There’s gold in them thar standards!

Note: This post is longer than usual–2230 words–& takes about ten minutes to read.

Several presidential candidates have been in favor of the gold standard including Ron Paul in 2012 and Rand Paul and Ted Cruz in 2015.   In response, Megan McArdle, explained why she agrees with almost all mainstream economists that the gold standard is a terrible idea.  McArdle describes herself as a libertarian, but whereas the gold standard is particularly popular among libertarians, she favors Milton Friedman’s version of libertarianism.  Friedman strongly advocated that monetary policy–the quantity of money, its value (inflation rate), and its price (interest rate)–should be determined by a government-run central planning agency (the Fed) and not be left up to private markets.  McArdle:

Money is a mysterious thing. It is a store of value, it is a medium of exchange. It is [a unit of account, which] in a fiat currency economy, [is] 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. …[For every] economy that has had inflation… 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… Deflation is what made the Great Depression so memorable. Deflation is so bad that almost everyone agrees that moderate inflation… 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. …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…

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 actuality, the most important issue for businesses is not the rate of inflation, but how predictable inflation is.  Businesses can adjust contracts by padding future prices to cope with inflation if it is stable.  It is unexpected changes in inflation that cause problems.]

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.

In 2011, many Americans wished to return to the gold standard because they were worried about excessive inflation.  Some state governments like North Carolina were even discussing plans to print new forms of money based on the gold standard:

Cautioning that the federal dollars in your wallet could soon be little more than green paper backed by broken promises, state Rep. Glen Bradley wants North Carolina to issue its own legal tender backed by silver and gold. The Republican from Youngsville has introduced a bill that would establish a legislative commission to study his plan for a state currency.

Matt Yglesias noted that

A similar measure already passed in Utah. But this reflects, among other things, a fundamental misunderstanding of the relationship between currency and promises. It’s actually a gold-backed currency that’s backed by nothing but promises. When America was on the gold standard, that meant that the government promised to give you such-and-such an amount of gold in exchange for a dollar. When FDR came into office, he decided the government needed expansionary monetary policy so he changed the price of gold. Under the Bretton Woods system, similarly, the government’s promise to convert dollars to gold lasted a few decades and then it went away. It’s a gold standard that represents a government promise that can (and will) be broken. Fiat currency is a government that’s being honest with you. It’s not pretending the money is anything other than what it is.

The practical response for Americans who question the forward-looking strength of the US dollar is just to buy another currency. Europe is run almost exclusively by center-right governing coalitions right now, so you can trust your money to them. Or maybe since all Europeans are socialists by definition you’d prefer to trust your money to the Canadian or British governments. You can buy Korean won or Australian dollars or Brazilian reals. You can even go out and buy actual bars of gold. …But whatever you do, don’t entrust your money to promises by the North Carolina state government to give you gold in the future. That’s just a sucker move that’s going to leave you get stuck holding the bag next time there’s a budget crisis.

I would not expect a new North Carolina dollar to catch on unless people begin to trust the North Carolina government more than the US federal government.  I certainly don’t.  Throughout history, whenever a crisis came, governments suspended the gold standard.  It happened in the US during the revolutionary war, the civil war, and the great depression, and it also happened in most European nations during WWI.

A major lesson of the Great Depression is that the sooner the big economies left the gold standard, the sooner they began recovery.  Ben Bernanke and Harold James (working paper PDF) found that there was a strong correlation between going off the gold standard and economic recovery during the great depression. Each nation recovered at the point on the graph where color begins.  France had a milder depression than the other nations initially did and so it held on to the gold standard through 1936 which helps explain why France didn’t recover as soon as the other nations.

Gold Standard depression

…recovery from the Great Depression does not begin until countries give up on the… gold-standard… Those countries that have central banks willing to print up enough money so that people are willing to spend it–it is when you adopt such policies that your economy begins to recover. If you don’t, you become France, which sticks to the gold standard all the way up to 1937, and never gets a recovery. When World War II begins, Nazi Germany’s production–equal to France’s in 1933–had doubled between 1933 and 1939. French production had fallen by 15%.

The gold standard limits monetary policy during recessions and makes recessions worse by causing deflation. 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‘s graph shows how three nations doubled their interest rate in 1931 because of trying to maintain the gold standard.  That cripled these economies and the 12% interest rate in Germany created an economic disaster that helped elect Adolph Hitler.  If Germany had not been on the gold standard, we might have avoided the economic disaster that ultimately produced the political disasters wrought by Hitler.

krugman fetters

Recessions were much more frequent under the gold standard as you can see on the following graph from dshort.  There were a lot more shaded vertical bars under the gold standard.

inflation recessions & gold standard

The only advantage of a gold standard in theory is that it could prevent inflation by limiting monetary expansions as long as governments stick with it, but they don’t.  And in practice even when governments do stick with the gold standard, there are still wide swings in inflation.  Matthew O’Brien noted that in the final years of the gold standard in the US, inflation ranged from almost 24% in 1920 down to negative 10% in 1931.

gold inflation

Going even farther back in the US history, the gold standard looks even worse as a way to avoid inflation.  The red arrow in the graph below marks the end of the gold standard during the Great Depression.  Although our data quality is poor for the gold standard era, inflation almost certainly reached higher peaks during the gold standard than it has in the eighty years since.  Inflation regularly rose above 13% during the gold standard and has never risen that high since.  Even more importantly, since abandoning the gold standard, we have never had significant deflation and the variance of inflation (the up and down motion) is MUCH less which greatly helps people plan for the future.

Inflation us gold standard

(Note that there are various estimates of inflation before the Great Depression and Robert Schiller’s estimates (graph, data) make the Gold Standard look even worse.)

The following graph shows the price of gold.  Pay attention to the red line which shows the real value of gold.  If gold=money, then a rise in the gold price is deflation and a fall in the price of gold is inflation.  There would have been extreme deflation in the 1973 and 1979 on a gold standard and then hyperinflation in the mid 1970s and early 1980s.

gold price

That is no way to run a monetary system.

Posted in Macro

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