Dispelling Economic Myths #2: The Gold Standard

[Guy Berger]

It's important to distinguish between three different issues: (A) commodity-based money (B) whether the economy should have a central bank and © what the central bank's role in the economy should be. There are people who think that commodity-based money is a nutty idea but nevertheless oppose having a central bank, and people who support having a central bank but don't think the Federal Reserve fulfills that role properly.

I'll focus on (A) and leave (B) and © for a different day.

A commodity-based currency involves fixing the price of a certain commodity by law. (One of the most mysterious things about goldbugs is that many are libertarians, and thus intensely against the government intervening in markets -- but apparently not if it involves fixing the price of gold.) That commodity can be anything, not just gold -- it could be butter, kittens or beach towels. There's no inherent reason to choose gold instead of other commodities, and I'm guessing that its popularity among the gold-standard crowd has a lot to do with nostalgia and/or ignorance.

One argument frequently used against "fiat money" (the kind we have in most economies) is that "it's just paper" or "it isn't worth anything". But this is obviously false -- I can go shopping with the dollars in my wallet and buy whatever I want, including gold. (Though the dollar price of gold will be determined by supply and demand, not the government.) As long as there are other people in the economy who are willing to accept dollars in ordinary transactions, there will be no problem.

A second frequently used argument is that the government can screw around with the supply (and therefore value) of money. Goldbugs are frequently agitated that the government will "debase" the currency by printing too much money and causing inflation. And indeed, the history of fiat money is littered with examples of out-of-control money-printing and hyperinflation. That said, these problems weren't invented with fiat money. A classic example is the Roman Empire -- during its history, the gold coin was continuously debased (by adding cheaper metals) which caused rampant inflation in the Imperial economy. Governments always have a short-term economic incentive to debase the currency, and it's not clear why legislating a fixed price for gold will solve this problem. The government can always legislate a new law. If a government has the political discipline to maintain the fixed price of gold, it probably also has the discipline to maintain the value of fiat money. (Though I suppose you could make some psychological arguments for why that isn't the case.)

Now onto the criticisms of commodity-based money. First, gold is obviously a commodity whose value is determined by supply and demand. If the government fixes the price of gold and the supply or demand changes, the price of gold can't adjust (assuming that the government actively intervenes in the market to maintain the price -- if not, a black market will develop); that means that the prices of every other good will have to adjust instead. For instance, let's say there is a huge discovery of gold somewhere in Africa; that will drive up the supply of gold, and reduce the value of gold (and hence the dollar). This means that the price of every other good in the economy will increase -- inflation. Likewise, let's say that the popularity of gold jewelry increases for whatever reason; this will drive up the demand for gold, and increase the value of gold (and hence the dollar). This means that the price of every other good in the economy will decrease -- deflation.

A second problem is that the supply of gold does not change at the same rate as the size of the economy. Let's say the economy grows by 3%. That means you have the same amount of money chasing a larger amount of goods. In other words, the economy will experience deflation. If the economy shrinks by 3%, there will be inflation.

A third problem results from the fact that, unless every person weighs their gold very precisely, there will always be an incentive for dishonest individuals to tamper with gold coins by shaving small amounts off. This could cause problems under certain gold standard systems.

I am sure there are other arguments I have not thought about.

[Jazzmoose]

The gold standard has to be one of the silliest things to get worked up about I've seen yet. Is it time to dig up William Jennings Bryan yet?

[GA Russell]

Well, I'll weigh in! Here are what I understand to be the Austrian responses to your views:

A commodity-backed currency doesn't fix the price of the commodity - it fixes the price of the currency.

A currency need not be issued by a government. American Express could issue gold-backed travelers checks (if it were not prohibited from doing so as it is now).

The popularity of gold is based upon its long history of being desired by peoples of many (all?) cultures, not nostalgia or ignorance. Should the day ever come when people no longer covet gold, the gold bugs will suggest another commodity to back the dollar.

The reason why you can buy what you want in the US with a US dollar is the federal Legal Tender law, which requires everyone to accept the dollar. If the Legal Tender law were ever rescinded, many people would no longer accept it if they could demand instead gold-backed currency.

Inflation is not an increase in price. It is an increase in the money supply. The government is able to increase the money supply at will because it is fiat money. Prices will increase to the extent that the money supply is increased less the increase/improvement in productivity.

If the economy (production) increases due to increased efficiency (productivity), prices will indeed fall without a change in the money supply. That is a good thing. That is not deflation, which is a decrease in the money supply.

Presumably, when Congress passes the law to back the dollar with gold, it will also outlaw its coins being fraudulently debased with inferior metals or shaved.

[Chuck Nessa]

Are we contributing to a paper Guy needs to write?

[Guy Berger]

Don't have time to tackle all of these at once, but I'll get to them as soon as I can:

Well, I'll weigh in! Here are what I understand to be the Austrian responses to your views:

A commodity-backed currency doesn't fix the price of the commodity - it fixes the price of the currency.

"$1 is interchangeable with x units of commodity G" (the fundamental idea of a commodity-based currency) is exactly equivalent to "the price of 1 unit of commodity G is $1/x dollars". So whether G is gold, gummy bears or guavas, a commodity-based currency involves fixing the dollar price of that commodity. The "Austrian response" seems like complete sophistry to me.

A currency need not be issued by a government. American Express could issue gold-backed travelers checks (if it were not prohibited from doing so as it is now).

Is American Express forbidden from doing this? Presumably if they wanted to, they could buy up a bunch of gold and issue IOUs with claims on that gold. As far as I know this is not illegal.

The popularity of gold is based upon its long history of being desired by peoples of many (all?) cultures, not nostalgia or ignorance. Should the day ever come when people no longer covet gold, the gold bugs will suggest another commodity to back the dollar.

Why not wheat or steel?

The reason why you can buy what you want in the US with a US dollar is the federal Legal Tender law, which requires everyone to accept the dollar. If the Legal Tender law were ever rescinded, many people would no longer accept it if they could demand instead gold-backed currency.

1) In plenty of countries with similar "legal tender" laws but poor monetary policy, people do indeed switch away from the "legal tender" and toward a more stable currency. When economic incentives exist to abandon a currency, people do so. That has not happened in the US.

2) In plenty of countries that don't have laws obligating the US dollar as legal tender, people STILL like to use USD for transactions.

Inflation is not an increase in price. It is an increase in the money supply.

I've heard this before and it's a truly bizarre statement. Whenever anybody (except apparently Austrian economists) talks about inflation, they mean an increase in prices. Try to explain the idea of inflation that involves falling prices ("BUT THE MONEY SUPPLY IS INCREASING!") to anyone.

The government is able to increase the money supply at will because it is fiat money. Prices will increase to the extent that the money supply is increased less the increase/improvement in productivity.

Yes, this pretty much true.

If the economy (production) increases due to increased efficiency (productivity), prices will indeed fall without a change in the money supply. That is a good thing.

I don't see why it's a good thing. At best, in a frictionless economy where prices adust instantaneously, it is a "nothing", because prices are just a unit of measurement. At worst, in an economy where prices adjust at different speeds, it can be very bad because it will lead to substantial economic inefficiencies.

That is not deflation, which is a decrease in the money supply.

Um....

Presumably, when Congress passes the law to back the dollar with gold, it will also outlaw its coins being fraudulently debased with inferior metals or shaved.

[Quincy]

A third problem results from the fact that, unless every person weighs their gold very precisely, there will always be an incentive for dishonest individuals to tamper with gold coins by shaving small amounts off. This could cause problems under certain gold standard systems.

You probably know this, but this is why the dime, quarter, half dollar and old silver dollars have ridges on the edges. A carry over from 1964 and before when those coins had silver in them. The ridges were to indicate whether or not they had been shaved of silver. The penny & nickel have smooth edges. No silver in them, so who cares?

[Guy Berger]

A third problem results from the fact that, unless every person weighs their gold very precisely, there will always be an incentive for dishonest individuals to tamper with gold coins by shaving small amounts off. This could cause problems under certain gold standard systems.

You probably know this, but this is why the dime, quarter, half dollar and old silver dollars have ridges on the edges. A carry over from 1964 and before when those coins had silver in them. The ridges were to indicate whether or not they had been shaved of silver. The penny & nickel have smooth edges. No silver in them, so who cares?

Shaving the edges off pennies and shipping the zinc to China -- that's where the money's at.

Guy

[The Magnificent Goldberg]

A second problem is that the supply of gold does not change at the same rate as the size of the economy. Let's say the economy grows by 3%. That means you have the same amount of money chasing a larger amount of goods. In other words, the economy will experience deflation. If the economy shrinks by 3%, there will be inflation.

Seems to me that this is the KEY point in the world of money. Ideally, the quntity of money needs to change by about the same amount, and in the same direction, as the productive capacity of the economy. Thus maintaining approximately stable prices.

Gold is the stuff that people like to think of in terms of money because it's not as ubiquitous as shit; in fact it's pretty limited in supply. If world money is tied to a commodity that is in limited supply, once the supply has been finished (ie all the gold in the world has been dug up), increases in production can only be made in a deflationary environment. But deflationary environments tend not to be conducive to the investments that increase productive capacity. Hence stagnation. And stagnation at a point at which a probably significant proportion of world population numbers itself among the have nots. What are they likely to do, seeing this is an absolutely permanent situation of a zero sum game?

MG

[catesta]

Are we contributing to a paper Guy needs to write?

If so, the most I can contribute is an illustrative image of Fiat.

I never was too good with my gazintas.

Edited January 3, 2008 by catesta

[The Magnificent Goldberg]

Are we contributing to a paper Guy needs to write?

If so, the most I can contribute is an illustrative image of Fiat.

I never was too good with my gazintas.

There's been a good bit of inflation since THAT Fiat! Look at those flares!!!

MG