On July 21, the Senate Banking Committee will vote on advancing the nomination of Judy Shelton to the full Senate for confirmation to the Federal Reserve Board of Governors. Shelton’s nomination has elicited a great deal of controversy, partly owing to her record as an advocate for returning the United States to a gold standard. Although a gold standard has some highly positive attributes in the abstract, it would be immensely difficult to implement in today’s world of modern central banks.
Under a gold standard, a country sets the price of a fixed unit of gold in terms of its own currency, and its currency is redeemable in gold. Since each country participating in the gold standard has fixed its own currency to gold, exchange rates between countries are fixed. In principle, a country can set its currency equal to a unit of any commodity, but historically, gold and silver have been the most notable examples. For example, in 1900, the United States set one pure ounce of gold equal to $20.67, which remained the price until 1933.
Gold standard proponents argue that such a regime is desirable for at least two reasons. First, it produces greater long-term price stability because it constrains the ability of the central bank to inflate the money supply and the price level. Second, as the philosopher and early economist David Hume argued in the 18th century, a gold standard causes trade imbalances to self-correct. According to Hume, a country that imported more than it exported would see an outflow of gold, decreasing that country’s money supply. The price level would then fall to the point at which domestic goods were cheaper than foreign goods. That country would then begin to export more and import less until the trade imbalance was corrected.
Most economists, however, are critical of a gold standard precisely because it constrains a central bank’s discretion, which they think is important, especially during times of crisis. While gold standard advocates may believe deflation brought on by a gold standard is desirable, many economists believe that falling prices lead to a “deflationary spiral,” where firms earn less from selling their goods and services, causing them to decrease production. Since employers generally tend to avoid cutting workers’ wages because wage cuts can hurt worker morale, companies nevertheless will lay off workers, who then have difficulty paying their bills. This produces a vicious cycle where prices continue to fall as employment levels and demand for goods and services fall.
Writing in opposition to Shelton’s nomination, former Federal Reserve economist David Wilcox argues that a gold standard prevents a central bank from cutting interest rates to make borrowing easier in order to provide stimulus during a recession. Following this line of reasoning, many economic historians argue that the gold standard played a major role in exacerbating the deflation of the Great Depression. Such painful episodes have caused most economists to favor fiat money regimes, in which central banks have full control over the stock of money and can adjust the money supply to target economic variables such as employment and inflation.
Are Shelton’s critics right that the gold standard is a bad idea? The answer depends on which historical gold standard is in question. As George Selgin has explained, the United States, over the course of its history, has operated under multiple regimes that could be characterized as gold standard or gold standard–like. The version that existed from roughly 1880 to the outbreak of World War I in 1914 (frequently referred to as the classical gold standard) was the United States’ “purest” gold standard because that system operated largely automatically and required no coordination on the part of central banks. In fact, the United States and several other participating nations did not even have central banks during this period.
Since the classical gold standard concluded just before the Federal Reserve’s inception, it is fair to compare US economic performance under this standard with its performance under the Fed. While the Fed’s track record certainly improved over time, multiple studies show that the United States experienced higher rates of growth and less instability under the classical gold standard than under the Fed.
What about the argument that the gold standard contributes to painful deflationary episodes such as the Great Depression? Before simply blaming the Depression on the gold standard, one needs to consider the fact that the interwar gold standard, unlike its prewar predecessor, required significant coordination on the part of central banks to manage gold reserves in order to maintain exchange rates. Poor policy decisions by the Federal Reserve and the Bank of France during this period led to gold hoarding, which shrunk the global money supply, further exacerbating the downturn. Therefore, it may be more accurate to describe the Great Depression as a central bank failure rather than the failure of a pure gold standard.
As indicated by the historical record, a gold standard regime is not necessarily a bad idea. The classical gold standard performed comparatively well in its day. However, a gold standard regime is not necessarily a good idea for today because virtually every country now has a central bank, and central banks are major players in monetary policy and financial markets. Unless we abolish central banks (an unrealistic proposition), instituting some sort of gold standard–like system would require trusting central bankers to administer the system well.
Given the disastrous results of the interwar system as well as the end of the ill-fated postwar Bretton Woods System (which also proved difficult to implement as its fragile design prompted attacks from speculators seeking to game exchange rates they believed central banks could not credibly control), it seems unlikely that a current-day version of a gold standard would work well. Moreover, as the interwar experience shows, severe economic downturns brought on by poor monetary policy can lead to support for less market-oriented policies, as politicians blame the downturn on supposed inherent flaws of the market economy rather than on bad policy.
Shelton is right to desire a monetary regime that is rules-based and that brings about stability. However, a gold standard is not the only way to achieve those goals. For example, Mercatus Center scholars David Beckworth and Scott Sumner have argued that the Fed should stabilize the growth of total spending in the economy (nominal GDP) along a predetermined, level path.
Since nominal GDP growth is the sum of inflation and real output, the Fed would allow inflation to rise during downturns and help reduce the real value of debt obligations facing consumers and firms. During expansions, the Fed would allow inflation to fall, so consumers could benefit from lower prices. By stabilizing nominal GDP, the Fed would allow inflation to fluctuate somewhat in the short run but stabilize both employment and inflation over the long run. Moreover, since nominal GDP is a single variable, nominal GDP targeting requires less knowledge and discretion on the part of the Fed than the status quo, where the Fed attempts to target unemployment and inflation separately and in a generally discretionary manner.
Therefore, nominal GDP targeting is one realistic way to do the sort of rules-based monetary policy that gold standard advocates want. As such, in a world of second-best alternatives, it would be better for gold standard supporters to avoid “making the perfect the enemy of the good” and pursue more achievable options such as nominal GDP targeting.