Hands of gold are always cold, but Bernanke’s hands are warm
Pop Quiz, hotshot! Take 5 seconds and think of the top 5 ideas popularly associated with Libertarians. Go on, I’ll wait…
OK, I estimate that over 90% of you put The Gold Standard somewhere on your list. Favoured by Austrian economists and the people who love them, perhaps most notably Ron Paul, many people (though few in mainstream economics) advocate the gold standard as a solution to our current (and/or future) economic woes. So I thought as part of my occasional series of posts that will annoy my fellow libertarians I would discuss the gold standard, what it is, the pros and cons of the gold standard as I see them, and why I am not in favour of the idea. I also plan to finish up with some more promising avenues for changing monetary policy, if that’s what you want to do.
First off, definition time! The term “gold standard” is used a bit loosely – while it literally refers to fixing your currency to the price of gold, many types of commodity price fixing have been deployed in the past. The British Empire ran on the Silver Standard for a long time (once upon a time the Pound Sterling was actually a pound of silver), but copper and even iron (those crazy Spartans) have formed the basis for currencies in the past. Gold is less often used principally because it is so rare (I’ve heard it said that all the gold ever mined wouldn’t fill an Olympic swimming pool). There are also many ways of achieving a gold standard effect, these being (in order of sophistication):
- Commodity Currency, making your money out of a precious metal.
- Making your paper currency redeemable for a specified value of precious metal, thus ensuring the Central Bank has to keep stockpiles of the precious metal.
- Having the Central Bank buy and sell the precious metal to keep the price constant, printing or retiring paper money as necessary to maintain the balance.
In fact even the precious metal part isn’t strictly necessary, it’s just that precious metals are highly storable, portable and divisible, which are useful traits in a currency. Still, any of the above should be thought of as being the same as the “gold standard” for the discussion below.
Some of these ideas are better than others (having paper money redeemable for gold makes more sense than having coins made out of Iridium for instance), but they all have similar macroeconomic effects, the chief of which is removing monetary policy control from the Central Bank. By forcing the price of money to be constant relative to some commodity there is no room left to control the rate of inflation; instead the money supply grows at the same rate as your precious metal stock (more or less). And this lies at the heart of the merits of the gold standard.
Proponents of the gold standard point to many advantages of the gold standard, and I’ll dissect them in decreasing order of sensibleness (at least as far as I’m concerned)
1. Monetary Constraint. This is the most common argument advanced by Austrian economists. Austrian business cycle theory holds that standard Central Banking practice results in too much inflation, which contributes to boom-bust business cycles. This video is quite a good summary, but the basic idea is that the extra money hits the economy unevenly, so some sectors attract disproportionate investment, and when these investments go bad, the result is a recession. My assessment of this theory improved following the Great Recession since by John Taylor’s estimation (this is John “Taylor Rule” Taylor for those who are unfamiliar with his work) monetary policy in the US was too loose for the early 2000s and that seems to have encouraged over investment in housing. Still, even granting the point that overly loose monetary policy is inadvisable, overly tight monetary policy isn’t a good idea either. An economy needs a certain amount of money to support the transactions that make up the economy. Pre-Industrial Revolution, economies didn’t grow so the necessary money supply was constant. But now the economy grows regularly, so the necessary money supply grows too. Eventually you run into a money shortage, which was one of the major motivations behind company stores, the companies didn’t have money so they effectively bartered with their employees. Furthermore, the Austrians aren’t necessarily right about this stuff. Bear in mind, it’s not just the left that thinks loose monetary policy is a good response to recessions, no less an economist than Milton Friedman argued that the Fed’s tight money policy was what turned a garden-variety recession into The Great Depression. Macroeconomics is an area where the quality of evidence is very poor, and people should avoid feeling overly certain of how things work. That means locking the central bank into one paradigm is probably a bad idea, no matter what the paradigm is.
2. Fiscal Constraint. I think this is a principal motivation for libertarians other than Austrian Economists. One of the reasons governments can borrow so easily is that they can print their own currency. This creates a sense of security for a government about repaying debt, which in turn makes governments more likely to borrow too much. I think this idea makes sense in theory, but in practice I don’t think it makes much difference. After all, Greece, Spain and Italy can’t print their own currencies and that hasn’t stopped them.
3. Ensuring the currency has “real value”. As strange as it seems to me, some people seem almost offended by fiat currency, believing that such currency has no “real value”, and is some kind of trick or fraud. Technically I suppose you consider fiat currency a trick, but it’s a very good trick – making something out of nothing is usually reserved for deities. Now fraud is a totally inaccurate description, when you receive a US dollar, you are getting exactly what you expect, so there’s no fraud going on there. I think the difficulty these folks are having is they believe that things can be said to be “worth” something in an objective sense. Value is a property of people (and their preferences), not of objects. It makes no sense to say something is worth x without specifying who thinks it’s worth x ultimately fiat currency is worth what the would-be recipients think it’s worth, which is true of everything else.
So if the gold standard (broadly construed) is not a good substitute for current monetary policy what would be? The best alternative I have heard is the drive for rules based macro policy, driven by John Taylor. Taylor argues that rather than leaving interest rates entirely up to the judgement of the Fed, the Fed should instead be required to specify a rule they will use to set interest rates, and if they deviate from the rule they have to explain to Congress why. You could even go further and mandate a particular rule by law, removing Fed discretion entirely. I don’t know if either idea is better than the status quo, but modern critics of the Fed should be looking at these types of alternatives, not to gold or other precious substances.