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Why A Gold Standard Is A Bad Idea
By Cam Hui on December 30, 2008 | More Posts By Cam Hui | Author's Website
Inflation is coming…
For as long as I can remember, Jim Grant has never been a cheerful fellow. In fact, there was a standing joke in my office that after reading Grant you could cheer up by reading King Lear. The thinking in Grant’s latest missive in the WSJ runs parallel to my recent post Giving inflation chance that with the massive fiscal and monetary stimulus coming down the pipe, inflation is inevitable. Jim wryly notes that “Frostbite victims tend not to dwell on the summertime perils of heatstroke.” He continued:
Prescience is rare enough in the private sector. It is almost unheard of in Washington. The credit troubles took the Fed unawares. So, likely, will the outbreak of the next inflation. Already the stars are aligned for a doozy. Not only the Fed, but also the other leading central banks are frantically ramping up money production…It is far less certain that, once the cycle turns, the central banks will punctually tighten.
A return to the gold standard would be disastrous
Given the enormity of the recent crisis, there have been calls for radical solutions. The hard money crowd, for example, has called for the return of the gold standard. However, a return to the gold standard would be disastrous. It would be a prelude to an global downturn of unprecedented proportions and doom future generations to heightened economic volatility.
First, a history lesson: Many years ago, people decided on the use of gold as a monetary standard. It turned out that gold has many nice properties that could be used as a store of value. Throughout human history, money has been predominantly based on gold but not always. It has also been based on other commodities. Peter Bernstein’s book The Power of Gold details the history of gold and commodity based monetary standards throughout history, from salt to large stones, some of which lay at the bottom of the sea.
As time went on, people found that gold, along with other commodity based monetary standards, was hard to carry around. Used in coinage, they could be difficult to divide and this division problem was a hindrance to commerce.
Then came the financial innovation called banking. You could deposit your gold in a bank. The bank would issue you a receipt and you could use that paper receipt for trade and commerce. The bank would lend out your deposit of gold to others. This was credit creation, which expanded the money supply. For every ducat lent out, that ducat would usually wind back up in the banking system, creating another ducat available to be lent out. Even with the imposition of reserve requirements that constraine the amount of loans they could make based on their deposit base, this form of fractional bank lending expanded credit and created enormous number of jobs and raised prosperity.
When kings and political rulers got into financial trouble, there was always a temptation to debase the currency. The current episode of paper money debasement began in earnest when Richard Nixon took the U.S. off the gold standard and the world went to a Dollar standard for monetary reserves. The trouble was, the U.S. Dollar wasn’t based on anything, other than the good name of the U.S. government.
Today we stand on the edge of a precipice. America is in recession but deeply in debt. It is about to print money to try to climb out of its hole. This consensus has been supported by pretty much all of the central banks and governments around the world. Some analysts have argued that the imposition of a gold standard would create the discipline on the monetary authorities from debasing the currency in this manner.
What does a gold standard really mean?
Let’s think this through - what does a gold standard really mean? Does the hard money crowd want us to go back to carrying around pieces of gold coinage around? In that case, how do we facilitate global trade?
Do we just want to revive a gold backing for money? There isn’t enough gold around in the world to support a gold standard at current gold prices. Rough back of the envelope calculations show that the Fed’s holdings of gold, assuming that it is unencumbered and not lent out, is worth around $200 billion at current prices. Remember that the U.S. Federal Reserve is one of the larger central bank holders of gold in the world. While that change might satisfy the gold bugs, it wouldn’t help the vast majority of the population around the world.
One of the assumptions of a gold standard is that the currency is backed by gold at a fixed rate. Anyone could turn in their Dollars, euros, Yens, Pound Sterling and so on, to the appropriate central bank and get gold at a fixed gold price. Such a monetary regime also implies a fixed exchange rate arrangement like Bretton Woods. Instead of allowing the market to determine currency prices, the world would return to fixed exchange rates and periodic exchange rate revaluations. Is that really the regime that we want to return to?
A gold standard also creates economic volatility in the economy. Monetary theory is based on the elegant formula MV = PQ. Holding V (monetary velocity) constant, changes in money supply directly changes the GDP level. Under a gold standard, money supply is restricted by the supply of gold, based on world mine output. National gold supply could shrink because of shocks. As an example, the Roman empire was subjected to credit crunches during wartime when hostile forces captured Roman gold and territory.
The problem of fractional lending remains under a gold standard. The banking system could still create credit. Under such a regime, if everyone decided to redeem their paper currency for gold, the money supply would collapse and the result would be another Depression. Do we want to get rid of the banking system?
If we were to take the radical step of eliminating fractional lending, going to a gold standard would mean a drastic shrinking of world GDP given the amount of money sloshing around the world today.
Culling the herd?
This is financial Armageddon. The result would be the financial equivalent of mandatory infection of the population with the Ebola virus. Maybe we could get Disney to lend a PR hand as we play “The Circle of Life” while we infect everybody with Ebola so people would be persuaded to sacrifice themselves for the Common Good.
The end of the Dollar as THE Reserve Currency
Let’s face it, the days of the USD as the principal reserve currency are numbered. Roger Ehrenberg over at Information Arbitrage believes that the US is at a strategic inflection point and the start of a downward spiral and I would tend to agree. The long term path of the Dollar and US influence is downward. Investors should prepare themselves for that eventuality.
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Good article. Even said more simply. If world govt’s fixed their currency to gold then this seems to assume a stable gold price. Big assumption as the speculators would just shift their attention from currencies to gold. How would gov’t stablize the price of gold? There in a nutshell is a big problem. Go study the 1930’s and you will realize how tricky that would be.Do world govt’s really want to regulate gold the same way it regulates illegal drugs? That’s what it would take and still be far from perfect.
Technically, a gold standard does not require gold coinage or convertibility. The common feature of all precious metals standards is that accumulation of the monetary stock of precious metal will parallel the growth rate of real output over time (this is the source of Friedman’s k% rule for money supply growth, and it can be thought of as fulfilling on Wicksell’s model of interest and prices, by keeping the cost of a new unit of money in line with the return on a new unit of capital). A central bank that is able to create and destroy base money thru open market operations can manage to the market price of gold. Is this tricky? Probably no more so than targeting the overnight cost of reserves. The problem in the late 1920s and early 1930s was that countries were still struggling to return to 1914 parity, when the real value of gold was twice as high.
And the overall problem with gold is that while its value is more stable than almost any other commodity, its production is not (or at least was not) nearly as smooth as growth in real economic output. If you pick the right endpoints for the price level under the classical 19th century gold standard, it worked wonders. However, if you look at all possible combinations of endpoints, it becomes apparent that the price level was prone to severe swings, meaning that money and output were frequently out of whack. For example, the oft-made statement that a gold standard is inherently deflationary is correct when considering a period like the Long Depression, but is entirely ignorant of the 1896-1914 period, when nominal output and prices were forced to catch up to surplus gold production.
The Fed could return to a gold price target without too much trouble, and if the target value were close to gold’s real value, the global financial system would not fall apart — not even close. The actual problem is the same one that plagued earlier precious metal standards — there needs to be some mechanism for resetting the target price when appropriate. That would be doubly important if marginal gold supplies become more costly to produce over time, which one would expect from a rare and finite resource.
I agree with Art, it is very possible to go to a gold standard without wrecking the global economy - heck - the world economy is being wrecked just fine without the gold standard… the GS would keep central banks from manipulating the value of money and serving their alterior motive, which is to devalue their currency in order to pay off their massive debts with cheaper money…
Just go read ‘Gold, The Once & Future Money’ by Nathan Lewis to understand why the author is dead wrong on ‘why we can’t go to a gold standard’.
Throughout the book, Lewis shows time after time that when ego-maniac gov’t figures beleived they were smarter than the rest, consequently going off the gold standard and then printing money - this feat of fiat always ended in diasaster… only until they returned to the gold standard did that countries economy become stable and growing without the burden of inflation and ‘panics’
We have been bombarded by monetarists’ and big gov’t intervention from the early 1900’s to the point that very few people in positions to make this decision even know, understand or remember the reason the gold standard works…
I wonder how the author will feel about the minor problems we would have (yes there will be transition pains) compared to Zimbabwe type hyperinflation that we will eventually (of even sooner) experience with the last big party to ’save our economy’ - politicians never get it right and they are showing their supreme stupidity as we speak…
The best thing that a Gold Standard really does is tie the hands of gov’t so they can’t overspend and wreck our economy… I can only dream…
Nate’s a smart if eccentric guy, but a key pillar of his argument for gold — that it’s “value doesn’t change” — is just dead wrong. Over long periods, its value relative to all other output has been remarkably steady (Frank Knight captured the process well in Risk, Uncertainty, & Profit). But over short and intermediate periods, and especially following periods of significant devaluation or revaluation (such as wars or expansion of the standard respectively) that assumption was always a DISASTER. You cannot “fix and forget” with gold, as such an arrangement cannot prevent the real value of gold from diverging significantly from its targeted price.
The solution is fairly straightforward — use the diffuse knowledge of markets to set the appropriate gold points, or overnight interest rate target, or whatever (even the target policy variable itself) so that optimal adjustments can be made when policy diverges from reality.
Wouldn’t you say that gold remains basically the same value and it is the dollar or whatever currency you measure is what is changing? In other words - while the dollar is taking a swan dive or soaring… the amount of goods one ounce of gold can purchase remains relatively the same… to say gold is changing radically in value in the short term really is the opposite of what is happening… if gold ’soars’ to $2,000/ounce - is it not the dollar that has radically changed values as it plummets? I am not a gold expert but i am a thinker and i know what the fed does to manipulate interest rates or create new money is very bad for an economy…. what say you?
Only over long enough periods, and if population and productivity maintain an upward trajectory for long enough, it won’t hold up over the long term either. If all debt were indexed, that would be OK, but even under gold, most debts were struck in nominal terms (which is why so many people hated the gold standard in periods like the LD).
Your argument holds up at times, and it would be 100% correct IF the amount of goods an ounce of gold could purchase (its relative price mentioned above) was relatively constant. If you can get a copy of Roy Jastram’s book on gold (ironically, The Golden Constant), and compare his purchasing power of gold index to incidents of major gold discoveries — and significant changes in global monetary arrangements — during the 19th century, you’ll see what I mean. There’s a reason the bimetallists reached their zenith in 1896 and disappeared soon after. It’s name is Witswatterrand.
If there is no inflation (or deflation) then the price of goods would not change significantly… only when the Central Banks subtract or add to the supply of money does inflation/deflation occur… so, if there were no ‘monkeying around’ with the money supply (M1) then gold would maintain a steady state - if the value of gold were to ‘drop’ because there were more gold than usual produced that year then folks would turn there gold in for money (bills) - if the reverse were true - gold became ‘more valuable’ people would trade in their dollars for more gold - in effect, contracting the money supply and therefore ‘evening out’ the money supply so that the ‘value’ of money did not fluctuate enough to harm the economy… it is okay for debt to be issued as a form of capital to help business expand - remember debt is not money… And as long as the ‘value’ of money is stable because it is linked to the value of gold then we can have a flourishing economy without the fear of inflation or deflation based on a phony control of interest from the Fed…
“If there is no inflation (or deflation) then the price of goods would not change significantly… only when the Central Banks subtract or add to the supply of money does inflation/deflation occur…”
Let’s see if this helps. At present, CBs determine the suppy of money (actually, the cost of a marginal unit of money in most cases) based on some target of their choosing, right? When the price of gold is the target, then CBs will not directly expand or contract MS in most circumstances. That will be determined by the amount of monetary gold and claims thereto. Thus, if mine output explodes as it did in 1896, MS does as well, without any intervention by those pesky central banker types, and a higher price level will unfold over time. If it slowly contracts, as it did up until 1896, then MS will have trouble keeping up with expected demands of economic agents (the banking system can do things to compensate, but these have limits), and price level will decline over time.
In other words, while MS is now a function of the objectives and activities of central bankers, under a gold standard, it is a function of the activities of gold miners and gold holders. Again, that conferred a remarkable price stability in the 19th century, as long as you look at the appropriate endpoints. Get a copy of Jastram if you can, and set it next to a copy of Hugh Rockoff’s 1981 paper on the lumpiness of gold discoveries in the 19th C. The dynamic practically leaps off the pages.
You’re wrong. The mechanism you describe is very effective at governing the value of money relative to gold (i.e., when money diverges from its gold parity), but as long as the parity rate is fixed, it does nothing to prevent inflation or deflation when the real value of gold changes, e.g., when above ground gold supply jumps ahead of or falls behind all other output, or when other output expands or contracts significantly. This is true whether a system is based on free minting, a gold window, or a gold price target.
Let’s say gold is fixed at $20/oz, but due to a sudden increase in supply, its real value is actually somewhere around $30. The bank or Treasury is going to exchange one ounce for $20, regardless — there is no arbitrage play to be had there. Instead, gold will be put on deposit, and the expanded supply of base money means that credit will become more plentiful, i.e., the real rate of interest will fall. And if it falls below the ‘natural’ rate (per Wicksell, the marginal expected return on a new unit of capital), the price level will tend to rise over time. Works in reverse in a deflation. And again, if all credit obligations were indexed, it wouldn’t present as big a problem. But they’re not, so it does.
And a historical note — the economy did not always flourish under gold, nor did it avoid periods of inflation or deflation. As with any system, there are good arguments for and against gold, but like everything in economics and the wider world, there are tradeoffs involved, and we should not allow ourselves to be swept up by myth making. Personally, I think gold can only become a viable solution if it has some kind of mechanism that keeps its nominal parity in line with its real value — which would have to be accompanied by an admission from its proponents that this was indeed a problem historically.
Ok, again, I am not a gold expert… but the problem is - Central Banks messing around with what ‘they think’ is the proper level of interest etc… that’s why we keep having bubbles or panics… they are artificially changing the rate of interest on capital available causing a false econommy…
by the way, do we have to go back to 1896 to show that a sudden increase in gold supply could effect the gold standard?
Gold production as remained very predictable with a world output growing at a rate of around 2% to 4%… how is this a a threat to using gold as a standard for the value of the dollar?
Wouldn’t you rather have the dollar’s true value remain steady and not be manipulated up and down creating booms and busts?
Instead of talking down a gold standard, why not try to defend the defenseless current system slowing taking us to poverty as a nation… tell me why the current system is the way to continue
I’m not disputing that an interest rate targeting policy is open to criticism (although whatever the form and target of monetary policy, interest rates are the vital link). I’m just trying to get gold standard advocates to focus on addressing the primary defect of historical gold standards — the divergence between real value and nominal parity. That defect works directly against your objective of keeping the real value of money reasonably stable.
My expertise is in the 19th century gold standard, not the 20th century gold industry. If the lumpiness of gold production has smoothed out dramatically, that would support your position. However, there’s still a longer term question of whether diminishing or increasingly marginal gold supplies (i.e., a rising real value of gold) could impose deflation on a growing global economy. If so, you’d still need to have some sort of adjustment mechanism for its monetary parity.
Good info… wouldn’t you think that with 20th century geoscience, advanced technology, analysis etc compared to 19th century mule with a prospector’s pan - that gold production would become more consistant and predictable as time goes by? I believe the big discoveries will become less and less and there must be a ‘finite’ amount of gold to mine for… and because the dental and jewelry demand for gold is a smidgen compared to the only other significant use is a ’store of value’ that gold’s value has a much better ability to remain steady… gold’s value really doesn’t change that much - the dollar certainly does - in relation to gold if you allow the dollar to ‘float’ with no restraint and reference point.
and isn’t this the real advantage of using gold as a standard? when people become fearful because their trust in the value of the dollar falls, volatile markets, waning trust in Gov’t - Gold acts as money (it is money) and therefore as long as gov’t can’t unilaterally create or shrink money supply - they would have to do it in relation to retaining a value constant to gold - there wouldn’t be a big deal for the Fed to remove currency or add it back to adjust for a small variation due to overproduction or higher cost of production etc of gold…
As you are more informed about 19th century gold - you should find many times that when money is tied to gold the gov’t, nation and economy enjoyed strong growth without inflation, the only time the gov’t & economies ever had trouble is when they ‘broke’ thier tie to gold - generally when a gov’t needed to raise a bunch of money to fight a war etc… they (central bankers/gov) desired to break this tie in order to inflate their currency in order to ‘pay back’ their big debts with cheaper currency… it has been documented time after time… only when they eventually returned to the gold standard did their ecoomomy regain it’s former glory.
and the amount of gold moving in or out of gov’s storage really doesn’t matter - just because gold moves ‘out of storage’ doesn’t impact it’s value… it’s the acutal act of linking the value of the dollar to a ‘commodity’ that can’t be manufactured, duplicated, counterfeit etc - so therefore it’s value can’t be hugely moved up or down because there is really no reason for it to move appreciably…
again, making it an excellant ‘guide’ or ‘link’ to a steady value… The only time we get into trouble with indeflation is when gov’t creates more ‘money’ than goods and services need and if they can do this without a ‘barometer’ to limit the devaluationist’s attempt to harm our money…
I cannot see why we shouldn’t reign in our politicians/central banker’s desires to politicize our money to effect, by fiat, public policy and control the Federal Gov’s desires resulting in direct harm to Free Market Capitalism…
“…wouldn’t you think that with 20th century geoscience, advanced technology, analysis etc compared to 19th century mule with a prospector’s pan - that gold production would become more consistant and predictable as time goes by?”
I believe that has been true to some extent, and would speculate that much or most of gold price volatility has arisen from the monetary side. Still, you seem to be missing the thrust of my argument, without which gold will continue to be a non-starter, imo. See below.
“I believe the big discoveries will become less and less and there must be a ‘finite’ amount of gold to mine for… and because the dental and jewelry demand for gold is a smidgen compared to the only other significant use is a ’store of value’ that gold’s value has a much better ability to remain steady… gold’s value really doesn’t change that much”
I once accepted that myth at face value, but it’s wrong, and it relies on a very naive concept of value. In isolation, neither gold nor any other good or service has any value; value is always determined and expressed in terms of exchange, actual or potential, i.e., value is always relative. A monetary unit ideally maintains a stable value against all other goods and services in the aggregate and, most importantly for the functioning of a financial economy, against all assets and liabilities. That latter feature is what allows human beings to transact far more efficiently across time than they would otherwise (e.g., you can go to a bank to borrow funds for a student loan from a number of faceless diverse strangers, instead of having only friends, family, or tribe as potential creditors).
Now assume that the gold industry reaches a point like you describe, where marginal production is increasingly difficult (I’d want to consult with a geologist before arguing the likelihood of that outcome, but it’s still a useful assumption for thinking conceptually about gold as a standard of value). You say that gold would then “remain steady”, but would it? You have to distingush between quantity and value. Assume that real economic growth expands at a long term rate that is positive, and that the supply of above ground gold does not change, and ask yourself:
What would happen to the relative value of gold over time?
If the USD is defined in terms of gold ounces, what would happen to the relative value of money?
If the relative value of money rises persistently, what effect will this have on the price level? On the debtor-creditor relationship? On the ‘output gap’ or similar measures of opportunity cost?
Once you’re comfortable with that exercise, you can vary the process, e.g., assume that gold supply and real growth are in equilibrium, but policymakers choose a gold price target that is out of whack with its relative value; or that production and parity are in equilibrium, but the global gold standard area suddenly doubles in size (as in 1873…not an imminent scenario, but one that could unfold if there ever were a successful return to a metallic standard).
While I’m personally agnostic on the issue, I don’t think gold advocates will make any headway until they start thinking and speaking in terms of relative rather than “intrinsic” value, and incorporate some sort of mechanism for readjusting the nominal value of gold when it diverges from its real (relative) value.
Enjoyed knocking it around with you.