Since the fall of the full international gold standard in 1914, the fiat money âsystemâ has wandered through four successive stages of disorder. In each of these, we can identify the eventual emergence of a âstabilization experimentâ. The first three all ended in dismal failures, sometimes catastrophic. Either the experiment was deeply flawed or halted prematurely or both. The presentâthe fourthâis headed in the same direction, driven by essential flaws in concept and implementation. We call this last the âglobal 2% inflation standardâ. It could not have been introduced at a worst time. The main uncertainty is whether it will come to an end in an asset price deflation shock, or a goods inflation shock, or both. Then there will be the fifth stage of disorder. Question: could the fifth stabilization experiment, if and when it emerges, be more successful than the previous four? That is running ahead of our story. Letâs go back to the beginning.
First Stage of Fiat System Disorder: 1914â31
Under the gold standard, currencies were fully convertible into gold or gold coin on demand. The base of the gold money system was essentially above-ground gold supplies. That system came to an end with the outbreak of World War I.
In the aftermath of that war, starting in the early to mid-1920s, there was the construction of a so-called gold exchange standard. Governments and their central bankers sought to restore stability after many years of violent fluctuations in internal and external values of the major currencies. The US dollar remained fully convertible into gold coin; amongst other main monies; some âreturnedâ to a âgold bullion standardâ (meaning that currency was convertible only for large amounts with the minimum being the 400 oz. bar, e.g. in the case of the UK); some adopted a âdollar standardâ (in effect a fixed exchange rate of the national currency to the dollar but underpinned crucially in the case of Germany by a treaty commitment as drafted according to the Dawes Plan of 1924). The countries outside the US in general (sometimes with a French exception) accumulated reserves in dollars (and to a lesser extent sterling) rather than metallic gold, and this was in accordance with the recommendations of the League of Nations (in particular as set by the Genoa Conference 1922). There a âdeflation-phobicâ committee of experts from the British establishment (including UK Treasury officials and Professor Ralph Hawtrey (a close friend of John Maynard Keynes)) who were adamant about the importance of âstable pricesâ determined the agenda (see Rothbard 2005).
The Federal Reserve had large scope to determine the path for the US monetary base; it eschewed automatic rules and effected large and volatile shifts in pursuing its discretionary policy objectives including sometimes economic stimulus (efforts to stimulate the recovery from steep recession as in late 1921 and 1922) or other times international currency diplomacy as conducted by New York Fed Chief Benjamin Strong with a particular focus on supporting sterlingâunnecessary if Great Britain had allowed monetary conditions to tighten under the influence of gold loss. The giant asset and credit market inflation which emerged in the US and Germany (then the second largest economy in the world at the time) revealed that Federal Reserve policy focused on whatever passing objective (e.g. cyclical fine-tuning, Strong helping out Norman) had been gravely inconsistent with sound money.
The question has to be asked: how could the Federal Reserve (founded in 1913) possibly judge the demand for high-powered money (monetary base) under the new banking regime in the US? In particular, there was considerable optimism amongst bankers and their clients that the creation of a lender of last resort (the Federal Reserve) mandated to provide emergency liquidity would mean that the repeated bank crises of previous decades were now impossible. Hence there should be less demand for cash as safety margin than pre-1914; and the shrunken proportion of gold in the monetary baseâmatched by an increased proportion of Federal Reserve notes and deposits at that institutionâwould surely mean a diminished overall demand for monetary base, everything else remaining the same.
The long-term interest rate market, transformed and considerably deepened by war financing, now took cues from the rate setting operations of the Federal Reserve. Previously money rates had been highly volatile and largely ignored there. The fact that short-term rates remained so low despite economic boom through the roaring 1920s as the Federal Reserve followed the aim of stable prices (thereby resisting the fall of prices that would have been in line with the eraâs rapid technological change) had a magnified and distortionary influence (downwards) on the long-term rates market (see Brown 2016).
This first stage of fiat monetary disorder including eventually its stabilization experimentâthe gold exchange standardâcame to an end with the bust of the global credit bubble (mainly US and German) as delineated by the declared bankruptcy of Germany in July 1931.
Second Stage, 1931â68
The second stage of fiat money disorder followed . It featured at first the huge exchange rate fluctuations of 1931â36. As early as the tripartite agreement of 1936, there was a short-lived attempt to restore stability internationally based on a truncated gold-dollar pivot. Later the Bretton Woods Agreements set the scene for a full global experiment in stabilization. This did not get under way in fact until the end of the 1950s (given widespread persistence of exchange restrictions in Europe especially until then). The US dollar was no longer on an internal gold standard (in fact US citizens had been outlawed from holding gold since 1934). The dollar was effectively convertible into gold for non-US residents though the universe able to take advantage of that was highly restricted.
The Fed had virtually total discretion in the setting of the path for monetary base subject only to there being no run on the âgold windowâ. By the mid-1960s, the Kennedy/Johnson Administration had installed Keynesian economists in positions of power who pursued their mythical trade-off between higher employment and inflation. Fed Chief Martin was no Keynesian but in the FOMC their influence was increasing. Martin saw the central bankâs mission as managing the public debt market which in the context of the Vietnam War had inflationary consequences (see Meltzer 2009a). The end of the stabilization experiment (Bretton Woods) came in a series of developmentsâthe floating of the gold price for non-official purposes in 1968, the transitory floating of the Deutsche mark (DM) and then its revaluation of 1969, the re-floating of the DM and the Swiss franc in May 1971, and finally the slamming shut of the gold window by the Nixon Administration in summer 1971 (see Brown 1988). In effect, ultimately the Bretton Woods architecture proved unable to prevent the US from lurching into a high inflation inconsistent with the systemâs continued existence.
Third Stage: 1969â85
Then there was the third stageâthe one featuring eventually the monetarist experiment. The collapse of the Bretton Woods system had brought about a generalized floating of exchange rates between the major currencies (interspersed with attempts to fix intra-European exchange rates). With any gold link to the dollar now absent, Germany and Switzerland took the lead in developing an ersatz gold monetary standard. The guiding principle: the respective central banks should expand the monetary base at a low near-constant rate, superficially resembling in concept the low rate of increase in above-ground gold supplies in the pre-1914 gold world. This was the central experiment now in monetary stabilization, and its designers rejected discretionary policy-making otherwise described as fine-tuning. Monetarism could gain credibility as an ersatz gold standard only if it became global with all the major economies including most of all the US joining the experiment. That occurred briefly in the late 1970s and early 1980s (President Carter appointed Paul Volcker to the head of the Fed in autumn 1978).
Even at that high point of the experiment, any resemblance between ersatz gold and the real gold standard was superficial. There was no built-in suppleness (e.g. under gold, a fall in prices of goods and services would lead to some increase in gold supplies as profits in the mining industry rose). There were no automatic mechanisms and unshakable beliefs in the standardâinstead this featured money supply targets which could be over-ruled, adjusted, or ignored, and political pressures could sweep monetarism aside. Moreover there was no large and stable demand for the fiat money base in these countries (where monetarism reigned)âexcept in so far as high reserve requirements provided artificial backing. Such requirements, however, were intrinsically fragile (not least because they remained subject to special pleading and arbitrage operations by the banking industry).
The end of the monetarist experiment did not come because of revealed fundamental flaws, such as volatility in demand for or inflexibility in supply of monetary base, emerging in a menacing way though this might well have occurred if it had endured. Rather already in 1985, then Fed Chief Paul Volcker yielded to huge political pressure to tackle the large US trade deficit (and more specifically the emergence of a ârust beltâ) which was widely blamed on a super-strong dollar.
In any case, the degree of overshoot (upwards) in the dollar at that time was dubious. After all, the fact that the Federal Reserve appeared to have abandoned its inflationary policies of the previous decades could surely unleash global demand on a permanent basis for the dollar as the obvious preferred international money; a cheap dollar would not reincarnate traditional manufacturing in an age of rapid globalization. Be that as it may, Volcker (who as under-secretary of the Treasury had been in charge of negotiating the dollar devaluations of 1972â73) harnessed the Federal Reserve to the Reagan Administrationâs efforts (as led by then Treasury Secretary James Baker) to devalue the dollar and specifically joined in the Plaza Accord (see Brown 2013).
The Volcker Fedâs abandonment of âhard moneyâ policies and the monetarist experiment led directly to the global monetary inflation of the late 1980s featuring virulent asset inflation, most spectacularly the bubble and bust in Japan. Germany was the last to abandon monetarism formally with the launch of the euro (see Brown 2014; Schwartz 2005).
Fourth Stage: Mid-1980s to Present Day (2018â?)
Out of the monetarist retreat (widely regarded as defeat and failure) was born the fourth stage of fiat money disorder. Within a few years there was the start of a new stabilization experimentâthe targeting of perpetual inflation at 2% p.a. A key milestone was the FOMC meeting of July 1996 which considered the issue of whether with inflation now down to below 3% the Fed should go easy on its drive to ever-lower inflation and accept a continuing stable low inflation around 2%. Janet Yellen presented the paper in favour. There followed no firm resolution. Nevertheless then Chief Greenspan agreed to a pause. A stronger commitment to a target of perpetual âlow inflationâ emerged in subsequent years, both under the late Greenspan years and more especially under Chief Bernanke.
The intellectual rationale for inflation targeting was rooted in neo-Keynesianism. A leading pioneer in the late 1970s was Stanley Fischer whose student-disciples included Ben Bernanke and Mario Draghi amongst others (see Fischer 1979). He argued that the tenets of monetarismâtargeting of money supply growth at a low level and the abandonment of fine-tuning the economyâwere mistaken. Demand for moneyâand particularly monetary baseâwas just too unstable now for an ersatz gold system to work well. And in any case, the monetaristsâ foreswearing of fine-tuning (a rejection which was consistent with the teaching of the contemporary classical economists such as Robert Barro (1976) who claimed that monetary policy could not stimulate the real economy if prevailing expectations were rational) was based on fiction. In the practical world where long-term wage contracting was common, monetary policy could stimulate the real economy. But to prevent such repeated stimulation bringing about ever-higher inflation, a target should be set for this (inflation).
The new experimentâinflation targetingâwas grounded on serious misconceptions and it could not have come at a worse time. Even under the gold standard or under monetarism, there existed no firm basis for any reliable prediction linking the path of money to near or medium-term price outcomes. In so far as monetary base was indeed a highly distinct asset for which a broad and stable demand existed, there could be reasonable confidence that a monetary control regime limiting strictly the growth of this aggregate would bound the extent of cumulative price fluctuations in both directions (a topic we will revisit in future chapters of this book). Yes, in the long run under a gold standard, there was a tendency for prices to revert to the mean. Even so, such an outcome was not guaranteed. Moreover, in the short and medium term, there was every reason to th...