The Fed was envisioned as operating within and facilitating adherence to the gold standard. While price stability was an important goal of the founders of the Fed, one to which they expected the Fed to contribute, their focus in founding the Fed was something else entirely. It was to solve "the currency problem." This is an unfamiliar term to modern ears, so it deserves a bit of explanation. Before the founding of the Fed, paper currency was supplied by national banks, but was subject to a collateral requirement that dated back to the Civil War; banks' note issues had to be backed by holdings of U.S. government bonds. The aggregate supply of notes was widely described as "inelastic," because expanding a bank's note issue was often costly and cumbersome. At times, the public demand for notes rose as the public sought to convert bank deposits into paper currency or gold. This typically occurred during the autumn harvest season and the holiday shopping season, as well as during so-called banking panics, when bank customers sought to pull deposits out of banks.

The inelasticity of the physical supply of bank notes meant that other adjustments had to take place instead...

Thus the preamble of the Federal Reserve Act lists as one of its purposes "to furnish an elastic currency." The ultimate objective can be thought of as keeping the defective legislative framework around U.S. banking from damaging domestic and international markets.

I gave some remarks on this at a London event for Mervyn King’s retirement. And appropriate of today’s discussion, I used historical examples. I made a distinction of during the 1930s, during the Great Depression, as countries left the gold standard, their currencies temporarily depreciated relative to other countries, and they had a temporary trade advantage because of that; but over time, as all the countries left the gold standard, exchange rates kind of normalized, kind of went back to where they started from, but nevertheless the whole world was nevertheless much better off because there was a global monetary expansion which was desperately needed at that time, in the 1930s.

So that was a positive sum game. It was a situation in which everybody gains because the benefits of — in that particular context, the benefits of growth-enhancing domestic policies spilled over into other economies.

I contrasted that with the Smoot-Hawley tariff, which was more of a zero sum game, where the — or even negative sum, because what was going on there was that each country was trying to divert trade in its own favor at the expense of its trading partners; and as that activity continued and as reprisals and payback continued, actually it destroyed the global trade pattern and was very costly to everybody.

So, what has this got to do with your question? I’m sure you’re wondering. (Laughter.) What it has to do with today is that it’s one thing to use trade or other kinds of interventions to divert — to artificially weaken your currency or otherwise to divert exports to your own producers at the expense of other countries. That’s a very different thing from a situation where countries are using monetary policy appropriately to achieve domestic growth, domestic reflation and that growth spills over and helps the economies of other countries as well. So I think that’s very much the difference, that the exchange rate effects and the currency effects are really secondary. What’s important is that each country provide the necessary monetary accommodation or fiscal accommodation to achieve — to achieve its potential output.

Economists still agree that Smoot-Hawley and the ensuing tariff wars were highly counterproductive and contributed to the depth and length of the global Depression. However, modern research on the Depression, beginning with the seminal 1985 paper by Barry Eichengreen and Jeffrey Sachs, has changed our view of the effects of the abandonment of the gold standard. Although it is true that leaving the gold standard and the resulting currency depreciation conferred a temporary competitive advantage in some cases, modern research shows that the primary benefit of leaving gold was that it freed countries to use appropriately expansionary monetary policies. By 1935 or 1936, when essentially all major countries had left the gold standard and exchange rates were market-determined, the net trade effects of the changes in currency values were certainly small. Yet the global economy as a whole was much stronger than it had been in 1931. The reason was that, in shedding the strait jacket of the gold standard, each country became free to use monetary policy in a way that was more commensurate with achieving full employment at home. Moreover, and critically, countries also benefited from stronger growth in trading partners that purchased their exports. In sharp contrast to the tariff wars, monetary reflation in the 1930s was a positive-sum exercise, whose benefits came mainly from higher domestic demand in all countries, not from trade diversion arising from changes in exchange rates.

The lessons for the present are clear. Today most advanced industrial economies remain, to varying extents, in the grip of slow recoveries from the Great Recession. With inflation generally contained, central banks in these countries are providing accommodative monetary policies to support growth. Do these policies constitute competitive devaluations? To the contrary, because monetary policy is accommodative in the great majority of advanced industrial economies, one would not expect large and persistent changes in the configuration of exchange rates among these countries. The benefits of monetary accommodation in the advanced economies are not created in any significant way by changes in exchange rates; they come instead from the support for domestic aggregate demand in each country or region. Moreover, because stronger growth in each economy confers beneficial spillovers to trading partners, these policies are not "beggar-thy-neighbor" but rather are positive-sum, "enrich-thy-neighbor" actions.

RON PAUL:  The price of gold today is $1,580. The dollar during these last three years was devalued almost 50 percent. When you wake up in the morning, do you care about the price of gold?

BERNANKE: Well, I pay attention to the price of gold, but I think it reflects a lot of things. It reflects global uncertainties. I think people are -- the reason people hold gold is as a protection against what we call "tail risk" -- really, really bad outcomes. And to the extent that the last few years have made people more worried about the potential of a major crisis, then they have gold as a protection.

PAUL: Do you think gold is money?

BERNANKE: No. It's not money. 

PAUL: Even if it has been money for 6,000 years, somebody reversed that and eliminated that economic law?

BERNANKE: Well, you know, it's an asset. I mean, it's the same -- would you say Treasury bills are money? I don't think they're money either, but they're a financial asset.

PAUL: Well, why do -- why do central banks hold it?

BERNANKE: Well, it's a form of reserves.

PAUL: Why don't they hold diamonds?

BERNANKE: Well, it's tradition, long-term tradition.

PAUL: Well, some people still think it's money.

Although commodity standards were last discussed when U.S. inflation was high and variable, Bullard noted that today, inflation is quite low.  He added, “Tying the currency to commodities when commodity prices are highly variable is questionable.” 

While a commodity standard forces accountability on the central bank, “it did not always work because governments sometimes changed the rate between the commodity and the currency,” Bullard said.  “Inflation targeting is another way to force more accountability to the central bank and anchor longer-term expectations.   Make the central bank say what it intends to do,” he said, “and hold the central bank accountable for achieving the goal.” 

“Inflation targeting,” Bullard concluded, “is the appropriate modern alternative to historical commodity standards.”

Q: There is an undercurrent of anti-Fed sentiment among the freshman Republicans. Support for the gold standard, anti-fiat currency… How do you respond to it?

A: I say I understand. I say gold is a very legitimate monetary system. However it will not end crises. It will not end credit bubbles. And it can be just as disruptive as a fiat currency – as an example the Great Depression when gold was hoarded and we had a very serious deflationary experience. Yes, the Fed contributed to it, but also governments contributed to it with their hoarding issues.

Q: But end the Fed?

A: I don’t see that a modern economy would function better without a central bank. We might have stable prices, but that is on average. In the meantime, we would have very strong deflationary pressures and very high inflationary pressures. The average is zero. That is the problem with that. It is not going to solve the world’s problems.

This problem is not new. For example, in the somewhat different context of the gold standard in the period prior to the Great Depression, the United States and France ran large current account surpluses, accompanied by large inflows of gold. However, in defiance of the so-called rules of the game of the international gold standard, neither country allowed the higher gold reserves to feed through to their domestic money supplies and price levels, with the result that the real exchange rate in each country remained persistently undervalued. These policies created deflationary pressures in deficit countries that were losing gold, which helped bring on the Great Depression.  The gold standard was meant to ensure economic and financial stability, but failures of international coordination undermined these very goals. Although the parallels are certainly far from perfect, and I am certainly not predicting a new Depression, some of the lessons from that grim period are applicable today.

And so there are a lot of dangers and risks with the gold standard, not to mention practicalities that would be difficult to put in place. There are good reasons why we left the gold standard in the '30s and got rid of it entirely later on.

So I guess my question would be, well, the Fed is not perfect. It's not a perfect system, but compared to what? And there doesn't seem at this point - just the evidence is of 180 countries or so in the world, there are a couple that share a central bank, but I don't know of any that doesn't have a central bank unless they use somebody else's currency.

So somebody's got to run the monetary policy, somebody has to determine how much currency is to be issued, somebody has to deal with the issues of financial stability, and in modern economies that's the central bank. And I believe that will be the case to the United States and I hope that it will be an independent and highly qualified central bank that does it.

The 20th century saw a gradual but steady departure from the gold standard, culminating in the closing of the U.S. “gold window” in 1971. It is not surprising that expectational stability would have been lost around the same time. When inflation was observed to rise in the 1970s, the public saw no obvious mechanism in place for bringing it back down, and so higher inflation became built into people’s long-run expectations.

Central bankers began to realize in the late 1970s how deleterious a factor inflation was and indeed, since the late 1970s central bankers have behaved as though we were on the gold standard.

The question is, would there be any advantage at this particular stage in going back to the gold standard? And the answer is, I don't think so because we are acting as though we were there.

Finally, perhaps the most important lesson of all is that price stability should be a key objective of monetary policy. By allowing persistent declines in the money supply and in the price level, the Federal Reserve of the late 1920s and 1930s greatly destabilized the U.S. economy and, through the workings of the gold standard, the economies of many other nations as well.

Although the gold standard could hardly be portrayed as having produced a period of price tranquility, it was the case that the price level in 1929 was not much different, on net, from what it had been in 1800. But, in the two decades following the abandonment of the gold standard in 1933, the consumer price index in the United States nearly doubled. And, in the four decades after that, prices quintupled. Monetary policy, unleashed from the constraint of domestic gold convertibility, had allowed a persistent overissuance of money. As recently as a decade ago, central bankers, having witnessed more than a half-century of chronic inflation, appeared to confirm that a fiat currency was inherently subject to excess.

But the adverse consequences of excessive money growth for financial stability and economic performance provoked a backlash. Central banks were finally pressed to rein in overissuance of money even at the cost of considerable temporary economic disruption.

If a country ran a trade deficit that exceeded private capital inflows, it would, in principle, finance the difference by shipping gold to other countries. Doing so reduced the money supply--and hence income and prices--in the country with the balance of payments deficit and increased the money supplies, incomes, and prices in the countries with balance of payments surpluses. As a result, the system had a built-in tendency to move the deficit and surplus countries toward balance. In fact, drains on a country's gold or foreign exchange reserves were typically countered by an increase in central bank's discount rate. The effect on income and prices was, in this case, not due directly to changes in the gold supply, but to the changes in interest rates that were implemented to limit the drain on gold.

However, principle and practice differed under the gold standard. Richard Cooper (1992) summarizes the contrast in the following terms: "The idealized gold standard . . . conveys a sense of automaticity and stability--a self-correcting mechanism with minimum human intervention, which ensures rough stability of prices and balance in international payments. . . .The actual gold standard could hardly have been further from this representation."

Barry Eichengreen (1996) describes the gold standard as "one of the great monetary accidents of modern times," owing to England's "accidental adoption" of a de facto gold standard in 1717. Sir Isaac Newton was master of the mint at the time and, according to Eichengreen, set too low a price for silver in terms of gold, inadvertently causing silver coins to mostly disappear from circulation. As Britain emerged as the world's leading financial and commercial power, the gold standard became the logical choice for many other countries that sought to trade with and borrow from, or emulate, England, replacing silver or bimetallic standards.

England officially adopted the gold standard in 1816. The United States moved to a de facto gold standard in 1873 and officially adopted the gold standard in 1900. The international gold standard refers to the period from the 1870s to World War I, during which time the major trading countries were simultaneously on the gold standard. Though many countries went off the gold standard during World War I, some returned to a form of gold standard in the 1920s. The final blow to the gold standard was the Great Depression, by the end of which the gold standard was history.

Eichengreen argues that the emergence of the gold standard reflected the specific historical conditions of the time. First, governments attached a high priority to currency and exchange rate stability. Second, they sought a monetary regime that limited the ability of government to manipulate the money supply or otherwise make policy on the basis of other considerations. But by World War I, economic and political modernization was undermining the support for the gold standard. Fractional reserve banking, according to Eichengreen, "exposed the gold standard's Achilles' heel." The threat and, indeed, reality of bank runs created a vulnerability for the financial system and encouraged governments to seek a lender of last resort to provide liquidity at times of distress. Such intervention was, however, inconsistent with the gold standard.

...

... In fact, drains on a country's gold or foreign exchange reserves were typically countered by an increase in central bank's discount rate. The effect on income and prices was, in this case, not due directly to changes in the gold supply, but to the changes in interest rates that were implemented to limit the drain on gold.

However, principle and practice differed under the gold standard. Richard Cooper (1992) summarizes the contrast in the following terms: "The idealized gold standard . . . conveys a sense of automaticity and stability--a self-correcting mechanism with minimum human intervention, which ensures rough stability of prices and balance in international payments. . . .The actual gold standard could hardly have been further from this representation."