Why Not Abolish the Fed and Return to the Gold Standard?

Why Not Abolish the Fed and Return to the Gold Standard?
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Authors:James Hamilton

Via Mike Shedlock, this item from MarketWatch caught my eye:

Newt Gingrich said that if elected president, he’d name [James] Grant to help run a commission looking at a possible return to the gold standard. And Ron Paul said, if elected president, he’d go all-in and name Grant– one of Wall Street’s best-known gold bugs– as the new chairman of the Federal Reserve….

“Unfortunately, I haven’t heard from Mr. Romney yet,” joked Grant when I called on him in his offices down on Wall Street. “I’m sitting by the phone, I’m ready.”

I presume that Grant would be advising any would-be policy-makers who listen to him the sort of thing that he wrote in 2010:

The classical gold standard, the one that was in place from 1880 to 1914, is what the world needs now. In its utility, economy and elegance, there has never been a monetary system like it.

I thought it would be worthwhile reviewing some of the reasons why I disagree with Grant on this point.

The graph below records the behavior of short-term interest rates over 1857 to 1937. Over much of this period, the U.S. maintained a fixed dollar price for an ounce of gold, and prior to 1913 (indicated by a vertical line on the graph) there was no Federal Reserve System. The pre-Fed era was characterized by frequent episodes such as the Panic of 1857, Panic of 1873, Panic of 1893, Panic of 1896, and Panic of 1907 in which even the safest borrowers would suddenly find themselves needing to pay a very high rate of interest. Those events were associated with significant financial failures and business contraction. After establishment of the Federal Reserve, the U.S. short-term interest rate became much more stable and exhibited none of the sudden spiking behavior that used to be so common.

Monthly short-term commercial paper rates in New York City, 1857-1937. Vertical line marks creation of the Federal Reserve in 1913. Source: Frederick R. Macaulay, The Movements of Interest Rates, Bond Yields and Stock Prices in the United States since 1856, 1938.

The pre-Fed financial panics were also accompanied by long contractions in overall economic activity, as indicated by the NBER dates for economic recessions noted in the graph below. Although of course we still had recessions after the Federal Reserve was established in 1913, they tended to be less frequent and shorter in duration.

Monthly short-term commercial paper rates in New York City, 1857-1937 with recessions as shaded regions.

Even so, one of the worst economic downturns in America’s history came on the Fed’s watch in the form of the Great Depression of 1929-1933. But it’s worth emphasizing that the U.S. was still on the gold standard through this period, with the price of gold fixed at $20.67 per ounce.

One of the problems with the gold standard is that when the real value of gold changes (as it does all the time) and the dollar price of an ounce of gold is fixed (as it must be by definition under a gold standard), that means dollar prices have to adjust in response to anything that happens to the gold market. With the economic and financial turbulence of the late 1920s and early 1930s, there was a big increase in the relative price of gold.

For example, to get an ounce of gold in 1929, a farmer would need to deliver a little over a hundred pounds of cotton. By 1932, it would take more than three times as much cotton to get that same ounce of gold. Whereas 18 bushels of wheat would be enough to buy an ounce of gold in 1929, you would have needed more than twice as much wheat to get gold in 1932. And since the price of gold in terms of dollars was fixed between 1929 and 1932, that means you’d need to produce about three times as many pounds of cotton or two times as many bushels of wheat in order to earn one dollar in 1932 as you would have needed to earn one dollar in 1929.

And those changes in the dollar valuation of the real goods that people produced meant an extra burden on farmers who owed debts denominated in dollars and added pressure to reduce the dollar wages paid to workers, all of which contributed to the magnitude of the downturn.

The cost of gold in terms of many other goods went up by less than it did for raw materials like cotton and wheat. I’ve picked a few specific items in the table above in order to communicate my point in concrete, physical units. But the same thing happened broadly to goods and services throughout the economy. In particular, the overall U.S. consumer price index fell by about 25% between 1929 and 1933, or, to put it another way, by 1933 you’d typically have to give up about 25% more of anything real– pounds of cotton, bushels of wheat, number of haircuts, whatever physical metric you like to think in terms of– in order to get an ounce of gold. That overall deflation was surely one force aggravating the magnitude of the economic contraction.

U.S. consumer price index, annually, 1922-1939. Data source: Hamilton (1987).

Another indication that the gold standard and its attendant overall dollar price deflation were making our problems worse is the fact that the U.S. recovery began more or less immediately with the elimination in 1933 of the legal convertibility of dollars to gold at the price of $20.67. And our experience was not unique. The 14 countries that decided to abandon the gold standard two years earlier than the U.S. began their economic recovery in 1932, as seen in the top panel of the figure below. Countries that stayed on gold, by contrast, experienced an average output decline of 15% in 1932. The U.S. recovery began after we abandoned gold in 1933, the Italian recovery began after they went off in 1934, and the Belgian recovery began after they went off in 1935. The three countries that stuck with gold through 1936 (France, Netherlands, and Poland) saw a 6% drop in industrial production in 1935, while the rest of the world was experiencing solid growth.

Average real growth rates across different country groups, 1930-1936. Top panel: countries that left the gold standard in 1931. Second panel: growth rates for the U.S., which left the gold standard in 1933. Subsequent panels: countries leaving in 1934, 1935, and still on as of 1936. Source: Bernanke and James (1991).

I don’t understand those who want to return to the good old days.

This post originally appeared at Econbrowser and is posted with permission.

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