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Advocates of the gold standards tend to be Libertarian in outlook, and Libertarians don't like government interfering in the free market. Yet a gold standard means that the government, or some other authority, is interfering with free market forces.

To explain, the Liberty Street Economics blog from the New York Fed (if the link doesn't work because of the government shutdown, try this one) presented what I interpreted as a cautionary tale about unwarranted government interference in the free market. The tale begins in the 1600s, when England was on a bi-metal gold and silver standard:

A bi-metallic standard is a monetary system consisting of two metals—usually gold and silver— where the government or the mint fixes the price between the two metals. As a hypothetical example, the mint might determine that 1 ounce of gold = £1 and 1 ounce of silver = 1¢. Therefore, 1 ounce of gold = 100 ounces of silver. The key to making a bi-metallic standard successful is two-fold. First, the mint and the public must be willing to buy or exchange 100 silver coins for a gold coin, and vice versa. This is called maintaining mint price parity. But just as importantly, the mint must be willing to buy gold and silver bullion from the commodity markets for £1 per ounce of gold and 1¢ per ounce of silver, respectively. This is called maintaining market price parity to the mint price. If external forces change the market price of the underlying metal—for example, if a gold rush causes gold to flood the market, forcing the market price for gold down—the mint must decide whether to continue buying gold bullion at an inflated price or to change the fixed rate between the gold and silver coins through a re-coinage.

In effect, it was a fixed exchange rate between gold and silver. Instead of letting the market decide the right value ratio between these two metals, the government arbitrarily fixed a rate. Of course, things started to go wrong:

When the market price of silver began to rise in the 1690s relative to the mint price, silver started flowing from England to the European Continent. So while the difference between the mint price and the market price fueled the incentive to clip silver coin and sell the clippings in the continental commodity markets, the poor mint quality made it even more difficult to detect a clipped coin, leading to a situation reminiscent of the Kipper und Wipperzeit crisis of the 1620s described in our earlier post. At the same time, the Royal Mint was paying more than market price for gold bullion, so gold bullion began to flow from the Continent to England.

A mis-priced exchange rate caused a monetary contraction:

By 1695, high-value gold coins were plentiful in England but there was a notable shortage of small-denomination silver coins, creating a monetary contraction. This led to a dual problem. First, the monetary contraction inhibited the ability to pay the armies engaged in the Nine Years' War. Second, because silver was used for small-denomination subsidiary coins, the coin shortage impeded everyday transactions between individuals. The Bank of England did not have the authority to intervene in the markets, so a "Commission on the Coinage" was chartered from 1694 to 1695 to deal with the crisis.

...and a recession:

In the second half of 1696, England's economy essentially stopped, and the ensuing monetary contraction led to massive unemployment, poverty, and civil unrest.

Here's what happened next:

In January 1696, the Act for Remedying the Ill State of the Coin of the Kingdom stipulated that by May 4, clipped coin would no longer be legal tender, and by June 24, clipped coin would no longer be accepted for tax payments. But the Royal Mint was woefully unprepared to replace the monetary base and had only minted about 15 percent of the silver coin needed for the exchange. Compare this to the preparation for issuing the euro, when European central banks stockpiled roughly 350 coins per capita in anticipation of the euro launch. While the milled-edge design used in the re-coinage prevented further coin clipping, it didn't address the ongoing attack on silver coinage by seventeenth-century arbitrageurs and the continuing silver outflows. These problems resulted in depositors flocking to the Bank of England on May 4 to demand specie. By May 6, the Bank of England was forced to forestall debt payments, and it was not able to resume payments until October, when it received a loan from the Dutch government...

The smallest gold coin, the golden guinea, and various forms of credit provided the only remaining liquidity in the market, with the Duke of Beaufort famously being forced to pay for a dinner by entering his name in a book at the height of the crisis. The crisis ultimately spurred a new era of economies driven by a broad set of financial instruments, not just specie, and laid the foundations for the later development of "fiat money," which is backed by full faith and credit in the issuing government, as we'll explore in a future post on the Continental Currency Crisis.

Instead of allowing a flexible, market determined, exchange rate to set the price between gold and silver, the government imposed a fixed exchange rate and crisis ensued. What is instructive is that this occurred in the context of a hard currency economy based on precious metals.

While I appreciate the intention of gold standard advocates of replacing the fiat currency system with a commodity based system as a brake on government spending, these kinds of unintended consequences are of the "we had to raze the village in order to save it" and not helpful at all.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui's blog to ensure it is connected with Mr. Hui's obligation to deal fairly, honestly and in good faith with the blog's readers."

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Source: Why A Gold Standard Is A Bad Idea (Government Interfering In Free Market Edition)