A Guide to the Gold Standard

7 Jul

April 1933, the US goes off the gold standard

The April 20, 1933 edition of the The New York Times read, “GOLD STANDARD DROPPED TEMPORARILY TO AID PRICES AND OUR WORLD POSITION; BILL READY FOR CONTROLLED INFLATION.”

The temporary suspension of the gold standard turned out to be anything but temporary, which reminds me of a Milton Friedman quote, “Nothing is so permanent as a temporary government program.”

The purpose of this post is to show that it is technically possible to implement a gold standard today. Many criticisms against the gold standard claim that it is not possible to shift to a gold standard. These criticisms range from – the money supply will fall, there will be chaos if many agencies control money supply, there is not enough gold in the world to shift to a gold standard. These criticisms are baseless and betray an understanding of what money really is.

Once we have clarified  (hopefully) that it is technically possible to implement a gold standard, whether we should shift to a gold standard is an altogether different question. So, the way to argue against the gold standard is to debate along ideological lines. If someone argues that we should not implement the gold standard because the government should control the money supply, that’s fine. The nature of the debate then  boils down to whether the government should control the money supply or not. However, if one argues against the gold standard saying that it is not possible to implement the same, the debate does not stand any merit.

I myself am guilty of the same misunderstandings that I attempt to clarify through this post. On 4 December , 2010, I had put a post in this blog with the title In defense of fiat moneyMuch of what you will read in this post will directly contradict what was argued earlier.

What is so special about gold?

First and foremost, the Austrian economists do not support the gold standard because it has some mystical properties. As our economy moved from barter to exchange based on money, gold came to be widely accepted as the best medium of exchange. This was because gold satisfied the many qualities of a good medium of exchange, like acceptability, durability, portability, homogeneity, scarcity.

Murray Rothbard in his book, What has the government done to our money, says

Historically, many different goods have been used as media (medium of exchange): tobacco in colonial Virginia, sugar in the West Indies, salt in Abyssinia, cattle in ancient Greece, nails in Scotland, copper in ancient Egypt, and grain, beads, tea, cowrie shells, and fishhooks. Through the centuries, two commodities, gold and silver, have emerged as money in the free competition of the market, and have displaced the other commodities.

Thus, the Austrians support the gold standard as gold is what the market accepted as money before the government monopolized the money supply. It is not for any economist to decide what commodity should be used as money. Our monetary history suggests that gold was established by the market as the best form of money. In case some other commodity had been established as money, we would have been arguing for a monetary system based on a different commodity.

What is the Gold Standard?

Simply put, a gold standard means a monetary system based on the commodity gold. Does this mean you will have to carry gold bars in trucks to make payment for buying real estate? No. You can make payments in paper receipts which will be redeemable in gold. Who has the obligation to redeem the paper receipts for gold? Obviously, the entity who has issued the receipts; which brings us to a very contentious question – who has the right to issue such redeemable paper receipts?

In a gold standard, anybody who has gold can issue such receipts. Suppose the government has gold reserves of 1 tonne. It can issue its own paper receipts, say the ‘dollar’ and define it as equal to 1 gram of gold. This will allow the government to issue 1 million dollars. Similarly, anyone can take out their own paper receipts. If you have 1 tonne of gold, you can take out your own receipts, and label it ‘rupiya’ and define it as 1 kg of gold. This will allow you to print 1000 rupiya. You can take this rupiya to the market and buy goods and services.

Will the market accept your rupiyas as payment? That will depend on your credibility in the market. Say you went to purchase a car and it costs 1 kg gold. You can use your one rupiya to buy the car. The car dealer can later knock at your door and ask you to redeem your one rupiya for 1 kg gold. If you do not redeem your rupiya, your credibility declines, and in the future, market participants may refuse to accept rupiyas.

Does this mean you will starve to death with nobody willing to sell you food? Of course not. Even if the credibility of your rupiya has gone for a toss, you can always turn in your gold to the government and receive dollar in exchange. Or you could turn over your gold to a bank whose currency is widely accepted by the public. Or, you could simply melt your gold into smaller units and use it directly for exchange.

The point I am trying to make here is that in a free market gold standard, the market will decide the paper receipts or currency that will be used. Will there be multitude currencies and chaos? No. History suggests that the market will eventually settle to a few different types of paper receipts. Maybe, only dollars will be used or maybe, currencies issued by certain trust worthy banks will be used. (It may be mentioned here that currency issued by different banks will not be a problem, just as having savings account at different banks is not a problem. Inter bank transactions can take place through a clearing house, as is presently done.)

Paper currency issued by different participants in the gold standard are simply receipts for a claim towards gold. As gold is the real money in a gold standard, we stumble on an important question. Who has the right to mine gold? Well, no points for guessing, but obviously the Austrian reply to this question will be – its a free market, everybody has the right to mine gold.

Suppose you want to buy a car, which costs 1 kg gold. You have two choices – either you can mine 1 kg gold and pay for your car, or you can choose to work somewhere and get 1 kg of gold as wages. Which option you choose depends on which activity will demand the least effort from your side – this is similar to saying which activity is preferable to you. Similary, a mining company will mine gold till the time it is profitable for it to do so. It may seem that in a gold standard, private  mining companies will earn super normal profits and will become masters of the universe. This is not true.

An example will clarify.

Assume a mining company can hire laborers for 1 kg gold per day to work on its gold mines, and each laborer can mine 5 kg of gold per day. Can such a situation arise in a free market? Of course not. Why would anyone accept 1 kg gold in payment for extracting 5 kg of gold? One can argue here that independently (without machinery of the mining company), the laborer will be unable to mine gold, and hence he may accept a lower payment that the value of gold he produces. Even then, what prohibits another company which can buy machinery and hire laborers to start mining operations? Eventually, as long as mining gold remains a profitable activity, the supply of gold will keep on increasing, adding to the existing supply of gold stock in the economy. Eventually, the “price” of gold (in terms of its purchasing power in buying goods and services) will fall to match the cost of extracting gold and we reach a sort of “steady state” supply of gold.

As we can see above, the supply of gold, which is to say the supply of money in a gold standard, is determined by the market. It is important to mention here that the initial stock of gold, as well as the addition to gold stock through mining, are irrelevant from the point of view of operation of the gold standard.

We can take a stylized example of an economy to understand the above point.

Assume an economy which produces only one good – say 1000 units of X. Assume the initial stock of gold in this economy is 1000 kgs and gold is the accepted medium of exchange. This 1000 kgs of gold is split between two market participants, say A and B, equally – 500 kgs each. What will be the price of one unit of X in this economy? X will cost 1 kg gold, and both A and B can buy 500 units each of X. Now, in the same example, assume that the initial stock of gold, which is split evenly between X and Y, is 1 kg. The price of one unit of X will be 1 gm and A and B can both still buy 500 units each of X. Now assume that because of a certain technological innovation, it has become easier to mine gold and the stock of gold in the economy increases to 2000 kgs. Ceteris paribus, the price of one unit of X increases to 2 kgs of gold and A and B can both still buy 500 units of each.

In a fiat money economy, the way to think about this is to imagine that one morning when you wake up, you are told that an extra “zero” has been added to all monetary denominations. So Rs 10 is now Rs 100. What used to cost Rs 10 before will now cost Rs 100. Similarly, if you were earning Rs 10 before, you will now earn Rs 100. In real terms, nothing changes. By adding an extra zero, we have increased the monetary base in an economy ten times. If the initial stock of money in an economy was Rs 10 lakh, it is now Rs 100 lakh. In real terms, nothing changes. In nominal terms, the purchasing power of rupee has fallen – what you could previously buy with Rs 10 will now cost Rs 100.

What is important is real consumption of goods and services. Money is simply used to exchange goods and services. If there is a huge initial pile of gold, prices will be quoted in tonnes or million tonnes. If we have very limited supply of gold, prices will be quoted in grams or milligrams. We can use any unit we want, it couldn’t matter less.

Can we shift to a Gold standard today?

Yes we can. Most of the criticisms against the gold standard have already been addressed above. We saw how in a free market gold standard, even though everybody has the right to issue currency, there is no chaos or dooms day. The market will choose as currency the paper receipts which have the highest credibility for redemption in gold. In fact, the term ‘dollar’ originated from coins which earned a reputation for their quality.

Murray Rothbard in his book, What has the government done to our money:

The dollar began as the generally applied name of an ounce weight of silver coined by a Bohemian Count named Schlick, in the sixteenth century. The Count of Schlick lived in Joachim’s Valley or Jaochimsthal. The Count’s coins earned a great reputation for their uniformity and fineness, and they were widely called “Joachim’s thalers,” or, finally, “thaler.” The name “dollar” eventually emerged from “thaler.”

We also saw how the initial stock of gold or increase/decrease in supply of gold pose no difficulties in the technical operation of the gold standard. These are not merely assertions but facts that can be verified by studying monetary history.

Though we have implicitly addressed the criticism that there is not enough gold to shift to a gold standard, lets discuss this again through an example.

Assume an economy is running on gold standard. The gold reserves in this economy is 1000 kg and a dollar is defined as 10 kg of gold. Thus, there are 100 dollars in this economy. Now, the government abolishes the gold standard and monopolizes the function of issuing currency in the economy. With the link between the dollar and gold reserves broken, the government is now free to print dollars without any corresponding increase in gold reserves. Ten years later, the supply of dollars in the economy has increased to 1000 dollars.

If the government wants to re-introduce the gold standard, with the initial stock of gold reserves (1000 kg ) and the inflated supply of  1000 dollars, the dollar will have to redefined from being equal to 10 kg of gold to 1 kg of gold. We can shift back to the gold standard with the same initial gold reserves but an inflated paper money supply. The question of insufficient gold reserves does not arise. Ludwig Von Mises had remarked that an ounce of gold is sufficient to run a gold standard. I think we can appreciate the significance of this quote in the context of the above example.

We now need to address a final point before closing this post. Lets continue with the above example.

Before the government redefines the dollar as being equal to 1 kg of gold, the “price” of gold observed in the fiat economy will be lower than this rate, i.e., the dollar will be overvalued and gold undervalued. This is to be expected as under a fiat money system, the supply of dollars increase as a much faster rate than the supply of gold reserves. Gold has to be mined from the depths of the earth while money can be printed in bulk effortlessly. In our example, assume the price of gold in the fiat economy is half a dollar for 1 kg of gold. This creates a confusion that we need  2000 kgs of gold to convert the 1000 dollars into gold and shift to a gold standard. Since the gold reserves are only 1000 kgs, there must be “insufficient gold.” As we have seen, this betrays an understanding that money is not an independent entity, but a unit of account. The dollar simply has to be redefined to “equate” the available gold reserves with the existing supply of paper money.

When the government redefines the dollar as 1 kg of gold, immediately we see that gold has “appreciated” and the dollar has “depreciated.” 1 kg of gold previously used to fetch you half a dollar. After the introduction of the gold standard and the redefined dollar, 1 kg of gold will fetch you 1 dollar.

If you are a gold mining company (or individual) and were previously selling a kg of gold for half a dollar, you can now exchange the same for one dollar. If it was profitable to sell a kg of gold at half a dollar, its two times more profitable to sell a kg of gold for a dollar. This will lead to more companies (or individuals) engaging in gold mining. This process will continue until rampant mining bids up the cost of gold mining to such an extent that the profit return on gold mining falls to the return observed in other industries. The laws of normal profit which apply to any other industry in a free market economy will apply in the mining industry too.

Why did the Gold standard collapse?

If indeed the gold standard is a workable solution, why did it collapse? To answer this question, we will have to take a voyage through the monetary history of the world. We can keep this topic for a future blog post. Suffice it is to say here that the gold standard did not meet its demise because of any inherent flaws.

Indeed, the gold standard did not collapse – it was abandoned by the government.

——–

A single blog post cannot do justice to a topic as wide as monetary systems. I intend to write more on this in the future. In case you are not convinced regarding some points or feel that more clarity is required, please feel free to drop a comment and I will try to elaborate further.

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7 Responses to “A Guide to the Gold Standard”

  1. Ishant Goyal July 8, 2012 at 5:49 am #

    Talking about inherent flaws, how about the absence of any monetary policy in Gold Standard? Surely you cannot imagine Central Banks as stylised Gold mining companies, controlling the flow of Gold into the economy. I haven’t read too much on the monetary history of the world, but I see Gold Standard as a system where all the currencies (of the nations that subscribe to it) are pegged to Gold, and in turn pegged to each other. And this is theoretically the same as having a single currency in the whole system. Constituent Central Banks would lose all monetary policy powers in such a scenario. If nothing else, I see this as the overarching reason why any international monetary system with a single currency would eventually collapse as the constituent economies try to break free in order to pursue their policies independently. Euro continues only so far as the homogeneity of the economies that use it continues; any signs of increased hetrogeneity would create tensions in the system, and if unchecked, would eventually break it.

    As for whether it can ‘possibly’ be used today, we need to define what we mean by ‘technically possible’. Does it mean ‘theoretically possible, but may not be practically possible’ or does it mean ‘theoretically and practically possible, but may not be feasible’ (because of the presence of a more efficient monetary system)? I think in this post, you set out to prove the latter, but ended up giving arguments in favour of only the former, and that too only in a stylised economy with a single market, a limited number of consumers and a limited number of commodities.

    We need to appreciate the fact that in our world today, we have ‘independent’ ‘sovereign’ nations. And Gold reserves are not uniformly divided amongst all of them. The mining of Gold would never be like that in a ‘free market’. On the contrary, it would become the most restricted one.

    I have many more points to say, but the gist remains that Gold Standard is an impractical, even if theoretically possible. Maybe not as much as the Barter System, but not too far away from it either.

  2. Ravi Saraogi July 10, 2012 at 2:08 pm #

    Hi Ishant.. Thanks for your comments.. Following are my thoughts on the points raised by you..

    “Talking about inherent flaws, how about the absence of any monetary policy in Gold Standard? ”

    What you are terming as an “inherent flaw” is one of the biggest advantages hailed by Austrians in implementing a gold standard – the absence of a monetary policy. Like the absence of a monetary policy is an “inherent flaw” in the gold standard for you, the presence of a monetary policy will be an “inherent flaw” in the fiat money system for an Austrian. So whether the absence of a monetary policy is an “inherent flaw” in the gold standard or not depends on your ideology of the role of the government in the society.

    “Surely you cannot imagine Central Banks as stylised Gold mining companies, controlling the flow of Gold into the economy.”

    I am not sure what you mean by this. In a gold standard, we don’t need a central bank.

    “And this is theoretically the same as having a single currency in the whole system. Constituent Central Banks would lose all monetary policy powers in such a scenario.”

    Yes, you are right that if all countries implement a gold standard, its equivalent to the world having a single currency. There would be no central bank and no monetary policy.

    “I think in this post, you set out to prove the latter, but ended up giving arguments in favour of only the former, and that too only in a stylised economy with a single market, a limited number of consumers and a limited number of commodities.”

    The objective behind this post was to show a gold standard is technically and theoretically possible to implement today. The way to interpret this would be that if there is a political will to implement the gold standard, it can be done. Whether we should implement a gold standard or not, in terms of whether it is a better system or not, are questions beyond the scope of this post. We could take this up in separate post.

    With regard to using small stylized examples, I don’t see why that is a problem. The “single market, a limited number of consumers and a limited number of commodities” do not invalidate the logic behind the argument.

    “And Gold reserves are not uniformly divided amongst all of them.”

    This is a broad topic which we can discuss in a separate post, but for starters – in domestic transactions, the stock of gold reserves do not matter, and for international transactions, the gold standard has automatic stabilizers.

    Your remaining points highlight why the idea of a gold standard sounds outlandish in today’s world. I am sure it does.

  3. Perry July 26, 2012 at 3:43 am #

    Hi, how how are you? I am wondering how you would propose to get this actually enacted in Congress? I have listened to Ron Paul speak about our financial difficulties and have been attracted to learning more about this standard. I am doing a research paper on the Golden Standard and am thinking specifically how such a change would get through both houses and the executive branch. Can you please clarify this for me the best that you can?

  4. Ishant Goyal July 26, 2012 at 5:24 am #

    Let me read more on Austrian economics and get back to you. My limited knowledge on the topic notwithstanding, I would still stand by my argument of impracticality of any system which takes monetary policy out of the whole world, both at the domestic and international level.

    As I said earlier also, it is not impossible to implement this system (for the time being forget about the political and the academic will, howsoever influential or non-influential the latter might be). But from the onset, it would be beset to doom due to the contradictory forces prevalent in the system. Economic heterogeneity would gradually take precedence over subscription to a system which does not account for it. So even though it might get implemented, it cannot possibly sustain.

  5. Ravi Saraogi July 26, 2012 at 2:37 pm #

    @ Perry – Hi.. Presently there is hardly any consensus for a return to a gold standard. We have moved so much further into a paper money system that any talk of returning to a gold standard appears outrageous.

    If the thrust behind advocating a gold standard is to abolish the discretionary powers of the Government in influencing the money supply, then a way forward may be to implement Milton Friedman’s idea of fixing the rate of growth in the supply of money. The money supply in an economy would then be put under an “auto” mode and away from the Government’s discretionary powers. This would obviously not be a gold standard, but would achieve one of the purported advantages of a gold standard – no peddling in the money supply by the Government.

    If the thrust behind advocating a gold standard is an appeal towards ideas of liberty and freedom, then the market should be left to decide the medium of exchange. It is hoped that such a free market would settle for gold as a medium of exchange. Any move towards such a direction would require very gradual steps – steps like Ron Paul’s Audit the Fed bill, which requires greater transparency in Federal Reserve’s activities. A move towards the gold standard would require severe curtailment in the powers of the Federal Reserve. Another important move would be to abolish enacted laws which make it legally binding to only use the dollar as legal tender. Abolition of such legal tender laws would open “competition” in the market for establishing a new medium of exchange. Euro Pacific Bank’s Gold card is a case in point. You can read more about this card here.

    I am not sure if the above answers your question, but do write back with your thoughts.

Trackbacks/Pingbacks

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    […] of Federal Reserve, from 1987 to 2006. And when the head of a central bank speaks approvingly of a gold standard, we should listen. Here’s what Alan Greenspan had to say in a January 2011 […]

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