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April 09, 2008


James Zuberi

The gold standard, based on the readings and my complete lack of knowledge about this topic, was not much worse than the fiat money of today if the countries which were intricately tied to the system were able to play by the established norms or "rules of the game." Rules of the game exist for all complex systems which different types of actors and today's fiat money hasn't done away with rules as much as it has provided a different set of rules.

First, Bordo describes that one major benefit of the gold standard was price stability. This is due to the fact that inflation under the gold standard was on average quite low in relation to the fiat money of today. Given the fact that inflation is still a major worry of modern economies it seems to me that this is a positive characteristic of the system. One caveat of this argument though is that the gold standard may have contributed to deflation. This is probably not a good thing.

Eichengreen argues that the use of the gold standard helped contribute to financial and economic crises of the early 1900s. This is not a new argument, at least given our past readings, because in 'Evolution of the International Economic Order' (this should be in italics) the author described how the gold standard contributed to situations in which developing countries were periodically put into situations where economic downturn and the nonavailability of money both happened at the same time; this mechanism contributed to the defaults or requests for restructuring of loans. But, to be fair, developing countries not being able to pay for their massive debts is not something that has really ended under the fiat money system and so the gold standard should not be completely at fault. The IMF as a lender of last resort seems to be a mechanism that helps countries avert financial ruin much more than what type of currency is the flavor of the decade.

At its heart, I think one major aspect of the two currency systems that is very similar is the reliance on animal spirits. Now I doubt that Professor Akerlof will address this topic in particular, but as some of the authors point out, the ability of a currency to hold value depends a great deal on the confidence that the users place on it. In this way fiat money and the gold standard merely instruments and the real differences lie in the creativity of the players to develop ways of stabilizing various vulnerabilities of the game by using rules. Including this final sentence, this weekly response has been a total of 450 words exactly, as in perfectly 450 words.

Wayne Feng

The plausible alternative to the Gold Standard would have been a fiat money system. Within this context you can have either fixed or floating exchange rates. While it is hard to determine whether the economy would have been better off under a different system, I believe that it can be generally argued that the Gold Standard was not a good system to begin with. From our readings for this week, John Dutton argued that there was relative stability in the long run under the Gold Standard. Berry Eichengreen counters this argument with evidence on the volatility of the Gold Standard, showing that the system does not actually provide stability in a different sense of the term. Eichengreen also argues that the fundamental pillars of the Gold Standard were credibility and cooperation. While Dutton points out how the rules of the game were not always followed, this demonstrates the fundamental flaws of the system, creating situations where it may actually be bad to play according to the rules, but necessary to maintain credibility. Another issue revealed by the reading by Albert Fishlow is the importance of who was the primary player in the world marketplace. Under the classical Gold Standard, England was the center of the world economy. After the Depression, the United States became the center of the world economy. For the United States, the goal of minimizing unemployment, especially in the late 1900s (1970ish) became a primary goal. Under a Gold Standard this would be much more difficult and the restrictions on how the central bank can affect the economy would be extremely limiting. While in hindsight it may be easy to say that the Gold Standard was not as good as what we may have now, it can be hard to say. For one thing the markets and technology needed for a floating exchange rate system may not have existed prior to the development of communication and computing technologies. Furthermore, even with a fixed exchange rate, the issue of which currency to peg value to as well as the relative carelessness of countries to ignore inflationary effects to pay off debt (as mentioned by Michael Bordo and Berry Eichengreen) also would have been a deterrent to adopting such a system. Lastly, it can be argued that the current system is still volatile and unstable. There may be less inflation, etc. but at the same time price stability is an issue and more importantly financial crisis still exist in the modern context. However, I believe that if under the Gold Standard, financial crisis would be harder to solve due to the “rules of the game” necessary. Eichengreen makes such a point with the recovery of economies which left the Gold Standard compared to those who left later.

Omar Nayeem

For its time, I think the gold standard was among the best available systems. One obvious advantage that comes with a gold standard is stability: since currencies are tied to gold, a relatively scarce commodity whose supply changes very little, money supplies and price levels should, in theory, exhibit long-term stability. As Eichengreen (1996) argues in Golden Fetters, the success of the gold standard rested on two principles: credibility and cooperation. Central banks had to show credible commitments to the gold standard by guaranteeing convertibility and by following “the rules” (described both in Bordo and in Dutton (1983)) that were put in place to keep exchange rates at par and to maintain reserve levels. An important consequence of this fact is that countries on the gold standard could not (or rather, were not supposed to) adopt policies to counter the effects of broader adjustment processes on their domestic economies. Such countercyclical actions violated the rules. The problem is that, while the system’s success depended on countries’ cooperation and commitment to follow the rules that facilitated adjustments, the incentives for an individual country to break these rules for its own gain were high. As Dutton (1983) finds, the Bank of England, which was seen as the leader of the global financial community, itself did not always follow the rules; it often took countercyclical actions. This fact is quite telling, given that Bordo characterizes the Bank of England as the “exemplar of central bank behavior” given that it “played by the rules over much of the period 1870 to 1914.” If Dutton’s findings and Bordo’s characterization are both accurate, it follows that it was not uncommon for central banks to break the rules by adopting countercyclical policies. Still, as Dutton notes in his conclusion (and leaves as an open question), the international monetary system was still stable during the time period. According to Bordo, average annual (worldwide?) inflation between 1880 and 1914 was only 0.1 percent.

Floating exchange rates, as we have today, make more economic sense than the fixed exchange rates that were imposed by the gold standard because of the fact that, under a floating exchange rate system, currencies are valued by market forces and therefore are not fixed at arbitrary levels in the long run. (Short-term fluctuations do occur under both systems, though.) Also, the gold standard requires cooperation among central banks (even though the effect of breaking the rules on stability does not seem to have been high) and, even if rules are broken, limits the effectiveness of central banks’ monetary policies. Modern central banks have a wide array of tools and policies available to them that they can use to influence real economic variables, such as inflation, output, and unemployment. Having a worldwide gold standard would curb both the permissibility and effectiveness of these tools and policies, but in the late nineteenth and early twentieth centuries, economic theory had not yet matured to the point where these tools and policies had been conceived. (Indeed, as Eichengreen (1996) notes, unemployment during this era was seen as the result of individual failure or laziness, not as a consequence of business cycles as economists view it today.) Furthermore, the requisite technologies and institutions that are needed to support a foreign exchange market were not present at this time. The real problems with the gold standard were seen with the onset of World War I and, just over a decade later, the Great Depression. Because money supplies were linked to gold reserves, decreased international lending from the country with the most favorable balance-of-payments position following World War I (the United States), combined with a large flow of gold into France, caused monetary contractions in other countries (Eichengreen (1996)). Eichengreen argues that, with these conditions, the stage was set for the Great Depression. So in hindsight, the gold standard did have its problems, but because of the limits of technology and institutions for the time period, I don’t know that any feasible alternative would have performed better.

M Larrain

Memo Question (Gold Standard)
M. Larrain

According to the readings the gold standard as an international monetary arrangement has both advantages and disadvantages. A great virtue of the gold standard is price stability. As Bordo documents, the average inflation between 1880 and 1914 rate was of 0.1 percent, much lower than the 4.2 percent observed between 1946 and 1990. It may also create a positive international environment which would foster international trade and foreign investment in the world. On the other side, according to Eichengreen the use of the gold standard might have helped contribute to the financial and economic crises of the beginning of the 20th century. This would include the Great Depression.

An important additional issue is that the usefulness of the gold standard depends fundamentally on credibility and cooperation of the financial community (see Eichengreen). According to Dutton, the problem was that the rules of the game were not always followed by countries.

To understand if the world economy would have been better off if it had adopted an alternative form of international monetary arrangement late in the nineteenth century we must first see what other form of international monetary arrangements are available. The main alternative to the gold standard is a fiat money system, and within this system, there are two main exchange rage regimes, a fixed one and a flexible one. However, both of these two extremes have pros and cons. A fixed exchange rate system has the advantage of decreasing inflation by eliminating “imported inflation”, but it also has problems of credibility that could lead to currency crises (see, for example, Krugman). A flexible exchange rate system, on the other hand, has the benefit of allowing the economy to adjust more rapidly to different types of shocks, and eliminates the possibilities of currency crises. On the other hand, it has the problem that it increases largely the volatility of the economy and can be prone to have more inflation, if external inflation is high. As can be seen from this very brief discussion, there are trade-offs to different monetary arrangements, and as a result, it is not clear to me if the economy would have been better off if during the late 19th century used it used a fiat money system instead of the gold standard.

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