Originally posted on Tuesday, April 17th, 2012
“The appeal of the historic gold standard lay in an institutional capacity to build confidence.” — Professor Harold James
In October 1990, then Professor Ben Bernanke co-authored with Professor Harold James NBER Working Paper No. w3488 entitled The Gold Standard, Deflation, and Financial Crisis in the Great Depression: An International Comparison. Its abstract notes, in part, that “Recent research has provided strong circumstantial evidence for the proposition that sustained deflation — the result of a mismanaged international gold standard — was a major cause of the Great Depression of the 1930s.”
Professor Harold James Photograph courtesy of Princeton University
It is of more than passing interest that while Chairman Bernanke recently presented some widely disputed criticisms of the gold standard in a lecture at George Washington University, his scholarly colleague Prof. James, currently Professor of History at Princeton University and the European Institute in Florence, and Professor of International Affairs at Princeton’s Woodrow Wilson School of Public and International Affairs, writing in project syndicate, put forward a substantially more nuanced assessment in a piece at Project Syndicate entitled Golden Rules for the Eurozone.
The European Monetary Union, as many of its critics maintain, looks a lot like the pre-1913 gold standard, which imposed fixed exchange rates on extremely diverse economies. But is that resemblance as bad as it sounds, or as the euro’s critics insist?
The appeal of the historic gold standard lay in an institutional capacity to build confidence. A completely fixed exchange rate rules out monetary-policy initiative, and consequently makes adjustment to large external imbalances very difficult to carry out. And the burden is unequal, because there is much more pressure on deficit countries to adjust via deflation than on creditor countries to allow higher inflation.
Pessimists are especially worried by the unpleasant gold-standard analogies and lessons. They foresee years and even decades of slow growth in Europe. Politically, too, the process of adjustment by deflation in deficit countries is so unpleasant and difficult that many pessimists think it will ultimately prove to be unsustainable.
But critics of the euro should take the gold-standard analogy more seriously. Like any system in the real world, it was more complex, more interesting, and also filled with more real policy possibilities than textbook caricatures suggest.
Among several astute observations:
The gold-standard rules look very different from the modern practice of monetary union, which relies on a single uniform interest rate. That one-size-fits-all approach meant that interest rates in southern European countries were too low before 2009, and too high in northern Europe. A gold-standard rule would have produced higher rates for the southern European borrowers, which would have attracted funds to where capital might be productively used, and at the same time acted as a deterrent against purely speculative capital flows.
The classical gold standard implied adherence to what were, in the 1920s, referred to as “the rules of the game,” Gold, the metal, was a critical element in maintaining the world financial order. Managing the standard required the bankers and financiers of the world to adhere to the “gold-standard rules.” When they did so, prosperity and security tended to result.
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