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Stability Under the Gold Standard in Practice

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Stability Under the Gold Standard in Practice This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: Money, History, and International Finance: Essays in Honor of Anna J. Schwartz Volume Author/Editor: Michael D. Bordo, editor Volume Publisher: University of Chicago Press Volume ISBN: 0-226-06593-6 Volume URL: http://www.nber.org/books/bord89-1 Conference Date: October 6, 1987 Publication Date: 1989 Chapter Title: Stability Under the Gold Standard in Practice Chapter Author: Allan Meltzer, Saranna Robinson Chapter URL: http://www.nber.org/chapters/c6739 Chapter pages in book: (p. 163 - 202) 4 Stability Under the Gold Standard in Practice Allan H. Meltzer and Saranna Robinson During her active career as a monetary economist and historian, Anna Schwartz returned to the history of monetary standards many times. In the famed A Monetary History of the United States, 1867-1960 (Friedman and Schwartz 1963), in her work as executive director of the 1981-82 U.S. Gold Commission (Commission on the Role of Gold in the Domestic and International Monetary Systems 1982), in her introduction to the National Bureau volume A Retrospective on the Classical Gold Standard, 1821-1931 (Bordo and Schwartz 1984), and in books and papers on British and U.S. monetary history before and after these volumes, she has both summarized past knowledge with careful attention to detail and added important pieces to our under- standing of the way monetary systems work in practice. One issue to which she and others have returned many times is the relative welfare gain or loss under alternative standards. Properly so; a main task of economic historians and empirical scientists is to test the predictions and implications of economic theory. Since theory does not give an unqualified prediction about the welfare benefits of different standards, evidence on the comparative performance under different standards is required to reach a judgment. Measures of economic welfare or welfare loss usually include the growth rate of aggregate or per capita (or per family) consumption or output, the rates of actual and unanticipated inflation, and the risks or Allan H. Meltzer is University Professor and John M. Olin Professor of Political Econ- omy and Public Policy, Carnegie Mellon University. Saranna Robinson is a graduate student in the School of Urban and Public Affairs, Carnegie Mellon University. The authors received helpful comments from Michael Bordo, Bennett McCallum, William Poole, Benjamin Friedman, and Anna Schwartz. 163 164 Allan H. MeltzedSaranna Robinson uncertainty that individuals bear. We use unanticipated variability of prices and output as measures of uncertainty and actual inflation as a measure of the deviation from the optimal rate of inflation. Eichengreen (1985,6 and 9) includes the stability of real and nominal exchange rates under the gold standard as one of the benefits of the standard. While the evidence of greater real exchange rate stability under fixed exchange rates seems clear-cut, the welfare implications are less clear. I Given the same policy rules and policy actions, greater stability of real ex- change rates under the gold standard may be achieved at the cost of greater variability in output or employment. This will be true if the alternative to exchange rate adjustment is adjustment of relative costs of production and relative prices when wages, costs of production, or some prices are slow to adjust. We, therefore, exclude exchange rate stability from the comparison and focus attention on the variability of unanticipated output, prices, inflalion, and the growth rate of output.2 The following section discusses previous findings about the stability of prices and output and the rates of inflation and growth. We then consider the comparative experience of the seven countries in our sample under the classical gold standard. Bretton Woods, and the fluc- tuating exchange rate regime. Like most previous comparisons, our first comparisons are based on actual values or their rates of change. The variability of unanticipated changes in prices and output under the three regimes is a more relevant measure of variability and uncertainty. We obtain measures of uncertainty about the levels and growth rates of output and prices using a multistate Kalman filter based on the work of Bomhoff (1983) and Kool (1983). Subsequent sections describe our procedures, present some estimates of comparative uncertainty, and consider the relation between shocks in Britain and the United States under the gold standard. A conclusion completes the paper. 4.1 Previous Evidence Bordo (1986) summarizes previous work on the stability of prices and output under the gold standard. For prices, there is strong evidence of reversion to a mean value. As is well known, the price level in most countries shows little trend under the gold standard if one chooses a period long enough for alternating periods of inflation and deflation to occur. This is true of the seven countries that we consider here; average rates of inflation under the classical gold standard range from 0.08 percent to 1. I percent.3 While the long-term stability of the price level under the gold standard is often commented on favorably, it is not clear that ex post stability is desirable independently of the way in which it is achieved. Alter- nating periods of persistent inflation followed by persistent deflation 165 Stability Under the Gold Standard in Practice do not have the same welfare implications as small, transitory fluctua- tions around a constant expected or average price leveL4 Long-term price stability achieved through canceling wartime inflations by severe postwar deflations imposes costs on consumers and producers, and particularly so, if the timing or magnitude of both the inflations and deflations is uncertain. A policy of maintaining expected stability of commodity prices, instead of stability of the nominal gold price, would have avoided postwar deflations by revaluing gold. In place of the long- term commitment to a fixed nominal exchange rate of domestic money for gold, countries could have made a commitment to a stable expected price level. Cooper (1982) computed the rates of price change in four countries using the wholesale price index numbers available for the period. Cooper includes the years 1816 to 1913 but, for much of this period, major coun- tries were not on the gold standard. We start the classical gold standard period in the 1870s when several countries chose to buy and sell gold at a fixed price, and we end the period in 1913, the last prewar year. Al- though many countries fixed their currencies to gold in the 1920s, the rules of the system differed and the commitment was weaker. Cooper’s data for the years 1873-96 and 1896- 1913 are shown in table 4.1. The cumulative movement in each period is relatively large, although the average annual rate of change in the first two periods is 2 or 3 percent. For comparison, we have included the percentage change in consumer prices for the same four countries during 1957-70, approx- imately the years that the Bretton Woods system had convertible cur- rencies. The comparison shows that while the average annual rates of change under the gold standard are similar (or lower) for some coun- tries, they are higher for others. The key difference between the price movements in the earlier and later periods is that there is no evidence of mean reversion in postwar data following Bretton Woods. Few would argue, however, that the deflations of 1920-21 or 1929-33, or the prior deflations in the nine- teenth century that contributed to the reversions, reduced welfare less than the inflation of the 1970s. Table 4.1 Percentage Change of Price Indexes, Four Countries, 1873-1913 and 1957-70 Years United States United Kingdom Germany France 1873-96 -- 53 - 45 - 40 - 45 1896-1913 56 39 45 45 1957-70 38 55 36 88 Source: Cooper (1982, 9); Economic Report ofrhe President (1971. 306). 166 Allan H. MeltzedSaranna Robinson A major, unresolved issue is the degree to which people could an- ticipate that inflation or deflation would occur. Bond yields are often taken as evidence of expected stability under the gold standard. Ma- caulay’s series on railroad bond yields declines during the deflation of the 1870s and 1880s but continues to decline until 1899 or 1901, after gold, money, and prices had started to rise. The Macaulay yields are higher during the deflation of the 1870s than at the start of World War I, despite nearly twenty years of inflation. Although other factors may have been at work, the raw data give no support to the proposition that bond yields are a summary measure of anticipated price move- ments under the gold standard. Rockoff (1984) presents some evidence suggesting that there was a basis for belief that prices would return to some mean value. His study considers the relation of gold mining and technological change in gold extraction to the relative price of gold. He concludes, tentatively, that many of the new gold discoveries and technical changes in methods of extraction were the result of an earlier rise in the relative price of gold. On his interpretation, long-term price movements for the period 1821 to 1914 appear to be the result of changes in demand along a relatively elastic long-run gold supply curve. Rockoff’s evidence suggests a long- term, gradual reversion of commodity prices operating on the relative price of gold and the supply of gold.5 This mechanism, relying on changes in the resources devoted to gold production and storage to maintain long-term price stability, is not clearly superior to other means of maintaining price stability. The fact that the mechanism operates with a lag of decades raises, again, the issue of whether it was antic- ipated in a sense relevant for people allocating wealth and choosing to consume or save at the time.
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