Tuesday, March 7, 2017

Good as Gold, II: What Is “The Gold Standard”?


Yesterday we noted that reinstituting the gold standard wasn’t all that bad an idea.  It would restore a measure of sanity to the financial world, plagued throughout the globe by “flexible standards” for currencies . . . despite the fact that “flexible standard” is a meaningless concept, useful only for confusing the public beyond hope of comprehension.
There are, however, two problems with implementing the gold standard.  One, what is “the gold standard”? and two, it isn’t feasible.  We’ll look at these problems in order.
Bela Pratt's U.S. "Half Eagle" — Five Dollar Gold Piece.
So, what is “the gold standard”?  It depends on who you ask.
To some people, reinstituting the gold standard means returning to those halcyon days when men were men, women were women, and all the money was gold, except for some silver and bronze for the peasants.
While we’re sorry to burst the bubble, the hard truth is that there was never a time in the entire history of the world when the entire money supply of any country, region, state, municipality, whatever, — or even a major part of it — consisted exclusively of gold.
That is, unless you define money as gold, and gold as money, then of course the entire money supply was gold . . . but you kind of cheated.
Benedetto Pistrucci's "Saint George and the Dragon" £1 Reverse.
One definition of money is “the medium of exchange.”  That being the case, any means by which you carry out exchange is, ipso facto, “money.”  (This is, in fact, one of the underlying assumptions of the "Banking Principle," in which money is defined as "anything that can be accepted in settlement of a debt.) For the entire money supply to consist of gold, however, all transactions would have to be carried out exclusively with gold, nothing else.
So we necessarily toss out that definition of the gold standard on the grounds that there just isn’t enough gold to function as money in the world, and it is historically inaccurate as well.
Another, more realistic understanding of the gold standard is that the unit of currency is defined as being a certain amount of gold, and the official, legal tender currency is either gold, or convertible into gold on demand.
Mind you, that doesn’t mean the legal tender currency is backed by gold.  It can be backed by anything.  During the heyday of the gold standard in the United States, 1878 to 1913, the legal tender banknote currency was not backed by gold, but by government debt.  It could, however, be converted into gold on demand.  In this understanding of the gold standard, the currency, whatever it’s made of, is legally the same as gold.
You can, of course, also have the case where the legal tender currency is not convertible into gold, but is simply measured in terms of gold, as was the case in the United States from 1933 until Nixon took the U.S. dollar off the gold standard as a result of the government having issued too much debt to finance the Vietnam War and the War on Poverty.
So what’s wrong with any one of these versions of the gold standard?
No, not alchemy, just converting into gold, not transforming.
Two things.  One, for a gold standard currency to be stable, it must be convertible into gold on demand.  That means the government must maintain sufficient gold reserves to be able to convert the legal tender currency into gold on demand.
That’s not a problem when the legal tender currency is backed by private sector hard assets.  The amount of currency in the economy is strictly limited by the need for it, and most transactions in the private sector, even in the nineteenth century, did not use currency.  Instead, they used bills of exchange, mortgages, letters of credit, demand deposits, promissory notes . . . just about everything except the legal tender currency.  A crude estimate is that actual legal tender currency was used in less than 5% of transactions, and that is probably a great overestimate.
The problem with the gold standard comes in when the legal tender currency is backed by government debt.  If the government is responsible, it will refuse to issue more debt (create more money) than what will exceed the demand for convertibility.  If the economy needs more money, that’s too bad.  Growth is stifled, and deflation occurs.  If the economy needs less money, that’s too bad, too.  Inflation spurs the wrong kind of growth.
. . . who took the U.S. off the gold standard.
The only advantage to a gold standard when the legal tender currency is backed by government debt is that it puts a brake on government spending . . .until, like Nixon, the politicians realize they either have to stop creating and spending debt-backed money, or give up the gold standard.
Two, there is no direct link between the amount of gold and the productive and consumptive capacity of the economy.  This means that prices of everything else in the economy can fluctuate wildly in terms of gold, depending on whether there is too much, or not enough relative to the supply of and demand for other goods and services in the economy.
For example (and let’s not get technical about the actual values involved), if you’re using a gold standard, you don’t know what an ounce of gold is worth on the market . . . but you do know that it is an ounce of gold.  Thus, a fixed standard based on gold means that all prices reflect the market value of gold, while the price of gold remains exactly the same at all times.
Thus, suppose a dollar is defined as being worth an ounce of gold, and a loaf of bread costs a dollar (again, don’t get technical here, we’re just trying to make the calculation easy).  Suddenly there is a discovery of gold that doubles the supply and cuts the value in half.  A dollar remains defined as an ounce of gold, but a loaf of bread now costs two dollars, or two ounces of gold.
That was, in fact, the problem in the first half of the nineteenth century when most countries were on the silver standard . . . and production of silver worldwide was shooting through the roof.  At one point the price of silver hit 23¢ an ounce.
That was when most of the European countries decided gold was more stable and thus a better bet as a standard.  There was also the fact that Germany wanted to screw Austria-Hungary, which maintained the silver standard for a while . . . and then screwed themselves after the Franco-Prussian War by accepting silver in place of gold at the official price, while the French were buying it on the world market at a quarter of its official value. . . .
So, while  a fixed gold standard has certain advantages over government debt and a flexible standard, it still has problems.  Is there, however, a better standard that would get around the weaknesses of using gold?
We’ll look at that tomorrow.
#30#

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