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We have been arguing rather strongly against a reintroduction of the gold standard. We hold that opinion basically because in the 1930s, it did a whole lot of harm under circumstances that are, in fact, remarkably similar to our economic problems today. Then, as now, a credit infused asset bubble burst leaving the private sector and financial institutions with very damaged balance sheets.

Repairing balance sheets meant borrowing and spending less, and saving more, which is what got the economy into a depression. A gold standard is not a good thing to have under these circumstances, as it ties monetary policy, preventing it from doing anything to soften the impact, quite the contrary.

The result in the 1930s, apart from a terrible economic depression and 25% unemployment, was falling prices, something we have managed to avoid this time around. Falling prices is of course the last thing you want when there is a large debt overhang in the economy, as it increases the real burden of that debt. This leads to a vicious cycle that Irving Fisher in the 1930s called a deflationary-debt spiral.

Monetary policy was powerless to stop this with currencies tied to gold but ultimately, countries left the gold standard. The earlier they did so, the less damage done to their economies, as it happens.

In Europe, they have the Euro zone which has recreated much of the same dynamics. It condemns countries to fiscal austerity without any offsetting monetary stimulus or devaluation.

Indeed, since it also eliminated currency risk, capital is moving perversely, creating bubbles in the periphery the previous decade, reversing course after the financial crisis and leaving the area as a wasteland now, reinforcing already troubled public finance dynamics. Real funny, these fixed exchange rate mechanisms. Creating terrible deflationary biases in the process, just when countries can least afford it.

Monetary policy
Monetary policy powerless in liquidity trap, in which rates are 'zero bound.' Even at zero bound (below which interest rates cannot fall), there is an excess of loanable funds and savings are much bigger than investment even at these low interest rates. In order to clear the market, interest rates should be negative, something which just isn't possible.

(click to enlarge)

Even 'money creation' by the central bank (or 'quantitative easing', QE) can't change that situation as credit demand is weak and the money just sits there as bank reserves:

Now, and here is where things get interesting, the gold bugs like Ron Paul argue that all that money creation will lead to hyperinflation and a debasement of the dollar. In the absence of inflation taking off, they point to rising gold prices as evidence and even argue that the monetary system should move back to being based on gold.

It turns out that Ron Paul himself invests according to these insights, putting his money where his mouth is. This is quite admirable, even if we wholeheartedly disagree with his convictions. These turn out to be rather extreme. Here is investment manager William Bernstein, who looked at Ron Paul's portfolio:

Mr. Bernstein says he has never seen such an extreme bet on economic catastrophe. "This portfolio is a half-step away from a cellar-full of canned goods and nine-millimeter rounds," he says.

His portfolio is full of gold and silver mining stocks like Barrick Gold (ABX), Goldcorp (GG) and Newmont Mining (NEM) and a whole host of smaller Canadian-based miners. Apparently not even ETF's like gold (GLD) or silver (SLV).

Ron Paul and Inflationary Expectations
While monetary policy isn't effective in a liquidity trap, it would do better if it were able to influence inflationary expectations. For instance, if the Fed could convince the public it would increase inflation towards 4-5%, this could have real effects in the economy. It would reduce real wages and increase hiring. Perhaps even more important, it would reduce the real burden of outstanding debt.

Some economist argue that the Fed should adopt an explicit inflation target or target nominal GDP, but it hasn't gone that distance, opting instead for managing expectations with the announcement of a prolonged period of low interest rates.

However, it is difficult to influence expectations anyway after the Fed had a anti-inflationary track record going back three decades, compounding the clogging of the normal transmission mechanisms of monetary policy via the credit market because we're in a liquidity trap.

But here is where Ron Paul and similar 'inflationistas' become handy. They do believe that inflation is under way, in fact, they believe 'hyper' inflation is on its way, which is why they invest in gold and denounce the Fed as a dangerous aberration.

By this point, the irony will not have escaped the alert reader. For monetary policy to work, we need more Ron Paul's! We need more inflationistas, people believing that the Fed is embarking on massive inflation!

We need enough of them for the Fed to be able to overcome their 30 year anti-inflationary track record and be able to move inflationary expectations higher so that monetary policy can regain some traction in the real economy.

Is that belief likely to materialize? Alas, as Shaun Connell has pointed out on these pages, Ron Paul's beliefs are not something of today or yesterday. Connell reminds us of the following couple of statements from Ron Paul:

I believe such a [gold] standard to be not only desirable and feasible, but absolutely necessary if we aim to avoid the very real possibility of hyperinflation in the near future, and economic collapse

Mr. Speaker, gold prices continue to soar -- or rather, the dollar continues to decline in value... we are witnessing the remonetization of gold, in disregard of the official U.S. Government position concerning the precious metal. The surge in gold prices is the world's vote of no confidence in paper currencies and the governments that promote fiat monetary policies.

That sound good. He really seems to believe what he is saying. Alas, closer inspection reveal that the first quote was from 1981 and the second from 1979, just before the Fed killed off inflation and gold prices started a long decline.

So it's not only the Fed that, by its 30 year anti-inflationary track-record isn't credible in moving inflationary expectations higher. It's also Ron Paul who has a credibility problem by making hyperinflation predictions for 30 years that utterly failed to materialize. And because both are not credible, monetary policy's effectiveness is impaired as the Fed is unable to influence inflationary expectations, which is a real pity.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Ron Paul, Gold, And Inflationary Expectations