The Gold Standard Lecture 12 – Thursday, 19 October 2011 J A Morrison 1 Isaac NewtonDavid Hume

The Gold Standard

Lecture 12 – Thursday, 19 October 2011J A Morrison 1

Isaac Newton David Hume

Lec 12: The Gold Standard

I. Intro: Why bother with Gold?II. The Gold Standard as an

Ideal TypeIII.Breaking the “Rules of the

Game”IV.Brief History of the

International Gold StandardV. Conclusion 3

Lec 12: The Gold Standard

I. Intro: Why bother with Gold?II. The Gold Standard as an

Ideal TypeIII.Breaking the “Rules of the

Game”IV.Brief History of the

International Gold StandardV. Conclusion 4

Historical Significance• Provides insight into most of

monetary history• Integral to First Era of Globalization• Enduring legacies in contemporary

system– International Monetary Fund– Distribution of worldwide gold supply

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Intellectual Significance• Robust alternative to current system

of floating ERs• Lessons from First Era of

Globalization• Parallels with current crises– China’s “dirty float”– Constraints and opportunities generated

by currency union (e.g. Euro)

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Lec 12: The Gold Standard

I. Intro: Why bother with Gold?II. The Gold Standard as an

Ideal Type• Breaking the “Rules of the

Game”• Brief History of the

International Gold Standard• Conclusion 7

II. THE GOLD STANDARD AS AN IDEAL TYPE

1. The Gold Standard Rules2. Purchasing Power Parity3. The Automaticity of the Gold

Standard

Remember our understanding of an exchange rate: the

valuation between the domestic currency and

foreign currency/currencies.

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In theory, the gold standard (GS) was an exchange rate

regime that related the member countries’

currencies through their valuations to gold.

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$ £

¥ €

Gold as an Intermediary

Example: £1 = 1 oz gold = $4.86

II. THE GOLD STANDARD AS AN IDEAL TYPE

1. The Gold Standard Rules2. Purchasing Power Parity• The Automaticity of the Gold

Standard

The gold standard ideal was that all currencies would be freely convertible through

gold.

This would secure purchasing power parity

(PPP).

And PPP would ensure complete market

integration.19

Purchasing Power Parity (PPP)

• Purchasing power (PP): command over goods and services– $919.50 = 1 oz gold– £639.43 = 1 oz gold

• PPP: money enjoys the same purchasing power in every market even after making necessary conversions– Implied PPP (based on gold prices): $1 =

£0.695

• PPP can be calculated using any “basket” of goods & services– The Economist uses the Big Mac! 20

PPP versus Market Rates• Implied PPP (from gold prices): $1 =

£0.695• If I can trade $1 for £0.695, I should

be able to buy gold at the same “price” in GB and in the US

• BUT Market Exchange Rate: $1 = £0.691

Why the difference? Why doesn’t arbitrage eliminate the difference?

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Let’s go through an example…

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$499 £429

But the market ER is $1 = £0.63

So, $499 = £314

Yet...iPads cost £429 in London!

That’s over £100 more!

Why don’t the Brits just buy their iPads here?

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Well, some do buy them here!

But, for many, the costs are greater than just buying it

in London.

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Valuation• Valuation: the relationship between

market price and underlying “value”• Different ways to calculate valuation– Stock: price-to-earnings-to-growth (PEG)

ratio– Currency: PP versus ER

• Over and Under– Overvalued: currency purchases less

than ER implies (PP < ER)– Undervalued: currency purchases more

than ER implies (PP > ER) 27

II. THE GOLD STANDARD AS AN IDEAL TYPE

1. The Gold Standard Rules2. Purchasing Power Parity3. The Automaticity of the Gold

Standard

The GS was meant to automatically ensure both the quantity of money in

the world and the distribution of money

around the world.

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GS Regulation of Quantity• Official/Mint Price: price of gold in terms of

local currency• Free Conversion: monetary authority

should…– Purchase gold with currency at the official price– Sell gold for currency at the official price

• Automatic Quantity Adjustment– Overvalued currency sell currency for gold

decrease in currency and increase of gold– Undervalued currency sell gold for currency

increase in currency and decrease in gold

• Sustained increases in gold price mining30

By regulating the quantity of currency automatically, adherence to the GS would

theoretically ensure domestic price stability.

After all, if the official ER did not match the PPP,

currency/gold would be converted. 31

What about the distribution of gold? Who gets how

much gold?

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GS Regulation of Distribution

• David Hume’s Price-Specie-Flow Model

• Assume: costless int’l transport & conversion

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Excess Gold in

US

Rise in US Prices

US Imports Increase; Exports

Decrease

US Exports

Gold

US Prices Fall; BoT

Equilibrates

Despite these advantages, policymakers have

frequently found it in their interest to bend the “rules

of the gold standard game”…

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Lec 12: The Gold Standard

I. Intro: Why bother with Gold?II. The Gold Standard as an

Ideal TypeIII.Breaking the “Rules of the

Game”• Brief History of the

International Gold Standard• Conclusion 35

As a formal matter, being on the GS required two

things:

(1) maintain exchange rate stability (“gold parity”);

(2) maintain convertibility between domestic currency

gold... 12

(1) Maintain Exchange Rate Stability (“gold parity”)

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--> the monetary authority commits to doing everything in

its power to ensure that the market ER with gold remains at

the predetermined, official “parity.”

(2) Maintain Convertibility between Domestic Currency

& Gold.

--> No restrictions on the purchase/sale of domestic

currency/gold. No restrictions on the import/export of gold or

currency.

But remember the balance of payments constraint.

States only have a few ways to reconcile imbalances of

payments...

Remember this slide?

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Lecture 6: Balance of Payments (Slide #38)

Following the gold standard rules precludes two…

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Reconciling the BoP under the Gold Standard

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1. Adjustment of Reserves2. Adjustment of Internal Prices &

Incomes 3. Exchange Rate (ER) Adjustment4. Exchange Controls

1. Capital Controls: Limit convertibility2. Commercial Policy

Bracketing option 1 (adjusting reserves), states face a difficult

choice between:

(2) allow price-specie-flow to dictate changes in domestic macroeconomic conditions;

(4.2) use commercial policy (tariffs, subsidies, &c.)

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These are the “golden fetters” that have put

policymakers in a “golden straightjacket.”

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But why can’t they just adjust reserves?

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Remember the asymmetric positions of deficit and surplus

countries:

Surplus countries can accumulate reserves ad

infinitum.

While deficit countries will eventually exhaust their

reserves.42

IV. BREAKING THE RULES OF THE GAME

1. Deficit Countries2. Surplus Countries

Deficit countries have frequently violated the two

formal “rules of the gold standard game.”

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Exchange Rate Adjustment

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• Specie: Change quantity of precious metal in coins

• Backed currency: Adjustment of official exchange rate

• Fixed fiat currency: Shift in “target” market rate

Limitations on Convertibility

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• Restrictions on market exchange, foreign investment, and import/export of currency (e.g. China today)

• Government imposed costs on conversion– Fees to convert currency via monetary

authority– Restrictions on conversion (e.g. delay at

the mint)– Tax on capital movement (e.g. Tobin tax)

IV. BREAKING THE RULES OF THE GAME

1. Deficit Countries2. Surplus Countries

Sterilized Intervention

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• Intervention: government maintains stable market ER by selling domestic currency in exchange for foreign currency– Foreign currency is then held in reserve

• Sterilization: government counters inflation by buying excess domestic currency with government debt (open market operations)

• Sterilized Intervention: intervention + sterilization

The result is that the exchange rate remains stable, domestic

prices and incomes remain stable, and the government simply amasses foreign reserves.

This saves the surplus country from having to adjust today.

It also provides reserves for a “rainy day” in the future.

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Surplus Countries under the Gold Standard

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1. Adjustment of Reserves2. Adjustment of Internal Prices &

Incomes 3. Exchange Rate (ER) Adjustment4. Exchange Controls

1. Capital Controls: Limit convertibility2. Commercial Policy

Maintained through intervention

Inflation countered by sterilization

The sky is the limit!

But it also shifts the burden of adjustment

entirely onto the shoulders of the deficit

country.

And it creates competition for reserves.

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This is what the US and France did in the 1920s.

And this is largely what China is doing today.

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Lec 12: The Gold Standard

I. Intro: Why bother with Gold?II. The Gold Standard as an

Ideal TypeIII.Breaking the “Rules of the

Game”IV.Brief History of the

International Gold Standard• Conclusion 54

Here are a few of the highlights of the emergence

and ascent of the international GS.

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Britain Adopts the “Silver Standard”

• 1696: Locke convinces Parliament to adopt silver standard– permanently fixed– Fully convertible units into specified

amounts of metal

• Locke combated bimetallism– “Silver is the instrument and measure of

Commerce in all the Civilized and Trading parts of the world.” (374)

– Let gold float vis-à-vis silver; no official exchange rate between gold & silver 57

From Silver to Gold • 1717: Newton overvalues gold vis-à-vis

silver– Gresham’s Law: overvalued gold drives out

undervalued silver– Britain is on de facto gold standard

• 1819-1821: Ricardo convinces Britain to adopt de jure gold standard– Exchange rate stability: return to pre-war parity!– Convertibility: no limits on convertibility

Throughout, Britain maintained a robust commitment to a metallic standard. All that changed was the metal. 58

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The US: Hamilton versus Jefferson

• Hamilton’s Reports– Report on a National Bank (1790)– Report on the Mint (1791)– Report on Manufactures (1791)

• Hamilton: Banks & Paper Money– Stimulate domestic industry– Reduce dependence on foreign trade & capital – Court financial interest political stability

• Jefferson: Specie & International Integration– Market integration efficiency & peace– Suspicion of financial interest: banks &

corruption– Insulation Southern dependence on North 60

US Monetary Policy• 1791: First Bank of the United

States– Triggered Constitutional debate on Art 1,

Sec 8: “Necessary & Proper” Clause– Bank issues extensive token/paper

currency, heavily leveraged

• 1792: US Mint Act– Bimetallism– Hamilton says, “What the hell: we’ll

have some specie too!”

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My Assessment• Hamilton was lazy– Did not bother with important technical

details– Just copied Britain

• But he had political savvy–Won public debate by citing British example– Got backing of powerful financial elites– Had Washington’s ear

• Jefferson was a philosopher– Better understanding of technical details– But too abstract and reactionary for public– Did not build a coalition in time 62

Maggie and Me at the First Bank of the United States in Philadelphia

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France• Nominally bimetallic• But traditionally a silver country• 1840s: gold discoveries

overvalued gold de facto gold standard

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Setting the Standard• 1867: Paris conference to officially

appoint gold as int’l standard• Conference wasn’t legally successful,

but inspired trend• 1870s– Germany moves toward gold– France attempts to undercut Germany by

attracting gold bimetallic block busts

• 1879: US goes to gold; Japan follows• Network Effect: value of being on

common standard increases as membership increases 67

Lec 12: The Gold Standard

I. Intro: Why bother with Gold?II. The Gold Standard as an

Ideal TypeIII.Breaking the “Rules of the

Game”IV.Brief History of the

International Gold StandardV. Conclusion 68

The gold standard certainly seems dated.

None of us had been born when the international gold standard system collapsed

in the 1970s.

But there are good reasons to understand it… 69

Importance of Gold• Era of fiat currency (1971-present) is

vast exception to rule; commodity currency has been norm

• Will the new era endure?– Nth Currency is a national currency– Can governments be trusted with fiat

currency?

• Key insights useful to new era– Emergence of capital controls in China– Challenges in EU: integration versus

domestic policy autonomy 70

Essentials of Gold Standard “Era”

• Few countries fully adhered to the “rules of the gold standard game”– Deficit countries violated formal rules:

convertibility and ER stability– Surplus countries violated informal

rules: amassed reserves

• Level of adherence correlated with:– Closeness to London– Relative size of economy

How might we explain this correlation? 71

Next time, we’ll discuss the decline and fall of the gold

standard.

This will allow us to examine the political

dimensions of exchange rate regimes in a rich

context.72