T C A Srinivasa-Raghavan: If dollar = gold, euro = silver

OKONOMOS

It is an old rule, as old as the Roman Empire: if you debase your currency, its value will fall. Edward Gibbon would have told you as much, without having the benefit of modern economic analysis or economists.

This is what is happening to the dollar. George Bush has pumped in so many dollars (trillions) since he became President that the dollar is losing value.

In the old days, when this happened to gold-based money, people would switch to silver, whose price went up. Now they are switching to the euro, which has been appreciating relentlessly. No one knows where the rate will finally settle, so lots of chaps are betting as well, which complicates things.

There is one difference between then and now, however. While silver producers used to be in the seventh heaven then, euro producers are in the dumps now.

There is a sub-paradox, too. The only lawful producer of dollars, the US, is actually very pleased that the dollar is losing value. Indeed, all countries are pleased when the currency they produce loses value.

Be that as it may "" for who can account for the silliness of economics "" a recent paper* by Michael D Bordo and Andrew Filardo throws some light on what we can expect in the coming years. Since a deflation seems very much on the cards, they have carried out a historical analysis of deflations.

In a deflation world GDP contracts, as do world prices. For one reason or another, everyone simply buys less than before. The key question, therefore, as Lenin asked in a different context, is what is to be done?

The first thing that history teaches us, say Bordo and Filardo, is that not all deflations are bad. "The historical record is replete with good deflations." This could be an important insight because it has such a direct bearing on the policy response.

The authors also say that "in many ways, the current policy environment better resembles that of the distant past than of the period from 1970 to 1995. This not only suggests that looking to the past may help resolve some current policy issues, but also that policy models might benefit from being calibrated to those developments in the distant past."

The key question, of course, is if "monetary policy can eliminate deflation of any magnitude just as it can eliminate inflation." The answer depends, they say, on where you are to start with.

The historical evidence suggests that emphasising monetary aggregates works well during periods of both high inflation and deep deflation but not when these are low.

In the end, though, a lot of it boils down to the credibility of the nominal anchor. In others, it is all a matter of faith because that is what influences private sector expectations.

Until the Americans went reneged, in 1971, on their promise to pay $ 42 per ounce of gold, the anchor was credible enough. Until 1990, the dollar did not become a full substitute for gold but since then it has been more-or-less that. It is hoarded in exactly the same way. But now, thanks to George W Bush, its credibility is under threat again.

Under the classical gold standard, there was an automatic check imposed by the quantity of gold being produced. In the long run, world prices always reverted to the mean because prices were anchored by the marginal cost of producing gold, which could be quite high.

But now, the marginal cost of producing dollars is almost zero, with the US free to print off as many dollars as it wants. The automatic check has disappeared.

It is important to know if the lessons from the gold standard regime are still valuable today. One thing is for sure: the paper money regime provides more flexibility to central bankers. But it also lacks the self-correcting mechanism.

The critical policy issue, therefore, perhaps for the next quarter century is how to get the paper currency regime to imitate the gold standard in the matter of self-correcting mechanisms.

A necessary condition for this is the ability and willingness of the monetary authority to pursue a low inflation goal.

There isn't much agreement over how exactly this is to be done, that is, via specific targeting or a zone approach. As to the issue of shocks, the paper doesn't have much to offer.

*Deflation and Monetary Policy in a Historical Perspective: Remembering the Past or Being Condemned to Repeat It? NBER Working Paper No. 10833, October 2004