A great piece on the gold standard

Grant (via the Mises blog), writing in the WSJ

For most of this country’s history, the dollar was exchangeable into gold or silver. “Sound” money was the kind that rang when you dropped it on a counter. For a long time, the rate of exchange was an ounce of gold for $20.67. Following the Roosevelt devaluation of 1933, the rate of exchange became an ounce of gold for $35. After 1933, only foreign governments and central banks were privileged to swap unwanted paper for gold, and most of these official institutions refrained from asking (after 1946, it seemed inadvisable to antagonize the very superpower that was standing between them and the Soviet Union). By the late 1960s, however, some of these overseas dollar holders, notably France, began to clamor for gold. They were well-advised to do so, dollars being in demonstrable surplus. President Richard Nixon solved that problem in August 1971 by suspending convertibility altogether. From that day to this, in the words of John Exter, Citibanker and monetary critic, a Federal Reserve “note” has been an “IOU nothing.”

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  • blr_p  On December 26, 2009 at 1:22 am

    From your linked article..

    The dollar is faith-based. There’s nothing behind it but Congress.

    What about the value of all the goods & services denominated nationally & globally in that currency ?

    They aren’t faith-based, they certainly exist and have value. Unless their total value decreases drastically in the near future, its hard to see anybody “losing faith” in the currency.

    And that’s really the crux of it all, so long as a country can keep growing, this so-called money system works. I’ll concede here that faith in a country’s ability to keep on increasing the total value of the goods & services it provides is the only incentive to use a particular currency over others.

    So if you can forsee a period of zero growth or negative growth for an extended period in the future thats when we will have to reduce printing of money. Because thats the point when it will no longer be feasible to service present debts based on the faith of future growth. This does not mean the system collapses it just means less gets printed.

    If no growth occurs, there is no more printing, whats in the system remains static and we have the equivalent of your much beloved “gold standard”.

  • Aristotle The Geek  On December 27, 2009 at 2:17 am

    # “They aren’t faith-based, they certainly exist and have value.”
    They do, loosely speaking. To be accurate however, one must say that things don’t have “value,” that “value” isn’t intrinsic, that people place a “value” on something/ “value” something.

    # “And that’s really the crux of it all, so long as a country can keep growing, this so-called money system works.”
    Depends on what you consider “works.” Inflation doesn’t “work” for someone who isn’t employed by the government or one who isn’t Warren Buffett.

    # “I’ll concede…”
    As Grant writes, pure fiat money is just a few decades old. Earlier money was backed by gold in someway. Now it isn’t. So yes, “faith” is an appropriate word.

    # “thats when we will have to reduce printing of money.”
    Not only printing, but also credit expansion through banks.

    # “Because thats the point when it will no longer be feasible to service present debts based on the faith of future growth. This does not mean the system collapses it just means less gets printed.”
    The beauty of fiat currency is that the government you can lawfully default on its debt, generate so much money that the creditors are screwed.

    # “If no growth occurs, there is no more printing, whats in the system remains static and we have the equivalent of your much beloved ‘gold standard’.”
    Wrong. The “gold standard,” to use the term strictly, refers to a system where all notes/credit are backed by gold. In a wider sense, it refers to any money generated on the free market. A system that become static after decades of government abuse can hardly be described as a “gold standard.”

  • blr_p  On December 27, 2009 at 2:59 pm

    # They do, loosely speaking. To be accurate however, one must say that things don’t have “value,” that “value” isn’t intrinsic, that people place a “value” on something/ “value” something.
    So long as printing of money does not exceed the total value of G&S, does it matter whether value is intrinsic or not ?

    # Inflation doesn’t “work” for someone who isn’t employed by the government or one who isn’t Warren Buffett.
    What about credit availability for ppl other than Warren Buffett. Is credit as easy to obtain in a system without inflation ?

    There is still inflation even with a gold standard but its low and this effect has been reproduced in a fiat system provided a central bank mandates it. That is the only sole purpose of the ECB, the fed does more and ours still more. I’m using the ECB as the model for how a central bank ought to operate.

    # The beauty of fiat currency is that the government you can lawfully default on its debt, generate so much money that the creditors are screwed.
    With a gold standard the chances of a default are reduced. But its still possible to default whenever debts cannot be repaid. It would appear the only barrier to default is fiscal prudence but otherwise what is the fall back.

    Were the UK & then US, at the time, justified in killing the gold std ?

    Was it not more important to be able to service debt & recover from a default than to reduce the chances of default which could happen for any number of reasons. In the simplest case if a govt borrows more than it can repay it will default no matter the system in place.

    # A system that become static after decades of government abuse can hardly be described as a “gold standard.”
    Ok, but does it indicate that the fiat system isn’t going to go away even in a crisis, upto as bad as the great depression. It was actually born out of it. Anything worse and we are in new territory. The fiat system does not prevent further crises but does it allow to recover less painfully than with the previous system.

    We’re not talking about a new concept here but one that was in place for a long time and then dethroned because it was incapable of solving the problems of the day in an acceptable manner.

    My point is — if the gold std was as good as its made out to be why has it not endured ?

    It would appear that its not that it did not allow economies to grown but made it difficult for them to recover in the event of a problem. The great depression did it in.

    You could argue they could have still stuck with it but a govt is tasked with a job of solving these problems when they occur. So one tries something new, another watches the effects and its outcome and concludes its a viable alternative. Soon after everyone jumps on the bandwagon.

    Does this not show that a a paradigm shift has occurred ?

    • Aristotle The Geek  On December 29, 2009 at 2:33 am

      Pressed for time this week. Will reply over the weekend.

    • Aristotle The Geek  On January 1, 2010 at 11:00 pm

      # “So long as printing of money does not exceed the total value of G&S, does it matter whether value is intrinsic or not ?”
      What is the “total value” of G&S? Value isn’t intrinsic, but subjective. Hence calculation of totals is impossible. An increase in money supply without any increase in production will lead to inflation because the valuations of millions of people are affected. One cannot use a formula to predict the quantum of change. That’s why the distinction matters.

      # “Is credit as easy to obtain in a system without inflation ?”
      Credit is a different concept altogether, though the politicization of economics masks this fact. In a free market, a person who “has” credit, who has proved his creditworthiness, won’t have problems raising debt. Politics brings in favoritism, red tape and uncertainty, and creditworthy people are left worse off than under a free market.

      # “There is still inflation even with a gold standard but its low…”
      True. Its not that free markets will be free of the phenomenon, only the soviet/ planning board/ central bank version of the same. The free market doesn’t think up Keynesian/ Mankiwean schemes.

      # “But its still possible to default whenever debts cannot be repaid…”
      I will quote myself like so: “government can lawfully default on its debt.” Under a fiat system, one can “default” by printing money, by eroding the value of existing money, and still not be in default “legally”/ “technically.” Under a gold standard/ free market, if one does not repay as per contract, one is in actual default. The Supreme Court will not have the right to declare that “Contracts, however express, cannot fetter the constitutional authority of the Congress.”

      # Were the UK & then US, at the time, justified in killing the gold std ?”
      No. One, governments should not spend more than they earn. Two, if they do, they must repay the debt by raising taxes. Only then will people act to tie the government down.

      Killing the standard only left governments free to steal without victims being aware of the fact. What is deliberate inflation, if not theft?

      # “The fiat system does not prevent further crises but does it allow to recover less painfully than with the previous system.”
      If the previous system refers to a bastardization of the gold standard with a central bank in partial control and governments in complete control of the economy, then yes, probably. But then you are comparing apples and oranges.

      # “if the gold std was as good as its made out to be why has it not endured ?”
      The gold standard was, is and will always be the best foundation for exchange. The problems cannot be attributed to it but to politics. As for why it did not endure, the answer to it is the same as the answer to “why does evil always triumph over good.”

      # It would appear that its not that it did not allow economies to grown but made it difficult for them to recover in the event of a problem. The great depression did it in.”
      I think you have misunderstood what the “gold standard” refers to, and are understating the effects of WWI and British economic policy of that period, and the influence of the (then) newly created Federal Reserve on the Great Depression in the boom and (then) bust. Its interesting that the depression would arrive a decade and a half after the formation of a central bank created to “make things easier.”

      # “Does this not show that a paradigm shift has occurred ?”
      I am not a big believer in paradigm shifts, at least as far as politics is concerned. There was nothing “unique” about any major event of the last century. Regarding systems, one can understand it if people upgrade to superior systems. But “upgrading” to junk makes no sense (one wonders how people can think that money that only derives its value from “because I say so” is superior to money that people value for its own sake) unless one understands that one of the motives is political control.

  • blr_p  On January 2, 2010 at 11:53 pm

    # An increase in money supply without any increase in production will lead to inflation because the valuations of millions of people are affected. One cannot use a formula to predict the quantum of change. That’s why the distinction matters.
    I still don’t understand why the intrinsic matters over the subjective except for the fact that one is more fixed and the other variable. If we reduce to the bare essentials the argument is about fixed rates vs. floats (subject to supply & demand).

    We don’t know the exact value of G&S in the economy, we only know that an imbalance occurs if inflation starts becoming more pronounced. If prices increase across the board then its a sure sign. This remains true whether gold is used or not. So the goal is always to keep inflation as low as possible.

    Now if that goal can be achieved over an extended period of time like it has been for the last 20 years in developed countries then the inflationary effects of fiat money have been contained. Does this not show that inflation can be managed in a fiat system ?

    If so then is the result any different to when a gold std was in place as low inflation is one of its advantages.

    # (one wonders how people can think that money that only derives its value from “because I say so” is superior to money that people value for its own sake) unless one understands that one of the motives is political control.
    Superior only in the sense that the present system can handle crises (internal & external) more gracefully than the previous system. This ability comes at a cost ie a central bank and all that it entails.

    If you do not trust a central bank to keep inflation low, why should you trust it or a govt to remain on the gold standard for generations?

    ..doesn’t the same “because I say so” apply as well ?

    It boils down to how much confidence one has in the particular govt and its currency etc. Losing that confidence can be very expensive.

    No, # One, governments should not spend more than they earn. Two, if they do, they must repay the debt by raising taxes. Only then will people act to tie the government down.

    Killing the standard only left governments free to steal without victims being aware of the fact.
    I suppose you mean vote the incumbent out for one that is less wasteful in its spending.

    But what are the costs of maintaining a gold system ?

    From here
    – loss of ability to tune economic policies to economic conditions resulting in higher unemployment. The stability caused by the gold standard is also the biggest drawback in having one. Exchange rates are not allowed to respond to changing circumstances in countries.

    If your currency becomes weak for some reason. The gold std forces the central bank to increase its interest rate to maintain its gold parity and the most likely result is a recession further compounding the initial problem.

    – the average rate of inflation or deflation over decades ceases to be under the control of the government or the central bank, and becomes the result of the balance between growing world production and the pace of gold mining.

    – gold convertibility increases the likelihood of a run on the currency, and thus amplifies recessions.

    – Check out the “coefficient of variation” of price instability & output between 1879-1913 vs 1946-1990 as explained here.

    # What is deliberate inflation, if not theft?
    I don’t think govts wilfully killed the standard, it died because it was not tenable any longer. The hard currency advocates lost the debate against the inflationists given the circumstances countries faced.

    # Under a gold standard/ free market, if one does not repay as per contract, one is in actual default. The Supreme Court will not have the right to declare that “Contracts, however express, cannot fetter the constitutional authority of the Congress.”
    Correct and it also led to numerous bank runs and panics during a downturn. The gold std officialy only came into being in 1900 by Act in the US but for most of the 19th century it was the defacto std.

    External defaults are more serious than internal ones which might explain why they were the last to be honored till 1971 compared to internal defaults which were done away with in the 30s so that the external debts could be met

    This external balance of payments default is what caused the UK to come off gold in 1931 & later the US in 1971.

    # The gold standard was, is and will always be the best foundation for exchange.
    Yes, so long as govts honour their obligations to redeem in it. I have difficulty seeing it ever return in the future.

    # The problems cannot be attributed to it but to politics. Politics brings in favoritism, red tape and uncertainty, and creditworthy people are left worse off than under a free market.
    Agreed, politics demands govts satisfy a larger portion of the electorate than their rivals. The question is why did politics matter when it did rather than earlier.

    I think one factor is more ppl (ie women) were given the right to vote. Notice the amount of ppl voting in the presidential elections in 1912 is much lower than in the 1920 and thereafter. In the US women got the right to vote in 1920 and 1918 in the UK.

    The gold standard had support so long as only a minority could vote and thereby affect govt. That minority was white men who paid taxes etc. Moment more ppl got the right to vote it became harder for a govt to stay in power and still meet existing obligations. This is why govts go into deficit as often and its manageable so long as those debts are repaid.

    # I think you have misunderstood what the “gold standard” refers to..
    I understood that the only thing that matters is the govt exchange a fixed amount of gold when its currency was surrendered.

    # ..and are understating the effects of WWI and British economic policy of that period,..
    Certainly WW1 played a major role in Britain’s fortunes, the debts owed to the US were overwhelmingly high. They pulled out of the std during WW1 only to return in 1925 for the sake of ‘national prestige’ at the same rate that existed pre-WW1 to protect their existing investments abroad.

    British banking benefitted at the expense of British industry that had to pay higher taxes to service war debt and cost them markets abroad as their goods were more expensive due to the higher exchange rate.

    The Dole (act passed in 1920) reached huge proportions as unemployment kicked in later in the 20s.

    If anything it could be said WW1 played a major role in why Britan could not afford to remain on gold for too long after and pulled out in 1931.

    # ..the influence of the (then) newly created Federal Reserve on the Great Depression in the boom and (then) bust. Its interesting that the depression would arrive a decade and a half after the formation of a central bank created to “make things easier.”
    – Here is a list of panics & recessions for the US. 100 years prior & after the Fed was created. Are the number of panics & recessions more or less prior to the Fed’s creation vs after ?

    – What about the time spent within a recession or the variation in GDP growth over a period of time.

    # I am not a big believer in paradigm shifts, at least as far as politics is concerned
    I meant the shift from hard currency to soft on a global scale. To go from money thats backed by gold to one that is not. Would this not qualify as a paradigm shift as far as money goes.

    “A complete change in thinking or belief systems that allows the creation of a new condition previously thought impossible or unacceptable.”

    The question remains whether the benefits of a gold system outweigh those of a fiat system ?

    • Aristotle The Geek  On January 8, 2010 at 4:02 am

      # “If we reduce to the bare essentials…”
      This is not a technical issue but a moral one. When a currency comes up on the free market, and it is generally some kind of gold standard, people are responsible for their own decisions. Even if inflation occurs, say, due to a gold rush, they were aware of the possibility before choosing the currency they preferred to deal in. In any case, everyone would be free to set their own terms as there would be no legal tender laws that would force them to accept paper as payment.

      In a command economy, its the central bank which “tweaks” interest rates—monetary policy is the fancy term—for a variety of reasons and people have no control over the same. Once you grant intrincism, you allow for the possibility of central planning. Which is impossible.

      # “If you do not trust a central bank to keep inflation low, why should you trust it or a govt to remain on the gold standard for generations?”
      Its not a question of trust at all. The government cannot have any role to play in the economy, and that includes “administering” the gold standard. The separation of the state and economics.

      # “But what are the costs of maintaining a gold system ?”
      For arguments, you look to statist economist DeLong? Here is my reply-
      * “loss of ability to tune economic policies to economic conditions resulting in higher unemployment.”
      – Separation of state and economics. Government shouldn’t meddle in the economy.
      * “Exchange rates are not allowed to respond to changing circumstances in countries.”
      – The “exchange rate” reflects the quantity of gold tied to the currencies. A country that overvalues its currency will see gold flee from its shores. Statists don’t like that. They always want to eat other people’s cabbages. Solution: don’t fiddle with the money supply.
      * “If your currency becomes weak for some reason.”
      – Bah! See above.
      * “the average rate of inflation or deflation over decades ceases to be under the control of the government…”
      – That is a bad thing? Only to a statist.
      * “…becomes the result of the balance between growing world production and the pace of gold mining.”
      – Meaning the market determines the rate, and I don’t like it; my friend Krugman concurs!
      * “gold convertibility increases the likelihood of a run on the currency.”
      – Only if you overvalue. Solution: don’t do it.
      * “But because economies under the gold standard were so vulnerable to real and monetary shocks, prices were highly unstable in the short run.”
      – Meaning what exactly? As if prices are very stable under fiat currency.

      # “it died because it was not tenable any longer. The hard currency advocates lost the debate against the inflationists given the circumstances countries faced.”
      It was never a question of tenability or a real debate in any sense. Governments didn’t want to follow any principles; the standard forced them to do so; hence they trashed it. The “circumstances” were convenient to them just like 9/11 was convenient to power hungry crooks in government.

      # “it also led to numerous bank runs and panics during a downturn.”
      A “bank run” would not occur if a bank that held deposits kept a 100% reserve. I recently read an article on the difference between a deposit contract and a loan contract. Don’t remember where, but not many people understanding the difference between the two.

      # “External defaults are more serious than internal ones”
      Stealing from one’s relatives is better than stealing from strangers? Again it comes down to living beyond one’s means. If governments learned to live on current income, and as long as one isn’t bribing ones voters or padding the pockets of special interests, that isn’t a difficult ask, there would be no defaults.

      # “I have difficulty seeing it ever return in the future.”
      So do I. I don’t expect thieves to have change of heart.

      # “I think one factor is more ppl (ie women) were given the right to vote.”
      Right to an extent. The real problem is that voting was used to determine standards rather than determine methods. Its like voting on whether murder should be a punishable offense or not vs. determining the maximum punishment for murder.

      # “I understood that the only thing that matters is the govt exchange a fixed amount of gold when its currency was surrendered.”
      The gold standard doesn’t require a government or government currency for it to function. The pure standard only requires gold coins being used as a payment mechanism. Private mints can do a far better job of quality control than any government anywhere in the world.

      # “at the same rate that existed pre-WW1 to protect their existing investments abroad.”
      That was the problem. The reinstatement should have occurred at a lower rate to compensate for all the money that was printed without any backing.

      # “Are the number of panics & recessions more or less prior to the Fed’s creation vs after ?”
      Don’t go by numbers. The question is how many of them occurred because of government interference in the economy?

      # “Would this not qualify as a paradigm shift as far as money goes.”
      When Wiemar and Zimbabwe play out on a global scale, something will give.

      # “The question remains whether the benefits of a gold system outweigh those of a fiat system?”
      For someone approaching the question from a moral position, it is a non-question. The mere presence of “fiat” makes it so.

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