Should borrowing costs go up in the United States because demand for gold has in India? Or because not as much of it is being mined in Australia?
These might seem like absurd things to ask — because they are! — but they’re what we’d be even more absurdly be saying yes to if we ever adopted a gold standard like President Trump’s two latest picks for the Federal Reserve, Stephen Moore and Herman Cain, have both advocated in the recent past.
Moore has slightly modified his views, and is now in favor of a broader but still similar, commodity-based standard, while Cain is reportedly close to withdrawing from consideration. Regardless of where they end up, their support for the gold standard to begin with should be disqualifying.
Why is the gold standard such a disaster? Well, that becomes clear enough if you think about what it does. It’s the idea, you see, that rather than trying to keep overall prices rising by 2 percent per year, the Fed should solely focus on trying to keep gold prices from rising or falling at all. That the dollar, in other words, should be worth the same amount of gold tomorrow that it was today, today that it was yesterday, and yesterday that it was all the days before. In practice, this would mean that the Fed would have to raise rates whenever supply and demand meant that gold prices “wanted” to rise, and only allow it to cut rates whenever they “wanted” to fall.
This is all based on the rather strange conceit that our standard of living isn’t determined by our ability to buy the things we actually need to, you know, live, but instead by our ability to buy gold. That’s why, back in 2009, Moore said that he thought “the big failure of the Bush presidency” was that “when he entered office the price of gold was $300 an ounce” but “when he left office the price of gold was $1,000 an ounce.” Now, this would be a forgivable idiosyncrasy as long as gold prices were counter-cyclical — that is, they rose when unemployment fell, and fell when it rose — so that we’d at least be adding or taking away monetary stimulus at the appropriate macroeconomic times under this system. But they’re not. Gold prices have actually tended to go up at the same time that unemployment has, especially so in the past 20 years.
Indeed, gold prices really started soaring just as the economy was crashing in 2008. Which is to say that, under the gold standard, we would have been forced to massively increase interest rates at what would have been the worst possible time. To give you an idea of how bad it would have been, University of Wisconsin economist Menzie Chinn estimates that interest rates would have to be around 20 percent today for the dollar to be worth as much gold as it was back in 2000. So the good news, insofar as there is any, is that we probably wouldn’t have had a housing crash. But the bad news is that’s due to the fact that we wouldn’t have had any economic growth, period. We would have had a self-induced depression worse than the one we got. But hey, if you were lucky enough to still have a job, you at least might have been able to afford a little more gold. So you’d have that going for you, which is ... nice?
When you think about it, this really shouldn’t be too surprising. That’s because the supply of gold depends on how much of it is being mined in places like Australia and South Africa, while the demand for it is largely a function of consumer tastes in China and India. None of these things, of course, has anything to do with the state of our own economy, so using them to decide how much help to give it will almost certainly result in some particularly ill-advised policy. Although to the extent that the price of gold is macroeconomically determined, it still doesn’t give us better than a 50-50 idea of what interest rates should be. Why is that? Gold doesn’t pay dividends or interest, so its price tends to go up the most when assets that do aren’t paying that much in inflation-adjusted terms. That can either be when interest rates are high but inflation is higher still, as in the 1970s, or when inflation is low, but interest rates are lower still, as is true today. The gold standard would correctly tell you to raise rates in that first case, but incorrectly in the second — and with devastating consequences.
So the gold standard is a lot like playing Russian roulette with the economy. It can turn recoveries into recessions, and prevent recessions from turning into recoveries just because the price of gold “wants” to go up at an inopportune moment, and we have to raise rates when everything else would tell us not to. But wait: It gets worse. This isn’t just about forcing governments to adopt bad monetary policies. It’s about stopping them from enacting good fiscal policies, too. Countries on the gold standard can’t run big deficits without markets wondering how committed they are to it — at which point, they would need to raise rates to reassure them. So even thinking about expansionary policy would require to them to impose even more contractionary policy. This isn’t a hypothetical, but rather a history of what happened in the 1930s.
The best that can be said about the gold standard, then, is that while it might be the worst guide to setting policy, seeing who’s supported it might be best guide to who shouldn’t be making policy.