Gold standard, Friedman's rule or today's Fed, three answers compared

Ask three conservatives what a dollar should be, and you will get four answers and a pamphlet. One says it should be a fixed weight of gold. One says it should be whatever a computer-simple rule says, growing at a steady percentage a year. One says that an independent central bank with a clear target is the best we can do. A fourth, with a gleam in his eye, says the government should get out of the money business entirely and let banks issue their own.

The disagreement is old and honest, and it deserves more than a shouting match. So I am going to lay the options side by side, define each one, grade them on four criteria, give each camp a fair hearing, and then argue for one.

The question and the yardstick

Money performs three jobs: it is a medium of exchange, a unit of account and a store of value. A monetary regime is the set of rules that determine how much money exists and what backs it. The question is which regime does the best job of keeping the value of money stable without creating other problems.

I will use four criteria.

One. Inflation record: how stable has the price level been under this regime?

Two. Flexibility in a crisis: can the regime respond to a panic, a war or a collapse in credit without breaking?

Three. Political risk: how easily can politicians bend the regime to serve short-term ends?

Four. Practicality: could it actually be adopted and run today?

The five regimes

The classical gold standard

Under a gold standard, a currency is defined as a fixed weight of gold and is redeemable for it. The United States was on a gold standard in various forms for much of its history. After the Civil War greenbacks, the country returned to specie payment on January 1, 1879, and the Gold Standard Act of 1900 confirmed gold as the standard. The classical international gold standard, roughly the 1870s to 1914, tied the major economies together with fixed exchange rates.

Bretton Woods

The 1944 Bretton Woods conference created a system in which currencies were pegged to the dollar and the dollar was convertible into gold, for foreign governments and central banks, at $35 an ounce. It governed the postwar economy until August 15, 1971, when Nixon closed the gold window, an event I describe in The Great Inflation of the 1970s was a policy choice, not bad luck.

Friedman's constant growth rule

Milton Friedman argued, from the 1950s on, that a central bank should not try to steer the economy by judgment. Instead, it should let a measure of the money supply grow at a fixed, steady percentage each year, a figure around the long-run growth rate of the economy. Friedman's view was that central bankers' discretion was a source of error: they act too late, overreact, and cause the booms and busts they then try to cure. The Great Depression, in his and Anna Schwartz's account, was a failure of discretion, in which the Fed allowed the money supply to collapse.

Hayek's competing currencies

In the 1970s Friedrich Hayek published Denationalisation of Money, proposing that governments abolish their monopoly on issuing currency and allow private institutions to issue competing monies. Market discipline would then punish any issuer that debased its currency, as customers would flee to a better one. It is the most radical of the proposals and the one that sounds most like present-day cryptocurrency enthusiasm, although the details differ greatly.

Today's discretionary Fed

The present system is a fiat regime: the dollar is not redeemable in anything, and the Federal Reserve sets short-term interest rates and manages its balance sheet to pursue its goals, with an inflation target of 2 percent adopted in January 2012. The Fed uses judgment, guided by data and by its own forecasts. The structure of its mandate is the subject of The Fed's dual mandate and the 1977 law that gave it two masters.

The comparison

Here is the table. It gives my judgment of each regime on each criterion, in a few words, and the reasoning follows.

Now the commentary, regime by regime.

A fair hearing for each camp

The gold camp

The case for gold deserves respect. Gold cannot be created by a committee. A government that wants to spend more than it collects cannot print the difference without breaking its promise to redeem, so the gold standard binds the politicians. Under the classical standard, the long-run price level was roughly stable, whatever the swings along the way. Compare that with the experience since 1971, when the dollar's purchasing power has fallen enormously. Americans who save, especially those with fixed incomes, are hurt by that erosion, as I describe in inflation hurts the poor most, and the arithmetic of a fixed paycheck. The gold camp also notes that the Founders wrote Article I, Section 10, which forbids states to "make any Thing but gold and silver Coin a Tender in Payment of Debts," and Article I, Section 8, which gives Congress the power to coin money and regulate its value. Gold and silver were the money the Founders knew.

Now the problems, which I must also state. A gold standard stabilizes the long-run price level at the cost of short-run instability. Prices fell for long periods in the late nineteenth century, a deflation that burdened debtors and fed the political revolt that produced William Jennings Bryan's 1896 speech about a cross of gold. The supply of gold depends on mining and discoveries, not on the needs of the economy. And in the Depression, countries that clung to gold longest suffered deepest. The economic historian Barry Eichengreen, among others, has documented that countries which left the gold standard earlier tended to recover earlier. A currency tied to gold cannot expand to meet a panic, and a central bank cannot act as a lender of last resort if every dollar it lends has to be backed.

There is also a transition problem. At what price would the dollar be fixed to gold? Too high, and you create a deflation. Too low, and you create an inflation. Returning is a harder problem than staying, and the gold camp has never given a fully convincing answer.

The Bretton Woods lesson

Bretton Woods deserves attention mostly as a cautionary tale. It was a gold-exchange system, in which the dollar was the anchor, and it depended on the United States restraining its own money creation. When American spending in the 1960s on the Vietnam war and the Great Society outran its willingness to tax, the system came under strain and then broke. The lesson for the gold camp is that a system tied to gold at the center can still be broken by the center's policy. The lesson for everyone else is that an anchor is only as good as the discipline of the one who holds it.

The rule camp

Friedman's case is that the biggest monetary disasters came from discretion, and that a rule would prevent both the inflation of the 1970s and the deflation of the 1930s. It is a strong argument, and it won a large share of the profession. When Paul Volcker became Fed chairman in 1979, the Fed announced that it would target the growth of the money supply, a move in Friedman's direction. It brought inflation down.

But the pure rule ran into a practical problem. The relationship between the money supply and the economy, the velocity of money, turned out to be unstable, especially after the financial innovations of the 1980s. The Fed abandoned the money-supply targets in the early 1980s, and the link he had relied on proved unreliable. A rule that depends on a stable relationship fails when the relationship moves. The enduring lesson of the rule camp is not the specific rule but the principle: policy should be predictable and judged against a standard. John Taylor's rule, which ties the interest rate to inflation and output, is a descendant of it, and the worked example is in The Fed's dual mandate and the 1977 law that gave it two masters.

The competing-currency camp

Hayek's idea is intellectually stimulating, and it follows from the same logic as every argument for markets: monopoly is bad, including monopoly over money. The idea that issuers would compete on the stability of their currencies is attractive. The difficulties are obvious. The government must accept the competing currencies for taxes and legal tender, or they have no standing. Networks matter in money, and a currency used by everyone has an enormous advantage. And no government in modern history has been willing to give up the power to issue money. I regard Hayek's proposal as valuable for what it teaches, that money's value comes from the issuer's credibility, and as impractical as a program. The Austrian school, to which Hayek belonged, is explained in The Austrian school in plain words, from Carl Menger to Friedrich Hayek, and the comparison with other schools is in Austrian, Chicago and Keynesian economics compared on one table.

The Fed camp

The defenders of today's arrangement make a pragmatic argument. A fiat system with an independent central bank can respond to crises, as the Fed did in 2008 and 2020, in ways that a gold standard could not. Inflation was low and stable from the mid-1980s into 2020, a period economists call the Great Moderation. An independent central bank with a numerical target gets many of the benefits of a rule while keeping the flexibility of discretion.

The objections are that the record is mixed. The same Fed produced the inflation of the 1970s and the inflation of 2021 to 2023, which I analyze in what caused the inflation of 2021 to 2023, weighing the honest evidence. The 2008 and 2020 responses, however effective as crisis management, enlarged the Fed's balance sheet and its role. And independence cuts both ways: an unelected institution that can create money without a vote is a concentration of power that a conservative should regard with caution. A related question, whether a central bank might issue digital money that the state can program, is explored in A central bank digital currency is a dollar Washington could program.

The verdict

I have to choose, so here is my choice, with my reasons.

I would not return to gold. I say that with respect for those who would. A gold standard is a sound constraint on a government that wants to inflate, but it is a blunt instrument in a crisis, its record in the Depression is poor, and the political path back is closed: no plausible transition is available, and the economy has been organized around other arrangements for half a century. If you want to hold gold as a store of value, that is a personal choice, and the page on gold and silver explains the terms, but I do not think the government should peg the dollar to it.

I would not adopt a pure money-growth rule, because the link between money and prices has proven unstable, though I would borrow its principle.

I would keep an independent central bank, with changes. First, a single mandate for price stability, with a published numerical target, written into statute by Congress. Second, a requirement that the Fed publish and explain its policy relative to a simple benchmark rule, such as Taylor's, so that departures are visible and justified. Third, limits on the Fed's balance sheet and on its purchases of assets other than Treasury securities, so that it does not become a channel for credit allocation. Fourth, ordinary Congressional oversight, since the money power is Congress's under Article I.

In plain words: keep the central bank, but make it keep a promise. A flexible institution is useful in a crisis. An unaccountable one is dangerous in a boom. The way to have both is a clear target, a visible standard and a legislature that remembers that the power to regulate the value of money was given to it, not to the committee that meets eight times a year.

If you disagree, I would welcome that, because the best monetary systems, like the best constitutions, emerged from disagreement among people who each saw a real danger. The gold camp sees the danger of an elastic currency. The rule camp sees the danger of discretion. The Fed camp sees the danger of rigidity in a crisis. They are all right about the danger they point to, and the task is to design an arrangement that guards against all three.

The case in brief

1. Five regimes compete for conservative loyalty: the classical gold standard, Bretton Woods, Friedman's constant-growth rule, Hayek's competing currencies and today's discretionary Fed.
2. Gold constrains politicians and kept the long-run price level roughly flat, but it is rigid in a panic, deflationary in the late nineteenth century and in the Depression, and impractical to restore.
3. Bretton Woods collapsed on August 15, 1971, because the issuer outran its own discipline, and Friedman's rule failed in practice because the link between money and prices was unstable.
4. Hayek's competing currencies teach that credibility is the source of money's value, but face legal, network and political barriers.
5. The best available answer is an independent central bank with a single price-stability mandate, a published benchmark rule, limits on its balance sheet and real accountability to Congress.

What you can do: read Article I, Sections 8 and 10 at the Constitution page, then ask your representative whether Congress should write a single price-stability mandate for the Federal Reserve.