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The Gold Standard. Lecture 12 – Tuesday, 20 October 2009 J A Morrison. Isaac Newton. David Hume. Admin. Papers Returned Upcoming Events 7 PM, Tues, 27 Oct: Screening of Niall Ferguson’s The Ascent of Money (2009) Thurs, 29 Oct: Deadline for Second Discussion Post. The Gold Standard.

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The Gold Standard

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The Gold Standard

Lecture 12 – Tuesday, 20 October 2009J A Morrison

Isaac Newton

David Hume


Admin

  • Papers Returned

  • Upcoming Events

    • 7 PM, Tues, 27 Oct: Screening of Niall Ferguson’s The Ascent of Money (2009)

    • Thurs, 29 Oct: Deadline for Second Discussion Post


The Gold Standard

  • Leftovers: Exchange Rates in the Balance of Payments

  • The “Gold Standard” as an Ideal Type

  • The Reality of the Gold Standard

  • Conclusion


The Gold Standard

  • Leftovers: Exchange Rates in the Balance of Payments

  • The “Gold Standard” as an Ideal Type

  • The Reality of the Gold Standard

  • Conclusion


Last time, we didn’t finish the lecture. So, we have some leftovers…


Last Thursday’s Lecture: Int’l Monetary Exchange in Theory

  • Introductory: Money is Hard

  • The Basics of Monetary Exchange

  • The International Connection

    • The Nth Currency

    • Exchange Rate Regimes

    • The Balance of Payments

  • Managing the Monetary System

Cover this Today

Moved to Lecture 14


Bunsen, I thought we were done with the balance of payments!!!

Well, Dewb, I thought you could use a refresher...


Remember that the balance of payments (BoP) reconciles all of a country’s financial transactions with the world.This includes trade, remittances, investment, loans, &c.


You should also remember that the ER regime determines, in part, how balance in the BoP is maintained.


BoP Adjustment where British Pound is Flexible


BoP Adjustment where British Pound is Fixed


 The ER regime determines whether these adjustments happen through the marketor throughintervention by the monetary authority.


 So, again, note that the regime is determined by what the monetary authority actually does, not what it promises to do.


The Gold Standard

  • Leftovers: Exchange Rates in the Balance of Payments

  • The “Gold Standard” as an Ideal Type

  • The Reality of the Gold Standard

  • Conclusion


Remember our understanding of an exchange rate: the valuation between the domestic currency and foreign currency/currencies.


In theory, the gold standard(GS) was an exchange rate regime that related the member countries’ currencies through their valuations to gold.


Gold as an Intermediary

$

£

¥

Example: £1 = 1 oz gold = $4.86


In 1925, Keynes elaborated the “rules of the gold standard game.” The rules were simple: (1) maintain exchange rate stability; (2) maintain convertibility between domestic currency and predetermined amount of gold.


The gold standard, as it existed in theory, was an ideal type. It was meant to embody the complete integration of domestic and foreign financial markets. The gold standard was meant to achieve purchasing power parity…


II. THE GOLD STANDARD AS AN IDEAL TYPE

Purchasing Power Parity

The Automaticity of the Gold Standard


Purchasing Power Parity (PPP)

  • Purchasing power: command over goods and services

    • $919.50 = 1 oz gold

    • £639.43 = 1 oz gold

  • PPP: unit of currency enjoys the same purchasing power in every market even after making necessary conversions

    • Implied PPP (based on gold prices): $1 = £0.695

  • PPP can be calculated using any “basket” of goods & services

    • The Economist uses the Big Mac!


PPP versus Market Rates

  • Implied PPP (from gold prices): $1 = £0.695

  • If I can trade $1 for £0.695, I should be able to buy gold at the same “price” in GB and in the US

  • BUT Market Exchange Rate: $1 = £0.691

  • Why the difference? Why doesn’t arbitrage eliminate the difference?

    •  moving and converting currency is not costless!


Valuation

  • Valuation: the relationship between market price and underlying “value”

  • Different ways to calculate valuation

    • Stock: price-to-earnings-to-growth (PEG) ratio

    • Currency: PPP versus ER

  • Over and Under

    • Overvalued: currency purchases less than ER indicates (PPP < ER)

    • Undervalued: currency purchases more than ER indicates (PPP > ER)


Gresham’s Law

  • Attributed to Sir Thomas Gresham (1519-1579)

  • The Law: “Bad money drives out good”

  • In our terms: “Overvalued currency drives out undervalued currency.”

  • Implication: don’t attempt to maintain official ER vastly different from market ER

     This is just a recognition that arbitrage will occur in currency markets, as it does elsewhere.


The gold standard ideal was that all currencies would be freely convertible through gold. This would secure purchasing power parity.And PPP would ensure complete market integration.


II. THE GOLD STANDARD AS AN IDEAL TYPE

Purchasing Power Parity

The Automaticity of the Gold Standard


The GS was meant to automatically ensure both the quantity of currency and the distribution of currency.


GS Regulation of Quantity

  • Official/Mint Price: price of gold in terms of local currency

  • Free Conversion: monetary authority should…

    • Purchase gold with currency at the official price

    • Sell gold for currency at the official price

  • Automatic Quantity Adjustment

    • Overvalued currency  sell currency for gold  decrease in currency and increase of gold

    • Undervalued currency  sell gold for currency  increase in currency and decrease in gold

  • Sustained increases in gold price  mining


By regulating the quantity of currency automatically, adherence to the GS would theoretically ensure domestic price stability.After all, if the official ER did not match the PPP, currency/gold would be converted.


What about the distribution of gold? Who gets how much gold?


GS Regulation of Distribution

  • David Hume’s Price-Specie-Flow Model

  • Assume: costless int’l transport & conversion

Excess Gold in US

Rise in US Prices

US Imports Increase; Exports Decrease

US Prices Fall; BoT Equilibrates

US Exports Gold

US has BoP Deficits


So, assuming no costs and perfect adherence to the “rules of the gold standard game”, everything with the gold standard should have been automatic and markets should have been completely integrated.


But that’s not reality.


The Gold Standard

  • Leftovers: Exchange Rates in the Balance of Payments

  • The “Gold Standard” as an Ideal Type

  • The Reality of the Gold Standard

  • Conclusion


III. REALITY OF THE GOLD STANDARD

Conversion Costs

A Brief History of the Gold Standard


Remember that we’ve been assuming no conversions costs, that it is costless to move from one currency to another through gold.In the market, however, there are costs to converting currency: transport, risk & insurance, opportunity cost of time.


What are the implications of these costs? What does it matter if it costs me 10% to convert my currency into gold and have it converted abroad into foreign currency?


 This means that my currency can be over/undervalued by up to 10% before it become profitable for me to convert it through gold into a foreign currency.


And what does that mean?


 That means that the market exchange rate can fluctuate within a band around parity—the official exchange rate—before the price-specie-flow mechanism prompts adjustment in the quantity of currency & distribution of gold.


Gold points are the price points at which it becomes profitable to convert currency into/out of gold.The gold band is the band around parity, bound by the gold points, in which the market ER might fluctuate.


What does that matter?


I know! It means that “fixed” ERs might still fluctuate in the market.


The existence of gold points and gold bands has an extraordinary implication:  even with a “fixed” ER, the market ER might not always be stable!


This matters for foreign economic policy.At a minimum, the “gold bands” provide some flexibility to states with a fixed ER.This might be a good or bad thing depending on whether you favor monetary discipline or monetary discretion.


Some states deliberately expand the size of the gold bands to provide themselves with even more flexibility.They do this by adding politically-imposed costs to the natural market costs of converting currencies.


Politically Imposed Costs

  • Overt Fees (e.g. seigniorage)

  • Deliberate delays by monetary authority (Adam Smith on Bank of England)

  • Exchange for low quality, worn coins

  • Capital controls (China today)


These manipulations are sometimes called gold devices, which are used to move the gold pointsand expand the gold band.


III. REALITY OF THE GOLD STANDARD

Conversion Costs

A Brief History of the Gold Standard


Here are a few of the highlights of the emergence and ascent of the GS.


Britain Adopts the “Silver Standard”

  • 1696: Locke convinces Parliament to adopt silver standard

    • permanently fixed

    • Fully convertible units into specified amounts of metal

  • Locke combated bimetallism

    • “Silver is the instrument and measure of Commerce in all the Civilized and Trading parts of the world.” (374)

    • Let gold float vis-à-vis silver; no official exchange rate between gold & silver


From Silver to Gold

  • 1717: Newton overvalues gold vis-à-vis silver

    • Gresham’s Law: gold drives out silver

    • Britain is on de facto gold standard

  • 1819-1821: Ricardo convinces Britain to adopt de jure gold standard

    • Exchange rate stability: return to pre-war parity!

    • Convertibility: no limits on convertibility

       Throughout Britain maintained a robust commitment to a metallic standard. All that changed was the metal


The US: Hamilton versus Jefferson

  • Hamilton’s Reports

    • Report on a National Bank (1790)

    • Report on the Mint (1791)

    • Report on Manufactures (1791)

  • Hamilton: Banks & Paper Money

    • Stimulate domestic industry

    • Reduce dependence on foreign trade & capital

    • Court financial interest  political stability

  • Jefferson: Specie & International Integration

    • Market integration  efficiency & peace

    • Suspicion of financial interest: banks & corruption

    • Insulation  Southern dependence on North


US Monetary Policy

  • 1791: First Bank of the United States

    • Triggered Constitutional debate on Art 1, Sec 8: “Necessary & Proper Clause”

    • Bank issues extensive token/paper currency, heavily leveraged

  • 1792: US Mint Act

    • Bimetallism

    • What the hell: we’ll have some specie too!


My Assessment

  • Hamilton was lazy

    • Did not bother with important technical details

    • Just copied Britain

  • But he had political savvy

    • Won public debate by citing British example

    • Got backing of powerful financial elites

    • Had Washington’s ear

  • Jefferson was a philosopher

    • Better understanding of technical details

    • But too abstract and reactionary for public

    • Did not build a coalition in time


Maggie and Me at the First Bank of the United States in Philadelphia


France

  • Nominally bimetallic

  • But traditionally a silver country

  • 1840s: gold discoveries  overvalued gold  de facto gold standard


Setting the Standard

  • 1867: Paris conference to officially appoint gold as int’l standard

  • Conference wasn’t legally successful, but inspired trend

  • 1870s

    • Germany moves toward gold

    • France attempts to undercut Germany by attracting gold  bimetallic block busts

  • 1879: US goes to gold; Japan follows

  • Network Effect: value of being on common standard increases as membership increases


The Gold Standard

  • Leftovers: Exchange Rates in the Balance of Payments

  • The “Gold Standard” as an Ideal Type

  • The Reality of the Gold Standard

  • Conclusion


The gold standard certainly seems dated. None of us had been born when the international gold standard system collapsed in the 1970s.But there are good reasons to understand it…


Importance of Gold

  • Era of fiat currency (1971-present) is vast exception to rule; commodity currency has been norm

  • Will the new era endure?

    • Nth Currency is a national currency

    • Can governments be trusted with fiat currency?

  • Key insights useful to new era

    • “Gold devices” continue for “fixed” ERs

    • How states manage dilemma of integration versus domestic control


Essentials of Gold Standard “Era”

  • Few countries fully adhered to two “rules” of GS

    • Convertibility

    • ER stability

  • Britain adhered most closely

  • Level of adherence correlated with:

    • Closeness to London

    • Relative size of economy

       How might we explain this correlation?


Next time, we’ll discuss the decline and fall of the gold standard.This will allow us to examine the political dimensions of exchange rate regimes in a rich context.


The Gold Standard

  • Leftovers: Exchange Rates in the Balance of Payments

  • The “Gold Standard” as an Ideal Type

  • The Reality of the Gold Standard

  • Conclusion

    ** Bonus: From Specie to Tokens & Beyond


It might be tempting to think that adherence to the gold standard was assured when states circulated only specie. But that goes too far.


Even in specie money systems, states violated both of the gold standard rules:(1) They routinely adjusted their exchange rates (except for England after 1696).(2) They imposed considerable costs on conversion.


Still, though, there was a decisive shift with the widespread adoption of token currenciesin place of specie.(token currency: currency backed by specie)


Even with token coins, it was possible to fulfill the spirit of the gold standard: ER stability & convertibility. But it was also easier for states to make ER adjustments and restrict convertibility.


From the standpoint of ERs, token currencies had the capacity to function like fiat currencies.States with token currencies—and currency boards today—might still implement policies that make the ER work more like a “floating” regime than a fixed regime.


Why Tokens?

  • Prevent clipping and save on wearing

  • Multiply the currency

    • Fiduciary issue: unbacked currency treated separately from backed

    • Proportional issue: all currency treated the same; fractional reserve ratio < 1

  • Minimize constant minting & melting

  •  Easier to adjust the ER and to limit convertibility


Why Not Tokens?

  • Requires understanding: it is possible!

  • Stop threat of counterfeiting

    • Domestic counterfeiters  advanced (industrial) production techniques

    • Foreign counterfeiters  international norm of mutual respect (i.e. John Locke’s fear)


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