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The United States embraced the principle of a currency whose value was
linked to gold from its founding in 1789 until 1971 – a period of 182
years. During this time, from the humblest beginnings, it became the
world’s wealthiest and most powerful state.
From that alone, you might think that a similar monetary approach today
might be a good idea. Instead, it is often regarded as “impossible.”
On the surface, this is stupid. There aren’t very many things that
people do for nearly two centuries that are impossible. Try to name one.
But, actually, this notion needs to be addressed. It’s what I call the “trauma of Bretton Woods.”
The Bretton Woods gold standard arrangement was not abandoned in 1971
because it was causing problems. This was after twenty years of
worldwide prosperity, in the 1950s and 1960s. Even Arthur Burns,
Chairman of the Federal Reserve in 1971, declared that he wanted it to continue. The problem was that it seemed to be breaking apart on its own accord, and nobody knew what to do. Maintaining it seemed “impossible.”
Didn’t we thus prove, from years of real-world experience in the 1960s,
that maintaining a gold standard system was “impossible”? And who wants
to go through that horrible experience again?
It was so traumatic.
People then cite many subsequent examples of a currency that is
“pegged” typically to the U.S. dollar, or deutschemark and then euro,
and then this “peg” fails spectacularly in some great currency
disaster. Just a few of the more recent examples of this include Mexico
in 1995, Thailand, Malaysia, the Philippines and Indonesia in 1997-98,
Russia in 1998 and arguably in 2014, numerous euro-pegged eastern
European countries in 2008-2009, and on and on and on. It seems like a principle that has been well demonstrated.
Thus, it makes a lot of people fidgety when I say that the actual cause of these disasters is not something inherent in a “fixed-value system,” whether the “standard of value” be gold, the dollar or the euro. Rather, it is due to the incompetence of currency managers.
The fact of the matter is that, while there are many “pegged
currencies” that blow up spectacularly in this fashion, there are also
many currencies with a fixed-value target that is maintained year after
year, placidly and with no apparent difficulty whatsoever. These are
the currency board systems. All six euro currency boards sailed through 2008-2009 with no problems. All
“euro pegged” currencies that did not use currency boards had major
difficulties. Thus, I often describe a gold standard system as a
“currency board linked to gold,” which describes about as much of this
notion of proper currency management as one can in five words.
If you are the sort that wants more than five words, you can read my latest book, Gold: the Monetary Polaris, which goes into great detail on exactly these topics, with many historical examples.
In 2001, Milton Friedman and Robert Mundell, two of the better monetary economists of the time, engaged in a discussion about “fixed or floating:”should a currency float, or should its value be “fixed” to some benchmark, whether the dollar, the euro or, perhaps, gold?
Friedman: ”Discussion of this issue requires replacing the dichotomy fixed or flexible by a trichotomy:
1. hard fixed (e.g., members of Euro, Panama, Argentine currency board);
2. pegged by a national central bank (e.g., Bretton Woods, China currently);
3. flexible (e.g., US, Canada, Britain, Japan, Euro currency union).
By now, there is widespread agreement that a global move to pegged rate
regimes [Friedman’s type 2] would be a bad idea. Every currency crisis
has been connected with pegged rates. That was true most recently for
the Mexican [1995] and East Asian [1997-98] crisis, before that for the
1992 and 1993 [European] common market crises. By contrast, no country
with a flexible rate has ever experienced a foreign exchange crisis,
though there may well be an internal crisis as in Japan.
The reasons why a pegged exchange rate is a ticking bomb are well
known. A central bank controlling a currency that comes under downward
pressure does not have to alter domestic monetary policy. … A hard
fixed rate [Friedman’s type 1] is a very different thing.”
Mundell: ” … I am also
convinced that an important part of the differences reduce to
linguistic problems. I can illustrate this by the use of the term
“fixed” exchange rates. I use the term “fixed exchange rates” to mean a
process in which the central bank fixes the price of foreign exchange
(or gold, but that is not relevant in the current context) and lets the
money supply move in a direction that keeps the balance of payments in
equilibrium [adjusts supply to match demand at the fixed-value parity] …
A currency board system. Under this arrangement, a country has its own
currency, but it is completely backed by a foreign currency to which it
is rigidly fixed. The money supply moves in exactly the same way as if
the country used the foreign currency to which it is fixed. This fits
Friedman’s category of “hard fixed.” …
Fixed rates. A looser form of fixed exchange rate system in which the
monetary authority exercises some discretion with respect to the use of
domestic monetary operations but nevertheless allows the adjustment
mechanism to work [the outcome is similar to that of a currency board,
although a wider range of operational tools are used]. A deficit in the
balance of payments [excess base money supply compared to demand, and
tendency for the currency to fall below its parity value] requires
sales of foreign exchange reserves to keep the currency from
depreciating, and this sale automatically reduces the money base of the
financial system … An analogous process occurs in the opposite
direction to eliminate a surplus.
Recent examples of this kind of fixed exchange rate system include
Austria and the Benelux countries which, over most of the 1980s and
1990s, kept their currencies credibly fixed against the [deutschemark].
Before 1971, under the Bretton Woods arrangements, the major countries,
with the single exception of Canada, practiced this system. Germany,
Japan, Italy and Mexico, for example, were able to keep fixed exchange
rates in equilibrium for most of the period between 1950 and 1970. The
gold standard system that prevailed before the First World War was
precisely such a system with a considerable amount of discretion on the
part of central banks [in terms of operating mechanisms] …
Pegged exchange rates. The distinction between fixed and pegged rates
that I find useful refers to the adjustment mechanism. Under a fixed
rate system, the adjustment mechanism is allowed to work [supply is
adjusted to match demand] and is perceived by the market to be allowed
to work. Whereas under “pegged” rates or “adjustable peg” arrangements,
the central bank pegs the exchange rate but does not give any priority
to maintaining equilibrium in the balance of payments [does not adjust
the base money supply automatically as a currency board would, but has
a discretionary “domestic monetary policy”]. There is no real
commitment of policy to maintaining the parity and it makes the
currency a sitting duck for speculators.”
Mundell made a distinction between today’s currency boards, and the
gold standard systems common before 1914: while currency boards have a
simple, automatic procedure, it was common for central banks pre-1914
to use a wide variety of operating procedures, over which they had some
discretion. However, in both cases, the “adjustment mechanism” of
increasing or reducing the monetary base produced a similar outcome.
Both Friedman and Mundell agree that there is a very large difference
between a “fixed” regime such as a currency board, in which there is a
proper “adjustment mechanism” involving changes in the monetary base,
and a “pegged” regime, where this “adjustment mechanism” does not exist.
Friedman calls this “pegged” arrangement a “ticking time bomb.” Mundell
says it “makes the currency a sitting duck for speculators.”
And that is why “pegged” currency systems blow up right and left. It is why the Bretton Woods gold standard arrangement blew up. It is that simple. Friedman and Mundell understood it.
Most central bankers do not. For them, proper currency management seems “impossible.”
What do you expect them to say in public? “I’m a dope?”
You can wish and pray and hope all you want for a gold standard
monetary system. But, unless someone knows how to run it properly –
using the principles outlined here by Friedman and Mundell – it will
always remain a wish.
In practical terms, nobody will even dare try it until you can
adequately answer the question: “Why won’t your system blow up like the
Bretton Woods system did in 1971, or Thailand in 1997?” For decades,
many gold standard advocates tried to avoid answering this question
with hand-waving and fluffery, because the fact of the matter was, they
didn’t know either. (With a few exceptions of course.) Ninety-eight
percent of people could never follow the (erroneous) details of these
various arguments, but 90% of them knew hand-waving and fluffery when
they saw it.
So, learn how to do it.
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