Tuesday, November 9, 2010

Edmund Conway

I was, until recently, Economics Editor of The Telegraph, but these days I am at the Kennedy School of Government at Harvard, where I will blog occasionally when I'm not knee-deep in homework. If you so fancy, you can still find my book - 50 Economics Ideas You Really Need to Know - here.

I almost spat my coffee across the room when I saw the headline plastered across the front of the FT this morning: Robert Zoellick, president of the World Bank, is calling for a debate on the return to the Gold Standard, it said. Of course, when you read the column upon which the news story is based (subscription only, this being the FT), it is far less clear that Zoellick really wants a return to the 19th century international macro-economic structure. Instead, he merely seems to have namechecked gold as a possible mechanism to help us wean ourselves off our reliance on the dollar as the world’s reserve currency.
But let’s pretend for a moment that he is being serious about a return to the Gold Standard. What would that mean? The easiest way to understand the consequences is by considering what economists catchily call the “International Macroeconomic Policy Trilemma”. It goes as follows: you can have any two of the following at any one time: fixed exchange rates, capital mobility and independent monetary policy. You can’t have all three.
As the chart below (courtesy of Dani Rodrik) shows, for the last few decades (since 1971 and the final nail in Bretton Woods’ coffin) we have sat on the right hand side of the triangle, with floating currencies and untrammelled capital markets (in most of the Western world at least). The Gold Standard era involved the free movement of capital and fixed exchange rates, but in exchange for this the members had to abandon any pretence of being able to control their own domestic monetary policies. Is this really what Zoellick wants? He does seem to imply as much in his FT column, emphasising the maintenance of an “open capital account”.
Well let’s spell out what a Gold Standard would imply today:
1)     If there were a major domestic recession, the countries would simply have to suffer it. They would not be able to cut interest rates to alleviate the pain. In other words, countries would have to deflate, and suffer the social pain that goes with this, if they are to keep to the Gold Standard in times of economic stress. This may have worked well in the 19th century, when the poorer households who would tend to be affected couldn’t do anything about it, but I can think of few circumstances under which a democracy (with one-man one-vote) would allow it.
2)     There would also be a second possibility of deflation (or for that matter inflation) because of the arbitrary factor of tying one’s currency to a metal. If there was suddenly a massive discovery of gold, this would pump extra inflation into the global system; if there was a drop-off in gold discoveries (as there was in the late 19th century), governments would find themselves having to impose swingeing pay cuts on their populations in order to keep to the Standard. The fundamental point here is that the amount of gold in the ground is finite, whereas the capacity of humans to increase their economic output and productivity is still increasing exponentially, and should continue to do so, barring the possibility of falling back into the dark ages.
3)     An end to banking as we know it. This might not sound so bad, given the horror the banks brought our way in the crisis, but it is worth dwelling on for a moment. The Gold Standard was incompatible with fractional reserve banking, and the Bank of England could barely carry out its role as lender of last resort in the 19th century without having to bend the rules significantly (which, as far as some are concerned, fatally undermined the system). I’m all for a reconsideration of how we structure the banking system (my favoured plan is to impose unlimited liability on bank owners) but let’s not leap into another monetary system without considering how far reaching the consequences would be.
None of this is particularly new, and Zoellick, a smart man, is no doubt aware of it. At some point in the coming years we will muddle our way towards one or other of the sides of that triangle. At the moment we are floating dangerously around it: as Mervyn King pointed out repeatedly before the crisis, the big problem in the global economy was that half of it was on a regime of fixed (or pegged) exchange rates and the other was on floating exchange rates – in a sense this contributed to the crisis. But don’t hold your breath for another Bretton Woods. As Barry Eichengreen points out in Globalizing Capital (I’d really recommend this book to anyone interested in the future of the monetary system – and for what it’s worth this is a debate that will only grow and grow), such grand conferences imposing a new monetary system are the exception rather than the norm.
And don’t expect a return to the Gold Standard. The problem is not that it is unfeasible. It has plenty of attractive features, among them the fact that it constrains governments from inflating their debts away. However, it is simply incompatible with democracy as we know it. If you are looking for an example, look no further than Greece. The euro area is an effective Gold Standard. Greece is in dire straits because it is pegged to the same currency as Germany, despite having unit labour costs that are dramatically higher (over time, in a globalised world these should converge). Because it is trapped in this quasi-Gold Standard, Greece can do nothing but deflate – impose massive pay cuts and suffer many years of recession. The euro is facing its biggest existential threat as a result. If it can’t survive, yoked to the same currency, what hope is there for the entire world to tie itself to gold?
I have no idea which of the extremities we will end up on. Some point to the Bretton Woods model, and indeed it is interesting that an increasing number of countries are talking actively about capital controls. However, the important thing to remember is the following: all of these systems have succeeded, and all have failed.
There is a half-century cycle at play here: we move from one macro-economic system, it works well for a few decades (due less to the explicit rules at play than the assumption that central banks will enforce them if necessary). Eventually, the system’s credibility breaks down, sometimes in the face of financial crises, sometimes in the face of war, sometimes because the economic superpower dynamics have shifted. What follows is a chaotic period, and then, when everyone’s energy is spent and all the economic emotion cried out, we shift to another system and the cycle starts again.
Throughout, what matters more than the institutions, be they gold or managed currencies or Bretton Woods, is the faith in them, which is far harder to ascertain.
We are currently at the moment of hand-wringing and tears, which means the next few years will be both fascinating and terrifying. Eventually, we’ll come to a solution. Everyone will believe the system has been repaired, and that Bretton Woods III or whatever we’ll call it will solve our international monetary woes. And they’ll be right. Until they’re wrong.
PS Quite a few decent blogs worth reading on this, including Krugman,Free Exchange and an earlier blog from Martin Wolf.
PPS Yes I know I’ve been away from the blog for ages. Apologies.

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