Gold Standard Questions

Questions To Think About:
What individuals or institutions are the biggest owners of the world's gold?
What would happen to the size of the world money supply if the entire world went back on the gold standard?
What are some economic problems with the gold standard?
What are some economic advantages of the gold standard?
Some libertarians like Alan Greenspan in the 1960s and Ron Paul today favor a return to the gold standard.  What might be a political (rather than economic) reason libertarians tend to favor the gold standard more than others?

There's gold in them thar standards!

Megan McArdle (a libertarian economics blogger):

Someone rather more partial to Ron Paul's arguments in favor of the gold standard than I am asks me to write a post outlining my objections to it. All right, here goes.

Money is a mysterious thing. It is a store of value, it is a medium of exchange. It is, in a fiat currency economy, worth only what people think it is worth, and what they think it is worth can be oddly affected by what they think it may be worth in the future, resulting in self-fulfilling feedback loops (at least in the short term). Even in non-fiat currencies, such as the gold standard, the value of the underlying asset can be changed by rising (or shrinking) demand for money. Economists studying this fascinating topic tend to suffer from migraines as they suffer from all the mysterious--hell, nearly mystical--attributes of money.

However, over the last fifty years, economists have settled on some very broad areas of consensus. The first is, as famous libertarian monetary economist Milton Friedman wrote, "inflation is always and everywhere a monetary phenomenon". When the supply of money outstrips the demand, prices rise. And this is by no means limited to fiat currencies; see the great Spanish inflation of the 16th & 17th centuries, thanks to the steady influx of gold from the New World. Or check out the price of basic commodities in mining towns during the Gold Rush, when all anyone had was gold.
The second is that a little bit of inflation is okay--possibly even beneficial, since it helps the economy to overcome the problem of sticky wages when the relative value of labour has fallen. But a lot of inflation is very, very bad. Exhibit A is Zimbabwe; Exhibits B-∞ are every other economy that has had inflation near or above the double-digit mark; the higher the inflation, the worse the economy did. The feeling that the currency will experience an unpredictable amount of inflation dampens the willingness of the citizens to save and invest, which is why so many third-world loans are denominated in dollars.
The third is that deflation is also bad, and at the lower percentage values, often even worse than inflation. This surprises/offends/meets with the frank disbelief of many "sound money" types, who think that, barring local shortage, in an ideal world everything ought to cost the same or less than it did when Grandpa was a boy. (These sorts of opinions are cemented further by the fact that Grandpa, who is often the source of them, is usually living on a fixed income, and therefore feels that he would make out better in a deflationary economy.) The problem is, deflation does rather devastating things to anyone who has debt, since they now have to repay what they borrowed in more expensive dollars. Deflation means that, thanks to the abovementioned sticky wages, the economy has to deal with demand shocks by lowering output. Deflation can result in what's known as a liquidity trap, a concept pioneered by liberal economist John Maynard Keynes and best elucidated by liberal economist Paul Krugman back before he left economics writing to focus on his hatred of George W. Bush. Deflation is what made the Great Depression so memorable. Deflation is so bad that almost everyone agrees that moderate inflation, in the range of 1-2%, is better than risking even a small amount of deflation.
Advocates of a gold standard dispute this. They argue that America experienced a long, slow deflation throughout most of the 19th century, without anyone getting hurt. What they neglect to mention is that people did get hurt, repeatedly, in the period's awful financial contractions. Though we don't have modern economic statistics for the period, it's pretty clear that recessions were longer and deeper than they are now.
This is not only due to the gold standard; the era's primitive financial system and its approach to financial regulation, which often ranged between lighthearted and foolhardy, also played substantial roles. But the gold standard also has to stand up and take a bow. There's a strong correlation, for example, between how long a country hewed to the gold standard, and how badly it suffered from the Great Depression.
The gold standard cannot do what a well-run fiat currency can do, which is tailor the money supply to the economy's demand for money. The supply of gold grows--or not--depending on how much of the stuff is mined. Demand also fluctuates for non-economic reasons; gold has uses besides being money, like industrial components and jewelry.
The lone advantage of a gold standard--and it is a real advantage--is that it prevents governments from inflating the currency. The problem is, this is only moderately true. The government, after all, can always modify its gold standard. Yes, you say, but it will pay a price in the markets, and this is true, but this is the same price it pays when it prints more fiat currency. Such practices do not go unnoticed for long.
As James Hamilton has pointed out, gold-backed currencies, like all money with a fixed exchange rate, are subject to speculative attacks whenever the government's financial position looks weak. Such speculative attacks often require punitive economic measures to fight off, which is one of the reasons that America suffered so nastily from the Great Depression--it raised interest rates in the middle of a recession in order to defend the credibility of its currency.
Also, since devaluations tend to produce sharp changes in the values of currencies, rather than smooth appreciations or declines, the economic dislocations are magnified. Imagine you're a company with a contract denominated in dollars. If the value of the dollar gradually declines, you lose a little, but not too much, since you periodically renew the contract, giving you time to adjust the amounts. If, on the other hand, the devaluation pressure builds up over a period of years, and then all at once the government has to devalue by 20%, you end up badly hurt. You might go out of business. Now multiply that all across the country, and you can see why recessions used to last for years.
In short, you don't get anything out of a gold standard that you didn't bring with you. If your government is a credible steward of the money supply, you don't need it; and if it isn't, it won't be able to stay on it long anyway. (See Argentina's dollar peg). Meanwhile, the limitations on the government's ability to respond to fiscal crises, the necessity of defending against speculative attacks in times of crises, and the possibility of independent changes in the relative price of gold, make your economy more unstable. It's a terrible idea, which is why there are so few economists willing to raise their voices in support of it.

Gold Bug Variations

The Unofficial Paul Krugman Web Page:

The legend of King Midas has been generally misunderstood. Most people think the curse that turned everything the old miser touched into gold, leaving him unable to eat or drink, was a lesson in the perils of avarice. But Midas' true sin was his failure to understand monetary economics. What the gods were really telling him is that gold is just a metal. If it sometimes seems to be more, that is only because society has found it convenient to use gold as a medium of exchange--a bridge between other, truly desirable, objects. There are other possible mediums of exchange, and it is silly to imagine that this pretty, but only moderately useful, substance has some irreplaceable significance.
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There is a case to be made for a return to the gold standard. It is not a very good case, and most sensible economists reject it, but the idea is not completely crazy. On the other hand, the ideas of our modern gold bugs are completely crazy. Their belief in gold is, it turns out, not pragmatic but mystical.

The current world monetary system assigns no special role to gold; indeed, the Federal Reserve is not obliged to tie the dollar to anything. It can print as much or as little money as it deems appropriate. There are powerful advantages to such an unconstrained system. Above all, the Fed is free to respond to actual or threatened recessions by pumping in money. To take only one example, that flexibility is the reason the stock market crash of 1987--which started out every bit as frightening as that of 1929--did not cause a slump in the real economy.

While a freely floating national money has advantages, however, it also has risks. For one thing, it can create uncertainties for international traders and investors. Over the past five years, the dollar has been worth as much as 120 yen and as little as 80. The costs of this volatility are hard to measure (partly because sophisticated financial markets allow businesses to hedge much of that risk), but they must be significant. Furthermore, a system that leaves monetary managers free to do good also leaves them free to be irresponsible--and, in some countries, they have been quick to take the opportunity. That is why countries with a history of runaway inflation, like Argentina, often come to the conclusion that monetary independence is a poisoned chalice. (Argentine law now requires that one peso be worth exactly one U.S. dollar, and that every peso in circulation be backed by a dollar in reserves.)

So, there is no obvious answer to the question of whether or not to tie a nation's currency to some external standard. By establishing a fixed rate of exchange between currencies--or even adopting a common currency--nations can eliminate the uncertainties of fluctuating exchange rates; and a country with a history of irresponsible policies may be able to gain credibility by association. (The Italian government wants to join a European Monetary Union largely because it hopes to refinance its massive debts at German interest rates.) On the other hand, what happens if two nations have joined their currencies, and one finds itself experiencing an inflationary boom while the other is in a deflationary recession? (This is exactly what happened to Europe in the early 1990s, when western Germany boomed while the rest of Europe slid into double-digit unemployment.) Then the monetary policy that is appropriate for one is exactly wrong for the other. These ambiguities explain why economists are divided over the wisdom of Europe's attempt to create a common currency. I personally think that it will lead, on average, to somewhat higher European unemployment rates; but many sensible economists disagree.

So where does gold enter the picture?

While some modern nations have chosen, with reasonable justification, to renounce their monetary autonomy in favor of some external standard, the standard they choose these days is always the currency of another, presumably more responsible, nation. Argentina seeks salvation from the dollar; Italy from the deutsche mark. But the men and women who run the Fed, and even those who run the German Bundesbank, are mere mortals, who may yet succumb to the temptations of the printing press. Why not ensure monetary virtue by trusting not in the wisdom of men but in an objective standard? Why not emulate our great-grandfathers and tie our currencies to gold?

Very few economists think this would be a good idea. The argument against it is one of pragmatism, not principle. First, a gold standard would have all the disadvantages of any system of rigidly fixed exchange rates--and even economists who are enthusiastic about a common European currency generally think that fixing the European currency to the dollar or yen would be going too far. Second, and crucially, gold is not a stable standard when measured in terms of other goods and services. On the contrary, it is a commodity whose price is constantly buffeted by shifts in supply and demand that have nothing to do with the needs of the world economy--by changes, for example, in dentistry.

The United States abandoned its policy of stabilizing gold prices back in 1971. Since then the price of gold has increased roughly tenfold, while consumer prices have increased about 250 percent. If we had tried to keep the price of gold from rising, this would have required a massive decline in the prices of practically everything else--deflation on a scale not seen since the Depression. This doesn't sound like a particularly good idea.

So why are Jack Kemp, the Wall Street Journal, and so on so fixated on gold? I did not fully understand their position until I read a recent letter to, of all places, the left-wing magazine Mother Jones from Jude Wanniski--one of the founders of supply-side economics and its reigning guru. (One of the many comic-opera touches in the late unlamented Dole campaign was the constant struggle between Jack Kemp, who tried incessantly to give Wanniski a key role, and the sensible economists who tried to keep him out.) Wanniski's main concern was to deny that the rich have gotten richer in recent decades; his letter is posted on the Mother Jones Web site, and makes interesting reading.

But, particularly noteworthy was the following passage:

First let us get our accounting unit squared away. To measure anything in the floating paper dollar will get us nowhere. We must convert all wealth into the measure employed by mankind for 6,000 years, i.e., ounces of gold. On this measure, the Dow Jones industrial average of 6,000 today is only 60 percent of the DJIA of 30 years ago, when it hit 1,000. Back then, gold was $35 per ounce. Today it is $380-plus. This is another way of saying that in the last 30 years, the people who owned America have lost 40 percent of their wealth held in the form of equity. ... If you owned no part of corporate America 30 years ago, because you were poor, you lost nothing. If you owned lots of it, you lost your shirt in the general inflation.

Never mind the question of whether the Dow Jones industrial average is the proper measure of how well the rich are doing. What is fascinating about this passage is that Wanniski regards gold as the appropriate measure of wealth, regardless of the quantity of other goods and services that it can buy. Since the dollar was de-linked from gold in 1971, the Dow has risen about 700 percent, while the prices of the goods we ordinarily associate with the pursuit of happiness--food, houses, clothes, cars, servants--have gone up only about 250 percent. In terms of the ability to buy almost anything except gold, the purchasing power of the rich has soared; but Wanniski insists that this is irrelevant, because gold, and only gold, is the true standard of value. Wanniski, in other words, has committed the sin of King Midas: He has forgotten that gold is only a metal, and that its value comes only from the truly useful goods for which it can be exchanged.
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Econbrowser: The gold standard and the Great Depression

Econbrowser: The gold standard and the Great Depression:

"Under a pure gold standard, the government would stand ready to trade dollars for gold at a fixed rate. Under such a monetary rule, it seems the dollar is 'as good as gold.'

Except that it really isn't-- the dollar is only as good as the government's credibility to stick with the standard. If a government can go on a gold standard, it can go off, and historically countries have done exactly that all the time. The fact that speculators know this means that any currency adhering to a gold standard (or, in more modern times, a fixed exchange rate) may be subject to a speculative attack. ...A gold standard only works when everybody believes in the overall fiscal and monetary responsibility of the major world governments and the relative price of gold is fairly stable. And yet a lack of such faith was the precise reason the world returned to gold in the late 1920's and the reason many argue for a return to gold today. Saying you're on a gold standard does not suddenly make you credible."

Ben Bernanke and Harold James found that there was a strong correlation between going off the gold standard and economic recovery during the great depression (NBER working paper version here). The gold standard causes deflation during recessions and limits monetary policy. That is also its main advantage the rest of the time. It prevents inflation by limiting monetary policy as long as governments stick with it, but they don't.

In the following graph, what would be inflation and what would be deflation if the US were on a gold standard?

 Click on graph to see full size.

Usually countries try to lower interest rates during a severe recession, but several countries dramatically raised a basic interest rate (the discount rate) in 1931 during the Great Depression in a failed attempt to preserve the gold standard.  Krugman:

[The graph] shows discount rates in the US, Britain, and Germany in the late 20s and early 30s, and highlights the way attempts to defend the gold standard led to perverse monetary policies at what was arguably a crucial moment.

The good news is that we don’t have a gold standard now, and thus aren’t as perverse. In truth, though, Asian crisis countries did raise rates in the 1990s

 Brad Delong points out that a major lesson of the Great Depression is that the sooner each of the biggest economies left the gold standard, the sooner they began recovery.  The arrows indicate ending the gold standard:

Gold standard

Wikipedia, the free encyclopedia:

The history of money consists of three phases: commodity money, in which actual valuable objects are bartered; then representative money, in which paper notes (often called 'certificates') are used to represent real commodities stored elsewhere; and finally fiat money, in which paper notes are backed only by use of' 'lawful force and legal tender laws' of the government, in particular by its acceptability for payments of debts to the government (usually taxes).

Commodity money is inconvenient to store and transport. It also does not allow the government to control or regulate the flow of commerce within their dominion with the same ease that a standardized currency does. As such, commodity money gave way to representative money, and gold and other specie were retained as its backing.

...A 100% reserve gold standard, or a full gold standard exists when the monetary authority holds sufficient gold to convert all circulating money into gold at the promised exchange rate. It is sometimes referred to as the Gold Specie Standard to more easily identify it from other forms of the gold standard that have existed at various times. A 100% reserve standard is [nearly impossible] to implement as the quantity of gold in the world is too small to sustain current worldwide economic activity at current gold prices. Its implementation would entail a many-fold increase in the price of gold. Furthermore, the "necessary" quantity of money (i.e. one that avoids either inflation or deflation) is not a fixed quantity, but varies continuously with the level of commercial activity.

I usually find that Wikipedia does a great job, but this entry goes off track in several places. For example, Wickipedia says that an advantage of the gold standard is that it would require periodic deflation. That was actually a major problem. Deflation is very destructive because it nearly eliminates banking.
Wikipedia also says, "Many liberal economists believe that economic recessions can be largely mitigated by increasing money supply during economic downturns.^[17]" but this is part of mainstream conservative economics too. As evidence, Wikipedia cites Greg Mankiw who is a conservative economist. Conservative economists have actually pushed the importance of active monetary policy much more than liberal economists because many conservative 'monetarists' like Milton Friedman wished to reduce the reliance on Keynesian government spending during recessions. That was a big reason for the conservative school of thought known as monetarism.  Another problem is that Wikipedia cites Alan Greenspan as a prominent proponent of the gold standard, but he abandoned that idea at least three decades ago when he went to work for the Fed and was put in charge of fine-tuning the money supply. Wikipedia also says:

Representative money and the gold standard protect citizens from hyperinflation and other abuses of monetary policy, as were seen in some countries during the Great Depression.

Representative money does not always protect citizens against hyperinflation because governments can always devalue the representative money. The Great Depression is a ridiculous example because it is better characterized as a period of deflation rather than inflation and governments generally devalue currencies during crises like that. As Milton Friedman documented, the main abuse of monetary policy in the depression was that governments did not expand the money supply (and devalue the currency) enough (nor quickly enough).  A big part of the problem was a desire to remain on the gold standard. Wikipedia goes on to contradict itself:

... the earliness with which a country left the gold standard reliably predicted its economic recovery from the great depression. For example, Great Britain and Scandinavia, which left the gold standard in 1931, recovered much earlier than France and Belgium, which remained on gold much longer.

A huge amount of the total gold in the world is still held by central banks as a kind of reserve currency for foreign exchange manipulation and to diversify risk.

...The total amount of gold that has ever been mined has been estimated at around 142,000 metric tons.^[12] Assuming a gold price of US$1,000 per ounce, or $32,500 per kilogram, the total value of all the gold ever mined would be around $4.5 trillion. This is less than the value of circulating money in the U.S. alone, where more than $8.3 trillion is in circulation or in deposit (M2).^[13] Therefore, a return to the gold standard, if also combined with a mandated end to fractional reserve banking, would result in a significant increase in the current value of gold, which may limit its use in current applications.

deflation

The graph below shows when each nation formally abandoned the gold standard, industrial production almost immediately recovered ostensibly because the money supply could expand more.  Unfortunately for France, they entered WWII shortly after they abandoned the gold standard.

Grasping Reality with Both Hands: "All of the five major economies of the world started out the Great Depression pursuing for the most part the orthodox gold-standard non-New Deal policies of the 1920s. All five of them had fierce political debates about whether to switch to a 'New Deal.' All eventually switched to their own version of the New Deal--Japan and Britain in 1931, Germany and the U.S. in 1933, and France not until 1937. Japan and Britain recovered fastest and most completely; Germany and the U.S. were in the middle; and France was the worst."