On many issues, libertarians can find common cause with either conservatives or liberals. There are, however, at least two areas in which libertarians stand completely alone – the drug war and the gold standard. I may deal with the drug war at a later date. Given the recent economic news, we’re going to have to deal with the gold standard sooner or later whether we want to or not. As they say, just because you don’t take an interest in monetary policy doesn’t mean monetary policy won’t take an interest in you.Take a moment to consider the scope of the recent nationalizations undertaken by Bush, Paulson, and Bernanke. Including the recent Citi bailout, the total comes to $7.76 trillion. When adjusted for inflation, the bailout will cost more than the following government programs combined (data provided by Jim Bianco of Bianco Research):
Marshall Plan: Cost: $12.7 billion, Inflation Adjusted Cost: $115.3 billion
Louisiana Purchase: Cost: $15 million, Inflation Adjusted Cost: $217 billion
Race to the Moon: Cost: $36.4 billion, Inflation Adjusted Cost: $237 billion
S&L Crisis: Cost: $153 billion, Inflation Adjusted Cost: $256 billion
Korean War: Cost: $54 billion, Inflation Adjusted Cost: $454 billion
The New Deal: Cost: $32 billion (Est), Inflation Adjusted Cost: $500 billion (Est)
Invasion of Iraq: Cost: $551b, Inflation Adjusted Cost: $597 billion
Vietnam War: Cost: $111 billion, Inflation Adjusted Cost: $698 billion
NASA: Cost: $416.7 billion, Inflation Adjusted Cost: $851.2 billion
TOTAL: $3.92 trillion
President-elect Obama has already made it clear that he will both continue and expand this lunacy, much like FDR continued and expanded the plans initiated by Herbert Hoover (rebranding them as the New Deal). Given the disastrous consequences these nationalizations will have on our economy, at some point even mainstream economists and media pundits will have to start talking about a return to sound money. The only questions are how soon will that happen, and how much pain will we have to suffer in the meantime?
What is a gold standard?
Very simply, a gold standard is a monetary system that ties the value of money in circulation at any given time to gold. Technically, what we’re really talking about is a commodity-based standard. When we use the term “gold standard,” we’re making an assumption that gold will be the preferred commodity, but given the right circumstances a free market might choose silver, platinum, nickel, or any other commodity that meets all of the criteria for money. In order for a commodity to serve as money, it must be portable, fungible, durable, divisible, and widely accepted. For three thousand years, gold has performed these functions better than any other commodity.
The easiest gold standard to envision is one in which we all walk around with gold coins in our pockets, but a gold standard does not require actual physical gold to be used in practice. Although there should be no restrictions against using physical gold for everyday transactions, there are perfectly good reasons to use paper money. Gold has a high value to weight ratio, so even ridiculously small amounts of gold can have significant purchasing power. At today’s rates, a single gram of gold goes for $26, but a gram of gold is far too small to be practical for everyday use. Gold is a very soft metal, and the normal wear-and-tear would quickly erode smaller denominations like a gram. For these and other reasons, both silver coins and paper money have historically been used under various gold-based monetary systems.
In practice, a gold standard would function as a currency peg. Under a gold standard, the bank issuing the paper currency (either a central or private bank) would maintain parity with a fixed weight of gold. For example, the dollar could be defined as 1/30th of a gram of gold. It would be the responsibility of the issuing bank to maintain that ratio by inflating or deflating the supply of money in circulation as needed.
If too many banknotes are printed relative to demand, the nominal price of gold will increase. In our example, it will now take, say, $32 to buy a gram of gold. The issuing bank would have to retire the excess currency, reducing its supply relative to gold so that it returns to its parity rate. Similarly, if too few banknotes are printed relative to demand, the nominal price of gold will drop. It will now take perhaps only $27 to buy a gram of gold. The issuing banks would then have to issue more paper currency to restore the 1/30th ounce parity. Under this system, the issuing bank has an incentive to keep its money honest by maintaining the parity rate. Too few banknotes, and people buy cheap gold. Too many banknotes, and there’s a run on the bank as people suspect the issuer cannot maintain its exchange commitment.
The system itself is not terribly complicated, but the implications for the economy are tremendous.
Why is a gold standard important?
A gold standard provides stability in the value of a currency. In the United States, a dollar was defined as 1/20th of an ounce of gold for a full century (1815-1914). From roughly 1800 right up until WWI, a dollar bought roughly the same amount of goods and services (actually, it bought a little more as technological improvements enabled the cost of goods to fall while production increased).
During the Great Depression, FDR made private ownership of gold a criminal offense, punishable by a fine of up to $10,000 (not payable in gold, I presume) and up to ten years in prison. Executive Order 6102 commanded all Americans to surrender their gold in exchange for paper at the standard 1/20th rate. Roosevelt then devalued the currency by dropping the parity rate to 1/35th an ounce. This rate was honored, however, only in exchanges with foreign central banks. At the time, foreign banks held considerably fewer dollar reserves, and the break with the domestic gold standard set the stage for massive inflation.
By 1971, only the US maintained even a nominal tie with gold, and foreign central bank dollar holdings had increased significantly after WWII. The inflationary policies that had been put into place ever since the days of FDR made it clear that there was no way the US government could honor its commitment to pay foreign central banks in gold at 1/35th an ounce. France was the first to call the US government’s bluff, and began to convert its dollar reserves into gold. Realizing that the jig was up, Nixon “closed the gold window” and severed the last vestige of a gold standard. Freed of even the pretense of fiscal responsibility, the US government shifted into high gear, inflating the money supply at an astronomical rate. The destruction of the dollar’s purchasing power has been so great that a dollar today only buys 3-5% of what a dollar bought in 1913, when the Fed was created.
Most mainstream economists and every single politician (with the exception of Ron Paul) take great pains to soft-peddle the harmful effects of inflation. Even otherwise free-market economists such as George Mason University’s Russ Roberts claim that the Fed has done a pretty good job managing inflation. How they make that claim in the face of the data is beyond me. Evidently, “a pretty good job” just means that it doesn’t take a wheelbarrow full of dollars to buy a latte at Starbucks (yet).
The monetarists, following in the footsteps of Milton Friedman, believe that there is no problem with inflation as long as the destruction of the dollar is gradual and predictable. But in this I believe they are overlooking a number of issues relating to inflation. Inflation does not occur uniformly throughout the economy. Wages are usually the last to catch up. This is certainly harmful to those people living on fixed incomes and salaries.
One of the main functions of money is to act as a store of value. Since money is durable (not perishable), we don’t have to make all of our exchanges as soon as we get some coin in our hot little hands. We can delay consumption for the future by saving a portion of our money. But in order to do this, we need the value of that money to remain relatively stable. Money should purchase roughly the same (or even slightly more) goods and services in the future as it does in the present.
Inflation, however, distorts the store of value function of money. Under an inflationary fiat monetary system, a dollar today buys far more than it will in the future. This acts as a disincentive to savings, which reduces the capital pool available for sustainable economic growth (for more on this, see And Then What?). This is one of the reasons for the pitifully low savings rate in the United States – in an inflationary environment, the real return on savings can turn negative. Under those circumstances, it is completely rational to convert cash balances into tangible assets (like housing) or to favor current consumption over future consumption.
This probably seems straightforward to most people. Nobody likes inflation, right? Wrong. Lots of people like inflation – they’re the ones who either work in government or just worship government power. To these people, inflation is the best thing since sliced bread and sunshine because it allows government to literally create money out of thin air. It is this inflationary prestidigitation that enables politicians to promise something for nothing, because they do not have to resort to direct taxation to pay for things like war and multi-gazillion dollar bailouts. They just wave the magic government wand, say, “Abra-Bernanke” and poof! “Free” money to buy votes with! If the value of the dollar and your life savings gets destroyed in the process, so be it.
Because of the political advantages that derive from inflation, the pressure will always be to inflate the money supply under a fiat system. The best check on this inflationary pressure is a gold standard, which ties the value of the money in circulation to a commodity that cannot be created out of thin air. But this denies politicians one of their most potent weapons, which is why the gold standard is relentlessly attacked by government flunkies and their accomplices in the media and academia.
Nevertheless, the gold standard has a number of advantages that one should consider. First, it has the advantage of actually being Constitutional. Article I, Section 10 states, “No state shall …make anything but gold and silver coin a tender in payment of debts.” To my knowledge, this restriction has never been repealed by Constitutional amendment. Second, the stability provided by the gold standard (when maintained) has never been surpassed by any other monetary system ever devised by man. Monetary stability is as vital to economic calculation as stability in physical measurement is to engineering. Would you want to live in a house that was built by a contractor whose tape measure changed every time he used it? Neither would I. Why would economic calculation be any better with a continually changing currency unit?
Of course, we could just keep all discussion of the gold standard in the shadows where it has been since 1971. After all, there is one other check on the inflationary pressures engendered under a fiat system – reality. At some point, the inflation becomes so oppressive that it simply cannot continue. Even the short-term stimulus effects of inflation cannot be continued without a geometric expansion of the money supply.
So what will it be? Should we consider a return to the gold standard, even if it means accepting the fact that we can’t have something for nothing? Or should we continue on our current path and get the wheelbarrows ready?
Note: Obviously, there’s a lot more to this discussion than I can go into here. If you’re interested, check out the following titles and links:
Gold: The Once and Future Money, by Nathan Lewis
What Has Government Done to Our Money?, by Murray Rothbard
Gold, Peace, and Prosperity, by Ron Paul
“Forget Bretton Woods II – We Need a Gold Standard,” by Walker Todd (Christian Science Monitor)
President-elect Obama has already made it clear that he will both continue and expand this lunacy, much like FDR continued and expanded the plans initiated by Herbert Hoover (rebranding them as the New Deal). Given the disastrous consequences these nationalizations will have on our economy, at some point even mainstream economists and media pundits will have to start talking about a return to sound money. The only questions are how soon will that happen, and how much pain will we have to suffer in the meantime?
What is a gold standard?
Very simply, a gold standard is a monetary system that ties the value of money in circulation at any given time to gold. Technically, what we’re really talking about is a commodity-based standard. When we use the term “gold standard,” we’re making an assumption that gold will be the preferred commodity, but given the right circumstances a free market might choose silver, platinum, nickel, or any other commodity that meets all of the criteria for money. In order for a commodity to serve as money, it must be portable, fungible, durable, divisible, and widely accepted. For three thousand years, gold has performed these functions better than any other commodity.
The easiest gold standard to envision is one in which we all walk around with gold coins in our pockets, but a gold standard does not require actual physical gold to be used in practice. Although there should be no restrictions against using physical gold for everyday transactions, there are perfectly good reasons to use paper money. Gold has a high value to weight ratio, so even ridiculously small amounts of gold can have significant purchasing power. At today’s rates, a single gram of gold goes for $26, but a gram of gold is far too small to be practical for everyday use. Gold is a very soft metal, and the normal wear-and-tear would quickly erode smaller denominations like a gram. For these and other reasons, both silver coins and paper money have historically been used under various gold-based monetary systems.
In practice, a gold standard would function as a currency peg. Under a gold standard, the bank issuing the paper currency (either a central or private bank) would maintain parity with a fixed weight of gold. For example, the dollar could be defined as 1/30th of a gram of gold. It would be the responsibility of the issuing bank to maintain that ratio by inflating or deflating the supply of money in circulation as needed.
If too many banknotes are printed relative to demand, the nominal price of gold will increase. In our example, it will now take, say, $32 to buy a gram of gold. The issuing bank would have to retire the excess currency, reducing its supply relative to gold so that it returns to its parity rate. Similarly, if too few banknotes are printed relative to demand, the nominal price of gold will drop. It will now take perhaps only $27 to buy a gram of gold. The issuing banks would then have to issue more paper currency to restore the 1/30th ounce parity. Under this system, the issuing bank has an incentive to keep its money honest by maintaining the parity rate. Too few banknotes, and people buy cheap gold. Too many banknotes, and there’s a run on the bank as people suspect the issuer cannot maintain its exchange commitment.
The system itself is not terribly complicated, but the implications for the economy are tremendous.
Why is a gold standard important?
A gold standard provides stability in the value of a currency. In the United States, a dollar was defined as 1/20th of an ounce of gold for a full century (1815-1914). From roughly 1800 right up until WWI, a dollar bought roughly the same amount of goods and services (actually, it bought a little more as technological improvements enabled the cost of goods to fall while production increased).
During the Great Depression, FDR made private ownership of gold a criminal offense, punishable by a fine of up to $10,000 (not payable in gold, I presume) and up to ten years in prison. Executive Order 6102 commanded all Americans to surrender their gold in exchange for paper at the standard 1/20th rate. Roosevelt then devalued the currency by dropping the parity rate to 1/35th an ounce. This rate was honored, however, only in exchanges with foreign central banks. At the time, foreign banks held considerably fewer dollar reserves, and the break with the domestic gold standard set the stage for massive inflation.
By 1971, only the US maintained even a nominal tie with gold, and foreign central bank dollar holdings had increased significantly after WWII. The inflationary policies that had been put into place ever since the days of FDR made it clear that there was no way the US government could honor its commitment to pay foreign central banks in gold at 1/35th an ounce. France was the first to call the US government’s bluff, and began to convert its dollar reserves into gold. Realizing that the jig was up, Nixon “closed the gold window” and severed the last vestige of a gold standard. Freed of even the pretense of fiscal responsibility, the US government shifted into high gear, inflating the money supply at an astronomical rate. The destruction of the dollar’s purchasing power has been so great that a dollar today only buys 3-5% of what a dollar bought in 1913, when the Fed was created.
Most mainstream economists and every single politician (with the exception of Ron Paul) take great pains to soft-peddle the harmful effects of inflation. Even otherwise free-market economists such as George Mason University’s Russ Roberts claim that the Fed has done a pretty good job managing inflation. How they make that claim in the face of the data is beyond me. Evidently, “a pretty good job” just means that it doesn’t take a wheelbarrow full of dollars to buy a latte at Starbucks (yet).
The monetarists, following in the footsteps of Milton Friedman, believe that there is no problem with inflation as long as the destruction of the dollar is gradual and predictable. But in this I believe they are overlooking a number of issues relating to inflation. Inflation does not occur uniformly throughout the economy. Wages are usually the last to catch up. This is certainly harmful to those people living on fixed incomes and salaries.
One of the main functions of money is to act as a store of value. Since money is durable (not perishable), we don’t have to make all of our exchanges as soon as we get some coin in our hot little hands. We can delay consumption for the future by saving a portion of our money. But in order to do this, we need the value of that money to remain relatively stable. Money should purchase roughly the same (or even slightly more) goods and services in the future as it does in the present.
Inflation, however, distorts the store of value function of money. Under an inflationary fiat monetary system, a dollar today buys far more than it will in the future. This acts as a disincentive to savings, which reduces the capital pool available for sustainable economic growth (for more on this, see And Then What?). This is one of the reasons for the pitifully low savings rate in the United States – in an inflationary environment, the real return on savings can turn negative. Under those circumstances, it is completely rational to convert cash balances into tangible assets (like housing) or to favor current consumption over future consumption.
This probably seems straightforward to most people. Nobody likes inflation, right? Wrong. Lots of people like inflation – they’re the ones who either work in government or just worship government power. To these people, inflation is the best thing since sliced bread and sunshine because it allows government to literally create money out of thin air. It is this inflationary prestidigitation that enables politicians to promise something for nothing, because they do not have to resort to direct taxation to pay for things like war and multi-gazillion dollar bailouts. They just wave the magic government wand, say, “Abra-Bernanke” and poof! “Free” money to buy votes with! If the value of the dollar and your life savings gets destroyed in the process, so be it.
Because of the political advantages that derive from inflation, the pressure will always be to inflate the money supply under a fiat system. The best check on this inflationary pressure is a gold standard, which ties the value of the money in circulation to a commodity that cannot be created out of thin air. But this denies politicians one of their most potent weapons, which is why the gold standard is relentlessly attacked by government flunkies and their accomplices in the media and academia.
Nevertheless, the gold standard has a number of advantages that one should consider. First, it has the advantage of actually being Constitutional. Article I, Section 10 states, “No state shall …make anything but gold and silver coin a tender in payment of debts.” To my knowledge, this restriction has never been repealed by Constitutional amendment. Second, the stability provided by the gold standard (when maintained) has never been surpassed by any other monetary system ever devised by man. Monetary stability is as vital to economic calculation as stability in physical measurement is to engineering. Would you want to live in a house that was built by a contractor whose tape measure changed every time he used it? Neither would I. Why would economic calculation be any better with a continually changing currency unit?
Of course, we could just keep all discussion of the gold standard in the shadows where it has been since 1971. After all, there is one other check on the inflationary pressures engendered under a fiat system – reality. At some point, the inflation becomes so oppressive that it simply cannot continue. Even the short-term stimulus effects of inflation cannot be continued without a geometric expansion of the money supply.
So what will it be? Should we consider a return to the gold standard, even if it means accepting the fact that we can’t have something for nothing? Or should we continue on our current path and get the wheelbarrows ready?
Note: Obviously, there’s a lot more to this discussion than I can go into here. If you’re interested, check out the following titles and links:
Gold: The Once and Future Money, by Nathan Lewis
What Has Government Done to Our Money?, by Murray Rothbard
Gold, Peace, and Prosperity, by Ron Paul
“Forget Bretton Woods II – We Need a Gold Standard,” by Walker Todd (Christian Science Monitor)
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7 comments:
There's no advantage in a gold standard over a fixed supply of fiat money. A fixed supply of fiat money would end inflation as surely as a gold standard would. A government on a gold standard could abandon the gold standard just as easily as it could expand a fixed supply of fiat money. This has happened often .
If a government wishes to fix the money supply, it can do this without adopting a gold standard. If a government wishes to expand the money supply it will do so. Asking a government which wishes to expand the money supply to adopt a gold standard is pointless. A government which wished to fix the money supply could do so without adopting a gold standard. A gold standard is unnecessary. What matters is a fixed supply of money.
Crosbie, thanks for your comment. I tend to agree with your larger point about the futility of expecting a government to forego the political advantages of inflation merely out of the goodness of bureaucrats' hearts.
To me, it seems the only way that any government can be expected to maintain a stable currency - regardless of the method employed - is if it becomes politically advantageous to do so. That is, people would have to want the benefits of a stable currency badly enough to make it a deal-breaker for any politician seeking elected office. I fear that it will take a great deal of economic pain before that happens, though.
And to your other point, it seems we also agree that the goal is currency stability - I'm personally agnostic on the means. If a purely fiat standard could be devised that served the same purpose, so be it. But my first question would have to be, "How would the monetary authority know what the appropriate supply of money would be relative to demand?" What would be the basis for comparison?
There's no question that governments have gone on and off the gold standard when it suited their purposes, but when it comes to currency stability over large periods of time, I believe the historical record favors the gold standard for that particular purpose.
Stephen M. Smith, thanks for your reply! Any size of money supply is appropriate as long as it remains unchanged. The monetary authority can always know the current supply is appropriate, regardless of demand. It must also know that any change in the supply is inappropriate.
Yes, Murray Rothbard made this same point in What Has Government Done to Our Money? And I understand what you and he are getting at – the rate of exchange between money and the goods and services purchased with it will fluctuate as needed. More goods and services relative to the money stock, and the dollar price goes down. Fewer goods and services, and the dollar price goes up.
But as I believe Rothbard and others would agree, money itself is a commodity. It is also subject to supply and demand. Sometimes individuals in the market demand more money, sometimes less. Fixing a fiat money supply in stone would necessarily distort the price signal for money itself.
In addition, there are some physical constraints to consider as well. Let’s say the fiat money supply is set at X amount. As the population increases, along with the amount of goods and services produced within an economy, each individual currency unit’s purchasing power increases. At some point, even the smallest currency unit’s purchasing power becomes too large for small everyday transactions. This is one of the drawbacks with using physical gold as well – even a single gram of gold is worth around $25 at today’s rates.
Tying the value of the paper currency to gold helps address these two issues. The real money supply (gold) remains relatively fixed, but the supply of currency can fluctuate in order to account for changes in the demand for that currency. The value of the currency relative to gold remains constant (providing the stability I think we’re both looking for), while the supply of the currency can change as the demand for currency changes.
But once again, I really appreciate your input. I certainly don’t have all the answers, but I think this is precisely the kind of conversation that we will have to have at the national level very soon. It’s good to know that there are people like you who can add real value to the discussion!
Mr. Smith,
Two good things....
1) Your writings have now found their way to Australia.
2) They think that I wrote it all.
http://www.countingcats.com/?p=1030
The discussion in the comment field in interesting in its own right. (I think you're old enough to remember the song by "Charlene" that they're talking about from back in the 70's.)
Thanks for the history lesson! No, I do not think we should continue on the same path and no I don't want to push wheelbarrows to Starbucks. I think we Americans need some education on our politics. We Americans need to start electing people to positions who are willing to change the paths we are following today, question the status quo and actually "think" about what we are doing and where we are going.
Great post. If real 'beginners' are reading this, they may be confused about the talk about 'banknotes'. I was listening to NPR the other day (don't judge me!) - and an economist had to explain what was meant when people like us say "The Fed is just printing more money" since most 'money' is held electronically these days. So, your dollar based holdings in your accounts would be backed, at least in some part, by gold.
Interesting to see the Swiss Franc vs. all other currencies. Over the past few years, the Swiss Franc has outperformed the dollar and Euro and - up until very recently - was backed by a stated percentage in gold.
They eliminated their mandated gold backing not too long ago due to info relating to their gold deposits originating from Nazi Germany. But they still keep a larger store of gold in their central banks than most of us so-called 'economic powerhouses'. Their economy and currency has been remarkably stable.
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