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Posted on 6 Feb 2018 by BullionStar

Should we Restore the Gold Standard?

This blog post is a guest post on BullionStar's Blog by the renowned blogger JP Koning who will be writing about monetary economics, central banking and gold. BullionStar does not endorse or oppose the opinions presented but encourage a healthy debate. 

Would it make sense to rebuild an international gold standard like the one we had in the late 1800s? Larry White says the idea has merit, David Glasner believes it isn't worth the risk. Over the years I've followed the back-and-forth between these two blogging economists, each of whom has done an admirable job defending their respective side for and against the gold standard. Let's look at one or two of the most important themes running through the White v Glasner debate.

Like a ruler measures distances, a nation's monetary standard serves as a measuring stick for the value of goods and services. People need to be able to set sticker prices with the unit, calculate profit and loss, negotiate labour contracts, and establish the terms of long-term debts using it. If the measuring stick is faulty, then all these important tasks becomes unnecessarily difficult.

Gold as Unit of Account

Since 1971 our measuring stick has been irredeemable paper currency, or a fiat money standard. Central banks try to ensure that, within the confines of their nation, the general level of domestic consumer prices stays constant, or at least rises at a constant rate of around 2-3%. And while the first decade of the fiat standard was a disaster characterized by high and rising inflation, central bankers in developed nations have generally managed to keep inflation on track for the last thirty or so years.

To re-establish gold as the measuring stick, each nation's unit of account—say the $ or ¥ or £—would have to be redefined as a certain fixed number of ounces of gold. Banknotes and central bank deposits, which are currently inconvertible, would be made convertible into an appropriate amount of gold. It is important that all nations return to the gold standard rather than just one, because one of the big advantages of an international gold standard is that with all currencies pegged to gold, it is much simpler for citizens of one nation to make calculations using another nation's unit. And this makes cross-border trade and investment easier to engage in.

Should banknotes and electronic fiat currency once again be made convertible into gold?

In Favour of the Gold Standard: Larry White

How well have the two standards served as measuring sticks? As the chart below illustrates, year-to-year changes in U.S. consumer prices were quite variable during the classical gold standard era, rising some years and falling the next. The source for this chart is from this paper that White has coauthored with George Selgin and William Lastrapes. The classical gold standard from which the authors draws their data lasted from 1880—when the majority of the world's major nations defined their currency in terms of the gold—to 1914 when the gold standard was dismantled on the eve of World War I. Data shows that the fiat standard that has been in place since 1971 demonstrates more predictable year-to-year price changes. Citizens of developed nations are pretty safe assuming that next year, domestic prices will rise by 2-3%.

Quarterly US inflation rate, 1875 to 2010

However, it is over longer periods of time that gold outperforms as a measuring stick. In the chart below, the authors show that the quarterly price level during the gold standard tended to deviate much less from its six-year average rate than during the fiat era. Because the general level of prices was more predictable under a gold standard, this provided those who needed to construct long-term debt contracts with a degree of certainty about where prices might be in ten or twenty years that is lacking under a fiat standard. White points out that this may be why 100-year bonds were common in the 1800s, but not so much now.

6-year rolling standard deviations of the U.S. quarterly price level

According to White, the main reason for the long-term stability of gold is the tendency for higher prices to encourage gold miners to increase the supply of metal, thus tamping down on the price, and conversely lower prices to encourage them to reduce production, thus buoying prices. In other words, prices under a gold standard were mean reverting. This mean reversion was generated "impersonally", or automatically, by the market, a superior sort of stability compared to that generated by a fiat standard, which depends on the skills and wherewithal of technocrats employed by the central bank.

Against the Gold Standard: David Glasner

David Glasner is skeptical about the gold standard because he doesn't agree that it mean-reverts fast enough. All of the gold ounces that have ever been mined continue to exist in vaults or under mattresses or around necks. Compared to this extant gold stock, the flow of new gold production is tiny. So if there is an increase in people's demand for gold, it is unlikely that new flows will be able to satisfy it, at least not for some period of time. Likewise, reduced gold production on the part of gold miners won't be able to vacuum up enough of the slack should people suddenly want less of the stuff. In either case, the price of gold will have accommodate shifts in demand by rising or falling quite a bit.

One thing that most monetary economists agree on is that fluctuations in the value of the item used as the standard—gold or fiat money—should not interfere with the "real" economy, say by causing unemployment or gluts of unsold goods. While many prices in an economy are incredibly flexible, like the price of stocks or gold or bitcoin, there are also many prices that are sticky, in particular labour. Under a gold standard, if there is a sudden increase in the demand to hoard gold, then there will be pressure on price of gold to rise. The rise in the gold price means that the general level of prices must fall. Goods and services, after all, are priced in terms of gold-backed notes. But with wages and many other prices locked in place, the response on the part of employers will be to adjust by announcing mass layoffs. Rather than cutting the sticker prices of goods, retailers will suffer though gluts of unsold inventory. This is a recession.

Glasner's favorite example of this occurred during the late 1920s. After WWI had ended, most nations attempted to restore the pre-war gold standard with banknotes once again being redeemable with fixed amounts of gold. But then the Bank of France, France's central bank, began to buy up huge quantities of gold in 1926, driving the gold price up. The U.S. Federal Reserve was unwilling to counterbalance what was viewed as insane purchases by the Bank of France, the result being the worst recession on record, the Great Depression.

What Type of Gold Standard?

Given that various commodity standards have been in place for centuries, why did it take till 1929 for a massive monetary mistake to finally occur? White blames this on large government actors, specifically central banks. In the initial international gold standard that ran from 1880-1914, nations such as Canada, Australia, and the U.S. didn't have central banks. Commercial banks in these nations chose to link their privately-issued banknotes to gold, the goal of these competing banks being to to earn profit rather than enact social policies. So earlier versions of the gold standard functioned far more naturally, without the meddling of large actors who refused to abide by the typical rules of a gold standard. It is for this reasons that White prefers that any return to the gold standard be packaged with an end to central banks, thus precluding episodes like the Great Depression from occurring.

David Glasner remains skeptical. According to Glasner, even the classical gold standard that ran from 1880 to 1914 required management, the Bank of England leaning in such a way as to counterbalance large demands for gold from other central banks and thus preventing anything like the Great Depression from occurring. And even if central banks were to be dismantled under a 21st century version of the gold standard so as to preclude an "insane" Bank of France scenario, there remains the problem of "panic buying" of gold by the public—and the resulting gold-driven recession this would cause.

So Where does that Leave us?

As I hope you can see by a quick exploration of the debate between Larry White and David Glasner, restoration of the gold standard is a complicated issue. I'd encourage readers who are interested to dive a bit deeper into the subject by reading David's posts here and Larry's here.

As for myself, White's work on the 1880-1914 gold standard has been helpful in removing many of the preconceptions I had of the gold standard, no doubt passed off to me by commentators who were never very familiar with the actual data. Nevertheless, I tend to agree with Glasner that under a global gold standard (with no central banks) a sudden spike in the public's demand for gold would impose large costs on the global economy. With citizens of the globe being so connected through the internet and free capital markets, these sorts of episodes might be more common nowadays than they were in the 1800s. I'm not sure the benefits of a gold standard, including exchange rate stability, make up for this risk. Given that Western central banks have done a fairly decent job of keeping inflation under control for the last thirty or so years, I'll give them the benefit of the doubt... for now.

JP Koning
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  • Moy Yew Hon

    Why restore back the gold standard? there are too many fake gold and blood gold going around. The idea of putting intrinsic value to back fiat is not really helpful. We had it before. Blockchain technology should be the one backing fiat as everything is traceable.. As i said before, there is no such thing as a fake bitcoin but there are tons of fake gold and blood gold circulating around. One thing for sure , i wont want my country to be printing more money just because they filled their vaults with tons of fake gold layered tungsten. It’s time for gold to have it’s kodak/myspace moment.

    • Hades Hellspawn

      If your country is that stupid as to hoard that much gold with no check on metallurgic inconsistencies (not that difficult to tell tungsten and gold apart for any competent metallurgist or undergraduate chemistry student), maybe it’s time for you to find a new country.

      • Moy Yew Hon

        every country wants to print indefinitely, will they have so much gold to back up their currency? so the only option is to fake their gold.. in order to print more..maybe its time for you to read more

        • dcohn

          DUMB. Fake their gold. Come now. There are so many simple ways to audit from scanning to size and weight calibrations and this is coming from just someone that knows Gold a bit but I know nothing about banking.

          They are thieves yes but adding in any measure to limit printing unlimited is better than printing unlimited. Meaning even if it fake gold its better then the current NO SYSTEM.

    • dcohn

      Yes I agree with the next post. To even imagine any country not verifying that the Gold is in fact GOLD is moronic.

  • D Frank Robinson

    What are the reasons for large and immediate international changes in the demand to hold gold? Governments going to war and threatening to make war. Gold demand reflects the level of state terrorism globally. The era of high levels of state violence began in the early 20th century. When rampage of statism ends gold will be restored as a standard naturally by international consent.

    • JP Koning

      Banking crises have also caused large increases in the demand for gold, both during the post-1971 era and during the gold standard that lasted from 1880-1914.

  • John

    The Gold Standard was some degree of constraint upon governments debauching their currencies but they still managed it before 1971. Now it’s unstoppable. Isn’t that the main problem to address? Debt-based government-printed money. End the Fed, etc.

  • Dennis Ellison

    the only way the fed has keep inflation low is by changing how it has been measured. it you use the formula from 1979 we have close to 10% inflation now.
    they are GOOD accountants they ask what the answers is to 2+2 before they cook the books

    • JP Koning

      I disagree. Research that crawls online stores for prices has provided plenty of confirmation of official US inflation figures. Check out http://www.thebillionpricesproject.com/

      • Dennis Ellison

        The CPI chart on the home page reflects our estimate of inflation for today as if it were calculated the same way it was in 1990. The CPI on the Alternate Data Series tab here reflects the CPI as if it were calculated using the methodologies in place in 1980. In general terms, methodological shifts in government reporting have depressed reported inflation, moving the concept of the CPI away from being a measure of the cost of living needed to maintain a constant standard of living.
        that is from shadow stats if it was calculated the way it was in 1979 we have 10% inflation

  • Inklet

    When there is a central bank, governments can spend creating new money. They only need taxes to regulate aggregate demand and tame inflation (and deflation).

    In a fiat system, the inflation generated by excessive spending relative to taxes leads to rising prices. The CPI calculation is only an approximation of the real erosion in value of the currency.

    In a gold standard, excessive spending relative to taxes reduces the amount of gold held (and vice-versa). Therefore, the % change in the gold holdings is a much more precise measure of the erosion (or increased value) of a currency produced by the imbalance in the spending/taxes equilibrium.

    It’s not that governments are constrained to spend, it’s just that they have a more precise and real time value of the erosion in the currency and therefore must take measures.

    For that reason I’d like the gold standard restored.

  • John Skar

    JP says “. Given that Western central banks have done a fairly decent job of keeping inflation under control for the last thirty or so years, I’ll give them the benefit of the doubt… for now.” Really, JP? A 97% depreciation (vis a vis gold) since 1971 is fairly under control? (That’s 7.6% per year for 47 years, by the way.) What most people overlook, in addition to the fact that the CPI is a moving target, is that normal productivity gains should reflect in a gradual deflation over time, rather than inflation.

    • JP Koning

      When I wrote “for the last thirty or so years,” I meant since the mid 1980s. Obviously the 70s were a mess.

      There isn’t a huge difference between a stable inflation rate of 2% and a stable 0%. If the former, people can easily organized their affairs to protect themselves i.e. by asking for a higher interest on savings deposits. It is only when inflation veers off target, or gets really high, that the big problems begin.

      • John Skar

        If we stipulate 3% as a rough benchmark for productivity gains, you still have a 5% debasement going on (2% inflation minus 3% productivity). And that’s if you accept the CPI as a fair measure of purchasing power, which I do not, given the self-serving changes to CPI calculation since your turning point of the mid 1980’s (ref: shadowstats.com). Couple that with the fact that savers had relatively high interest rates on their savings during the 1970’s, compared to <1% currently. The debasement appears less in nominal terms, but is similar in real terms. If you look at it from the standpoint of a typical retiree trying to live on a combination of savings and retirement income, I think the current period is just as harsh as pre-1980.

    • dcohn

      HAHAHAHAHA Inflation under control. Are you kidding.

      They bend the numbers as they deem needed each second.

  • Bill Gradwohl

    What I never hear mentioned is the elimination of national currencies and currencies in general. Prices of everything would be set as G:S:C so a typical car would cost 35:10:0 meaning 35 units of gold, 10 units of silver and no units of copper. The units could be ounces, grams, or whatever could be agreed upon. No one would care if the gold was minted in the US, Russia, or on mars.

    This would eliminate currency arbitrage, exchange rates, central banks and would mean that government is out of the “money” business. Price inflation would be a market force, not the whim of some banking cabal. Deficit spending with central banks monetizing the debt would be impossible. Wars would be less likely as now they need to be paid for in cash G:S:C, not thin air “money”.

    • John Skar

      I like the basic idea, but are you going to establish fixed, or floating rates of exchange between the 3 metals? Why not just use gold and the required number of decimal places?

      • Bill Gradwohl

        Let “the market”, an honest market, set the price of each metal. Silver and copper aren’t going to disappear so we might as well use them in their traditional role as sound money to provide a medium of exchange for less costly items. If these metals were again used as real money, their prices wouldn’t fluctuate that much because it wouldn’t be in anyone’s interest to do so. History says that would be the case. It’s much more difficult to dig ore out of the ground than it is to press the enter button on a number with 12 zeros as is now the case.

        However, I’m not completely opposed to your suggestion. I don’t really want to walk around with gold dust in my pocket to buy a stick of gum. Having said that, I also don’t think we would carry any metal on us at all for transactions of any sort. Blockchain technology could replace credit/debit cards and the metals would sit in vaults. Should such a system arise, any number of commodities could be monetized.

        The evil of banking occurred when the bankers discovered they could create fraudulent paper certificates. Government was brought into the scheme so they could take their cut of the con game AND not expose the bankers for their obvious crime. Sound money would eliminate the evil that is the current fiat system.

    • JP Koning

      Getting rid of national currencies isn’t an odd idea at all, indeed folks like Glasner and White have written favorably on this topic. But getting rid of paper money altogether would be a big regression. People want to carry currency, not coins, because it is lightweight and convenient. No one wants to go on a vacation loaded down with a hoard of gold and silver.

      • Bill Gradwohl

        I live in the Caribbean and have a tourist related business. Over the years, more and more of our transactions are on credit cards for which we pay 4% to the bank for the privileged of making them rich.

        Cash is on its way out for a number of reasons, not the least of which is control by the gov’t and the banks, but I repeat myself. Although I personally prefer cash, the bulk of the sheeple want convenience and the illusion of protection that a credit card provides. These are the same people that vote because they believe it makes a difference and it’s their sacred duty.

        Their “friend”, the credit card company will make sure the big bad business people don’t abuse them and the average pick pocket or highwayman doesn’t want plastic. What they fail to realize is that we will eventually build the 4% service fee into our prices, as will every other merchant, and so they end up paying the freight. The end user ALWAYS ends up paying the freight which is why I advocate for an end to corporate taxation because corporations don’t pay taxes, they collect them to keep the rubes (their customers) ignorant of how much they REALLY pay to support their gov’t.

        What I want is an end to fractional reserve banking, and banking as we currently know it. Banks should end up being brokers to bring those with funds to meet with those looking for a loan. I’d gladly pay for honest banking services such as storing my precious metals and being part of a blockchain infrastructure to allow me to use my money via plastic, facial recognition, retina scans, etc without having a wallet. It’s only the misuse of the technology that exists that people object to. That misuse is largely done by gov’t.

        BTW – before retiring I was a white hat hacker that broke into corporate data centers under contract. I understand the technology and I know how to make it secure. It’s the legal system that causes all the holes and the lack of punishment for those that are actually caught. My solution is to kill all predators that INITIATE violence or fraud. No need for prisons or cops.

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