The Myth of the Gold Standard
by Edwin Ivanauskas | Tags: Personal Finance, Investing, Banking
Due to a combination of the recession in the U.S. and the typical fear mongering that comes with one, gold as an investment has been in the spotlight. People like Glenn Beck will tell us that the collapse of our economy is on the horizon and the only way we can be safe is by putting our investments in gold, among other sillier things.
I don't intend to discuss gold as an investment and inflation hedge. Rather, I will bust the myths about the gold standard. I intend to get past the distorted view people have about the gold standard.
First we need to go over the facts about what a gold standard is and how it compares to our current system (known as fiat money).
The gold standard and the U.S. dollar
Gold Standard
The gold standard is a form of commodity money. This means that the currency has a certain amount of gold that backs it and sets its value. Traditionally textbooks will tell us that the gold standard has a set of advantages and disadvantages including:
Advantages:
- Controls for inflation
- Controls exchange rates
Disadvantages:
- Cannot use monetary policy as a stabilizing force
This short and simple list gives the primary arguments we see for and against a commodity backed currency.
Fiat Money
Unlike a commodity backed currency, fiat currency is backed by nothing. A government tells its citizens that a certain note is to be used as legal tender and its value changes based on a variety of factors. This is what all large modern currencies are.
The biggest disadvantage of the gold standard is that it does not allow a country to use monetary policy to control the growth and stability of an economy. Monetary policy consists of:
- controlling the supply of money
- controlling the availability of money
- controlling the cost of money
Central banks like the Fed can do these things by:
- Buying or selling bonds to increase or decrease the supply of money
- Increasing or decreasing reserve requirements of banks, thus changing availability to borrowers.
- Setting interest rates, thus affecting how cheap it is to borrow
On a gold standard, a central bank can't control the money supply as it is based on the supply of gold.
Now that we have a little background information, we can discuss how this is related to gold as an investment? I'll present the view advocated by Libertarians like Ron Paul. Their biggest argument is that a gold standard helps control inflation. Ron Paul states that "a dollar today is worth 4 cents compared to a dollar in 1913 when the Federal Reserve got in". They believe that this is due to the Fed being able to print money whenever they want which erodes the value of that money.
Printing moneyThe Fed printing money is an example of controlling the money supply; this is called "open market operations". For example, the economy is growing fast and the fed is afraid of an increasing money supply also increasing inflation. In this case they will set an interest rate target and to reach that target they will need to lower the supply of money. To do this the Fed will give banks securities for cash, which lowers the amount of money the banks have available, thus lowering the supply of money available in an economy.
And they have an important point, let's look at the numbers. Here is a graph showing the CPI (inflation) in the US from 1910 to 2010:
Right at 1971 when the gold standard was abolished, the inflation rate accelerates.
Is it really that scary?Let's take a starting number... say, $10. Let's put that in a fake investment account that returns 20% per month and let it sit there for 5 years. Let's now see what happens with that money.
It looks like something must have happened around month 45 that made this graph accelerate so fast. But clearly it can't be going off the gold standard in such a simple example.
So when we have these exponential graphs, how do we tell the true growth? We graph the natural log of those numbers. Here is what the U.S. CPI data looks like when the exponential factor is controlled for:
Here is the Money example using the Natural Log:
This allows us to see what the true effects of inflation are without the noise generated by the exponential nature of the data source. When we look at inflation in this way, we see that there in fact is no accelerating growth in the time after 1971 but that it's just an arbitrary point in time.
The reason for the exponential increase in this example is the same as the increase in our inflation. When you are taking a percentage of the previous number, you will always get an exponential increase.
This in itself (including the bread example used by Ron Paul) is meaningless when looking at inflation. The acceleration isn't brought on by the Fed abusing their powers to create money; it's a feature of the math behind exponential growth.
But that doesn't get past the fact that inflation constantly increases the level of prices, so isn't that a problem? Let's explore what kind of effect inflation actually has on people.
The effects of inflationThe problem with inflation is that it erodes the purchasing power of an individual. Let's assume inflation is 3% and you have 100 dollars sitting in your wallet. If you are looking at buying something for that $100 but decide to wait one year, that item will now cost $103. So while you have the same amount of money, it can't buy as much as it could in the past. And in this way, your purchasing power is eroded.
The way we deal with this is through savings and investment. Just putting money in a high interest savings account can yield around 1.5% return. If you have money to put into longer term investments you can grow your money, but due to inflation it won't grow as quickly as it would with no inflation. If we had a steady rate of inflation at 3% and managed to hold our money in fairly liquid investments for 3% return, our money's purchasing power is no longer being eroded, but is held steady.
Inflation affects different groups of people in different ways. If you have a large amount of debt, inflation helps you because the terms of your debt stay the same and higher inflation can offset the real value of what you owe. Similarly, if you are a lender, inflation is bad for you as it lowers the value of the money you regain from your loans.
If we had 3% inflation every year guaranteed, we could take this into account when making transactions. A lender could write this inflation into his contract terms and a consumer could know what the value of their dollar will be the next year. This also allows savings and investments to grow at a predictable rate. So the best case scenario is to have a predictable inflation rate so we can make financial transactions with inflation accounted for. If inflation were 3% every year at a constant pace, then it would have very minimal effect on us. While reducing inflation altogether would be great, it is not realistic. Therefore the best way we can effectively "control" inflation is by making it as predictable as possible.
So when we had the gold standard, did it control inflation? The way to look at this would be the percent change in inflation from year to year. The lower the % change from year to year, the more predictable inflation is.
When we divide the graph pre- and post - 1971 we see that there were some large swings for about a decade after but there were far larger swings in the period before 1971. So why these large swings when the currency is backed by gold supply rather than by the whims of the Fed? The answer is that the variations are caused by the changes in the supply of gold.
A common example of gold supply shocks is the Free Silver Movement of 1896. From 1880 to 1896, there was a 23% deflation in the U.S. This was very bad for farmers whose debts increased dramatically due to the changing price level. Here is an example to show what effect this might have:
| Year | 1880 | 1896 |
|---|---|---|
| Revenue | $100 | $77 |
| Expenses | $85 | $66 |
| Interest | $10 | $10 |
| Profit | $5 | $1 |
A farmer was making $100 a year, he paid $10 in interest and $85 in other expenses, and this left him with $5 in profit after all was accounted for. Now let's go to 1896, the farmer now only has revenues of $77 due to the 23% deflation, he still pay $10 on the debts as the contract was created beforehand, he also pay $66 in expenses (also lower due to deflation). Now they have only $1 in profit. Since nothing else has changed beyond the price level (inflation), they have lost 80% of their original earnings.
But this was very good for the creditors who gave these farmers their loans as the money paid on the loans had far more real value due to the inflation. The solution advocated by the farmers was to create a bimetallic standard which incorporated gold and silver rather than just gold.
The issue was that the supply of gold had decreased. The bimetallic standard was never implemented but the problem went away as the U.S. had inflation of 35% from 1896 to 1910. For those interested, the Wizard of Oz was based on this bimetallic standard political movement.
History shows that gold in fact did very little to control inflation and in many cases, as in 1896, was quite a problem. The gold standard did not control inflation due to it being based on the supply of gold. When there were a large amount of gold finds, inflation increased. When there were few gold finds, inflation was low and there was even deflation. As we can see from the graph, after the gold standard was eliminated, deflation was almost never an issue, while it was far more common under a gold standard.
HyperinflationAs illustrated by the recent Zimbabwe inflation, hyperinflation can still be a problem in our modern world. So is the cause of this a rogue central bank trying to deflate the debt of a nation?
No, the cause of hyperinflation is irresponsible fiscal policy by governments. When a government is having revenue issues, it may sometimes turn to the printing presses and create money. As inflation grows out of control it accelerates even further because now the government has to stay ahead of inflation to pay its bills. This can lead to inflation rates of 624% as seen in Zimbabwe in 2004.
The Gold Standard and Exchange Rates
Another argument in favor of the gold standard is that if major currencies are based on the supply of gold, their exchange rates will be stable. When a central bank uses monetary policy, this changes the value of a currency in relation to other currencies because there is no common standard.
Yes, major currencies based on fiat decouple them from each other, meaning currencies can go up and down in value relative to each other. This is why the dollar has been weaker relative to other currencies.
While this is a problem, it is heavily outweighed by the benefits of having monetary policy. I'll use the current situation in Europe as an example. European nations had separate currencies before the establishment of the Euro in 1999. The European Central Bank (ECB) is committed to control inflation first and foremost. Eurozone members abide by the ECB; this is where the problem with Spain came in.
In short what happened was that Spain had a boom (partly due to the housing bubble) which led to capital inflows, which also pushed up wages in Spain. When the bubble burst, Spanish wages were left overpriced compared to wages in other Eurozone nations. Since Spain has no control over the value of their currency, they couldn't adjust for their high wages. This led to high unemployment because it is far easier to move capital around the Eurozone than it is to move labor, so Spanish laborers were stuck in Spain with no jobs.
So while the cause of the crisis had nothing to do with the fixed exchange rates, the inability to fix the crisis was because of the fixed exchange rate. Had Spain not been part of the Eurozone, their currency could devalue relative to other currencies and capital would not leave the nation so quickly causing mass unemployment.
While this example is not directly related to a gold standard, it does show that fixed currencies (like those under a gold standard) limit the ability of a nation to respond to economic crises.
Conclusion
So what can we learn from this? What do proponents of a gold standard say its effects would be?
- Under a gold standard, inflation would no longer erode the value of money.
- Fixed exchange rates would not allow the dollar to be devalued
All of the arguments I've seen for a gold standard just assert that the above two are correct. They have placed some kind of assumption on the effects of the gold standard without looking at the reality of it. So what have we found to be the truth about these two important points proponents of the gold standard bring up?
- Inflation needs to be predictable, fiat currency is shown to be more effective at doing this
- Proponents of the gold standard are correct here, but they fail to take into account the far more severe negative aspects of not having monetary policy. They just aren't looking at the big picture.
Gold is just a metal like iron, copper, and silver, so why the special treatment? Gold gets this special treatment because society found that it needed a more efficient way to exchange valuable goods than through barter. To that end, gold was found to be a convenient way to facilitate exchange. No special properties of this metal, or any historical data shows gold to be better at backing currency than anything else, or nothing at all.
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Stephan
Edwin | Finantage
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