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Jeffrey A. Miron

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The Fed Versus the Gold Standard

Posted: 04/18/2012 12:18 pm

Bashing the Federal Reserve has become a major indoor sport. Tea Partiers and libertarians blame the Fed for the housing bubble, and they fear the Fed's accommodative policies will re-ignite inflation. Republican presidential candidate Newt Gingrich has vowed -- if elected -- to replace Ben Bernanke as Fed chairman. And the most vocal Fed critic, Republican presidential candidate Ron Paul, wants to "end the Fed" and return to a classical gold standard.

Does all this Fed bashing and gold-standard loving make sense? Is the mainstream dismissal of the gold standard appropriate, or are the Fed critics really on to something? Here is a calm assessment that will disappoint both sides in this debate.

Mainstream economists of every political persuasion have long recognized that the Fed's record is far from perfect. Most dramatically, Milton Friedman and Anna Schwartz blamed the Fed for the Great Depression, and subsequent scholarship has largely accepted this view. Ben Bernanke, at a 90th birthday party for Friedman, famously quipped to him and Schwartz, "You're right; we did it. We're very sorry. But thanks to you, we won't do it again."

More broadly, few economists dispute that the Fed has contributed, at times, to the boom and bust cycles in the post-WWII economy. Many also believe the Fed should have deflated the housing bubble earlier.

With respect to the recent financial crisis and recession, most economists give the Fed higher marks, accepting at least the possibility that Fed actions prevented an even more severe downturn.

Yet even here the positive evaluations are mixed with criticisms and concerns. Prominent economists were skeptical of the Fed's support for TARP, of the Fed's implicit Wall Street bailout via purchases of mortgage backed securities, and of quantitative easing and perpetually low interest rates. Many worry that the Fed is overestimating its ability to reverse these polices if inflation heats up.

Thus, most observers acknowledge both past Fed mistakes and the potential for future difficulties. This might seem like a strong indictment.

The right question, however, is not whether the Fed has been, or ever will be perfect, but rather how economic performance under the Fed compares to some feasible alternative, such as the pre-1914 gold standard favored by most Fed critics.

So let's compare economic performance under the two regimes.

By one measure, the gold standard did outperform the Fed: inflation averaged about 0% under the gold standard but more than 3% in the post-war period. This is the fact that most animates Fed detractors.

But so long as inflation is predictable, it is hard to see much benefit from 0% versus 3%, since markets readily adjust to a higher rate if it is steady. And inflation was not stable during the gold standard period; years of deflation preceded years of inflation, balancing out at zero by dumb luck.

In any case, inflation is only one component of economic performance. The more important aspects are how fast real output grows and how much this growth fluctuates.

As it turns out, real output has grown slightly faster under the Fed than under the gold standard, and the volatility of real output growth has been somewhat lower.

Thus by the measures that matter most, economic performance was worse under the gold standard than under the post-war Fed. Gold standard defenders must therefore put implausibly large weight on inflation outcomes, rather than real output growth, to justify their perspective.

Nothing in this assessment, to be sure, means the gold standard was a terrible system; U.S. economic performance was indeed solid under the gold standard.

And much criticism of the gold-standard period is misplaced or exaggerated. The financial panics that plagued the period were not due to the gold standard but to specific features of the pre-1914 banking system. Recent research, moreover, suggests that panics were less frequent than indicated earlier, and their impact less severe.

Available evidence, therefore, does not show that the gold standard was markedly worse than the Fed, but neither does it show the opposite. Thus recent vilification of the Fed, and claims that a gold standard can solve U.S. economic problems, are without empirical foundation.

The crucial problem for the U.S. economy is not its monetary system but the unsustainable path of future entitlement spending. Unless the U.S. gets its debt outlook under control, any monetary system will face inexorable pressure to inflate these debts away.

 

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