggravated the already great debt burden of developing countries. In addition, the high U.S. interest rate also has caused rising demand for the U.S. dollar and the ensuing rapid appreciation of the dollar relative to other major currencies in the foreign exchange market. Too strong a dollar has adverse effects on U.S. exports and import-competing industries, contributing to the deterioration in the current account of the U.S. balance of payments. The currently strong dollar-resulting from a large inflow of capital induced by the high interest rate in spite of persistent deficits in the current account-is not a sustainable pattern of balance of payments, and it could make U.S. industries more prone to provoke protectionist pressures.
It was also argued that the high real rate of interest and the overvalued dollar imposed serious constraints on the monetary management of the EC countries and Japan in recent years. For the EC countries, particularly France, the sharp appreciation of the dollar-or depreciation of the European domestic currencies-meant rising import costs with an inflationary impact on the domestic market. This is an added burden on the stabilization policy of the EC governments at the expense of the monetary measures that otherwise would have been taken in the pursuit of economic recovery. Frequent market intervention by the monetary authorities in defense of their own domestic currencies also puts considerable strain on the operation of the European monetary system.
This situation explains why the EC countries have been urging the United States to intervene in the foreign exchange market in order to lower the value of the dollar and to take into account the developments in the foreign exchange market in the conduct of monetary management. The United States, however, has been reluctant to subscribe to the idea of intervention, not necessarily because of President Reagan's free market philosophy but because of their doubt that the intervention at the usual scale would have any significant effect on the exchange rate, given the sheer size of the world financial market; the total pool of internationally mobile dollar assets is estimated at more than a trillion dollars. The Council of Economic Advisors, in fact, held the view that "a feasible strategy for bringing the dollar down would involve looser monetary policies and tighter fiscal policies. Both of these changes would tend to lower real interest rate (at least in the short run), making capital movement into the United States less attractive and thus driving down the value of the dollar." In short, we realize that the fiscal deficits are a matter of concern not only to the United States, but to the international community as a whole.
The supply-siders think they have found a solution to this problem in their proposal to return to a gold standard in the United States. What is unfortunate about this proposal is that fiscal excess-that is, a large deficit-is not compatible with any type of monetary standard, and that it requires, more than anything else, political determination to resolve it. Unfortunately, moreover, we have to agree with Milton Friedman that if it is not politically possible to reduce fiscal deficits without a gold standard, it will not be politically possible to do so with a gold standard.
Another pressing problem in the world economy is found in the LDC's debt burden, which has been aggravated by rising protectionism against the LDC's exports and by the rising interest rates in recent years. On the other side of the coin, there is clearly a growing anxiety in the international financial market over the possibility of defaults by certain LDCs. In dealing with the debt problem, it is important to recognize that in order to weather this debt crisis there is no other real alternative in the long run than an expansion of LDC exports. Would a return to the gold standard help the LDCs increase their exports or reduce their imports? When appreciation of the gold dollar vis-a-vis paper currency results from a U.S. return to the gold standard, many LDCs whose currencies are currently linked to the U.S. dollar would be pushed into devaluation in defense of their balance of payments. Furthermore, dollar-dominated oil prices in terms of local currency will go up sharply together with other import prices, exerting a strong external pressure on domestic inflation. Given the observed tendency of LDC governments to adopt accommodating monetary policies, it may well be that an extended period of dollar appreciation would drive LDCs into a vicious circle of devaluation and inflation without helping their balance of payments over the long term. The interest cost of debt repayment and external borrowing would decrease, but this would be more than offset by lower export earnings and higher import bills, with a net negative effect on the external account. Chances are that the LDCs would be in even greater need of cash at a time when banks world over are increasingly wary of their exposure in the LDCs.
From the foregoing analysis, we are led to the opinion that the United States cannot, at least under the present circumstances, successfully go back to a gold standard without causing serious dislocation in international economic relations. Any question of restoring the gold standard, therefore, must be addressed in terms of international rather than domestic considerations. This is especially true for the United States for the simple reason that the dollar is currently playing the pivotal role in the international monetary system. In other words, the idea of reviving the gold standard should be based on an evaluation of the performance of the current international monetary system based on the SDRs severed from gold and flexible exchange rates. This is particularly true in view of the fact that there is a growing awareness that overfluctuation of exchange rates and the resulting instability in the international financial market are serious drawbacks inherent in the present arrangements. There is also a growing feeling that we need to find some way to enhance order in international financing and we need to stabilize the dollar, the major reserve currency, by anchoring it to something.
Finally, it is important to recognize when discussing institutional problems that the institution itself is one thing, and how it is run is another. Therefore, the judgement as to the efficacy of an institution depends on the judgement as to its ability to adapt itself to the actual condition under which it operates and, at the same time, its inherent ability to withstand human abuses as much as possible. On balance, monetary experiences in the past seem to indicate that the gold standard was weaker in the first and somewhat stronger in the second characteristic than the current paper standard.