Phillip Cagan’s 1984 Reflections on a Gold-Convertible Currency

Milton Friedman published Studies in the Quantity Theory of Money in 1956, a seminal anthology of papers from five economists, leading with “The Monetary Dynamics of Hyperinflation” –the recent PhD dissertation of Phillip Cagan (1927-2012), which became an instant classic.  So, Cagan was thought to be a “Monetarist” a dozen years before that phrase was even coined by my UCLA teacher, Karl Brunner.

Soon after August 15, 1971 when President Nixon opted to renege on the Bretton Woods pledge to convert foreign official dollar reserves into gold on demand (rather than simply devalue the dollar/gold ratio), we entered a long and painful period of extremely high worldwide inflation.

Even as measured by the gentler “core” CPI (less food and energy), U.S. inflation averaged 9% from 1974 through 1981, reaching 12.2% in 1980.   When President Reagan took office in January 1981, the Fed had pushed the fed funds rate above 19% – up from 9% six months earlier.

We can’t always fix such big problems by thinking small, so the prolonged stagflation of 1968 to 1982 led several economists to propose fundamental, even radical monetary reform, preferably on a global scale.  Such ambitious reform plans commonly involved making dollars convertible in tangible assets, such as gold or a group of commodities.

I was invited to testify before the 1982 Gold Commission, perhaps because of a decade of published and personal connections to Milton Friedman and Karl Brunner.  I had echoed conventional objections to a gold standard before, and was probably expected to do so again.  But that would have been too facile. I instead took the occasion to review periods of long and impressive prosperity when currencies were linked (or re-linked) to gold, invariably followed by instability and crises when they weren’t.

Other economists attempted to replicate some key advantages of being able to convert dollars to gold and vice-versa at a predictable guaranteed rate, yet do so without using gold. In 1983, Greenfield and Yeager proposed the “Black-Fama-Hall” system (melding similar analyses of Fischer Black, Gene Fama and Robert Hall) in which the unit of account would be defined by convertibility into a basket of commodities, rather than just gold and/or silver.

Chicago School monetarists were generally quite critical of any of these ideas, except, as we later learned, Phil Cagan.  

After Brunner moved to the University of Rochester and his star pupil Alan Meltzer to Carnegie-Melon, they held legendary Carnegie-Rochester conferences which I attended.   

After the conference on April 15-16, 1984 I kept the paper by Phillip Cagan of Columbia University, “The Report of the Gold Commission (1982)” later  reprinted in Carnegie-Rochester Conference Series on Public Policy 20 (1984) 247-268.  In it, Cagan flirted with hopeful thoughts about hypothetical hybrid standards, such as Black-Fama-Hall, but not before he said this about gold:

The appeal of the gold standard… is that it solves to problems.  First, if control over the quantity of transactions balances becomes more difficult and discretionary policy is unable to achieve reasonable stability of the price level, convertibility can provide the needed control of the relevant monetary quantities for stabilizing the price level.  Second, even if monetary policy continues to be capable of achieving stability of the price level, discretionary control may still fail to do so, as in the past, because of inadequate determination or inability to pursue polices that are successful (for political or other reasons). Convertibility provides a mechanism for making a commitment to price stability.

I see no escape from the conclusion, inherent in the position of the advocates of gold, that only a convertible monetary system is sufficiently free of discretion to guarantee that it will achieve price stability… If one is looking for some kind of long-last commitment of a constitutional nature, a convertible monetary system seems to be the only practical possibility.