Gold Standard and the Definition of Price Stability

I hear a lot of people saying that the root problem of the financial crisis is fiat currency. There is no restriction on creating paper money so too much gets printed, they opine. Their conclusion is that paper money needs to be backed by gold. So buy the precious metal because when the dust settles, we’ll be on a gold standard.

I disagree. The problem hasn’t been that the fiat currency now in existence didn’t have an anchor. It has had one since the early 1980s: Price stability rules followed by the central banks. Those rules required central banks to keep the inflation rate close to 2% a year, and this constraint placed restrictions on the amount of money that could be printed.

However, the way the price-stability rule was implemented had a flaw. If this flaw is fixed, then I believe we have a much better shot at a return to an era of sustained prosperity than under a gold standard.

A standard based on a properly implemented price-stability rule promises a much better way to limit paper currencies than gold because it imposes discipline in a sustainable way. The supply of money can be varied to keep price deflation and depression from occurring. Gold, on the other hand, is not elastic. It’s fixed in supply; the history of the gold standard is full of deep and prolonged depressions.

Gold’s severe economic dislocations gave rise to populist movements bitterly opposed to hard currency (see, for example, William Jennings Bryan’s Cross of Gold speech in 1896). Moreover, history books show that in the face of such opposition, governments rarely ever did adhere to the standard. Over time, they ended up printing more money anyway.

So what’s the flaw to correct in the price-stability-rule monetary system? It’s the definition of price stability. It included only prices for consumption goods and services. Prices for assets were excluded. When the latter began taking off, starting with tech stocks in the 1990s and then real estate prices in the 2000s, the central banks said it was not their concern.

This was the mistake. A target of 2% for the CPI was still too easy because it pumped out enough liquidity to create asset bubbles that went pop. That’s what events are telling us now. If monetary policy had also been set with reference to asset prices, these bubbles could have been kept from becoming large enough to destabilize the U.S. financial system and economy.

So a more appropriate definition of price stability would include asset prices. This may result in negative growth rates in the CPI at times, but it need not entail a deflationary spiral because of the elasticity of the money supply, as I wrote a year ago in a column entitled Ensuring financial stability.

Comments

[yuman:]

So you would propose something like consumer and asset price index, CAPI instead of CPI. Then if the stock market rallies, Fed will have to tighten the money supply and the real economy will contract. The monetary tools don't seem suited for managing the virtual economy.

Apr 22 01:39 AM

[Nathaniel C:]

How is 2 percent inflation price stability? That means prices double every 36 years.

Inflation is not some mysterious force. It is caused be excessive money supply growth exceeding real GDP growth. The point of a gold standard or any standard is to prevent the government from debasing our currency by printing money (look at Zimbabwe). If we were under a gold standard the Federal Reserve would not be able to literally print 1.5 trillion to buy MBS.

I do believe that one of the underlying causes of this crisis is our illegal monetary policy run by the Federal Reserve. Thanks to their great work the dollar has lost 95% of its value since 1913. Inflation discourages savings (why put your money into a savings account at 0.2%). Inflation is a hidden tax that has destroyed the middle class as wages have not kept up with inflation since the 1970's.

Apr 22 03:14 AM

[Simon Smelt:]

As discussion by central banks (on their club website - the Bank for International Settlements) indicates, the danger of ignoring asset price inflation is now being acknowledged.

However, a narrow focus on Consumer Price Inflation (CPI) cannot simply be expanded to mechanically incorporate asset price movements. Items covered by the consumer price index are usually bought to consume. Assets may well be bought for investment purposes and price increases may have wholly different causes and effects. If a central bank was to target price stability for assets this would tend to choke off growth and discourage investment in such assets.

The difficulty is in differentiating asset price bubbles from "normal" or "reasonable" movements in assets. But, do we want the Fed deciding how much the major constituents of asset prices (let's say Dow plus commercial and domestic property) can move in any year before it takes action?

Apr 22 04:54 AM

[Vuke:]

Part of the problem is the obsessive bureaucratic belief is that only they can "fix" something. And that any problem calls for more bureaucratic intervention.

If gold were freely convertible anywhere in the world and left to find its own level any currency that misbehaved would soon be punished by being rapidly converted. Gold, then, can stand as a referee without anything being "fixed" as as long it is not manipulated.

Apr 22 08:41 AM

[yellowhoard:]

Couldn't agree more Vuke.

However, you're making the basic mistake of thinking that politicians anywhere can act honorably and make hard choices.

The discipline required by a gold standard would guarantee constant voter dissatisfaction with the ruling class.

Apr 22 08:54 AM

[Speedspirit:]

At this time of crisis a FIXED exchange rate would eliminate manipulation of currancy and let productivity be the driver not paper.

Apr 22 09:12 AM

[Vuke:]

>>>However, you're making the basic mistake of thinking that politicians anywhere can act honorably and make hard choices.
<<<

I couldn't agree more Yellowhoard. The very nature of the system seems to attract the worst of the opportunists.

But my thinking was exactly that. By having gold freely convertible every citizen could vote with their dollars on a daily basis. If the politicians want to run wild with paper the results would soon become clear. Gold then becomes the real currency with paper floating up and down against it.

A fixed gold price gives "them" the power to fix it. My instinct is to leave them only with the power to run the post office, now that we have internet and couriers.

Apr 22 10:21 AM

[DONE_SONZ:]

Price stability?What price stability?The charts dont lie.Paper printing is just too easy and cant be trusted.

Apr 22 10:42 AM

[MGA_1:]

I can only go by what I've read, but interestingly enough, I've read that many of our previous depressions were because of money printing even when we under the gold standard - the banks simply printing in excess of their gold reserves (and they at times ignored species redemption) and there was an eventual deflation of the money supply with a subsequent depression.

I would actually expect a slow deflation under a gold standard - if your productivity is going up, your per unit cost should be going down and hence prices get cheaper. I'd be fine with this.

Irregardless, the current fiat only money regime looks to be a disaster. $1.2 trillion quantitative easing by the fed and $2 trillion budget deficits make me scratch my head and wonder what I'm holding in my wallet.

Apr 22 11:05 AM

[Vox Rationalis:]

"So a more appropriate definition of price stability would include asset prices. This may result in negative growth rates in the CPI at times, but it need not entail a deflationary spiral because of the elasticity of the money supply."

Suppose asset valuation were inclulded. Would higher interest rates have contained the mania without crushing economic growth?

Falling prices need not result in a deflationary spiral to be destructive. Consider a single firm facing falling prices. Margins are squeezed, and it produces less as the marginal break-even point shifts. Further, it invests less, as falling prices result in lower returns on that investment. Expand these micro effects to the entire economy, and I think it's clear how economic growth is slowed by falling prices.

Now consider the housing mania. From June 2004 to June 2006 the Fed raised the federal funds rate from 1.0% to 5.25%. In May 2004, prime was 227 basis point less than the the 30-year mortgage rate; by December 2006, prime was 211 basis points HIGHER. Basically, during this time the prime lending rate remained tied to the cost of funds, while mortgage rates did not.

(Freddie Mac and Federal Reserve data)

Apr 22 11:20 AM

[Gedankonomist:]

"...the gold standard is full of deep and prolonged depressions."

Like what?

"However, the way the price-stability rule was implemented had a flaw."

I'll say it has a flaw. The flaw is that it is controlled by a few wealthy, well-connected power hungry elitists who want to rule the world.

OTOH, gold supply is controlled by how much effort you want to expend into obtaining a few grams of the stuff out of tons of ore. If you ask me, I prefer the latter.

Apr 22 04:11 PM

[capt Brian:]

For you to say anything to discourage savings is not a good idea. If you do not like the money, buy something that goes up all the time, like a single premium deferred anuity. Would 7.25% with no risk of capital and above 7.25% available if the mkt decided to go up make you recind your statment? There are things out there, you know, that do not have risk. Even if you put your savings in gold and in a safe place, it would, over the time, be more valuable. But to insinuate to folks trying to learn to "make it" that savings is futile, is a great dis-service. Save young man! Go read the book, "The Richest Man in Babylon", then tell me again not to save.

Don't not save. Save 10% of everything you get, and don't touch it until you cannot earn any more, and you won't have to.


On Apr 22 03:14 AM Nathaniel C wrote:

> How is 2 percent inflation price stability? That means prices double
> every 36 years.
>
> Inflation is not some mysterious force. It is caused be excessive
> money supply growth exceeding real GDP growth. The point of a gold
> standard or any standard is to prevent the government from debasing
> our currency by printing money (look at Zimbabwe). If we were under
> a gold standard the Federal Reserve would not be able to literally
> print 1.5 trillion to buy MBS.
>
> I do believe that one of the underlying causes of this crisis is
> our illegal monetary policy run by the Federal Reserve. Thanks to
> their great work the dollar has lost 95% of its value since 1913.
> Inflation discourages savings (why put your money into a savings
> account at 0.2%). Inflation is a hidden tax that has destroyed the
> middle class as wages have not kept up with inflation since the 1970's.

Apr 22 06:04 PM

[capt Brian:]

The gold standard, weren't you listening to me before, go read my comment stream, and just do your own math. WE CANNOT go on the gold standard. To do so would require our mony backed up by gold, and unless the government is gonna recall ALL the money out there, and start over they would have to cover it all. Now you do your own math.

Start with how many dollars are out there, your figure my figure..

Mine is one quadrillion. lessee, that is 1,000,000,000,000,000.00

So now you have to figure out how many ounces of silver in a tonne, (24,000) already did it for you but you check me... now at current level, $889.60/oz. (was 866 when I made the coment last time) that means you(the gov't or the FED) has to find an ounce to put in storage, so each of my 889's are worth one ounce.

Take the money supply and divide it by 889... and you have how many ounces the govt has to have in storage to be on a fair gold standard. Now, there are other ways, but it would be stealing the wealth of our nation to get it done. Is that their plan, or yours?

mymath says you would need, 1154734411085.45 ounces / 24000 = 48113966 tonnes of gold,

goodnight on the gold standard, figure out something else.

Apr 22 06:15 PM

[Balderdash:]

this idea is quite silly. productive, growing assets should go up in price absent inflation as their productive capacity increases. that means the fed would have to differentiate which is a productive asset vs a speculative asset (i.e. a tech stock with no earnings vs an oil field or factory)

now i agree that housing should be in the CPI, since it isn't a productive asset, just a large consumable.

the problem is that money arises naturally as a medium of exchange, not as a government declaration. gold standard or otherwise. any attempt to legislate or control the medium of exhange results in distaster.

Apr 22 08:39 PM

[Balderdash:]

this idea is quite silly. productive, growing assets should go up in price absent inflation as their productive capacity increases. that means the fed would have to differentiate which is a productive asset vs a speculative asset (i.e. a tech stock with no earnings vs an oil field or factory)

now i agree that housing should be in the CPI, since it isn't a productive asset, just a large consumable.

the problem is that money arises naturally as a medium of exchange, not as a government declaration. gold standard or otherwise. any attempt to legislate or control the medium of exhange results in distaster.

Apr 22 08:39 PM

[paxjds:]

Gold is natures natural stability substance. Get gold and you dont have to worry about the silly games the bankers of the world do to currencies. Get gold, and go play golf in lieu of writing articles and watching the market.

Apr 22 10:46 PM

[Allan Frain:]

All that is needed for Fractional Reserve Central Banking to work is omnicient and benevolent Central Bankers and a Congress and Administration unbeholden to their ill-gotten wealth and power.

Wake up and smell the roses. We are witnessing an historical real-life demonstration of the moral and policy hazards of putting great arbitrary economic power in the hands of a relative few. Maybe the author needs a few more years of this reality. The longer this economic/policy farce continues, the lower our standard of living will fall and the less taste the public will have for a repeat performance.

Apr 23 08:10 AM

[Vox Rationalis:]

Balderdash wrote (twice):

> now i agree that housing should be in the CPI, since it isn't a productive
> asset, just a large consumable.

The "consumable" (utility, or rent equivalent) element of housing IS included in CPI. The investment aspect is not. "Shelter" makes up 33% of the entire CPI-U (www.bls.gov/cpi/cpiri2...).

Apr 23 12:12 PM

[huskerbob:]

We don't need a gold standard. I don't want to replace fiat money. I don't want to get gold mixed up with the idiocracy and criminal class any more than it already is. Just let the US mint coin enough money (silver and gold) to keep up with demand instead of this ridiculous rationing! Why is the government sitting on all that gold? Who needs it when you have a printing press? Sell it already!
We can't trust politicians to manage our money. So let them have their fiat currency plaything. Let the central banks mint all their gold and sell it off over time - what do they need it for? It's just a barbarous relic, right? Stop announcing sales and just do it already! Stop rationing gold and silver!
Sorry, I ran out of exclamation points and will have to end this post.

Apr 23 01:17 PM