Monday, 16 October 2017


Three Comments on the Gold Standard

December 12, 2011
in Blog

The financial crisis in 2008, the uncertainty about the future of the Euro and the doubts on the efficiency of monetary policy has brought some renewed interest in the gold standard as an alternative monetary system; or, at least, as a benchmark to evaluate if central banks did actually performed better or worse. This interest, however, comes with some critiques of the gold standard. Three of these critiques outstand:

  1. The gold standard caused the Great Depression.
  2. The gold standard is unstable; shocks in the quantity of gold can cause economic instability.
  3. The gold standard is expensive.

These critiques, however, are imprecise, if not wrong. Let’s take them in turn.

“The gold standard caused the Great Depression”

It is a common argument that the gold standard was one of the main causes of the Great Depression. “Since the Fed had to play by the rules of the gold standard game, its hands were tied and could not perform the required expansive monetary policy. Therefore, the gold standard provoked a fall in money supply, and this was a major driver of the Great Depression. Should the Fed have been free of the gold standard rules, the monetary authorities would have been in a position to soften the crisis. A more flexible regime, like the one with fiat currencies is, therefore, preferable to the gold standard.”

There are several points to review on this line of argumentations.

In the first place, the gold standard stopped working de facto with World War I. The interwar period had a flexible, or exchange, gold standard, a completely different institution. In the case of a flexible gold standard, some monetary authority needs to manage the “flexible” part of the standard. This gives place to monetary policy. However, the central aspect of the gold standard is that it neither requires nor has a place for management or monetary policy. The difference between the two systems is not a matter of degree, but a central aspect. Both systems should not be confused. According to this critique of the gold standard, what failed was the monetary authority in the management of the flexible gold standard, not the gold standard in itself.

It is true, that some critiques are more elaborate and do not find responsibility in the gold standard, but in the “gold standard mentality” (the rules of the game). Even though the gold standard was broken by World War I, its mentality stayed in place. However, as we discussed in a previous post, the actions of the Fed does not fit with a gold standard mentality.

There is still a second and important aspect. It is true that monetary shocks can have effects on the economy, and that the monetary policy may not have been the best in this period. But it is not true that the monetary aspect was the only relevant variable affecting the economy. Economic regulations, taxes, tariffs, regime uncertainty, political tension, among other factors also played an important role. All these factors go against an economic recovery; on the contrary, they contribute to economic stagnation and recession. The ceteris paribus in the economic analysis, which consists in changing one variable at a time, is an important analytical practice, but the world does not work under ceteris paribus, especially during crisis and business cycles. It is not enough, then, to observe the monetary policy and conclude that the Great Depression was the outcome, without controlling for the other variables. To assume that the ceteris paribus holds in the real world can overemphasize the real effect of the variable under observation. One should also consider the possibility that market regulation, tax increments and regime uncertainty where the cause of why the Great Depression lasted so long.

Not only was the gold standard already broken, and the monetary authorities did not abide by the “rules of the gold standard game” (especially the United States and England), but other major factors were also in place. To see in the gold standard the cause of the Great Depression is to look in the wrong place.

In addition, economic analysis is not about absolute, but about comparison and relative performance. The question between monetary regimes is not about which one is perfect, there is no such thing, but which one is better in relative terms. If, as Kurt Shculler points out at Free Banking Blog, one is willing to make the gold standard responsible for the Great Depression, shouldn’t one be equally willing to make central bank’s fiat money responsible of the Great Recession?

“The gold standard is unstable”

“Ok… maybe the gold standard may not have played such a major role in the Great Depression, because a different monetary regime was actually in place and the major countries were actually doing monetary policy. Nonetheless, the system can be unstable in the case of gold shocks. If the quantity of gold duplicates overnight, this can result in economic problems.”

There is a point to this critique. It is true that if the quantity of gold duplicates, a sudden adjustment in the market will be required to the new conditions. But this is no less true for the case of central banks and fiat currencies. Shouldn’t the same problems take place if a central bank duplicates the quantity of fiat money?

Therefore, the critique is wrongly articulated. Which of the two systems proves to be more unstable? The track-record of devaluations and inflation under the watch of central banks does not offer a very promising case for fiat currencies. Take, for instance, two periods in the United States. A basket of goods valued $100 in the year 1890, was valued $108 in the year 1913. This is 8% inflation in 23 year, which is equivalent to 0.34% annual inflation. Probably, most central banks would fear deflation with such a low inflation.

If we stand in 2008, the same representative basket of goods had a price of $2,422. This implies an annual inflation of 1.61% since 1913. Even though the monetary regime previous to the Fed may not have been a pure gold standard, where different states faced different regulations, still it remains that the Fed could not outperform the banking system previous to 1913 in keeping the value of money stable. [See Selgin, Latrapes and White (2010)] The inflation performance of the Fed, however, offers a specific historical sample, and the shocks critique is more general.

“Weren’t commodity money discoveries a problem, even if afterwards inflation was brought under control? One should differentiate between different kinds of “shocks.” Not all gold discoveries were unexpected shocks, but the result of a specific companies in the search of gold. This is an endogenous shock that helps to equilibrate the market. Different is the case of gold that was discovered without intention. The former shocks are endogenous, the latter exogenous. The endogenous shocks face uncertainty on when (and how big) the discovery will be; but gold is the objective of the search. The exogenous shocks are the ones that can be a problem.”

Were they? One of the most important events was the Price Revolution, which implied a sixfold increase in the level of prices in 150 years (from second half of the 15th century to the first half of the 17th century). A sixfold increase in the price level in a period of 150 years amounts for a 1.1% annual inflation rate.

While it is true that, in theory, the gold standard can suffer monetary shocks, there are no important historical records of this being a serious problem. On the contrary, the historical record of central banks suggests that if this kind of monetary shocks are a concern, the idea of central banking should be revisited.

“The Gold Standard is Expensive”

“Ok… maybe gold standard is not unstable, but certainly is expensive. A lot of gold needs to be immobilized in safety deposit boxes at banks and cannot be allocated to alternative uses; fiat currency allows us to free those resources and, therefore, is a more efficient monetary system– if central banks learn how to improve their inflationary performance.”

There are three problems with this argument.

In the first place, the gold is not locked in safety deposit box as if it were wasting its time anymore than the dollars, that are in my wallet but I don’t use, are a social loss of welfare. The fact that there is no physical use in hoarded gold by the banks does not imply there is no economic use. Just as Hutt argues that the rope that protects the alpinist from falling offers a service even if the alpinist does not fall, reserves of gold offer a service as well. Would, for instance, paratroopers be willing to do away with the secondary emergency parachute to free resources? Hedging operations in the financial markets offer this kind of protective service, and the fact that economic agents are willing to trade on them reveals there is economic value attached to this service.

In the second place, to sustain that the gold standard is expensive requires some type of measurement of how much it actually costs. Milton Friedman estimated that the cost of acquiring new gold reserves was of 2.5% of NGDP. However, as White (1999, pp. 42-48) points out, Friedman assumed 100% reserves of gold. If this estimation is corrected for fractional reserve banking, the same estimation results in a cost of 0.05% of NGDP. At prima facie this number does not look very expensive. What fractional reserves do is free gold resources to be used on alternative uses.

Third, the fiat monetary regimes and the gold standard do not differentiate from each other only in what is used as money: fiat currency or gold. In free banking gold is “outside money,” meaning that gold is exogenous to the banking sector. Banks do not issue gold, banks issue “inside money” in the form of banknotes (money substitutes). With central banks and fiat currencies, the difference between the banking sector and outside money becomes blurred, or it is completely washed away. Now, it is the banking system that issues money proper, rather than it being a market phenomenon. Therefore, it is not just the difference between the cost of producing fiat currency or gold, but how the institutional differences that this change implies affect the overall performance of money markets.