Gold Standard Does Not Always Bring Credibility

... Monetary policy rules are no short-cut to credibility in situations where vulnerability to economic and political shocks, not time-inconsistency, are overarching concerns for investors.

Adopting a new gold standard, or some other hard currency peg, is often touted as a good way for poor, developing nations to attract foreign investors. But if the last era of globalization is any guide, the benefits of doing so are nil. Rather than a "good housekeeping seal of approval," adoption of a gold standard by the poorest developing countries a century ago served as a "thin film" of credibility -- and foreign investors often saw through such maneuvers, according to Niall Ferguson and Moritz Schularick writing in The "Thin Film of Gold": Monetary Rules and Policy Credibility in Developing Countries (NBER Working Paper No. 13918).

This study challenges research over the past decade that has suggested that, prior to World War I, the gold standard helped nations who adopted it because they could borrow money at lower interest rates than countries that didn't use the standard. By examining interest rates and economic control variables for 57 countries from 1880 through 1913 (more than twice the number of countries examined in previous studies), the authors found that while developed nations did see a benefit from adopting the gold standard, developing nations did not. "History shows that monetary policy rules are no short-cut to credibility in situations where vulnerability to economic and political shocks, not time-inconsistency, are overarching concerns for investors," they conclude.

In the late nineteenth and early twentieth centuries, the world saw a spate of globalization that in some ways rivals today's global capital flows. By 1913, foreign investments in Argentina, Chile, and South Africa stood at around 200 percent of those nations' gross domestic product (and at 100 percent or more for the GDPs of Brazil, Mexico, Egypt, and Malaysia), roughly twice the levels of today. Some 40 percent of Britain's capital flows between 1880 and 1913 went to countries other than the comparatively rich settler economies. Today, only 10 to 15 percent of global capital market flows go to less developed nations.

Some researchers have looked at that period and concluded that adhering to such a strict monetary rule as the gold standard allowed nations to lower their risk premiums by up to 40 basis points. Other studies found that fiscal policy and economic fundamentals played the key role, not the gold standard. Looking at a wider dataset -- 34 independent countries and 23 British colonies -- and using a wide variety of assumptions and regressions, Ferguson and Schularick found a more nuanced answer. The colonies received lower interest rates based on their links to Britain, not their fiscal condition or adherence to the gold standard. The remaining 16 relatively developed countries saw a reduction in risk premiums of up to 50 basis points when they had a gold standard. But the 22 less developed countries from Eastern Europe, Latin America, and Asia saw no such benefit, no matter which of the several regression measures the authors used.

It's even questionable that adherence to the gold standard was really the key to lower interest rates for the developed nations, the authors write. Instead, other factors were at work, they suggest. For example, these nations "were twice as open, they traded about twice as much with other gold standard countries, their exports were less dominated by primary products, and they were better integrated into world markets as measured by their considerably smaller shipping distances from London. Their income levels, in other words, can be seen as a proxy for a number of other characteristics that were likely to bolster market confidence in their long-run commitments to gold."

By contrast, poor developing countries could make the commitment to gold but didn't necessarily have the credibility to convince lenders that they would stick with it. Investors of that time focused instead on the nations' vulnerability to the ups and downs in world agricultural markets, global trade, and world economic growth.

Another reason poor countries didn't get better lending terms was the political risk involved. "[T]he credibility gains through gold standard adoption may have been low in poor countries simply because political instability was high," the authors write. "[W]here the political and social fabric of a country is still crisis-prone, its monetary regime is likely to be a second-order concern for the market."

They conclude: "In the last era of globalization, as today, investors priced country risk on the basis of a complex mixture of economic fundamentals and political factors such as colonial statusÂ…. The key historical lesson from the 'natural experiment' of the gold standard era is that in the poor periphery - where policy credibility is a particularly acute problem - rule-bound monetary policy did not result in credibility gains."

-- Laurent Belsie

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