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Home , Coinage Act of 1834, Gold standard, Gold Standard Act

FEDERALRESERVE An Anchor of

BY STEPHEN SLIVINSKI ome modern critics of the That doesn’t mean that prices How the gold suggest that it wouldn’t change under a gold stan- Scould be eliminated and replaced dard. In practice, the price level of standard works in with a . They claim that nations would tend to move in tandem monetary policymakers are apt to under this arrangement. The mecha- theory and practice bend under pressure to inflate the nism that drives the movement in the . A gold standard, on the price level is the other hand, can serve as an anchor for that results from trade between the currency that puts a limit on the nations. For example, assume that a growth rate of the supply. technological innovation increases There are benefits to a gold stan- economic growth in the . dard, but there are costs too. The Since the supply of gold, and therefore history of the gold standard provides the money stock, is fixed, prices in the important context for the suggestion United States will fall since it is cheap- that the United States should return er to produce goods domestically as a to a commodity-backed monetary result of the innovation. Prices of U.S. system — gold historically being exports to other countries would fall the most commonly used commodity. too. That leads to lower demand for Additionally, policymakers and the U.S. imports — which are now rela- public could benefit from a greater tively more expensive — and increased understanding of how the gold stan- demand for U.S. products dard works, even if reforms of the abroad. do not include its Under a gold standard, the restoration. currency and the commodity by which it is backed travel togeth- Mechanics of a Gold Standard er. In the example above, the In the United States, the gold standard trade surplus would also result in operated for most of the 18th century a balance-of-payments surplus in and the early before the which gold from overseas would creation of the Fed. (See sidebar). find its way into the coffers of In the absence of a , U.S. banks as foreign traders use nations that committed to the gold dollars to purchase U.S. goods. standard agreed to redeem their The stabilizing effect of the currency at a fixed price of gold. The gold standard manifests itself gold standard effectively fixed here in how prices would react to exchange rates between participating this surplus. The new gold in the Historically, many countries have linked nations since those were United States will reverse the their currencies to gold. Pictured, in 1963 themselves fixed to gold. When initial price decline. Meanwhile, the a member of the vault staff at the the stock of gold is relatively fixed, exodus of gold from abroad will lower of New York this arrangement can provide a the price level in the countries that checks the melt number and inscribed on each . ORK predictability that currencies not traded with the United States since anchored by a commodity standard smaller amounts of gold equal

ANK OF NEW Y may fail to produce. The supply of a shrinking of the money supply. VE B money is constrained by the amount Equilibrium is reached when the rela- of gold in the vaults of each nation. tive prices between nations converge. By contrast, created by central banks and not backed by a Weighing the Costs and Benefits OR SECTION, FEDERAL RESER T commodity in relatively fixed supply While anchoring the money supply to : CURA could be devalued simply by printing gold may have obvious benefits, there OGRAPHY T more of it. are risks to consider. One potential PHO

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downside is the effect that a discovery of large amounts of gold standard, by definition, makes the money supply gold would have on the price level. This was a problem in the procyclical — when the economy contracts, so does the late 1840s when the California introduced large money supply. For supporters, this is a benefit: It can limit amounts of gold into circulation, causing a “monetary the potentially expansionary impulses of central bankers. shock” and a rise in the price level of goods. In addition, Supporters also point out that the system can work without mining and minting gold is costly. Economist Milton a central bank officiating the movement of gold. Instead, Friedman once estimated that the resource price of produc- each government must make a credible commitment to ing gold and maintaining a full gold standard for the allow currency holders to redeem their bills for a predeter- United States would be more than 2.5 percent of GDP. mined amount of gold. One way to do this is to pass a law However, that cost could fall over time as new technologies that fixes the exchange rate between gold and the currency. are developed. In the United States, the of 1900 set the Some believe that gold flows between nations serve as a price of one ounce of gold at $20.67. However, keeping such check on . Tame inflation over the long term was a credible commitments may prove difficult in the wake of strong characteristic of the gold standard. Yet gold flows unexpected shocks and geopolitical upheaval. could transmit detrimental shocks, both monetary and non- monetary, between economies. In the past, vulnerability to Central Banks and the Gold Standard economic shocks caused prices to be highly unstable in the Much of the 20th century featured a mixed system in which short run. Economist Michael Bordo of Rutgers estimated central banks and the gold standard existed simultaneously. the “coefficient of variation” in the price level under the The ideal role of central banks when an international gold historical gold standard. A higher coefficient indicates more standard is in force is to sustain the fixed exchange rates short-term instability. For the United States between 1879 and allow prices and output to vary as required by the and 1913, the coefficient was 17, which Bordo notes is quite movement of gold across borders. When gold is flowing into high. Between 1946 and 1990, when central banks were able the country, for instance, the central bank should raise to deviate from the automatic responses required by the the interest rate at which it lends to banks — the discount gold standard, it was only 0.88. By association, real output is rate — to facilitate the inflow. Conversely, the central bank also highly variable under a gold standard. The coefficient should lower the discount rate to facilitate the gold outflow for variation was 3.5 between 1879 and 1913. But between when a balance-of-payments deficit materializes. 1946 and 2003 it was only 0.4. However, there can be temptations for central banks to Central banks would later mitigate the costs of stop playing by the rules. Monetary policymakers could economic shocks by pursuing countercyclical policies. Yet a “sterilize” the gold flow: They could buy or sell domestic

The U.S. Gold Standard Before the Fed Between the nation’s founding and 1971, the United States notes and certificates that were redeemable in specie. had been on one form or another of a gold standard. The During the war, a partly decentralized national banking authors of the Constitution were of the opinion that any system existed in which federally chartered banks would money minted by the federal governments should be backed deal in “greenbacks” issued by the U.S. government backed by some “specie” standard (i.e., gold or ). by little specie. The return to an operational gold standard On the recommendation of Secretary of State Alexander occurred in 1879 when the U.S. government resumed Hamilton, the U.S. Congress passed the . payments of gold to dollar holders who demanded them. That officially put the United States on a bimetallic stan- By that point, however, a series of Supreme Court decisions dard in which the dollar was defined as equaling a specified had made the greenbacks , which over time weight in gold or silver. However, the ratio between gold and crowded out state-issued currency. silver that the act established — 15 grains of silver to 1 grain The United States tied itself to a monometallic of gold — served to undervalue gold relative to silver after standard with the Gold Standard Act of 1900. It set the the act was passed. This was particularly true over the next dollar price of gold at $20.67 per ounce, effectively relegating three decades as mines in yielded more silver. As a silver to a subsidiary role in the monetary system. This meant result, gold began to flow out of the United States and silver that dollars would circulate alongside silver , and the began to flow in. While gold and silver coins were still U.S. Treasury would aim to sustain the dollar price of gold. accepted as legal tender, gold coins became quite scarce. The creation of the Federal Reserve in 1913 took away The put the United States on a from the executive branch the explicit power of money de jure gold standard. It moved the ratio of silver to gold to stock maintenance. The history of the 20th century would 16-to-1. That helped remedy the imbalance, and gold coins show, however, that the relationship between a gold became more common in the United States. standard and the central bank was an uneasy one. Before the Civil War, state-chartered banks could issue — STEPHEN SLIVINSKI

6 Region Focus | Second Quarter | 2010 securities — in other words, either expand or contract the exchange rate. Foreign governments were also allowed to money supply relative to gold — to shield the domestic trade in their dollars to the U.S. government in return for money supply from the external disequilibrium. This would gold. The expectation was that the United States could cred- weaken the ability of the gold standard to anchor the value ibly commit to maintaining the standard over the long term. of money in the economy. In the early 1950s, the United States held close to 60 per- Economic downturns, political pressures, and wartime cent of the world’s gold reserves. By the 1960s, however, threatened the gold standard in the 20th century. Just as it dollars began to rapidly flow out of the United States as a was at the peak of its effectiveness in 1914, result of the Fed monetizing the debt issued to pay for broke out. Britain, the banking center of Europe, experi- spending on the Great Society social programs and the enced a run on sterling and enacted trade and exchange . The inflationary policies of the United States controls, including a postponement of domestic and inter- put pressure on currencies that were linked to the dollar to national payments. This basically made the international revalue their currency to satisfy the balance of payments — gold standard nonoperational. Other countries instituted pressure that reached its peak in 1970. Additionally, U.S. gold similar capital controls. In addition, the issuance of short- reserves were beginning to dwindle because foreign govern- term debt to finance the war effort in the United States led ments were rapidly trading in their dollars for gold. Many the federal government to pressure the Fed to abandon the foreign policymakers were not convinced that the U.S. gold standard rules on exchange rate targets and instead government would regain a commitment to exchange rates focus on keeping the interest rates on war bonds low. per the Bretton Woods rules in the near term. To put an end After the war, the developed nations tried to reconstruct to the international pressure, President the gold standard. The 1917 U.S. embargo on gold exports finally took the dollar off gold in 1971, effectively killing the was lifted in 1919, and the of the dollar at the international gold standard. prewar gold price was restored in 1922. The gold value of the dollar rather than the soon became the refer- Gold and Today ence point for other currencies. The post-war gold standard Since the episode of runaway inflation in the 1970s, was faced with new challenges, though. High tariff barriers monetary economists have learned a number of lessons. during the 1920s hindered the price adjustment process. Foremost among them is an understanding of how central Also, the United States, France, and England began routine bank credibility is vital to monetary policy. In some sense, sterilization of gold flows. that is also a lesson of the gold standard years. Regardless of The economic pressures of the weak- the signals central bankers use to navigate policy, public ened support for the gold standard. Britain left the standard trust that they will stay the course is essential to making the in 1931 after a massive gold outflow. The United States policy work. Even under a gold standard, the stability pro- followed in 1933 when emergency measures allowed the vided by the commodity anchor dissolves if the central bank federal government to abrogate all gold-related clauses in all can’t or won’t credibly commit to the rules of the standard. public and private contracts. In 1934 it devalued the dollar Today, the price of gold is just one of a number of by raising the fixed price for gold to $35 per ounce. signals that Fed policymakers may use to make decisions Emergency measures also allowed the issuance of Federal about the direction of monetary policy. Since the 1980s, Reserve notes that did not have to be backed by gold. World the Fed’s independence and need to maintain its credibility War II drove central banks even further away from the gold have largely been helpful in keeping inflation under standard as they again sought to keep government borrow- control even when it has to occasionally embark upon ing costs low at the expense of the fixed exchange rate. Trade countercyclical policy. Many of the traits that supporters and capital restrictions also hindered whatever cross-border of the gold standard value, such as long-term price stability, price adjustment might have occurred. have materialized over the past 20 years under a fiat money After the war, the finance ministers and treasury secre- system not directly tethered to the price of gold. taries of the Allied nations met in Bretton Woods, N.H., to It’s unlikely that the nations of the world will adopt the reconstruct some form of a gold standard. The agreement gold standard again. But the lessons of central bank credi- essentially linked the dollar to gold and, in turn, all other bility are a product of the gold standard years. Strong public major currencies were linked to the dollar. Yet it also allowed expectations about how the Fed conducts policy may produce some flexibility for central banks to pursue changes in the the same benefits today that a gold standard once did. RF

R EADINGS

Bordo, Michael D. “Gold Standard.” In David R. Henderson (ed.), Meltzer, Allan H. A History of the Federal Reserve — Volume 1: 1913- The Concise Encyclopedia of . Indianapolis, Ind.: Liberty 1951. : University of Chicago Press, 2003. Fund Inc., 2007. Timberlake, Richard H. Monetary Policy in the United States: An Hetzel, Robert L. The Monetary Policy of the Federal Reserve: A Intellectual and Institutional History. Chicago: University of Chicago History. New York: University Press, 2008. Press, 1993.

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