The gold standard and other monetary regimes.

Bordo, Michael D.

In recent years, my research has focused on three topics that I discuss here: the performance of the gold standard and its Bretton Woods variant; the gold standard as a rule - that is, as a credible commitment mechanism; and the performance of alternative monetary rules.

The Performance of the Gold Standard

and Bretton Woods Monetary Regimes

Under the classical gold standard, adherents' monetary authorities were required to fix the prices of their currencies in terms of a fixed weight of gold and to buy and sell gold freely in unlimited amounts. The pledge to fix the price of gold provided a nominal anchor for the international monetary system. Under the Bretton Woods system, in contrast, only the United States fixed the price of the dollar in terms of gold. All other convertible currencies were pegged to the dollar. Also under Bretton Woods, free convertibility of gold into dollars was limited. Thus, Bretton Woods was a weak variant of the gold standard.

Comparing the performance of a number of important nominal and real macro variables across four regimes (the classical gold standard, the interwar period, Bretton Woods, and floating exchange rates) for the G-7 countries, using annual data, reveals that the Bretton Woods system was the most stable for virtually every variable. The gold standard was second. Further, the Bretton Woods convertible period (1959-71) had the lowest standard deviation of both the inflation rate and the growth of real output.(1) Under the classical gold standard, the standard deviation of both variables was higher than under Bretton Woods and the recent float.(2)

Although the classical gold standard was not characterized by short-run price stability, it did exhibit long-run price stability from 1821-1914.(3) For a number of key countries from the eighteenth century to the present, the gold standard episodes are virtually without inflation persistence compared to the post-World War II era when inflation is significant and positive.(4) Inflation persistence was lower in the fully convertible Bretton Woods period (1959-71) than in the preconvertible period and the subsequent floating exchange rate period.(5) This illustrates the importance of the stable nominal anchor provided by the gold standard and its Bretton Woods variant.(6) As is argued in the next section, the gold standard also may have provided a credible commitment mechanism.

Finally, although the Bretton Woods system in its convertible phase was the most stable monetary regime of the past century, it was also short-lived. Whether it was stable because of the regime, or because of the absence of large shocks compared to other regimes, is an empirical question. Some recent evidence suggests it reflected both influences.(7)

The Bretton Woods system collapsed both because of fatal flaws in its design (the adjustable peg in the face of improved capital mobility, and the confidence problem associated with the gold dollar standard) and conflicting policy objectives between the key deficit and surplus countries.(8)

The Gold Standard as a

Commitment Mechanism

The evidence that inflation under the gold standard and Bretton Woods was markedly less persistent than under regimes without a nominal anchor suggests that the gold standard rule of convertibility was a credible commitment mechanism. In the recent literature on the time inconsistency of optimal government policy, the absence of such a mechanism leads governments that pursue stabilization policies to experience inflation.(9) Once the monetary authority has announced a given rate of monetary growth, believing that the public expects it to follow through, the authority has an incentive to create a monetary surprise either to reduce unemployment or to capture seigniorage revenue. With rational expectations, the public will come to anticipate the authorities' perfidy, leading to an inflationary equilibrium. A credible precommitment mechanism, by preventing the government from cheating, can preserve long-run price stability. The gold standard rule of maintaining a fixed price of gold can be viewed as such a mechanism.

The gold standard is a form of contingent rule.(10) The monetary authority maintains the standard except in the event of a well-understood emergency, such as a major war. In wartime it may suspend gold convertibility and issue paper money to finance its expenditures; it also can sell debt issues in terms of the nominal value of its currency, on the understanding that the debt eventually will be paid off in gold. The rule is contingent in the sense that the public understands that the suspension will last only for the duration of the wartime emergency plus some period of adjustment: afterward the government will follow the deflationary policies necessary to resume payments at the original parity. Following such a rule also will allow the government to smooth its revenue from different sources of finance: taxation, borrowing, and seigniorage.[11]

My research with Finn E. Kydland shows that the gold standard contingent rule worked successfully for three core countries: Britain, the United States, and France. In these countries, the monetary authorities adhered faithfully to the fixed price of gold except during major wars. During the Napoleonic War and World War I for England, the Civil War for the United States, and the Franco - Prussian War for France, specie payments were suspended, and paper money and debt were issued. But in each case, after the wartime emergency had passed, policies for successful resumption were followed.(12) Indeed, successful adherence to the rule may have enabled the belligerents to obtain access to debt finance more easily in subsequent wars. Other countries, including Italy, which did not maintain gold convertibility continuously, followed policies consistent with long- run convertibility.(13)

The gold standard rule also may have been enforced by reputational considerations. Long-run adherence to the rule was based on the historical evolution of the gold standard. Gold was accepted as money because of its intrinsic value and desirable properties. Paper claims, developed to economize on the scarce resources tied up in a commodity money, became acceptable only because they were convertible into gold. Support for the international gold standard likely grew because it provided improved access to the international capital markets of the core countries. Countries were eager to adhere to the standard because they believed that gold convertibility would be viewed by creditors as a signal of sound government finance and the future ability to service debt.(14)

The Bretton Woods system also can be understood as a form of contingent rule (or rule with escape clauses).(15) For nonreserve currency countries, the rule was to maintain fixed parities, except in the contingency of a fundamental disequilibrium in the balance of payments, and to use monetary and fiscal policy to smooth out short-run disturbances. For the United States, the center country, the rule was to fix the gold price of the dollar at $35 per ounce and to maintain price stability. However, if a majority of members (and every member with 10 percent or more of the total quotas) agreed, the United States could change the dollar price of gold.

For the nonreserve currency countries, the rule was defective because the fundamental contingency was not spelled out, and no constraint was placed on the extent to which domestic financial policy could stray from maintaining external balance. For the United States, the rule suffered from a number of flaws. First, because of the fear of a confidence crisis, the gold convertibility requirement prevented the United States in the early 1960s from acting as a center country and elastically supplying the reserves demanded by the rest of the world. Second, as became evident in the later 1960s, the U.S. gold reserve requirement was useless in preventing the U.S. monetary authorities from pursuing an inflationary policy that, in the end, undermined the system. Finally, although there was a mechanism for the United States to revalue the dollar, the monetary authorities were loath to use it for fear of permanently undermining confidence in the dollar.

The short life of Bretton Woods, the fact that its existence was punctuated by more speculative attacks on currencies than under the classical gold standard, and evidence that its credibility bounds (gold points) were frequently violated,(16) suggests that it was a less-than-successful credible commitment mechanism

Alternative Monetary Rules

Many economists have argued that monetary rules would be superior to discretionary monetary policy in providing stable prices and output.(17) In the 1960s and 1970s, economists compared alternative hypothetical rules with actual performance using macroeconomic models.(18) This effort ignored the Lucas critique: that estimated parameters of the model would change in response to a regime change.(19) With Ehsan U. Choudhri and Anna J. Schwartz, I have developed a method to make counterfactual comparisons of alternative monetary rules to avoid this problem. Using the Beveridge - Nelson technique,(20) we isolate underlying components of variables that do not change with regimes.

We use our procedure to compare the variance of the price level forecasts under the monetary regime followed by the United Kingdom from 1976-85, which incorporated base drift, with a hypothetical constant money growth rule. The United Kingdom would calculate the next period's target level on the base of the actual, rather than the previously announced, target level for the current period. Our results suggest that if the Bank of England had followed a constant money growth rule, the forecast variance of the trend price level would have been reduced by more than half.

Our current research extends the same methodology to the United States since 1880. We compare the price level and output stability of the various monetary regimes that prevailed. For each regime, we plan to estimate both trend and short-run components of nominal as well as real variables, and then to identify the effects of both long- and short-run factors on overall variability of prices and output. We also will simulate the effects of three types of policy rules, each of which has been studied in recent literature: simple monetary growth rules, feedback rules, and a gold standard rule or a commodity basket rule. In that way, we will address the question of whether a monetary rule would have done much better in promoting long-run price stability than the Federal Reserve's monetary policy in each of the monetary regimes since 1914. Finally, we will simulate the short-run behavior of money supply under alternative rules in order to examine the implication of these rules for the short-run behavior of output.