Bashing the Idea of Central Banks

I saw Ron Paul on the Colbert Report the other night. As usual, he was bashing the concept of a central bank, arguing for a return to the gold standard, which he asserted would bring down the price of oil. This sort of delusion keeps coming up, though it is actually much more rare than it seems on account of all the media attention Ron Paul gets. Still, it deserves countering, because the audience cheered his comments, presumably not knowing the implications of what he was suggesting.

Would a return to the gold standard bring down oil prices? Measured in plain old dollars, yes. There is a problem with this, however. First off, it is not within the power of the Federal Reserve or any other central bank to change the relative price of oil, for example as a percentage of your paycheck -- at least not without catastrophic consequences. To see why, let's go through the steps the Federal Reserve would have to take to re-peg the dollar to gold and what would happen as a result of each step.

As I'm writing this, the gold price is $1,530.60 per ounce. If the Fed wanted to peg the dollar to gold at the current rate, what it would have to do would depend on further market pressures on the gold price (whether it wanted to go up or down). Pegging to gold would mean the price would remain $1,530.60 forever. If people started buying more gold, thus putting upward pressure on the price, the Fed would have to encourage people to sell their gold and buy dollars instead, so that its gold reserves didn't get depleted. The way to do this is to raise interest rates. Gold pays no interest, so it is not attractive if you can make money by keeping your money in currency (like dollars) rather than gold -- as long as you believe the currency is stable. Raising interest rates could re-stabilize the gold reserves and ensure the price stays the same.

The problem is: the economy is fragile, and the prices for many consumer goods are rising only very slowly at best. Higher interest rates would mean loans would also become more expensive, and putting your money in a bank account earning interest more attractive. Spending money now is also less attractive if you believe things will be cheaper tomorrow. Better to wait and earn interest on your cash today and then buy later. Consumer spending and company investment would fall. This would mean fewer orders for goods, less work for factories and construction companies, etc etc. This would lead to another recession, negative growth, rising unemployment, and falling wages. As demand for goods falls, so will demand for oil. As the ripples of a second American recession spread over the world, demand for oil could fall globally. It is therefore very plausible that the oil price could fall faster than wages, making oil cheaper. The downside is that wages as a whole would fall and unemployment would rise. This is a high price to pay for a cheaper tank of gas.

But let's not stop here. I believe the current price of oil reflects global uncertainty and the unusual conditions we see today -- in other words: I think there's a gold bubble. It's therefore also very possible the gold price would want to fall. If people around the world believed the Fed's commitment, they would start buying dollars and selling gold, since dollars would provide a better return. The dollar price would go up (compared with other currencies). This would make American exports more expensive in other currencies, and imports really cheap. Companies in America (like Caterpillar, the one that makes excavation equipment) that rely on exports, would be severely damaged. America's current account deficit would widen even further. What's more, the Fed would have to move to extreme measures to keep the gold price UP. It would have to loosen monetary policy even more. Since it cannot really do this, the gold price would likely fall, making the Fed look foolish and unable to be trusted. This would all cause the very thing Ron Paul despises: loose monetary conditions and possibly bubbles.

It all boils down to the fact that the gold standard is arbitrary. Why should we maintain a constant price for gold? Who cares? Gold has no, or little, intrinsic value other than that it is shiny and pretty. The current system is to "peg" the currency to consumer prices, targeting a slow rise of about 2% per year in most countries. It makes much more sense to preserve a currency's overall purchasing power as measured in everyday goods, rather than its nominal value in a good that most people will never own very much of and still fewer can have any real use for. Gold, like any single commodity, is also unstable. A gold mine in South Africa shutting down (this happens) would cause interest rates around the world to rise and tip the global economy into recession. Why do that?

Having an "oil standard," by the way, would be foolish for all the very same reasons, even though oil is a critical good we frequently need. If we pegged the dollar to oil, interest rates would rise dramatically every time there was a shortage of oil, plunging at least the American economy into recession, but probably much of the rest of the world along with it. Oil would still get more expensive in real terms, because wages and prices for other goods would fall as oil stayed put. Eventually the fall in demand caused by the recession would bring oil down, causing loose policy again and a recovery. This is the nasty boom-and-bust cycle associated with old-school capitalism, the same type we thought we'd beaten until the last crisis. Still, though, accepting an oil or gold standard would mean accepting a boom-and-bust cycle that we could have zero control over. Most of us think steering against such cycles and evening them out is a good thing -- this is one goal of central banks'.

Note, too, that this boom-and-bust could all be caused by supply shocks rather than too-high demand. One could actually argue for lower interest rates in response to supply shocks, even though this would accelerate oil-price increases. This is because oil is so important. As its price rises, people and companies are forced to cut back on other spending so that they can continue to buy (more necessary) oil. This could cause overall prices except oil to fall, especially if unemployment is already high (like today in America), meaning bargaining for higher wages is difficult. Rather than let everything else fall, there's a reasonable argument for stimulating the economy in response to the growth-killing effect of an oil supply shock.

Besides, as oil becomes dearer over the decades, there will be a slow shift away from it. Eventually, it won't be such an important commodity, so an oil standard would become increasingly anachronistic, in addition to never having been a good idea in the first place.

Inflation-targeting of consumer prices remains one of the best ideas central banking has ever had. It's not enough, and not all other ideas have been good, but let's not throw the baby out with the bathwater and return to a system that doesn't make sense anymore (it only ever made sense because gold had just happened to become the default world currency) out of pure nostalgia. I'll give you a hint on what to focus on for stability: property bubbles and flows of "hot money." Central banks are re-thinking their approaches to these, too. Let them get on with it. And STOP interviewing Ron Paul! It reminds me of Paris Hilton's energy policy suggestions, except that hers were actually logical!


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