Is Mitt Romney Entirely Economically Illiterate?

One has to ask, because the latest idea being spouted by the Republican party is, in economic terms at least, madness.

That idea, in case you missed it, is, in the words of the FT headline today, to “eye a return to the gold standard”. Drafts of the party’s forthcoming convention platform, to be fully unveiled next week in Florida, indicate that it will set up a “gold commission” investigating the possibility of bringing back the link between the dollar and gold.

The Gold Standard, in case you forgot, was the tacit agreement which managed the international monetary system in the 19th century. Under it, each country’s currency was pegged to a certain amount of gold – so, for instance, a pound was worth a fourth of an ounce of gold. Theoretically, you could take that pound to the Bank of England and get that much of the precious metal in return.

The system worked pretty well in the 19th century – most notably it kept inflation under control. Throughout that century most of the Gold Standard economies had low and occasionally negative inflation rates. After all, since the US or UK governments were duty-bound to exchange every dollar or pound with the gold in their vaults, they couldn’t exactly print money at will to try to pay off their debts.

However there were some problems. The relatively minor ones were that the gold standard did little to prevent financial crises – there were a series throughout the 19th century – and it meant that the entire world economy was vulnerable to the ebbs and flows of gold mining. If there was a gold shortage around the world, it meant imposing global deflation (a natural consequence if gold stocks in central banks weren’t expanding at the same rate as economic growth and the demand for money).

But the main reason a return to the gold standard would be madness is that it is simply incompatible with democracy. The best way to understand this is through a graphic (bear with me) that shows you what is and what isn’t possible when you try to construct an international economic system.

This diagram drawn up by Harvard economist Dani Rodrik to explain what is sometimes called the “trilemma” of international economic policy, sometimes the “impossible trinity”. In an ideal world, you might strive towards all of the three objectives in the boxes above. You might want fixed exchange rates so that you can predictably trade with your neighbours. You would want to have complete capital mobility, so people can bring money in and out of your country at will, helping foster investment. You might want to be able to control your own monetary policy, moving interest rates as necessary to shield you from recessions or from overheating.

The problem is that while you can have two, it’s impossible to have all three of these at any one time. It simply doesn’t work.

The Gold Standard, as you have probably already spotted above, had both fixed exchange rates (fixed, of course, to gold) and  free movement of capital, but in order to achieve this, each member state had to give up setting its own monetary policy. This makes sense: it had to control the speed of its economy based not on whether it was overheating or slumping but on how much gold it had in its vaults, and whether it was enough to satisfy demand for its currency.

As a result, countries in the Gold Standard frequently had to impose deflation – wage cuts and unemployment – on their economies in order to keep their currencies fixed to gold. That was feasible when they couldn’t answer back, but following the era of the mass franchise, people understandably lost their patience with such a system. They lost patience with a system which would impose extra unemployment on them simply because some nameless central bankers decided that should be the case.

Is that really the kind of system Mitt Romney wants to return the US to?

Let’s imagine he isn’t entirely economically illiterate, and is considering something more like the Bretton Woods system, in which the world’s major economies keep fixed exchange rates and have nationally-determined interest rates. That’s fine, but it would involve giving up the free flow of capital moving around the world.

The Romney-Ron Paul argument is that linking a currency to gold (and that was what happened under Bretton Woods – although in that case it was only the dollar linked to gold, and other currencies around the world to it) will prevent a politician from over-spending. But, lest we forget, when Richard Nixon realised the costs of Vietnam were getting out of control, he simply brought the Bretton Woods agreement to an end. That was in 1971; we’ve been in a non-gold, floating rate fiat money world ever since.

Now, in fairness to Mitt Romney, clearly there is a problem with the way the international monetary system fits together. It certainly needs re-examining. But while it’s very easy to dangle the prospect of returning to a gold standard in front of people, it’s far more difficult to come up with a system that will actually work.