Blind faith in government
I recently participated in Alternative Money University at the Cato Institute. It was nice to see so many young students who are interested in exploring monetary ideas beyond New Keynesian DSGE models.
Presentations by Larry White and George Selgin had the effect of slightly changing my views of the gold standard. On balance, I’m still opposed to going back to the gold standard, but the reasons have more to do with likely government interference in the regime, rather than any flaws in a true laissez-faire commodity standard.
Larry White often point outs that the pre-1914 gold standard (which was less interventionist than either the interwar or Bretton Woods versions), did pretty well by several metrics. Long run inflation averaged near zero, and business cycles seem roughly comparable to the post WW2 era. The strong bias against the gold standard among mainstream economists may not be well founded.
I’ve previously accepted these empirical claims, although I’ve also believed that the gold standard would likely do worse in modern times. If 1879-1914 business cycle volatility actually was comparable to modern times, that might reflect two offsetting factors. Nominal shocks (year-to-year inflation or NGDP volatility) were probably greater during the classical gold standard, but wages were more flexible. In my view, those two factors roughly offset to produce business cycles comparable to the post-WW2 era. The gold standard might not do as well with our modern economy, which has less wage flexibility.
So why did I slightly my views change? George Selgin presented evidence that even the 1879-1914 gold standard in American was badly distorted by foolish banking regulations, which introduced unnecessary instability into the overall economy. These regulations prevented banks from providing additional currency during the fall harvest season, when money demand was high. In contrast, Canadian banks were allowed to do so. As a result, we had a number of financial crises that tended to begin in the fall of the year, whereas Canada had a far more stable banking system.
Even worse, regulations that prevented bank branching led to the US having tens of thousands of small, poorly diversified unit banks, thousands of which failed during the Great Depression. Canada had a very small number of highly diversified banks with branching all across the country, and it this difference that best explains why Canada has avoided the repeated banking crises seen in the US.
If the US had adopted the less regulated Canadian (or Scottish) model, we probably would have avoided banking crises such as 1907-08, and thus the classical gold standard would have looked even better.
Again, I’m not advocating that the gold standard be adopted today. For instance, I worry how it would perform in the modern era of ultra-low interest rates. Gold demand could increase sharply at zero nominal interest rates. And we still have a dysfunctional banking system. And highly interventionist governments. And we’d probably need an international agreement. Rather, I am making this claim:
The classical gold standard of 1879-1914 performed fairly well, and if it had been combined with an unregulated laissez faire banking system it probably would have performed extremely well.
I’d guess that 80% to 90% of economists would disagree with this claim, but it is very likely true. Even among economists, there is an almost knee-jerk skepticism about laissez-faire monetary arrangements and an irrational faith in governmental institutions. The profession would do well to read the research of Selgin, White and others on the actual performance of unregulated monetary and banking arrangements. Consider the following:
1. The Fed began in 1914, right at the end of the classical gold standard. It was set up to stabilize the financial system, to avoid the sort of banking crisis that we saw in 1907. And yet the next 20 years were far worse than any other period in American history. Did historians conclude that the Fed had been a failure? No, it was praised as a great success of the progressive era, ending the instability of the supposedly dysfunctional classical gold standard.
2. Indeed, even the entire 1914-1982 period was clearly a failed experiment. The interwar fiasco was followed by the Great Inflation. This led to the severe recessions in 1974 and 1982, partly caused by Fed-created nominal instability. And yet people who advocated, “ending the Fed” during the 1980s were viewed as crackpots. Their claims were not implausible, and I say this as someone who doesn’t want to end the Fed.
3. The 1982-2007 period did see a major increase in monetary stability. By the end of this period, Fed officials were taking credit for the “Great Moderation”. They were basically saying, “We did it, we stabilized inflation and NGDP growth rates.” But when everything fell apart after 2008, the Fed (and outside intellectuals) insisted that the recession was due to bad luck, caused by external shocks leading to a banking crisis, and not caused by tight money. But if bad luck caused the Great Recession, why didn’t good luck cause the Great Moderation? Why should the Fed take credit for that success? In fact, good policy did cause the Great Moderation, but bad monetary policy caused the Great Recession.
4. For a decade, politicians and pundits have complained about the banking system. Too much power, excessively high fees, etc. Then when an outside party threatens to come in and provide competition to banks, allowing consumers to transfer money at much lower costs, these same politicians and pundits are outraged. How dare Facebook provide competition to the banking system! That competition (they say) is “monopolistic”.
There is a deep skepticism about allowing market forces into the monetary system, despite a long history of failed, counterproductive government interventions. In contrast, there is a sort of blind faith in government institutions. Even when institutions such as the Fed had clearly failed, historians simply refused to recognize the obvious. Given the way American students are indoctrinated with “fake history” in our school system, it is amazing that America still has a reasonably capitalist economy. (Actually it’s not amazing; almost no one pays attention in school.)
PS. I find Larry White’s careful and nuanced defense of the gold standard to be far more persuasive than the arguments of some recent Fed nominees, who seemed to think Bretton Woods was a successful “gold standard”, but the Great Depression was somehow not a failure of the gold standard. Exactly how do they define a “gold standard?”
PPS. In his talk, George Selgin pointed out that after the 1907 crisis, a number of reformers were advocating something like the Canadian system. Unfortunately, the very powerful Senator Aldrich of Rhode Island was in the pocket of Wall Street interests, and we ended up with an interventionist central bank that not only failed to alleviate the problems of the National Banking System, for a considerable period of time it actually made the instability even worse. This Selgin paper is a good introduction.