My passing remark about the role of gold in the Panic of 1873 provoked plenty of discussion, so I thought I’d have a preliminary go at a post I’ve been thinking about for a while.
The global financial crisis has been an intellectual disaster for those supporters of free markets who rely on mainstream arguments such as the efficient capital markets hypothesis. But it’s been something of a boon for fringe free-market viewpoints such as those of the Austrian school and (an overlapping group), advocates of the gold standard. Members of this group have been predicting disaster at least as long, and (relative to their numbers) at least as loudly, as social democratic critics of financial deregulation.
So, it’s worth presenting my critique of the gold standard in several parts, which can be classed as microeconomic, macroeconomic, empirical and political, along with some miscellaneous points. I don’t claim any particular originality for it, but I’m presenting on the basis of my own analysis rather than directly citing a source (I’d welcome pointers on this)
The microeconomic case is simple. A commodity money such as gold requires that stores of a valuable commodity (useful in jewelry, dentistry and a wide range of industrial applications) be held and carried about for purposes that can equally well (or better) be served by pieces of paper or by entries in a database. This wastes resources and adds to transactions costs.
The macroeconomic case is that adhering to a gold standard is equivalent to adopting a monetary growth rate rule (of the type advocated by Milton Friedman) except that the rate of monetary growth is determined randomly by developments in the goldmining industry, and in non-monetary demand for gold (from a quick look, it’s recently been around 2 per cent, which is lower than the rate of global output growth, implying a deflationary bias). Obviously this is going to perform worse than a fixed monetarist policy, so the only basis for advocating gold is that you don’t trust governments to adhere to such a policy, let alone to manage anything more sophisticated. But if governments are that untrustworthy, why wouldn’t you expect them to dump or debase their gold coinage when it became inconvenient (as has, of course, happened quite a few times).
The empirical case was spelt out in a previous post. None of the various versions of the gold standard that have been adopted in various countries at different times have yielded macroeconomic performance better than that of the period since World War II (unless you count the Bretton Woods system as a kind of gold standard, in which case you have to deal with the fact that the system did not preclude the inflation that eventually ended gold convertibility).
Finally, there’s a political argument. There are many different versions of the gold standard, some of them radically incompatible with others. For example, there’s a big difference between requiring notes to be backed by an equal amount of gold and simply requiring that they be convertible into gold at a guaranteed rate. The first is highly deflationary while the second is vulnerable to breakdown. Then there’s the question of wars and emergencies. Gold standard advocates differ between those for whom preservation of gold convertibility trumps everything else, including national survival, those who’ll allow emergency reliance on fiat money but demand restoration of convertibility at the original parity, and those who suggest convertibility at a new rate that ratifies wartime inflation. Given all these different viewpoints, it’s hard to see how a political movement supporting any particular version of the gold standard could ever reach critical mass.
As an aside, I calculate that the price of gold has risen about 20-fold, and the stock of gold has approximately double since 1944 when it was set at $35/oz (from memory), the general price level in the US has risen 10-fold, real global output has risen a bit less than 10-fold (sources to come on all this). So the ratio of the total value of gold to the total value of output is about 40 per cent of what it was. Among other things, that doesn’t seem to imply a widespread belief that the adoption of a gold standard is imminent.
John Quiggin 
John,
“The microeconomic case is simple. A commodity money such as gold requires that stores of a valuable commodity (useful in jewelry, dentistry and a wide range of industrial applications) be held and carried about for purposes that can equally well (or better) be served by pieces of paper or by entries in a database. This wastes resources and adds to transactions costs…”
1. Without a single country in the world on a gold standard, then there must be no great stores of gold sitting around unpoductively. Right? In fact it is the very inferiority of fractional reserve fiat money that creates the large speculative/hedging demand for gold bullion. Since the holding of actual money is always a sacrifice, if gold were money, there would be little or no speculative/hedging demand for gold. While a switch to a gold standard might deny on net either more or less gold to non-monetary uses, those uses would see a far more stable value of gold under a gold standard.
2. As Alan Greenspan understood, the resource cost of a home wiring fuse is many times the cost of a penny that can be substituted for it, but few would call this a valid economic argument.
3. There is nothing in a gold standard that will preclude database entries.
Regards, Don
So if ( and that is a big if) a gold standard hadn’t completely screwed the economy since the war, we would have had a five fold deflation since the war.
Ten times the output/twice the available gold.
We could have currency competition within a given market, or a dual currency system. 2 legal tenders one used by the Govt, the fiat currency and the second a basket commodity currency in larger denominations.
What we want is a system that punishes bad economic decisions and gives people an opportunity to hedge themselves. This is not a utopian/perfect system but i think over time the bumps will be ironed out somewhat better.
Economist their textbooks and the models they run, fail because money is more than barter, its trust inscribed. Austrians in the main,are really the only people who understand this.
“The global financial crisis has been an intellectual disaster for those supporters of free markets who rely on mainstream arguments such as the efficient capital markets hypothesis.”
Quite the contrary I would have thought. It seems to me the market did a superb job at providing the means and ways to house all the fiat money created by central banks everywhere. It would appear that means increasingly lending it to people who have little chance of paying it back and that has some very real consequences now. Essentially a lot of individuals, firms and various levels of Govt come to rely on those steady repayments and when they fall badly in arrears all hell breaks loose.
It remains to be seen whether Govts via central banks can create even more fiat money and give it to people and institutions who haven’t earned it to correct this parlous state of affairs. I must say from what I’ve seen to date and what’s on the drawing board I’m not convinced. Neither are a helluva lot of others by the looks of things and therein lies a further problem, which appears to run counter to attempts to correct the former.
Gold is a financial asset without counterparty risk that could stablise bank balance sheets and is a key inflation indicator, the gold price, historically, is a near perfect reflection of negative real interest rates.
It is a currency risk and inflation vigilante outside the control of state central banks. The bailouts are actually funded by the theft of savings in the same way new share issuance is the theft of equity, and the potential for future dilution is the key forward driver of gold prices.
All paper money eventually returns to its intrinsic value and sovereign default is the rule, not the exception.
Gold is therefore a unique fiat stress indicator and might have a role putting limits on credit creation by indicting the moneyness of credit.
Gold (and silver, to a lesser extent) has been money since civilisation began and it remains a key asset of central banks and trades on the currency desks of traders with a turnover of about 20 billion dollars a day.
Gold will still be money when dollar hegemony is a footnote in the history of human folly.
Should we prefer that the obligations of a spendthrift hegemon that accrues seigniorage and reserve currency privledges backed by the barrel of a gun to define all value. I think not!
The merits of returning to a gold standard are debatable, but on balance there are actually some good arguments for returning to gold.
One argument often used against the gold standard is that the volatility of gold prices would destabilise the economy. Yet the volatility of gold prices is largely a result of the fact that gold is only used for speculative purposes now. Under gold standards, gold values were actually more stable. Indeed, under gold standard currencies even the discovery of major new gold deposits had a less destabilising effect on the economy than the wanton printing of fiat money by central banks.
Another argument that John touches on here is that it is economically wasteful to mine gold simply in order to store it in bank vaults, when it could be used for other productive purposes. Yet it could equally be argued that it is economically wasteful for people to simply invest their money in gold for speculative purposes, or as somewhere to park their money whenever confidence in fiat money declines, when that same capital could be more productively invested elsewhere in the economy.
This is not correct. A gold standard merely requires that the national unit of account is some weight of gold. Whether money is backed by metal or grain or government debt or space blankets is an entirely separate matter. An important matter no doubt but not relevant to the question of whether a gold standard is a good idea.
The world is a closed economy. It is only within that context that a gold standard entails a relatively static money supply. However even that isn’t the full story. Under a gold standard an inflation decreases the incentive for gold mining as the profit margin on mining gets squeezed. And deflation expands the profit margin.
Bretton Woods was a gold stardard. No policy can preclude a change in policy. To expect that of any policy is silly. To use it as a key criticism of a policy is weird. All the painful inflation happened in the 1970s and 1980s after the gold standard policy had ended.
The only meaningful data in here is that the general price level has risen 10 fold whilst the gold price has risen 20 fold. If the USA had stuck with the $35 price then they may have had deflation equivalent to a nominal price decline of 50% over a 64 year time line. In other words a pretty harmless deflation of 1% per annum.
Of course if we roll the clock back just three or four years we have a gold price about half what it is today (and it was also near it’s ten year average which is my quick first pass rule of thumb for monetary stability). So it wouldn’t shock me to find that the price level still has some catching up to do. If Greenspan and friends had kept it in that general region then I suspect we would be seeing a lot less problems today.
So what. A quick survey of the people next to you could tell you much the same thing. And the gold price in 1968 wasn’t going to tell you that Nixon would bring on gold prices near the moon.
It is interesting to watch what Nixon promised when he announced the end of the gold standard. And who he blammed. And then consider how seriously his actions failed to deliver on his promises. You can his announcement here:-
http://alsblog.wordpress.com/2008/01/25/nixon-ends-gold-convertability/
NIXON: “your dollar will be worth just as much tomorrow as it is today”.
When the world was on a gold standard we had:-
1. Stable consumer prices.
2. Stable commodity prices.
3. Stable exchange rates.
By comparison the price stability we have today is very second rate.
There are still a number of questions about how a gold standard would operate in practice. One is that there would be a big difference between how a full reserve system and a fractional reserve system would operate.
One problem I can see is that it would be relatively easy for anyone who privately owned gold to generate large seigniorage profits. Suppose if I had one million dollars worth of gold stored in a vault somewhere. Then suppose if I printed certificates redeemable against my gold supply to the total value of maybe two or three million dollars, and these were then accepted as payment by others and began circulating in the economy. So long as everyone didn’t try to redeem gold at once (a fair bet), I would be okay.
Maybe someone here understands the finer workings of a gold standard better than I do, and could set me straight.
The Bretton Woods era wasn’t one of stable consumer or commodity prices – the Korean wool boom is just one example. The Bretton Woods era, unlike earlier gold standard periods, was one of macroeconomic stability and full employment, until its breakdown in the early 1970s. But most economists would focus on Keynesian economic management when trying to explain both the success and the ultimate failure of this system (of course, with different weights).
Still, if what you are advocating is a return to the Bretton Woods system, presumably with modifications to make it more sustainable, I don’t have a huge problem. My post is really directed at those who want to restore a 19th century version of the gold standard, with individual national currencies backed by gold (in many versions with 100 per cent reserve requirements), and no role for fiscal and monetary policy.
Well we are not so far apart as I imagined then. In terms of Keynes it is worth noting that his prefered international monetary system replaced gold with a commodity basket called the Bancor. In every other regard it would essentially be a gold standard. If we went that way today it would offer a significant improvement. I’d support such a reform. The Bancor could do for the worlds currencies what the ECU did for European currencies. And a treaty based approach as used in the EU would be the best way to achieve such a reform. Still gold centred system would be marginally better again if for no other reason but transparency.
Except that 100% backing wasn’t what they used in the 19th century. Take for instance Australia. We had no national currency until around 1913. Prior to that we had a competitive currency system where state issued notes and private banks issued notes. The value of these notes was denominated in gold weight and they were redeemable in gold but this never meant they were 100% backed. And certainly the money supply in general was not gold backed as some modern opponents of fractional reserve banking would have you believe. Banks had assets and they had cash flow and gold flow issues to manage. However 100% backing was never used.
The Murray Rothbard crowd want the world to outlaw fractional reserve banking (not quite with punishment of death but none the less draconian) and introduce a currency that is 100% backed by gold. This is something that has no historical precedent of any signficance. In my view most of them are barking mad on this issue and we are better off with our existing inflation targeting system with all it’s failings.
The Supply Side school advocates a return to a gold standard without all the baggage of 100% backing or bans on fractional reserve banking. If you want this view of monetary policy you need to read authors such as Nathan Lewis.
http://www.amazon.com/Gold-Future-Money-Nathan-Lewis/dp/0470047666
I’ll be the first to admit that the community of gold bugs has it’s cranks. However don’t throw out the baby with the bathwater. And don’t discard the gold standard just because some advocates tie it to extreme and untested fantasies.
I want the nations of the world to use gold as their unit of account. I don’t have any reform agenda regarding what they back their currencies with (store of value) or what they use as their medium of exchange.
p.s. Technically Australian notes were redeemable in Pound Sterling. However most were redeemable in Pound Sterling gold coin.
An example of a private bank note from the era can be viewed here:-
Inscribed on the note is it’s contractual promise.
Now your talking my language. Step one is don’t make one nation the centre piece of the system.
So did Keynesism or Bretton-Woods cause the crisis of the 70’s? If you change two vital parameters to test a hypothesis your result will be inconclusive. It seems we are seeing the same thing today where the powers that be don’t know (and never did know) whats really happening and are pulling the levers indiscriminately. If I were Big Ben Bernanke I would be freaking out that my theoretical work which scored me a place at the front of the academic gravy-train is now being put through the experimental wringer. Remember, nobody believes a theoretician, except himself, and everyone believes an experimentalist, except himself.
I don’t believe Bretton Woods caused any crisis. However it’s design made it easy to blow apart. Keynes to his credit wanted a more robust system. I don’t agree entirely on his idea of moving from gold to the Bancor however at least his system didn’t grant the USA centre stage in the management of the system. It would have been better if several other major nations had also maintained a direct link to gold. If the Soviets had linked to gold and the French and British as well (for old times sake) then the US could still have left the gold standard but it would have kept most of the pain for itself. Tragically (in the Shakespearean sense*) the relative size of the US economy, it’s military position after WWII and it’s sound institutions almost made Bretton Woods and the US dollars rise as a global common currency a tragic inevitability.
If you are going to fix to gold you should be allowing interest rates to float. The fact that governments so often tried to manipulate both in the name of Keynesianism almost guaranteed tension within the monetary system.
* http://en.wikipedia.org/wiki/Shakespearean_tragedy
In that case, this isn’t step one, since we will first need to create a political institution that can sit at center of the system.
TerjeP – didnt Keyes promote a tax on surplus nations to fund IMF loans instead of interest based loans? Is that what imply by a more robust system?
Alanna – I’m not familiar with such an idea but Keynes may have proposed it. I certainly wasn’t makeing reference to this. In terms of context it is worth recalling that both the IMF and the World Bank were part of the setup and the IMF today is busy doing things way outside it’s original brief.
What I meant was that his proposal was more robust in that one key nation altering it’s monetary policy position wasn’t going to bring the system apart (as Nixon did in 1971). The relatively politically decentralised nature of the the 19th century gold standard was it’s strength. Gold was the centre piece of the system rather than the US dollar and abandonment of the gold link by one nation didn’t entail abandonment by all nations.
Although abandonment by Britian for example did typically mean abandonment by much of the Commonwealth which is why Australia suffered deflationary forces after Churchill re-established the link to gold at the pre WWI price level in 1925. And why there was a debate in favour of devaluation (reflation) in Australia at the time (an idea the conservative parties successfully opposed). I don’t think Churchills deflation caused the great depression but across the commonwealth it no doubt left a lot of enerprises in a weakened position when the depression hit.
An ideal way forward for the world today would be if both the Euro and the US dollar were each fixed to gold via a simple change in target for open market operations (they need not buy or sell any gold to achieve this). And the rest of the worlds nations either fixed to gold autonomously or else lined up behind the US dollar or Euro. The technical aspects of such a reform could be put in place in a week or two. The political aspects would no doubt take much longer.
The less orderly way to achieve such a system would be for one or more nations to lead the way by simply adopting a gold standard unilaterally. Although ironically given the reason it was chartered the IMF today works to actively discourage any such move.
Either way a gold standard will only establish stability if the gold price they return at properly balances the interests of lenders and borrowers. Typically this would mean a strike price somewhere between the one year historical average and the ten year historical average.
Of course a gold standard would make both Adam Smith and Karl Marx proud of us. đ
Recommended Reading To Study How And Why The Present Fiat Money System Has Collapsed. As most Western economists grew up with fiat monetary systems they know nothing about what happens when they inevitably collapse.To become better informed, I strongly recommend that interested people read Ludwig von Mises “Notes and Recollections” then his “The Theory of Money and Credit”. Take particular notice of his 1952 addition of a new section titled âMonetary Reconstructionâ.
Then there is a book of essays by von Mises, titled, “On The Manipulation of Money and Credit.” This last book is a von Mises authorised translation of the essays on the subject, by devotees Percy L. Greaves and Bettina Bien Greaves. It has recently been reprinted under the title: ” The Causes of Economic Crisis and other essays before and after The Great Depression.”After the 1929 crash, the J. M. Keynes, Irving Fisher arguments won out in the early 30’s against honest money. This present so called credit crunch is the ultimate outcome of their policies, as von Mises clearly foresaw. Hence the 1952 addition to âMoney and Creditâ.A great pity that his “Money and Credit” was not published in English until 1936. After Fisher’s demise Milton Friedman and others from the Chicago School popularised the modern fiat money regime.
It is impossible to impart the knowledge that is contained in all of the above publications, in a short essay. But those who go to the trouble to acquire and read them will be richly rewarded. It is of course not like reading the Time Magazine, The Womens Weekly or a popular novel, but there is a substance in these books that is unobtainable anywhere else.I hasten to add that in 2006 a Spanish scholar Jesus Huerta De Soto of Universudad Rey Juan Carlos, Madrid, published a book titled “Money , Bank Credit, and Economic Cycles”.
I have a copy of this book, but so far have only perused sections that took my immediate interest. But it is an excellent book too.Also interested people can read a short account of the success of West Germany, Japan and Taiwan after WW 2 in my book titled âUnderstanding Personal and Economic Libertyâ. See chapter 11 page 97. In my recommended reading list at the end of the chapter I strongly recommended:âProsperity Through Competitionâ and âGermanyâs Comeback in the World Marketâ, both written by West Germanyâs Treasurer Ludwig Erhard. Also a great history has been written by Edwin Hartrich and titled âThe Fourth and Richest Reich.â
Hartrich was an American Journalist in Germany before WW2. During the War he served as an Officer in the U. S. Army, witnessing first hand the great invasion and battle to the end. He then became part of the occupation forces and as a keen observer, witnessed all that happened. He got to know Erhard and interviewed him on his policies. All becomes clear with the reading of these three books alone. There are a number of others too which are of great interest, but these three give a reader a really comprehensive history.
Hartrichâs book also shows how WW1 and WW2 were inevitable as the result of teachings in German universities. I thought this interesting as Ludwig von Mises made a similar statement in his âNotes and Recollectionsâ. Ronald Kitching.15th December 2008. A new book titled: The Ethics of Money Production. By Jörg Guido HĂŒlsmann, professor of economics at the University of Angers in France and the author of Mises: The Last knight of Liberalism, is the first full study of a critically important issue today.I cannot comment on this book, as I have not yet read it, but Prof. Hulsmann is a first rate Austrian Scholar.
For those interested in ending fiat money completely I’d suggest that the most orderly approach would be:-
1. Fix the currency to gold at an appropriate price using nothing more than open market operations.
2. For legal contracts define the national currency as meaning a certain weight of gold.
3. Remove the regulatory barriers that currently impede the creation of private promisory notes (ie bearer bonds).
4. Stipulate that the fiat notes will expire after a given date thus creating an incentive for people to swap them for the private sector alternative. Given the private sector production requirements this would create I’d set the expiry date at least a couple of years into the future.
Given the will a single term of government should be sufficient.
However 99% of the benefit comes from step number one alone. The other steps are mostly cosmetic.
Sjk – no that simply isn’t true. To be sure a concensus approach is best but there is no need for any authority or institution at the centre of a restored international gold standard.
Terje
Why do you want gold to be the unit of account? Why is gold preferable to say, seashells, silver or iron?
SJ – Seashells are not so fungible and there isn’t a ready spot market for them or an established cost structure for bringing new seashells to market. Iron is very common and has loads of significant alternate uses.
I wouldn’t be entirely opposed to an iron standard or a silver standard however when it comes to assigning monetary properties the market seems more inclined to work with gold.
The global supply of gold is large relative to annual production of new gold. For a large closed economy such as the world a near static monetary base is the most appropriate one for stability.
Gold also has a stong historical context and in political terms there is at least a modest gold standard movement whilst the push for a silver standard or iron standard is relatively absent.
Before the regulators stopped trade in the suite of e-gold currencies (hopefully only a temporary setback) the liqidity of e-gold was orders of magnitude more massive than the liquidity of e-silver, e-platinum and e-pladium. Further more pretty much all of the suite of online digital currencies that have emerged and survived are either tied to a national currency or to gold. All this suggests that the market is pre-disposed to using gold as a monetary unit whilst with iron and silver there is very little such predisposition.
Ideally the national unit of account would simply emerge from the free interaction of free people in much the same way that language emerges and evolves. However whilst ever there is a government levying taxes denominated by some unit of account I believe the governments inclination will hold sway over the market in general. As such gold is in my book the right compromise position.
The major point is really that the national currency should be anchored to a natural commodity or some such basket of commodities. If you can sell the world on a silver standard or an iron standard then I won’t complain.
p.s. I should also have mentioned that gold consumption is extremely low. It doesn’t get used up. And whilst it is used to make jewellery this is readily recycled back into monetary form as and when required. In fact in places such as India where much of the worlds gold jewellery is produced the gold in jewellery remains substantially monetary in nature due to the way in which the jewellery is used. By comparison silver has significantly more industrial application.
So Terje, would those who want to do away with a fiat money system, because they believe that banks cause inflation by lending, have to prohibit the printing and issuing of private money by banks? Was this the position taken by Ron Paul in his late presidential campaign?
Wellbasically,
You can do away with fiat without stopping private banks from issuing promisory notes. In fact if you did the former I would dearly hope that you would permit the latter.
A lot of Ron Paul supporters want 100% backing (presumably state enforced). I don’t agree with this view at all. I have listened carefully to Ron Paul himself on this issue and I have yet to see him explicitly state that he would ban lending between consenting adults (including bankers). Although he rightly points to private lending practices as transmitting the errors made within the state fiat system.
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