Gold Standard Fallacies I

Understanding Gold 8

There’s a very odd thing about a gold standard.  Hardly anyone understands it, least of all economists.  It’s not like there is no record of the previous three centuries.  From the late 1600s until the 1970s, major developed economies maintained their monetary base by linking their currency to the stability of gold.  We have the ability to examine the recorded history of economies that operated under gold standards.  The data is available and can be held to a microscope.  There is no necessity to solve a historical gold standard riddle through spelunker discoveries, translation of crude hieroglyphics, or archeological ruin digs—though from the misinformed institutional discussion of gold, one may believe this is the case.

The academic history of the gold standard is like a Stalin group photo.  Depending on one’s ideological purity with, or threat to, Stalin’s leadership, subsequent releases of the photo edited out those individuals who crossed the constantly changing party line.  Soviet censors disappeared them from the photo as if they never existed.  It is the altering of history by omission.  Academia has done its best to edit out the gold standard from institutional memory by omission.  Despite its prominence and wide acceptance in monetary history for three centuries prior to 1971, today there is only cursory acknowledgement from academia of the gold standard’s role and sadly, even less understanding of it.  

What remains of gold standard discussion in academia and the mainstream financial media is filled with misinformation.  Academia equates the gold standard to an economic version of a shadowy, scary, urban myth boogeyman.  Sure, the global financial system is unstable and in the process of spinning out of control, but it could be worse.  The gold boogeyman could return.  As long as Keynesian thought maintains its near monopoly stranglehold on the academic curriculum, serious discussion of gold’s monetary stability remains the provenance of alternative sources.

Purpose of a Gold Standard

A gold standard can only do one thing.  It can maintain the stability of a currency’s value.  That’s it.  That is the sole purpose of monetary policy despite misguided Acts of Congress that attempt to legislate desired economic goals.  A producer needs a stable currency to equitably enter into long-term contracts and plan for the future.  Savers and pensioners need stable currency to maintain the value of their savings that represent their productive effort.  Wage earners need stable currency to honestly reward their economic output.  An economy needs stable currency to lay the foundation for sustained economic growth.  The global economic system needs stable currency to facilitate equitable free trade, reduce tensions, and advance mankind.  Anytime the value of a currency changes, someone is cheated—either a debtor, creditor, saver, pensioner, wage earner, or recipient of the terms of a contract.  Government has an inherent bond with its citizens to maintain currency stability.  When it cheats its citizens of their productive efforts through currency manipulation, it breaks the trust and society frays. 

Because a gold standard maintains the value of currency, justification for currency manipulation requires demonization of gold.  Gold’s stability thwarts currency manipulation.  Academic orthodoxy is happy to accomplish this goal.  The mere mention of gold in professional circles immediately associates one with the pejorative “gold bug”.  This is code for craziness and is a career killer for any serious member in the policy realm.  In this day and age, one would think a gold standard advocate could out oneself from the closet without career recrimination.  This relegates serious discussion of a gold standard from public institutional learning to private citizen-based knowledge sharing.  Into this vacuum, entrenched gold fallacies solidify in the economic canon.

The Supply of Gold

Every discussion of a gold standard starts with the availability of gold.  Gold’s preciousness limits its availability.  The argument is that there is not enough gold to back currency.  Currency supply is therefore limited to the availability of gold reserves, which in turn limits economic progress. This recent Bloomberg article exploring the revival of interest in a gold standard illustrates the misconception.

“Decades ago, the amount of cash circulating in a country was often limited by the stash of bullion held in its coffers.”

Again, countries have successfully operated gold standards in the previous three centuries.  If the amount of gold held in reserve restricted currency managers from issuing the supply of currency demanded by an economy, operational gold standards would never have enter into existence.  History would not have recorded a 300 year history of successful gold standard operation.

David Ricardo described this fallacy in his “Principles of Political Economy” in 1821:

….. it will be seen that it is not necessary that paper money should be payable in specie to secure its value; it is only necessary that its quantity should be regulated according to the value of the metal which is declared to be the standard….. A currency is in its most perfect state when it consists wholly of paper money, but of paper money of an equal value with the gold which it professes to represent, (pp. 238-44, Everyman’s Library edition)

Under a gold standard, there is no connection between the amount of gold reserves that back a currency and the currency issuer’s ability to meet the currency demands of an economy.  The only “real” reason that a nation need hold gold reserves under a gold standard is for trust.  A gold standard that provides convertibility, the citizens right to exchange currency for gold at the parity rate, forces government honesty.  Under a gold standard with convertibility, currency devaluation results in the POG rising above the parity rate and an outflow of gold.  The outflow of gold forces the currency manager to either return to the parity rate or deplete its gold reserves. (In the case of Bretton Woods instead of the Fed reducing excess currency supply that resulted in persistent gold outflows, Nixon terminated the international monetary system linked to gold.)  This explains the automaticity of a gold standard.  A gold standard requires no hindsight data, Ph.D theory, legions of supporting economists, or Maestro Fed Chairman brilliance for operation.  The gold signal is self-correcting.  Any change in currency from the fixed parity point signals that the currency manager must adjust currency supply to meet demand.  In the case of devaluation, the currency manager reduces supply until the parity point is reached.

From 1880 to 1930, the U.S. monetary base increased from $897 million to $6,999 million.  Gold reserves varied from 10% to 60% of base money.  The dollar gold parity point remained at $20.67/oz throughout this period.  The U.S. gold standard accomplished this because there is no connection between currency issuance and gold reserves.  From 1880 to 1970 U.S. base money expanded by 69x.  (Adjusted for FDR’s 1933 devaluation of gold from $20.67 to $35/oz, the “gold value” expansion of base money was 41x.)  During the same period total world gold supply expanded by 6.51x.  Again, under a gold standard there is no connection between the availability of gold and a currency manager’s ability to expand supply as needed.

Japan had virtually no gold reserves from 1950 to 1975.  Yet, Japan remained on the Bretton Woods international gold standard until its collapse.  Bretton Woods linked the dollar to gold and the yen to the dollar at fixed rates.  Bretton Woods established the yen on a gold standard despite the absence of any gold reserves backing the yen.  Japan cut taxes every year and grew like crazy during the BW era on the twin foundation of stable gold-backed money (with no gold reserves) and low taxes, the magic formula for growth.

Hjalmar Schacht in 1923 returned Germany to a gold-based rentenmark after hyperinflation made worthless the Weimar mark.  He did this with the Rentenbank apparently holding no gold bullion, in a weeks time, operating from a janitors supply closet, with a staff of one secretary.  Schacht accomplished this by managing the rentenmarks supply to maintain the gold parity.  Even amid complete economic ruin with no gold reserves, it is possible to link a currency with gold, achieve stable money, and return to economic growth.

There is ample historical evidence that under a gold standard currency supply is in no way related with gold reserves.  Yet this canard is accepted as fact and repeated as conventional financial wisdom.  Over the previous three centuries, educational institutions and global citizenship accepted the opposite as fact.  They inherently understood gold’s stability and the necessity of currency linked to gold.  Among all the tremendous advances in science, medicine, and technology, monetary policy has progressed backward.  We are repeating the same cyclical monetary error that has limited economic progress since the beginning of organized financial society.  Seduction from the lure of “free money” and its deleterious effects seems eternal.  

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