What is monetary standard
Myth: The gold standard is a better monetary system.
Fact: The gold standard causes deflation and depressions.
The far right advocates the gold standard because it gets government out of the business of controlling the money supply. They fear that printing money creates inflation, and retracting money causes recessions. But the opposite is also true: printing money cures recessions, and retracting it cures inflation. Governments in the last 60 years have used these policies with tremendous success. There has not been a single depression or bank panic in any nation anywhere in the world using Keynesian monetary policies. But during the Gilded Age of the late 19th and early 20th centuries, depressions and bank panics were common. The historical record is so strong that mainstream economists reject the gold standard almost universally.
Once the subject of heated national debate over 100 years ago, the gold standard today has nearly disappeared as a political issue. The world has abandoned the gold standard in favor of so-called "paper money," and only a diminishing group on the far right continues to call for its return. However, if mainstream economists (on both the left and the right) have anything to say about it, there will never be a return to "that barbarous relic," as John Maynard Keynes called gold over 60 years ago.
Even so, defenders of the gold standard include such former presidential candidates as Jack Kemp and Stephen Forbes. Furthermore, the rise of well-funded, right-wing think tanks in the last few decades has managed to resurrect the issue. Therefore, reviewing the arguments of the "gold bugs" -- as they are irreverently known in academia -- is well worthwhile, if only to screen our presidential candidates for obsolete economic ideas.
The reason why the far right opposes the current money system is because it allows the government to control the size of the money supply. They argue that an unscrupulous government might pay its bills by printing more money, which would cause inflation. They also argue that shrinking the money supply allows the government to create recessions. Under a gold standard, the total value of money would be fixed (or nearly so), and the market would adjust itself efficiently around it. In his book, The Theory of Money and Credit, Ludwig von Mises wrote: "The excellence of the gold standard is to be seen in the fact that it renders the determination of the monetary unit's purchasing power independent of the policies of governments and political parties."
Mainstream economists, however, have a powerful counter-argument. The current system might, in theory, allow an unscrupulous government to create inflation or unemployment, but it also allows the government to fight inflation and unemployment. And that is a tremendous achievement, because not one nation around the world using Keynesian monetary policy has experienced a depression in the last six decades. It appears that we eliminated depressions when we eliminated the gold standard.
It hasn't been for lack of opportunities. In 1987, the U.S. stock market crashed, in a "meltdown" that was even worse than the Crash of 1929. But the Federal Reserve had learned its lessons from the Great Depression, and this time it responded correctly: with a sharp expansion of the money supply. And not only was there no depression, but there was no recession either -- in fact, the remarkable economic boom of the 80s continued without even a bump. Under a gold standard, the Fed would have been robbed of this anti-recessionary weapon.
Of course, the gold bugs have developed a set of apologetics for arguments like these. To put everything in perspective, it is helpful to trace the evolution of the monetary system, from its very beginnings to the rise and fall of the gold standard. The reason for starting at the beginning is twofold: even the basics are disputed by people who believe themselves informed on the issue, and many lay persons might not know them anyway. So, with apologies, let's start with the invention of money.
The history of monetary systems
The first economic activity was undoubtedly bartering. Two people would make a direct exchange: say, food for furs. However, bartering is a most inefficient trading system. If the person with furs wanted food, but the person with food wanted wood carvings, they would have to search for a third party with wood carvings before they could make their trade. And the third party may not want either of their tradeables, requiring a search for a fourth party -- as you can see, the process quickly becomes unworkable.
The invention of money solved this problem. As a medium of exchange, money allows people to conduct multi-person bartering without all the effort of searching for a hundred people before making the transaction that everyone wants. True, a hundred people may indeed be involved in the final transaction -- but no thought or planning has to go into it, because money, by some miracle of economics, eliminates such a need. In short, money is a tool that allows for easy and painless multi-person bartering. In and of itself it has little or no intrinsic value.
But the invention of money presented a problem of what should be used for it. Suppose that a common resource like stones was used for money. The problem is that tradeable goods are limited -- it may take all day to hunt game or weave a rug. When you put your final product on the market, buyers will compete for it, because, after all, everyone desires to hoard wealth. The first buyer may pick a rock off the ground and offer it to you, whereupon a second buyer will pick up two rocks and better the offer. Soon a bidding war erupts, with buyers picking up rocks as fast they can. In the end you might receive an entire rock quarry for your marketed good. This example highlights two absurdities. First, this is the essence of inflation. When there is too much money available, prices soar, and tons of money are needed to buy things. Second, it is a waste of human and natural resources to dig up so much money -- people might as well devote all this effort to producing the actual goods.
So early money had to be made out of something rare. Silver and gold met this requirement, although some societies used other rare materials, like conch shells among African tribes. However, money that is too rare has the opposite effect described above. Suppose that a village is using gold for money, but unfortunately there is only one gold nugget. Whoever possesses that nugget will be able to buy literally anything in the village -- but only once. After surrendering the nugget for an item, that person will then have to turn around and offer literally anything to get it back. Because the village has numerous people waiting in line to use the nugget for money, economic activity will slow down to a crawl, unemployment will rise, and the result is a recession. This example highlights another principle: money needs to be divisible. The village's economic activity would be doubled just by cutting the gold nugget in half. Of course, dividing money is the same thing as expanding the money supply.
So the amount of money has to be optimal -- not too much, but not too little, to support the natural amount of trading that goes on. As you can see, this calls for some knowledge of the amount of economic activity that normally occurs. An economist would need to measure this activity, and calculate how many coins would cover this activity without causing either inflation or unemployment. One of the practical ways to do this is to watch the economic indicators: when inflation starts rising, cut back on the money supply; when unemployment starts rising, expand the money supply. This approach is called Keynesian monetary policy, after the British economist who devised it, John Maynard Keynes. But when the money supply is determined by some completely arbitrary factor, like the amount of gold that happens to be in the hills, then the odds that the money supply will match the amount needed are virtually zero.
An insufficient money supply is not the only thing that can cause a recession. Recessions commonly occur when people start hoarding money. In normal economies, there is a circular flow of money, as my spending becomes part of your earnings, and your spending becomes part of my earnings. But for some reason, you may see tight times ahead, and decide to save your money to get through them. But this only makes things worse on me, because I am depending on your spending. So I respond to tight times by hoarding my money also. The result is a drop in economic activity, rising unemployment, and recession. Keynesian monetary policy calls for expanding the money supply, which puts more money in the hands of consumers, restores their confidence, and encourages them to begin spending again.
Gold bugs argue that we don't need to adjust the size of the money supply to match the level of economic activity -- the value of money will automatically adjust itself to the level of economic activity. Here's how it works. Suppose three people live in a village, and they have 100 gold coins among them. And suppose this covers 100 units of work. A loaf of bread may require five units of work, and therefore cost five gold coins. Now suppose that their economy grows to 120 units of work. There are two ways for the money supply to adjust to this new activity. The villagers could simply add 20 more coins to their money supply, so they now have 120 coins. Or they could let the value of the coins increase.
How would that work? Well, suppose the extra 20 units of work is being produced by just one of the three villagers. Obviously, he is eager to sell his product, just as the other two are eager to buy it. But no one can afford the sale, because there is insufficient money. So they artificially "create" money by lowering their prices for all their other goods, to increase their savings so they can buy it. For example, a loaf of bread still requires five units of work, but they may lower its price from five to four gold coins. The extra gold coin can now be used towards the purchase of the new product. This process is called deflation.
Prices do indeed inflate and deflate in this way. The problem is that this process is terribly inefficient. In real economies, prices tend to be "sticky" -- that is, enormously resistant to change. (At least in a downward direction. In an upward direction, they climb easily. This is good if you want to fight inflation, bad if you want to fight unemployment and recessions.)
There are several reasons for price stickiness. One is psychological -- people hate to cut their prices and wages. Another is that salaries and wages are often locked into contracts, the average of which is three years. And for many, raising prices incurs certain costs (reprinting, recalculating, reprogramming, etc. not to mention a dip in business) that may not make the price change seem worth it. Even if they do decide to change prices, it takes many companies quite some time to put them into effect. Sears, for example, has to reprint and remail all its catalogues. But perhaps the most important reason is that in a big and complex economy, people just don't realize at first when goods start becoming excessive on the market, and the glut may have to reach severe proportions before people notice it and take action.
Price stickiness means that the value of money is slow to adapt to changing economic conditions. Economists have found it much faster and simpler just to expand the money supply and cut the recession short. The Great Depression, for example, dragged on for ten years, with the natural deflation of money proceeding at a glacial pace. It wasn't until World War II that the government was forced to conduct a massive monetary expansion (to fund its defense spending). The result was such explosive economic growth that the U.S. economy doubled in size between 1940 and 1945, the fastest period of growth in U.S. history. Another example is Japan in the 1990s. Its economy has stagnated for five years now, and many economists have criticized its government for not doing enough to expand the money supply. But whatever the solution, the important point is that Japan's government has done very little, and its economy has not deflated or adjusted itself -- Japan's economic pain continues five years later.
But let's return now to our history of money. Historians debate the exact sequence and nature of events that led to our current monetary system, but the following fictionalized account is often retold and widely accepted as reasonable.
Suppose that an economy starts by using gold coins. There are disadvantages to circulating gold: large purchases require lugging around lots of the heavy metal, and a family might be worried about protecting its gold reserves from thieves. So people may decide to store their gold in a secure, centralized location: perhaps the goldsmith, who already protects his store of gold in a large safe. The goldsmith accepts their gold, and, to keep a record of who owns what, writes them a receipt for their deposit. So the goldsmith has now become a banker.
When the people have spent their pocket change and need to draw on their gold reserves for more, they can visit the bank and make a withdrawal. But that wastes a lot of time and effort. Instead, people can just buy their goods with their receipts for gold, rather than the gold itself. The seller then becomes the new owner of the receipt, and the share of gold it represents, and he can visit the bank and trade the receipt for gold any time he wants. Of course, he may want to use the receipt himself in another sale. In this way, people start circulating receipts for money, and paper money is born.
The banker soon decides to facilitate this system, by issuing receipts that say, "This bank will pay the bearer of this note 10 gold units upon demand." Now the receipts have become banknotes. and the bank has become a bank of issue. The banknotes, like the gold coins they represent, are called commodity money, because they are based on commodities like gold or silver.
But under the new system, the banker notices that people are visiting his bank much less frequently. His gold stocks are just sitting around. So he gets a bright idea: he'll print up some new banknotes
and issue them as loans. The new banknotes are not backed up by actual gold reserves, but he can get away with this because only a percentage of the note-bearers come in on a given day asking for their gold. It's profitable for him, because he collects interest on the loans, and it's profitable for the people, because they can increase their productivity. So from now on the bank will issue banknotes on a fractional reserve, and the bank itself will become a trust, because people must now trust that the banker will have the gold reserves to cover their withdrawals. And the banknotes are no longer called commodity money, but fiduciary money, after the Latin word fide, meaning trust.
Of course, if too many people come in at once demanding their gold, the banker is out of luck. Experience may teach him that he needs to keep a reserve ratio of 1 gold unit to 3 banknotes. Any more banknotes and he might not be able to cover withdrawals. Still, this is a somewhat risky business, because it creates the possibility of a bank run or bank panic. That happens when people become afraid that a bank may not be in sound condition, and they start withdrawing their gold to protect themselves. Once this process starts, however, it becomes a vicious circle, as disappearing reserves create yet more panic and more customers running to the bank to be the first to withdraw their gold. The result is a bank failure, leaving most of the customers holding worthless banknotes. These sort of bank panics have the effect of reducing the money supply, which can -- and often did -- result in higher unemployment, recession and even depression.
Fiduciary money was widespread in Europe by the early 19th century. During the Napoleonic wars, however, Britain found itself hard-pressed to fund its war effort. So the Bank of England temporarily scrapped the fiduciary system and issued fiat money instead -- money whose value was determined not by gold, but by the command, or fiat, of the government. After the war, England returned to a fiduciary gold system, although people were not allowed to cash in their notes for gold unless it was for very large amounts, usually for international trade.
Temporarily suspending the gold standard in favor of fiat money during times of war became common over the next century. During the American Civil War, the government interrupted its policy of gold convertibility and issued nonconvertible "greenbacks" instead. During World War I, all belligerent nations did much the same. It is interesting to note that during times of war, when a nation's survival is on the line and it must boost productivity, the economic policies its leaders resort to are always liberal ones. Fiat money, tax hikes and Keynesian monetary expansions result in booming economies, hence the truism that "war is good for the economy." It took economists and politicians over a century to learn that these policies could be applied during times of peace as well.
In 1821, Britain became the first nation to switch to a full gold standard. Until then, nations had used a bimetallic regime of gold and silver. In the 1870s, the U.S. and the rest of Europe followed suit, after the discoveries of huge gold deposits in the American West. From then until 1914, the world would operate under a unified gold standard. This era is known as the Gilded Age, and it offers us a chance to assess the advantages and disadvantages of the gold standard, or at least an early version of it.
Bitter controversy over the gold standard was a hallmark of the Gilded Age. It was widely regarded as a tool of the rich. Democratic presidential candidate William Jennings Bryan spoke for the poor when he charged, famously, that "You shall not crucify mankind upon a cross of gold." The U.S. suffered three depressions during the Gilded Age, and the gold standard and its bank panics were often held to blame.
Throughout this era, the value of gold was fixed at a certain price. One U.S. dollar, for example, was defined as 23.22 grains of pure gold. A British pound sterling was defined as 113.00 grains of pure gold. This meant that the total value of a nation's money supply was determined by the size of its gold reserves. Furthermore, fixed rates meant that international exchange rates were also fixed. In other words, the world operated under a single, unified monetary system. One British pound always equaled 4.8665 U.S. dollars (113.00/23.22), at least according to the official rate. The actual rates might fluctuate, due to the shifting supply and demand of international trade, but the nations set up a system to make sure that they never fluctuated too far from the official rate. This system was rather complex, but basically it kept exchange rates stable and close to the official rate by making sure that nations with trade deficits paid their bills quickly and directly in gold. (1)
But there were economic consequences to such a system. Suppose Britain ran up a trade deficit with the U.S. and promptly paid in gold. The U.S. money supply would expand, and its economy would experience a mixture of inflation and growth. Conversely, the British money supply would shrink. Theoretically, this should have resulted in deflation, but in practice it resulted in widespread unemployment, due to price stickiness. Therefore, outflows of gold from a country were often very painful to its economy. And when people learned that gold was leaving the country, they often conducted bank runs, trying to withdraw their gold before it ran out. Thus, the Gilded Age was replete with bank panics and failures.
The Gilded Age was brief, lasting from the 1870s to 1914, when World War I broke out. During the war, nearly all nations either placed restrictions on gold convertibility or issued non-convertible paper money. But one of their top priorities after the war was the recreation of the full gold standard. It took several years before they succeeded. Britain restored its gold standard in 1925, but in an act of folly, made the pound worth $4.86 again in U.S. dollars -- its old, pre-war parity. Unfortunately, the pound was overvalued at this price now, due to changes in the price of gold, and Britain subsequently experienced a drastic outflow of gold. Again, severe unemployment was the result, not the expected deflation. Britain would struggle with unemployment for the rest of the decade.
By 1928, all the major currencies and most of the minor ones had returned to the gold standard. But the coming Great Depression would lay bare all its disadvantages. A unified monetary system meant that no nation could protect itself from a disaster that occurred in another nation. When the depression struck in the U.S. it quickly ricocheted across the Atlantic. In the U.S. two gigantic bank runs caused over 10,000 bank failures. So many people were left holding worthless banknotes that the money supply shrank by about a third -- a catastrophic reduction.
When Roosevelt took office in 1933, unemployment had soared to nearly 25 percent. His inauguration took place literally in the middle of a third bank panic. Roosevelt stopped it in its tracks by doing something novel: he intervened. He declared a "banking holiday" that closed banks to the public for eight days, to prevent further withdrawals. During that time, the banking system was reorganized. When banks finally reopened, banks deposits actually exceeded bank withdrawals. It was a tremendous political success for Roosevelt, and America's last bank run. Later under the New Deal, bank deposits would become insured by the federal government.
After the Great Depression struck, the world wasted little time severing its ties to gold. Britain left the gold standard in 1931, as did the U.S. in 1933. By 1937, not a single country remained on the gold standard. After World War II, the U.S. partially restored the gold standard for international trade. And to prevent citizens from bank panics, it made its currency inconvertible at home. In 1971, a diminishing gold supply and growing deficits caused the U.S. to suspend the gold standard even for international trade. Ever since, international trade has been based solely on the dollar and other paper currencies. Today, there are no mainstream economists who call for a return to the gold standard; it is widely regarded as a fringe idea of the radical right.
Modern arguments on the gold standard
Gold bugs cite two reasons in particular for returning to the gold standard. The first is that it prevents nations from an irresponsible expansion in the money supply to pay its debts. This is what happened to Argentina. After printing too much money and suffering disastrous inflation, Argentina passed a law tying its currency to the U.S. dollar. This may not be the optimal strategy for Argentina, but it's far better than what it was doing. Likewise, Italy has sought a measure of monetary responsibility by tying its currency to the German mark. So the gold bugs do have a few case histories to point to.
Even so, this reason is weak. Argentina did not need a gold standard to tie its currency to a more responsible country and solve its problems. Furthermore, a monetary policy that's right for one country might be completely wrong for another. For example, in the early 1990s, Europe tried to unify its currency by tying it to the German mark. But subsequently the German economy boomed while the rest of Europe became mired in double-digit unemployment. And following Germany's anti-inflationary monetary policy only made things worse, because it was exactly the opposite policy they should have been following. Finally, many countries have established long and sound reputations with fiat money -- Switzerland, Japan and the U.S. for example.
The second reason cited for a gold standard is because it creates certainty in international trade by providing a fixed pattern of exchange rates. The current system contains a degree of uncertainty -- in the last five years, the dollar has swung between 80 and 120 yen. This tends to make economic analysis and planning difficult for international traders. The costs of such uncertainty are difficult to determine, but they are expected to be significant. However, trade comprises only 10 percent of the U.S. economy, and compared to the enormous benefits of fiat money, these costs are minuscule by comparison.
What are the benefits of the current system? The most important has already been mentioned: the elimination of depressions. Being able to expand the money supply in times of unemployment and recession is a critical tool for government. Before World War II, eight U.S. recessions worsened into depressions (as happened in 1807, 1837, 1873, 1882, 1893, 1920, 1933, and 1937). Since World War II, under Keynesian monetary policies, there have been nine recessions (1945-46, 1949, 1954, 1956, 1960-61, 1970, 1973-75, 1980-83, 1990-92 ), and not one has turned into a depression. In fact, no nation in the world has suffered a depression under Keynesian policies.
The current monetary system also gives us protection from less scrupulous or unfortunate countries. A bank run that starts in Europe is not going to end up in America, thanks to the flexibility and autonomy of the Federal Reserve Board.
And fiat money also gives economists a chance to tie the appropriate size of the money supply to what's actually happening in the economy. In the end, the amount of gold a nation has is completely irrelevant to its level of economic activity. Gold is a commodity that experiences price swings. A change in dentistry or electronics is enough to change the entire market. To see how unrelated it is, consider the following trends. Since the U.S. dropped the gold standard in 1971, the price of gold has risen tenfold. But consumer prices have risen only two and a half times. If the U.S. had instituted a full gold standard in 1971, the result would have been the worst deflation since the Great Depression. And considering that widespread unemployment is usually the result, not deflation, it is easy to see the why such a policy would increase the risk of a depression.
Gold bugs also face an enormously challenging question: what kind of gold standard would they like to create? One based on fractional reserves? But that led to countless bank runs. Furthermore, as a practical matter, it doesn't stop banks or governments from changing the money supply, simply by changing the amount of fiduciary notes.
So the only purist alternative is a return to commodity money, where a bill is backed 100 percent by gold. But there is no longer enough gold in the modern world to cover the needed economic activity. We have already mined all the major deposits, and without new discoveries to match the growing economy, a pure gold standard would see a troublesome fall in commodity prices. Even worse, industry is also increasing its demand on the gold store. In past centuries gold had very little secondary use, so it proved useful as money. Today, modern technology has found a growing number of applications, and industry is consuming more and more of it. In response to all this, a monetary authority could periodically reduce the amount of gold defined as the dollar, but this is no different from the floating, fiat money that the gold bugs so bitterly criticize.
So the gold bugs would have to resolve historical and theoretical challenges of King-Midas proportions before they could ever reinstate the gold standard. But if a workable gold standard requires a tremendous amount of design, effort, regulation and safeguards, we might as well use fiat money, which is already simple and enjoys a successful track record.
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1. The method of paying trade deficits during the Gilded Age worked something like this. Suppose Britain bought more products from the U.S. than vice-versa. Britain therefore owed the U.S. money; it had a trade deficit. Obviously, the British needed to pay the Americans in their own currency, dollars. So the British demand for dollars rose, and this drove up the price of the dollar on the foreign exchange market. The British could have simply paid the higher price, but they also had a second option by international agreement. They could convert their British pounds into gold, ship it to America, and then sell the gold for dollars at the higher American price. This saved them money only when the deficit became large enough to justify the cost of a trans-Atlantic shipment of gold. This cost threshold was known as the "gold point," and it ensured that the actual exchange rate did not fluctuate too far from the official exchange rate. In short, this system meant that Britain paid its deficit quickly and directly in gold.Source: www.huppi.com