Larry White on the International Gold Standard

Over on Free Banking, Larry White linked to an article where he advocated the international gold standard in combination with free banking. The article began with a focus on problems with the Euro and the role of possible currency devaluation:

Soros hopes that with one pan-European government, financially conservative Germany would no longer rule the roost. The ECB could then pursue looser monetary policy, which he supposes would cure the ills of countries with weak economies and mounting public sector debts. This view is widely shared.

By contrast, when retired Dutch central banker André Szász says that the euro was flawed from the start, as he did earlier this year, he means that it is a mistake to have “a monetary policy of one-size-fits-all.” Such a monetary policy will be too loose for some countries and too tight for others, or, as he puts it, interest rates will be “too low” for some countries and “too high” for others.

This criticism is linked to the so-called optimum currency area analysis, which holds that to share a single currency, two or more economies should have harmonized business cycles so that a single monetary policy (interest rate) fits them all. Absent harmonized cycles, devaluation or exchange rate depreciation is supposed to help an economy in recession reduce its unemployment rate by lowering real wages or by stimulating real output through greater real exports.

Both of these diagnoses arise from false premises. They both rest on the wishful thinking of Keynesian economics, in particular, that an artfully timed discretionary monetary policy will improve or stabilize an economy’s real performance by improving or stabilizing real variables. That is to say, these arguments take for granted an ability to exploit the Phillips Curve (to lower unemployment by cheapening the monetary unit), alternatively known as exploiting the “money illusion” of the workforce.

In fact, the real illusion here is our supposed ability to exploit the money illusion. A policy regime of printing more money and devaluing does not improve real economic performance or dampen business cycles. It does just the opposite. The historical evidence on that question is clear.

While I favor free banking, I don't favor an international gold standard. Rather, I favor a monetary regime that stabilizes the growth path of nominal GDP. This sometimes requires printing money, and sometimes the floating exchange rate depreciates, resulting in more exports.

If we consider a situation where some error has resulted in inadequate money creation so nominal GDP falls below target, the result would likely be slower growth or even reduced real expenditure, real output, and employment. In other words, this error would lead to a recession.

Fixing the error, and returning nominal GDP back to its target growth path, would involve expanding the quantity of money, which could involve a depreciation in the exchange rate, and an expansion of exports (and in the demand for import competing goods.) This would be one avenue by which the expansion in the quantity of money would increase nominal expenditure back to target, which would lead to a recovery of real output and employment.

More importantly, it is quite possible that preventing the exchange rate depreciation would require that less money be created, so that nominal GDP would remain below its targeted growth path. Given that lower growth path for nominal GDP, recovery would require that prices and wages shift to a lower growth path, so that real expenditure and output can return again to their previous growth path.

So, what about White's claim that both approaches are based upon an ability to exploit a phillips curve or involve the exploitation of money illusion?

White describes exploiting the phillips curve as cheaping the monetary unit to reduce the unemployment rate. I don't see it that way and instead favor the natural rate hypothesis, with a focus on nominal GDP.

More rapid growth in nominal GDP--the flow of money expenditures on output--results in rising sales for firms. The firms respond by raising prices more quickly as well as expanding output more quickly. The more rapid growth in output results in more rapid growth in employment, and so a reduced unemployment rate.

That firms are raising their prices more quickly is a cheapening of the monetary unit, but that isn't what causes unemployment to fall. It is rather another consequence of more rapid growth in nominal GDP. Oddly enough, to the degree that firms meet growing sales by raising prices by less and expanding production by more, unemployment falls by more. Given the growth rate of nominal GDP, the larger the increase in the inflation rate, the smaller the decrease in the unemployment rate.

The natural rate hypothesis is the view (which I hold) that the more rapid growth in output and employment are temporary. Worse, output and employment have temporarily moved to a higher growth path inconsistent with the productive capacity of the economy--which depends on "supply-side" factors like technological improvement, the population and willingness to work, and saving, investment, and the accumulation of capital goods. Not only will the growth of real output and employment slow back to its initial rate, it will slow below its long term trend growth rate, to return to its previous growth path. The unemployment rate will rise again to its initial level as employment returns to its lower, equilibrium growth path.

Unfortunately, the inflationary consequences of the more rapid growth in nominal GDP persist. In fact, during the short run adjustment--when real output remains on a higher and unsustainable growth path, the inflation rate is lower than its final value. During the adjustment to the long run equilibrium, the inflation rate must rise above its long run rate, and that is when unemployment rises. In this situation, there is a sense in which the higher inflation is depressing real expenditure and causing the higher unemployment. (Of course, this is simply an increase in unemployment from an unsustainable low level.

So why support more rapid growth in nominal GDP if any benefit in terms of output and employment is transitory? It is because a slowdown in nominal GDP growth is subject to a similar analysis.

In the short run, slower growth in nominal GDP (including negative growth) results in slower or reduced sales. Firms respond by slowing their price increases and the rate at which they expand production. With production growing more slowly, employment grows more slowly. The unemployment rate rises. In more extreme cases, prices, production, or employment may fall rather than grow more slowly.

Again, it isn't that the lower inflation causes higher unemployment, it is rather that the slower growth of nominal GDP--the flow of spending on output--is causing both slower inflation and higher unemployment. Further, if the firms responded to the slower growth in sales by raising their prices a smaller amount, or even cutting them, the slow down in money expenditures would be consistent with a smaller slowdown in the production of goods and services, and so employment would be less depressed and the unemployment would rise by less.

And in the long run? Real output returns to potential--to levels consistent with supply-side factors, as does employment, while inflation slows further. As real output and employment recover--moving to a higher growth path--inflation must slow even further, temporarily falling below its long term growth path. Again, the slower inflation results in more rapid growth in real expenditure, resulting in increased sales along with the recovery in production and employment. The slower inflation is causing the falling unemployment.

So, how does this analysis of the Phillips curve fit in with nominal GDP targeting?

Suppose some error result in slower growth of nominal GDP. The slower sales result in slower inflation and slower growth in production and employment. The unemployment rate rises. A monetary regime that reverses such a deviation in nominal GDP, so that it grows at a higher rate to reverse this downward deviation results in more rapid sales and firms reverse the decreases in production and employment. But this doesn't involve a shift in production and employment above potential--beyond the level determined by supply-side factors. On the contrary, it simply reverses the downward deviation. The unemployment rate rises above the natural rate and then falls again.

As long as some of the initial slowing and then recovery in the flow of money expenditures results in changes in at least some prices, then inflation slows and then "recovers" as well. However, describing the reversal of the temporary disinflation as somehow exploiting money illusion seems inappropriate. What it is doing is forestalling the long run adjustment that would result in even more disinflation.

The relevant issue is whether the recovery of nominal GDP to its previous growth path will hasten the recovery of real output, employment, and unemployment, or rather will firms and households that have already fully, or partially adjusted to the slower, or lower growth path of nominal expenditure, respond to the recovery of nominal GDP by raising production beyond potential, along with an associated temporary expansion in employment and reduction in unemployment.

Presumably, the answer to that question very much depends on expectations. A regime of targeting the growth path of nominal GDP would likely have only weak disinflationary forces allowing for a recovery of output. However, confidence by firms and households that a monetary regime will reverse any deviation of GDP from the targeted growth path should both dampen any actual deviations and hasten their reversal.

As for devaluations, adverse changes in international competitiveness are a type of adverse productivity shock. As with other such shocks, a regime that targets the growth path of nominal GDP generates a higher growth path of prices and reduced real output. The decrease in the market prices for foreign exchange results in higher import prices and a reduction in the real value of exports.

A lower growth path of nominal (and real) wages is an alternative approach to adjusting to this adverse shock without any change in the exchange rate. In my view, the situation that foreign goods are more difficult to obtain is better signaled by an increase in the prices of imported goods than reduced employment opportunities at the trend growth rate of money wages.

It is true, of course, that nominal GDP targeting naturally leads to a question of optimal currency areas. What area's nominal GDP should be targeted? (Admittedly, I tend to take the parochial view that the nominal GDP of the U.S. should be targeted.)

I think the key requirement for an optimal currency area is factor mobility--particularly labor. It would seem to me that a shift to a higher growth path of money wages in one region and a lower growth path of money wages in another region is only useful if it serves as a signal for migration. If such migration is difficult, impossible, or even not desired, then changes in product prices seems like the more appropriate signal of the necessary change in real incomes and the allocation of resources between local and distant production.

However, I also believe in competition in currencies, so that individual households and firms should be free to adopt the currency used in some other "area" regardless of what seems optimal to me. I doubt, however, that currency competition will ever result in any kind of gold standard, much less an international one.