The Gold Standard
Prerequisite: Banking
With Ron Paul's popularity increasing and the Tea Party on the rise, the gold standard is entering the public mind for the first time since the breakdown of the Bretton Woods system in 1971. It might be possible to have a gold standard under free banking (although I believe it would not be chosen as the backing under a completely free system), but under central banking, it fails pretty badly.
Under a gold standard, the government uses monetary policy to fix the price of gold. If the price of gold goes higher then the price set, the government sells gold and buys money. If the price goes too low, they buy gold until its price goes back up.
The gold standard is usually advocated as a way to stabilize the value of money. A gold standard works by mostly stabilizing M. The quantity of gold in the world is around 165,000 tons of gold and the annual production is around 3000 tons, meaning the supply is quite stable. There are several reasons why the gold standard is a poor choice to maintain price stability.
1. Gold has other uses besides money - principally jewelery, but also industrial uses. If there is a demand shock for jewelery or a technology shock that increases the demand for these alternate uses, gold will be converted from being used as money to the alternate uses, causing an unexpected deflationary shock to the economy.
2. Even if the other uses have constant value, there will be a utility loss to the economy equal to the opportunity cost of the other uses of gold. Every gold coin in a bank vault represents a necklace unmade or a microchip unbuilt. Gold standard advocates occasionally talk about how gold has intrinsic value, whereas paper does not. However, it is precisely because gold doesn't have highly valued alternative uses that it became the currency and not iron or copper.
3. Gold may be effective at stabilizing M, but it does nothing to stabilize V. If there is a banking crisis, the money multiplier may collapse leading to massive deflation. While free banking has some mechanisms to stabilize MV, gold standard based central banking does not.
4. Theoretically under a gold standard, the government maintains a stable peg to a the price of gold, but there is no law of the universe forcing them to stick to it. A government can change the price of gold by fiat almost as easily as they can print more money. History is littered with examples of governments devaluing their gold either by adding other metals to their coins or by explicitly changing the price. Inflation under a fiat currency tends to be low and stable. Gold standards are characterized by slow steady deflation punctuated with massive inflation whenever the government decides to revalue. If your primary value is stable prices, it is unclear which of the two systems is preferable.
5. The gold standard may make the Austrian business cycle worse. Under a fiat currency, a monetary boom causes misallocation of capital by lowering interest rates and making unprofitable investments look temporarily profitable (the boom phase). After prices adjust upward, the malinvestments become obvious causes the bust. However, in a gold standard, price inflation must eventually be followed by deflation (to keep long term prices stable), compounding the bust.
6. If the economy is hit by a shock that increases the demand to hold money as a form of savings, such as an asset bubble popping, prices will begin to fall. In order to offset the deflation, the government may be tempted to devalue the currency (more $ per oz of gold). However, rumors to that effect will cause people to horde gold even more, since they will get more $ in the future for their gold coins. The rumors of devaluation will put further downward pressure on prices, causing even more economic turmoil.
Gold standards are a reasonable method of managing a currency. Many countries though out history have done so with minimal hassle, however, they aren't perfect. In my opinion, it is better to focus on creating institutions that constrain the central bank to committing to a explicit target, either inflation or NGDP and sticking to it.
With Ron Paul's popularity increasing and the Tea Party on the rise, the gold standard is entering the public mind for the first time since the breakdown of the Bretton Woods system in 1971. It might be possible to have a gold standard under free banking (although I believe it would not be chosen as the backing under a completely free system), but under central banking, it fails pretty badly.
Under a gold standard, the government uses monetary policy to fix the price of gold. If the price of gold goes higher then the price set, the government sells gold and buys money. If the price goes too low, they buy gold until its price goes back up.
The gold standard is usually advocated as a way to stabilize the value of money. A gold standard works by mostly stabilizing M. The quantity of gold in the world is around 165,000 tons of gold and the annual production is around 3000 tons, meaning the supply is quite stable. There are several reasons why the gold standard is a poor choice to maintain price stability.
1. Gold has other uses besides money - principally jewelery, but also industrial uses. If there is a demand shock for jewelery or a technology shock that increases the demand for these alternate uses, gold will be converted from being used as money to the alternate uses, causing an unexpected deflationary shock to the economy.
2. Even if the other uses have constant value, there will be a utility loss to the economy equal to the opportunity cost of the other uses of gold. Every gold coin in a bank vault represents a necklace unmade or a microchip unbuilt. Gold standard advocates occasionally talk about how gold has intrinsic value, whereas paper does not. However, it is precisely because gold doesn't have highly valued alternative uses that it became the currency and not iron or copper.
3. Gold may be effective at stabilizing M, but it does nothing to stabilize V. If there is a banking crisis, the money multiplier may collapse leading to massive deflation. While free banking has some mechanisms to stabilize MV, gold standard based central banking does not.
4. Theoretically under a gold standard, the government maintains a stable peg to a the price of gold, but there is no law of the universe forcing them to stick to it. A government can change the price of gold by fiat almost as easily as they can print more money. History is littered with examples of governments devaluing their gold either by adding other metals to their coins or by explicitly changing the price. Inflation under a fiat currency tends to be low and stable. Gold standards are characterized by slow steady deflation punctuated with massive inflation whenever the government decides to revalue. If your primary value is stable prices, it is unclear which of the two systems is preferable.
5. The gold standard may make the Austrian business cycle worse. Under a fiat currency, a monetary boom causes misallocation of capital by lowering interest rates and making unprofitable investments look temporarily profitable (the boom phase). After prices adjust upward, the malinvestments become obvious causes the bust. However, in a gold standard, price inflation must eventually be followed by deflation (to keep long term prices stable), compounding the bust.
6. If the economy is hit by a shock that increases the demand to hold money as a form of savings, such as an asset bubble popping, prices will begin to fall. In order to offset the deflation, the government may be tempted to devalue the currency (more $ per oz of gold). However, rumors to that effect will cause people to horde gold even more, since they will get more $ in the future for their gold coins. The rumors of devaluation will put further downward pressure on prices, causing even more economic turmoil.
Gold standards are a reasonable method of managing a currency. Many countries though out history have done so with minimal hassle, however, they aren't perfect. In my opinion, it is better to focus on creating institutions that constrain the central bank to committing to a explicit target, either inflation or NGDP and sticking to it.