Central banking under the gold standard

Carnegie- Rochester

Conference

Series on Public Policy 29 (1988)

125 136

North- Holland

HE GOLD STA

ICHAEL D. BORDO Carnegie Mellon University and University of South Carolina

Marvin Goodfriend paper

which

will

be

literature. The paper

has written an

a carefully crafted, well-thought-out

important

focuses on

contribution

central

to

the

gold

standard

banking policy under the gold

standard. Its concern is with a fairly limited set of issues from the vast gold standard literature. Specifically, the paper examines short-run policy by and

a central bank to maintain gold convertibility and to stabilize prices interest rates. The

gold

standard

of relevance

is a domestic

gold

standard, since very little reference is made in the paper to internatioblal issues. The focus on short-run policy also avoids any discussion of the issue of the relative performance of the gold standard compared to other monetary standards, or with issue of the long-run viability of the gold standard. The key conclusion of the paper is that to affect the price level and

interest rates, monetary

policy

under

a gold

standard must

involve

activist gold policy which influences the nonmonetary gold stock. The framework of the paper

is a rational expectations

asset-pricing

model. Section II of the paper sets up the model with four assets: money (fiat money); gold

(held as a durable

asset but

not as money);

bonds:

physical capital. The model solves for the equilibrium price/rate of return for each asset and identifies the sources of stochastic disturbances th.3 can

affect

them.

The

key findings

in this

section

are:

(1) the

real

interest rate is independent of shocks to both the money and gold markets; (2) the price level is independent of shocks to the gold market; (3) the real price of gold is independent of monetary shocks. Section III extends the theoretical The gold standard is defined

as a

framework to the gold

standard-

fixed price of gold in terms of money.

The standard can be maintained by folio ing either pure gold policy -- t exchange of gold for bonds -- or pure monetary

olic

To maintain the standard using either type of policy, all

0 167 - 2231/88/$3.50

0 1988 Elsevier Science Publishers

B.V. (North-Holland)

that is required is that the difference between the growth rate of money and the growth rate of the nonmonetary gold

stock equal the difference

between the transactions service shocks growth rate (shocks to the growth rate in the demand for money) and the gold preference shocks growth rate (shocks to the growth rate of the demand for nonmonetary gold). To maintain this equality (equation 33b) the government itself does not actively

have

to be included in the arbitrage process. It can be done by the private market (i.e., by

corrrnercialbanks) as long as the appropriate amounts of

and nonmonetary gold are provided by the government.

money

In addition and

most important, it is argued that maintenance of convertibility does not require that the government hold gold reserves. This pure gold standard is then contrasted with the more traditional classical gold standard -- for example, the Barro (1979) model but

omitting

accounting for gold production. The key difference between the classical case and the pure gold standard, in this view, is the introduction of a gold reserve ratio, only because the Bank of England had one and it became popular in

the

literature. Goodfriend

then

demonstrates

that

a central

bank, committed to freely exchanging, on demand, money for gold and vice versa, while maintaining a fixed gold reserve ratio, uses up the degrees of freedom of both monetary and gold policy. To follow an activist monetary or gold policy and alter the price level or nominal interest rate, it must allow the gold

reserve ratio

to vary. The

paper

presents

an

excellent

discussion (Section 3.3.1) of the use of interest-rate policy to manage the gold reserve ratio and price

level in the

face of gold preference

and

transaction service shocks, and of the use of interest-rate and price-level smoothing by a centraT bank under the classical gold standard. The final part of the paper applies the analysis to the history of the gold standard. A distinction

is made between varieties of gold standard:

(1) a pure and private gold standard is compared to (2) a gold standard ith

fractional

reserves

and

(3)

a

government-operated

gold

standard.

Fractional reserves are held in gold not because it is necessary to meet redemption demand but to satisfy minimum transaction costs of exchanging earning

assets for gold upon redemption demand (government involvement in a

gold standard account and

reflects

its

monopolizing

role

the

in defining

issue of

the

currency).

value of

the

Goodfriend

unit of

views

the

latter as crucial to control of the interest rate, the gold reserve ratio, and the price level, Goodfriend reinterprets the Bank rate controversy. He comes out on the side of the traditional vie

of England altered Bank rate as

126

the key to management of the international gold standard. revisionist view of

ccloskey and

Zecher

He rejects the

(1976), based on the monetary

approach to the balance of payments, that perfect arbitrage in goods and asset markets made

central banks

inconsequential.

To have an effect

on

world interest rates and prices, according to Goodfriend, the central bank had to have a national monopoly of the currency. Using his framework, Goodfriend reinterprets the role of a lender of last resort, viewing Bagehot's rule (1873) (of lending freely at above the market

rate of

interest

interest) as providing

rate,

alternatively

as

an

an elastic currency

at a ceiling

irregular

interest-rate

form

of

smoothing. Finally he criticizes worldwide

elimination

the

by Barsky et

in

concert with the Bank of England to smooth interest rates. According

to

the

interest

rates

Federal Reserve,

in

the

acted

of

in

(1987) that

is

establishment

seasonal

al.

1914

explained by the

of

the story

which

Goodfriend, because the Fed was not a profit-maximizing central bank as was the Bank of England

(and other major

central banks),

it was willing

to

follow an interest-rate smoothing policy at the cost of a fluctuating and suboptimal gold reserve ratio. As noted, a central bank with a monopoly over the currency could then influence world interest rates.

In what follows I first raise several points related to analytical issues covered in Sections II and III of GoJdfriend's paper and then focus my attention on the application of the analysis to the history of the gold standard.

A

I

(1)

ANALYTICAL

ISSUES

Disregarding the effect of shocks from the goods market on the gold market

and,

more

important omissions. commodity and

a

leaving

fundamentally,

Under the gold

significant

gold market

impinged directly

on

gold

production

standard gold was an

fraction

countries -- especially at certain

out

of

production

times. Thus real

economic

important

in a number

disturbances activity.

are

of

to the

Also

the

diversion of capital from nongold-producing sectors affected the real interest rate. These shocks are co the long run and are recognized

nly believed to be important in

as a key source of long-run price

level instability, but at specific times in history such as the late 184Qs, 185Os, and late 1890s they run.

(2)

The argument

can be

t 127

intained

ithout go1

reserves (earlier made by Black

(1981) and Fischer (1986)) contravenes

the essence

of a gold standard. Fundamental to a gold standard are

maintenance

of a fixed price of gold

and redemption

on

demand of

If the public wishes to redeem paper money in

claims in terms of gold.

gold, in Goodfriend's scenario, the central bank has to sell a bond and then buy gold to meet the demand. Presumably this takes time and involves

transaction

If the

costs.

central

bank

cannot

instantly

redeem its liabilities in gold, then it violates the fundamental of the standard. The failure to redeem its liabilities in gold, it occurred

under well-understood

contingencies

rule

unless

such as a war or

a

financial crisis, would lead the government to lose credibility with respect to its commitment to follow the gold-standard rule. A promise to redeem

in the future at a discount sufficient to keep the money

price of gold unchanged (the suggestion in footnote 6) assumes that the extra cost of paying the discount is less than the investment in credibility capital by maintaining an earnest in the form of a gold reserve. The historical record teaches the opposite. The case for

a

private bank to hold reserves that Goodfriend makes applies also to a central bank. Thus it is questionable that the fixed dollar price of gold can be supported by either monetary or gold-stockpiling policy (Section With

IIi.1). a

gold

reserve

ratio

demonstrates (Section IILZ), gold demand

will

involve

in

place,

as

Goodfriend

admirably

shocks to money demand or to nonmonetary

both money

and

gold.

The

shocks

can

be

temporarily accommodated by pure monetary policy if the gold reserve ratio

adjusts.

Ultimately,

however,

as

the

history

of

the

gold

standard has taught us, the reduction of the gold reserve ratio, in response

to

financial

adoption

of

the

innovation

standard

by

to the point where (Triffin, 1960).

continued

(transaction

new nations the

service

shocks)

(gold preference

standard

was

no

longer

and

shocks) viable

Because of the very short-run time frame of the analysis, which treats the gold

closed

stock

as

fixed,

and open economies.

the model

no

explicit

distinction

is made

between

Unless an implicit assumption underlying

is of a very large economy, many real world issues of the

gold standard

in an open economy cannot be addressed. These include

the use of discount rate policy, 'gold policy," and other policies to affect the level of gold reserves.

128

B.

HISTORICAL

ISSUES

There are a number of instances where, in my opinion, the application of the model to the history of the gold standard does not quite jibe with the

generally

understood view

of

the

period.

In what

follows

I focus

primarily on the classical go?5 standard. The issues to be discussed are the author's treatment of: (1) private versus government gold sLandards; (2) the Bank rate con:roversy; (3) the lender of last resort; (4) pricelevel and interest-rate smoothing. 1.

Private Versus Government Gold Standards. --

The distinction Goodfriend

makes between private and government gold standards is hard to relate to the experiences of England and the United States where government involvement has always been paramount. Thus from the beginnings of the standard

in eighteenth-century

England,

the government

defined

the

standard. The gold standard first appeared de facto in England in 1717 as a consequence of overvaluing of silver at the mint by Sir Isaac Newton. In the United States the bimetallic standard dated from 1792 when Congress defined the weight of silver in a dollar and the weight of gold in a gold eagle. Before the eighteenth century the monetary system based on metallic coins was not officially a standard. Coins circulated by weight, governments arbitrarily announced their values, and the free market kept prices in line with the weights, which were often out of line with official values. The invention of milling

in

the late seventeenth century to maintain the quality of the coinage was a key factor making

the establishment of the standard possible

(Redish, 1987). The United States never had a pure and private gold standard- It

was not pure because the country was on a bimetallic standard -- an effective silver

standard until

1834, thereafter

an effective

gold

standard. It was not private since the government defined the value of gold and silver coins and was ready to buy and sell the metals at the fixed price. Finally, the First and Second

Banks were not established

United States to give the government a role

111.

Goodfriend argues

on page

revenue

government

for

the

and

in the gold standard as

Rather they were to

aid

in the

in

set up to raise

unifying

the

COUntrY

(Timberlake, 1978; Fraas, 1974). 2,

The Bank

Rate

Controversy.

An

implication

that

I re

y central bank

argument in Section I

its domestic currency could affect world interest rates using its gold

129

policy. In my opinion, the Bank of England was the only central bank under the classical gold standard capable of such action. London, a net creditor, had special importance under the gold standard because it was

the

location of

capital,

co

odity,

and go'lcumarkets

that

served the world. As a consequence the Bank of England was able to use its Bank rate

to affect world

interest rates despite

a WlativelY

small gold reserve -- the famous "powerful bank rate weapon with a thin film of gold" (Sayers, 1951, p. 116). Other countries with much larger gold

had considerably

reserves

less pulling power

(Lindert,

oreover, though the Bank of England had a monopoly

1969). currency

towards

the

end

of

the

nineteenth

century

as

a

of the private

financial institution, it was relatively weak compared to the rapidly developing clearing banks. It had to supplement Bank rate with other instruments to make it effective (Sayers, 1951). (3)

Goodfriend's interpretation of Bagehot's

The Lender Of Last Resort.

rule as a ceiling interest rate at which the supply of currency is perfectly elastic applies to one special case -- an internal drain accompanied by an external drain. Bagehot made a distinction between the policy

to follow

in each of

the

cases of an

internal and an

external drain. In an internal drain "the best way for the Bank... to deal

with

a

drain

arising

from

internal

discredit

is

to

lend

freely..." (1873, p. 48). In an external drain, "the Bank of England requires the steady use of an effectual

instrument. That instrument is the elevation of the

rate of interest" (1873, p. 46). In the case of both an internal and an external drain, Bagehot's famous rule comes into play "Very large loans at very high rates are the best

remedy

for

the worst

malady

of

the money

market

when

a

foreign drain is added to a domestic drain" (1873, p. 56). The

implication of the paper is that ;n response to a liquidity

crisis per se (i.e., an internal drain), the Bank should Wercst

impose an

ceiling. TO the contrary, the appropriate prescription is not

a high rate but a clear signal to the public and the banks that their demands

for

currency

addition, the

term

and

reserves will

"irregular

be

freely

acco

smoothing'" is misleading.

Lender-of-

last-resort lending action is the opposite of smoothing. crisis need not threaten the ys true. In the United States it 32 but not in 1933, since the panic 130

ultimately

led

to

a

run

on

the

reflected the public's fear of i run on

the

discount

currency

rate

to

is the

stem an

dollar,

hich

in turn

may

have

inent devaluation ( igmore, 1987). A

reason

a central

external

drain.

bank must

Thus

raise

its

the Credit-Anstalt

crisis in Austria in 1931 was converted from a banking panic to a run on the schilling after the Austrian National Bank, acting as a lender of

last resort,

bailed out

the

Credit-Anstalt

without

imposing

a

penalty rate (Schubert, 1987). 4.

Price-Level And Interest-Rate Smoothing.

An implication of the paper,

based on the considerable amount of attention paid to the subject, is that price-level and interest-rate smoothing were important policies in the classical gold standard era. The historical record

suggests

that this may not have been the case. Little evidence exists that gold standard central banks were much concerned with smoothing the price level before I914 (although Dutton (1984) did find a limited effect in his Bank-rate-reaction fur&ion). McGouldrick

(1984),

may

The German Reichsbank, according to

have

followed

smoothing as it altered its portfolio

a

policy

of

interest-rate

in a countercyclical fashion,

but its policy was not the general rule among gold standard central banks. Perhaps we can interpret the evidence by Bloomfield (1959) and others that many central banks violated "the rules of the game" by sterilizing gold flows as evidence

it is true that under the interwar

the case is not clear. However, gold

exchange

followed.

standard,

Moreover,

such

for interest-rate smoothing, but

smoothing

Goodfriend's

policies

view

that

were the

more

widely

objective

of

maintaining an adequate gold reserve ratio was to pursue price-level and

interest-rate

smoothing

is

contemporaries. Their arguments (1)

to

strengthen

the

not

supported

by

the

writings

of

for building up gold reserves were:

lender

of

last

resort;

(2)

to

maintain

convertibility in the face of an external drain (Bagehot, 1873); and (3) to contribute to national security (Cassel, I935).

Analysis of additional issues using Goodfrie OUM

be of considerable interest. I

131

occasionally

left it; (3) the reasons for the high variability of real

output and price levels under the gold standard (Bordo,

(1982)

;

eltzer

and Robinson,

(1988)).

ere not followed?

132

as it

(1981);

Cooper,

because smoothing policies

Street. Reprint of the 1915 xW.k:~

(1873)

Hw York:

Arno Press.

Barro, R.3. (1979)

oney and the Price Llevel Under the Gold ShndarQ. JOLURQZ, 89:

Barsky, R.B., (1987)

13-33.

ankiw, N.H.,

iron,

3.A.

and

The Worldwide Change in the Behavior of Prices in 1914. Conference.

Ecsnontic

Interest &&?s

estern Economics Association

and

Infwmt ional

Vancouver, British Columbia, July.

Black, F. (1981)

Reserves. A Gold Standard with Double Feedback and NeE!& rtB:'!ra assachusetts Institute of Technology.

imeo) Sloan School, Bloomfield, A.3. (1959)

Monetary Policy Under the International

Gold Standard

/880-1914.

New York: Federal Reserve Bank of New York.

(1981)

The Classical Gold Standard: Some Lessons for Today. Federal Ressme t?ankof St. Louis Review.

Cassel , G. (1935)

The Downfall of the Goki Standard.

Oxford: Clarendon

Press.

Cagan,

P, (1965)

Determinants

and Effects

of Chumges in the Stock of

1960. New York: National Bureau of Economic Research,

(lM2)

The

Gold

Standard:

Historical

133

Facts

and

Future

Prospects.

Dutton, J. (1984)

The Bank of

England and the

International Gold

A.J.

Schwartz

Standard:

(eds.), A

Rules of the New

Game

the

.D. Bordo

Evidence.

Retrospectivs

under

OR the

Classical

ar,.i COZCZ

Chicago: University of Chicago Press.

Standard,l821-1931.

Fischer, S. (1986)

Monetary Rules and Commodity Money Schemes under Uncertainty. 17: 21-35.

Jolusncll of Monetary Economics, Fraas, A,, ;r:19r’4;j

lhe

Second

Bank

of the United

States: An

Instrument

Interregional Monetary Union. Journal of Economic

History,

for

34:

447-62. Friedmans 11.. and Schwartz, A.&. (1963)

A Monetary

History

of the United

States

1867-1960.

Princeton:

Princeton University Press. Lindert, P.H. (1969)

Key

Currencies

md

Gold

Princeton

1900-1913.

Studies

in

International Finance, No. 24. ccloskey, D.N. and Zecher, J.R.

(1976)

How the Gold Standard Worked 1880-1913. Johnson Payments.

(eds.),

The

Monetary

J.A.

Approach

Frenkel and H.G.

to

the

BaZunce

of

Toronto: University of Toronto Press.

cGouldrick, P. (1984)

Operations of the German Central Bank and the Rules of the Game,

1879-1913.

M.D. Bordo

Retrospective OR the CZ&caZ

and

A.J.

Schwartz

Gold Stmtdard,

1822-1931.

(eds.),

A

Chicago:

University of Chicago Press. eltzer, A.H. and Robinson, S. (1988)

Stabilit

Under

the Gold

Standard

oney, History and hternational

a

J.

Schwartz.

Chicago

(forthcoming).

134

in Practice.

Finance:

University

.D. Bordo

ays in Honor of of

Chicago

Press

Redish, A. (1987)

The

Evolution of

University

the Gold

Standard in England,

of British Columbia

1770-iR30.

(Mimeo).

Sayers, R.S.

(1951)

The Development of Central Banking After Bagehot.

History Review,

Economic

2d ser., 4 (no. 1): 109-16.

Schubert, A. (1987)

Tne

Credit-Anstalt

Revisited.

Crisis

of

193i:

A Financial

Crisis

Journal of Economic History, 47: 495497.

Timberlake, R.H., Jr. (1978)

The Origin of Central

Banking

in the

United

States.

Cambridge:

Harvard University Press. Triffin, R.

(1960)

Gold cmdthe Dollar Crisis.

New Haven: Yale University Press.

Wigmore, B. (1987)

Was the Bank Holiday of 1933 A Run on the Dollar Rather than the Banks? Journal of Economic History,

135

47: 739-756,