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(This item originally appeared at Forbes.com on August 30, 2012.)
http://www.forbes.com/sites/nathanlewis/2012/...nancial-crisis/
A friend tells me that the soft-money advocates will always argue something
along the lines of: �What if the financial crisis of 2008 had happened and we
were on a gold standard?� They imply that a gold standard system would have
made the crisis much worse.
Well, what if?
All of these kinds of soft-money arguments tend to boil down to the notion of
devaluing the currency during a time of crisis. The actual strategy
could be an overt currency devaluation, or it might be related to very low
interest rates, or printing an excessive amount of money to deal with one
problem or another, target="_blank" leading to
a decline in currency value. A gold standard system would prevent a
currency from declining in value; and thus, any excessive money-printing of
this sort.
Let�s take, for purposes of example, target="_blank" a
period from the end of June 2008 to the end of June 2009. The U.S. stock
market had not yet begun to fall rapidly in June of �08; indeed, the S&P
500 finished August at about the same level as it ended June. By the end of
June 2009, the S&P500 was already recovering rapidly from its low in
March 2009.
The value of the dollar was target="_blank" $930.25 per ounce of
gold at the end of June 2008. At the end of June 2009, it was $981.75 per
ounce. Thus, on a point-to-point basis, the dollar was not devalued during
this crisis period. Indeed, if the U.S. had been on a gold standard system at
the time, let�s say at a parity of $1000/oz., the outcome would have been
about the same on a point-to-point basis. The value of the dollar would have
been $1000/oz. at the end of June 2008, and the same $1000/oz. at the end of
June 2009.
The dollar did not remain at an even value throughout the crisis period. Nor
was it devalued, as the Keynesians like to imply. No, the dollar went up! In
October of 2008, the dollar hit a high of $712.50/oz. (London PM fix basis).
It then fell back. This spike in dollar value was reflected also in exchange
rates with other currencies. The Federal Reserve�s broad target="_blank" trade-weighted
dollar index went from 95.76 at the end of June 2008 to a high of 112.49
in November 2008, before falling back to 105.35 at the end of June 2009.
The basic reason for the financial crisis of 2008 was bank insolvency. Many
banks had made too many loans to borrowers who could not pay them back. The
prospect of widespread and chaotic bank default loomed. This spike in dollar
value, in the middle of the crisis, just added a new problem to an already
problematic scenario.
A gold standard system would have prevented this spike in dollar value. The
value of the dollar would have remained at a stable $1000/oz. throughout the
crisis period. If other countries were also using gold standard systems, then
the exchange rates between their currencies and the dollar would have
remained fixed and predictable, instead of varying wildly.
Why did the dollar spike higher in value during this time? The simplest
reason is that demand was greater than supply. Beyond this, we have to
hypothesize a little bit.
Dollar base money consists of two elements: banknotes and coins, and bank
reserves recorded as deposits with the Federal Reserve. Because bank reserves
do not pay interest, banks have tended, over time, to reduce their holdings
of bank reserves. This increases profitability. However, having less reserves
also increases banks� dependence on short-term borrowing via the money market
to deal with liquidity needs. As the crisis intensified, and indeed in the
years since that time, banks found that they could no longer borrow from
other banks easily or reliably. Banks didn�t trust each other anymore,
because they knew that many banks had insolvency problems. Thus, banks wanted
to keep more cash on hand, in the form of Federal Reserve bank reserve
deposits.
Bank reserves thus expanded, from about 5% of base money outstanding to about
50%. This is a big move, but it actually just brought banks back to where
they were in the 1950s, when bank reserves accounted for about 40% of base
money. As a percent of deposits, bank reserves increased to about 15%, again
roughly where it was in the 1950s.
Banks �demanded� this increase in a forthright way: they borrowed it
voluntarily from the Fed, via the discount window, at interest. Thus, it is
fairly safe to say that this represented a legitimate increase in base money
demand. No wonder the dollar�s value was rising during that time, until this
demand was met by the Fed.
A gold standard system is intended to increase supply to meet increased
demand, so that the currency maintains a stable value. If the dollar has a
tendency to rise, as it did in late 2008, a gold standard system would have
automatically increased the monetary base to keep the value of the dollar at
its gold parity.
If this increase in the monetary base, via the normal operating mechanisms of
a gold standard system, was for some reason not sufficient, the Fed could
have also acted as a �lender of last resort� in the 19th-century meaning of
the term, or what I have called �19th Century Central Banking.� In fact, this
is what the Fed did, via its discount window lending. This action is entirely
consistent with a gold standard system, and mirrors what the Bank of England
did in the 19th century while keeping the British pound pegged to gold.
Discount window lending is intended to be short-term, to respond to
short-term changes in the need for bank reserves, which historically were
closely related to the harvest season. However, the dramatic increase in
banks� desire to hold reserves has been a persistent pattern for some years
now. With a gold standard system, these short-term loans would eventually be
replaced with a longer-term adjustment in base money outstanding, likely
through purchases of either gold bullion or Treasury bonds. In fact, this is
exactly what Ben Bernanke did with �QE1,� which replaced discount window
lending with MBS on the Fed�s balance sheet.
Many other things were done during this crisis period. Banks such as
Washington Mutual, Countrywide Financial, Merrill Lynch and others were
restructured or merged. AIG was bailed out by the federal government, thus
indirectly bailing out AIG�s creditors. TARP was passed. Fannie Mae and
Freddie Mac were effectively nationalized. Citigroup was recapitalized by the
federal government. A blanket guarantee on money market funds was applied,
and many other additional steps were taken.
Whether these were good ideas or bad is a topic for further discussion.
However, one thing they have in common is: they could have all been done
within the context of a gold standard system. Indeed, the most effective
action, corresponding to the stock market bottom in March 2009 and its quick
recovery afterwards, was a ruling by the FASB that banks were allowed to mark
their assets �to model,� which is to say, make up their values. The Fed had
nothing to do with this.
Thus, we find that what the Fed did during the crisis of 2008 was, in fact,
much like what would have happened with a gold standard system. If anything,
a gold standard system would have operated more quickly and more smoothly,
supplying additional base money as soon as the dollar began to rise in value,
an indicator of increased base money demand. Also, a gold standard system
would have maintained the dollar at an even value, for example a parity of
$1,000/oz., throughout the period, thus avoiding the additional turmoil of
currency instability piled upon the existing problem of bank insolvency.
The Fed was created for exactly this purpose. It was always intended to
operate alongside a gold standard system, and did so for 58 years, from 1913
to 1971. In the Federal Reserve Act of 1913, it states: �Nothing in this act
� shall be considered to repeal the parity provisions contained in an act
approved March 14, 1900,� which referred to the Gold Standard Act of 1900. It
was only in later years that the Keynesians managed to turn the Fed into a
supposed all-purpose economic Mr. Fixit via the magic of monetary distortion.
Actually, with a gold standard system, it is likely that the Fed could have
been much less involved in 2008. The reason banks had a sudden need for more
reserves in 2008 is that they began the crisis with so little. During the
gold standard era, from 1865 to 1971, banks consistently held much larger
reserves, target="_blank" on
the order of 30%-50% of total base money outstanding. The reason
that banks were holding such small reserves at the beginning of the crisis is
related to their expectation for constant, daily Fed involvement in money
markets, which has become a characteristic of the past few decades of the
floating fiat dollar. If banks had started the crisis with their historically
much higher reserve levels, then there might not have been a need for Fed
action at all.
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