James Hamilton speculates on the consequences of a US move to a gold standard in 2006.
What if we’d been on the gold standard?:
If the U.S. had decided to go back on the gold standard in 2006, where would we be today? That’s a question my friend Randy Parker recently asked me. Here’s how we both would answer.
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In 1929, the U.S. was on a gold standard, with the exchange rate fixed at $20.67 per ounce of gold. Geopolitical insecurity and financial worries warranted an increase in the relative price of gold, which, with the dollar price of gold fixed, required a decline in the dollar price of most everything else. Speculators bet (correctly) that Britain would abandon the standard in 1931, but the U.S. fought against the speculation, with the Federal Reserve Bank of New York raising its discount rate from 1.5% to 3.5% in October 1931. This sharp increase in interest rates at a time of great financial turmoil succeeded in defending the parity with gold, but produced an economic disaster.
What’s the alternative, he asks, to abandoning the gold standard when staying on it requires raising interest rates in the face of a declining economy?
Or the other option would be to say, no, we really mean it this time, honest, we’re serious about this whole gold standard thing. So, we drive interest rates higher and watch the deflation mount. Outstanding debt that is denominated in dollars becomes more and more costly for people to repay, and we’d see a really impressive level of bankruptcies and business failures. The cycle would continue until the politicians who promised to stay on the gold standard are driven out of office and the deflation spiral could finally be ended by the new leaders choosing option 1 [abandoning the gold standard] after all.