It is always interesting to read critiques of a gold standard for students of Austrian Economics and free-markets – so often they attack a system that was not a gold standard and miss the insight into many of the problems that plague the world’s economies today. Let’s start from a free-market viewpoint to gain more insight.
If you were stranded on a deserted island with dozens of other ship-wrecked victims and you started a mini economy and specialized in gathering coconuts as your work, and some other islander came to you and suggested you trade the fruit of your day’s labor for a piece of paper with ink numbers on it, you would laugh out-loud at the suggestion, because paper and ink aren’t worth anything. Why would you trade your effort for something without any intrinsic value? The point is that a free-market would not choose paper money – such a system is imposed upon markets by governments who make paper legal tender (and take away the ability to use other forms of money equally) for tax payments and all other forms of payment. Paper money is a distortion to free-markets, and it is important to understand what effects such a distortion has on free market processes over time, because our current economic crisis is filled with them, which is why calls for a return to a gold standard are growing louder and louder.
For thousands of years throughout history, free-traders and free-men chose gold as the most consistent currency. Aristotle himself defined the characteristics of good money as being durable, portable, divisible, fungible, and intrinsically valuable. Gold is one of the few items that has met these characteristics nearly perfectly over time – and that is why it has been the choice of free-markets as money for thousands of years. That is why Thomas Jefferson observed in his classic explanation of why a gold standard was considered an indispensable part of the US Constitution and a result of a proper understanding the history of mankind in his quest for freedom:
“Gold is the perfect medium [for money], because it will preserve its own level; because, having intrinsic and universal value, it can never die in our hands…[Paper money] is liable to be abused, has been, is, and forever will be abused, in every country in which it is permitted.”
Once upon a time there were economists who studied and praised free-markets and the incredible power of the invisible hand – men like Adam Smith and David Ricardo. David Ricardo even assumed a 100% convertible gold standard in the model of his theory of comparative advantage of trade. And once upon a time there were founding fathers of this nation who understood the dangers of paper money and sought to separate the power of money and state in the original US Constitution by only granting government the power to coin, weigh, and measure metals as money. Some may call it antiquated, but there are those of us who still believe in free-markets. There are those of use who still believe that free markets and free men are the best hope for mankind and for peace and prosperity on this earth.
From a free-market perspective, paper currency is a distortion, and it is important to understand how a free-market operates under a gold standard to understand what distortions tend to manifest themselves under paper currency regimes (none of which have lasted in history by the way, including fairly recent attempts over the last century). As Alan Greenspan observed, "to the extent that there is a central bank governing the amount of money in the system, that is not a free market."
There are five primary benefits of a true 100% convertible gold standard based monetary system that the world needs more desperately than ever today. First, gold balances international trade and makes it mutually beneficial. Second gold prevents debt levels from getting out of hand. Third gold relates the preferences of consumers directly to producers, allowing them to optimize production and physical capital stock to demand. Fourth gold requires immediate and consistent adjustments in competitiveness by companies, countries, and individuals (labor). Fifth gold does not allow deficit spending so it acts a check on runaway government spending and forces real debate on spending tradeoffs. Let’s look at these benefits briefly.
Gold balances trade and makes it mutually beneficial. In the free-market model of David Ricardo which proved that there would be mutual gains from international trade even if one country had a comparative disadvantage in producing every good traded, a 100% convertible gold standard was assumed in his free-market analysis model. Here’s how it worked. If one country imported more goods than it exported, that country would have to export gold to pay for it. The good-importer’s gold/money supply would drop and so would its prices as a result. Meanwhile the exporter of goods would import gold paid for them, and its money/gold supply would rise and so would its prices. Eventually prices would drop in the importing country and rise in the exporting country to the point that trade of gold and goods would balance, and each country would specialize in producing the goods in which it had a comparative advantage in ways that would optimize production and profits for all. In such a system, trade was thus mutually beneficial because it balanced and constantly adjusted itself to the realities of consumer demands. This is significant in today’s world because paper currencies do NOT balance trade, and chronic trade imbalances grow to the point of being unsustainable. Trade becomes a battle of governments rather than a feast of producers guided by consumers. Our current system is not a free-market but a mess of battles over intervention that leads to tariffs, trade tensions, massive debt accumulation by deficit countries, conflict among nations, and often war. More and more economists are growing to realize that the lack of balanced international trade is a major ingredient of our current economic crisis. One reason gold is being looked at closely again is that a free-market using real money balances trade naturally. So far all the central planning agencies (central banks) filled with Ph. D.’s in economics don’t seem to be able to balance trade.
Fiat currencies tend to lead ultimately to massive over-indebtedness, and just as occurred in the 1920’s, debt/GDP ratios have sky-rocketed in our current paper currency regime to the point that long-term consumer deleveraging must occur. When the monetary system is a 100% convertible gold standard, debts cannot grow out of hand and debt/GDP does not sky-rocket because each ounce of gold lent must exist first, cannot be printed out of thin air, and must be loaned by its owner/earner to someone else. In essence there is no leverage other than temporary versions such as futures instruments that ultimately must settle. This is a difficult concept for modern Keynesian-trained economists to grasp. Fractionalized banking would not exist and banks would be intermediaries, not high-risk gamblers. Keynesian economists often suggest a gold standard is problematic because it can lead to bouts of deflation. It is difficult for them to imagine a world without excessive debts, but without excessive debts, deflation is relatively benign. In fact many of the years of the most robust GDP growth in US history accompanied benign deflation, just as a boom in computers accompanied lower prices for them as productivity soared.
Another power of a free-market 100% gold standard, is that consumers relay their preferences directly and without interference to producers through demand and prices. Herein lies one of the most insidious disadvantages of a fiat currency where Keynesian credit infusion is periodically used. Producers cannot differentiate between a real dollar of consumer demand and demand from newly created money/credit that distorts the message from the true underlying demand of consumers. Thus production and output decisions are not optimized in a paper currency regime as they are in a free-market. Instead, producers respond to the combination of consumer preferences and newly created credit that goes into higher-than-otherwise aggregate demand. This produces a number of problems that are at the heart of our current global economic crisis.
As John F Kennedy once observed, “The great enemy of truth is often not the lie – deliberate, contrived and dishonest – but the myth – persistent, persuasive, and unrealistic.” The world seems to be repeatedly grappling with the myth that a paper currency can be effectively managed in a way that doesn’t create massive distortions and instabilities over time.
It is important to understand that credit inflation is, after all, artificial demand. It does not come from consumers, it comes from printing money. Instead of consumers relating their true underlying demand preferences to producers who can then optimize the production of those demand preferences for maximum profit, producers get the wrong messages – as they have again and again during the last 50+ years of Keynesian credit inflation policies. Demand was artificially inflated, and new credit creation flowed into hot-spots exacerbating booms and busts. As John Mason, one of the true treasures of seekingalpha.com, has shown so well over a dozen or so articles these past months, firms did not make incremental adjustments to adjust to international competition and shifts in demand, nor did labor as a result of the false messages of credit inflation since the late 1960’s in particular. Instead, new highs in aggregate demand were essentially underwritten by the US government, and firms did not re-tool and re-orient their capital toward real sustainable demand messages of global consumers. International competitiveness problems were papered over amidst new highs in aggregate demand created by new highs in credit inflation. Chronic misallocations of resources were not penalized, and chronic over-production was not cut back, allowing over-capacity to grow in the US and abroad. The result has been lower capacity utilization over the course of each cycle, a capital stock and labor skill set that has not made incremental changes toward competitiveness that would have been required if they got true consumer messages, ¼ of the labor force un or under-employed, and a skewing of resources and income disparities toward the rich who are better able to protect themselves against the ravages of credit inflation over decades.
Nor, under a 100% gold standard where every ounce of spending must exist in the real world, can governments spend more than they can borrow or tax – and any increase in their spending as a percentage of GDP is at once clearly discernible to the populace and must meet their agreement to be prolonged. If the government wants to spend a million ounces of gold, it must get it first, either through borrowing or through tax revenues. Deficit spending is a construct of a fiat currency, not a gold standard – without at least a partial fiat currency, Keynesian stimulus is not really possible. And in fact it is the desire of governments around the world to spend more than they take in, and of bankers to leverage their operations, that is the primary reason the gold standard was abandoned. A central bank and fiat currency are central tenets of Marxism precisely because they exert enormous control over an economy. Part of the debate on a Gold Standard is really over who should have that control – Ph. D. economic bureaucrats and bankers, or consumers and the market.
The reason the World Bank head and others are increasingly looking at a gold standard is that it solves many of the basic problems the fiat currency system has created – excessive debt levels, chronic trade imbalances, chronic declines in competitiveness, and huge misallocations of resources. (in part II of this series we’ll look at US monetary system history and some of the criticisms of a gold standard)
Disclosure: GLD, SLV, various mining stocks