Many are surprised to learn that famed central banker Alan Greenspan has been a longtime supporter of the gold standard. But the record is clear. Greenspan published an essay in support of a gold standard with unregulated banking titled “Gold and Economic Freedom” in July 1966. He remained an advocate of the gold standard at the time of his appointment as Chairman of the Federal Reserve in 1987. And he has continued to wax about the gold standard in the time since leaving the Fed.
Among other things, Greenspan recognizes that the gold standard constrains government spending – and borrowing.
Much such infrastructure would have to be funded with government debt. We are already in danger of seeing the ratio of federal debt to GDP edging toward triple digits. We would never have reached this position of extreme indebtedness were we on the gold standard, because the gold standard is a way of ensuring that fiscal policy never gets out of line.
By now, the level of indebtedness has exceeded the value of U.S. GDP by an additional 35 percent. And the annual budget does not appear to be on course to reverse this trend any time soon. Under a commodity standard, like the gold standard, maintaining this risky position would be difficult, if not impossible, for the federal government.
Unlike Greenspan, most economists today see the gold standard as an arcane relic. But what if Greenspan is correct? Is it possible to regain the advantages of a gold standard today?
The Modern Monetary System and Fiscal Discipline
As Greenspan explains in his ’66 essay, government borrowing is backed “only by the government’s promise to pay out future tax revenues.” The gold standard limited the extent to which a government can borrow because gold, unlike fiat money, cannot be printed. Governments are chastened for largess. Under a gold standard, money printing intended to support government borrowing quickly motivates investors to move gold to countries where it can earn a higher inflation-adjusted return. And the lost gold only returns after investors are compensated for the increased rate of inflation or the rate of inflation falls.
The modern monetary system, on the other hand, has developed in a manner that facilitates state borrowing. I do not mean to accuse any particular person of intentional mischief. I simply note that financial regulation and monetary policy have developed in a manner that increasingly supports fiscal expansion.
Consider the Basel Accords, which have charted the path of international financial regulation in recent decades. The guidelines provided by the Accords allow banks to hold supposedly safe debt – sovereign bonds – in lieu of reserves. Since these bonds typically earn a positive return and, even in the case of negative rates, tend to increase in value during a liquidity crisis, bank demand for sovereign debt has been practically insatiable. And this is only more true in an era where central banks dictate the value of short-term interest rates while also squeezing the yield curve by buying long-term bonds.
As Basel II/III was being implemented, Ben Bernanke radically transformed the Fed’s operating system. To avoid short-run inflation and expectation of it by investors, Bernanke preferred to increase the quantity of reserves in the system while simultaneously paying banks risk-free interest not to lend those reserves. The alternative for a central bank would be to choose the level of reserves circulating within the financial system while allowing the competitive market to determine the rate of interest.
In this era of unprecedented control, the central bank has supported a massive expansion of federal borrowing. Since the Federal Reserve now sets the short-term rate, it can maintain historically low interest rates that support large fiscal deficits. Jerome Powell, the current chair, has even advocated for increases in federal spending in a wish to coordinate monetary and fiscal policies.
This system of monetary control suffers from massive tail risk. The value of the dollar depends upon the expectation that the government can repay its debts in the future. As Greenspan pointed out, the ability of a government to borrow depends on its convincing investors that the government will receive future taxes sufficient to repay the debt. With historically low rates set by the Federal Reserve, there is essentially no constraint on government spending except for the threat of default.
Gold and Fiscal Discipline
In light of the current fiscal position of the United States, there is a smattering of irony around the widespread disapproval of a gold standard among economists and policymakers. Perhaps more ironic, the gold standard failed not due to its natural functioning but due to an attempt by policymakers to circumvent the natural functioning of the gold standard so as to avoid the consequence of money printing in Great Britain during World War I. Such was the premise of the gold exchange standard where European central banks agreed – half-heartedly – to treat British pounds on par with their legal defined gold equivalent.
The system collapsed because it was politically unpopular. Those directing policy were unwilling to cooperate in a system that they felt did not benefit them. France withdrew its gold from England starting in 1927 and the system became inoperable. Growing demand for gold reserves by central banks led to plummeting asset prices and chaos in financial markets. The gold standard didn’t fail because of the nature of a commodity standard, but rather, due to a failed intervention that sought to insulate governments and investors from the effects of Europe’s departure from the gold standard during World War I.
As economist F.A. Hayek recognized in a 1935 interview with The Economist, it is unlikely that the world could return to a gold standard as it had functioned before World War I. To do so would require that major holders of gold reserves would be willing to reduce their holdings, essentially donating to central banks that arrived late to the gold standard. When the international gold standard was established during the 1870s, gold and silver circulated as money. Bank lending depended on holdings of these metals as reserves. To attempt to return to the classical gold standard today would likely face difficulties that would outweigh the benefits.
But actors in the financial system would be happy to treat commodities as money if the cost of doing so was sufficiently low. There is nothing stopping any of us from opening a money market mutual fund account and writing checks or using a debit card linked to the account. Technologically, there is little reason individuals could not hold accounts denominated in a commodity like gold or silver except that they would suffer short-term capital gains taxes, in addition to the cost of accounting, for their regular transactions. Even in a world where the dollar is legal tender, savings accounts could be denominated in gold and gold would, therefore, serve as money.
We could allow for a de facto gold standard at little cost. And this standard would ensure that investors could discipline government for borrowing excessively. If citizens were allowed to save their income in gold-denominated accounts without extra costs of taxation and financial regulation, disciplining their government would be as easy as changing the form of one’s savings account.
The lowest cost means of gaining the advantages from gold would be to remove all taxes and regulatory costs that inhibit citizens from treating commodities as money. In the case that citizens could keep their savings in a commodity ETF against which they could write checks or use a debit card, protecting one’s financial position from inflation would be as easy as opening a new account. The financial system would naturally encourage fiscal responsibility and could, perhaps, prevent a fiscal crisis that is growing more likely with every federal budget.