Tuesday, August 28, 2012

Why the Gold Standard Is the World's Worst Economic Idea, in 2 Charts

From the conclusion of William Jennings Bryan's "Cross of Gold" speech:
Having behind us the producing masses of this nation and the world, supported by the commercial interests, the laboring interests, and the toilers everywhere, we will answer their demand for a gold standard by saying to them: "You shall not press down upon the brow of labor this crown of thorns; you shall not crucify mankind upon a cross of gold."
And he was right - the gold standard is an absolutely terrible economic idea. Yet, as the Atlantic points out (I shamelessly stole the title of this post from an Atlantic blog post by the same name), Ron Paul has managed to convince the world (or at least the Republican Party) that the gold standard leads to stable prices - which has been perhaps the greatest con job of his career.

It's been such a successful con that the Republican Party is even poised to advocate a return to the gold standard as a part of its 2012 party platform. However, even the Financial Times article has trouble spelling out potential benefits of this policy, instead noting only that
Any commission on a return to the gold standard would have to address a host of theoretical, empirical and practical issues.
Inflation has remained under control in recent years, despite claims that expansion of the Fed’s balance sheet would lead to runaway price rises, while gold has been highly volatile. The price of the metal is up by more than 500 per cent in dollar terms over the past decade.
The article finds the drawbacks much easier to describe concretely, however:
A return to a fixed money supply would also remove the central bank’s ability to offset demand shocks by varying interest rates. That could mean a more volatile economy and higher average unemployment over time.
So, the Republican Party is really looking to increase economic volatility and unemployment in order to ... stabilize the price of gold? Does that seem like a smart tradeoff to anyone else?

It is true that a gold standard can lead to stable prices over the long run (as in, from one century to the next), but it doesn't matter to me at all whether prices next century are the same as this century - I, and everyone who is alive right now, will be dead by 2130, so we shouldn't care about long-run price stability. What matters to us much more is short- and medium-term price stability - how does the gold standard fare on that front?

Here's a chart of inflation in the U.S. during the most recent period of time the U.S had a gold standard:

Source: The Atlantic.

So, under the gold standard, you could have inflation as high as 24%, and just a few months later, you could see deflation of 16%. Wow, what stable prices!

On the other hand, here's a chart of US inflation during the past few years - years during which the Fed was practicing quantitative easing, which many conservative commentators, politicians, and economists were sure would lead to runaway inflation:

Source: The Atlantic.

OMG, would you look at the ... utter lack of runaway inflation or deflation. On the other hand, if you want to see runaway inflation and deflation, perhaps you should take another look at the rates of inflation and deflation under the gold standard in the previous chart.

But why are prices so volatile under the gold standard? I'll explain - let's assume, for the moment, that the price of gold is fixed and immutable over time (note: this is a bad assumption, but it simplifies my explanation, so we'll stick with it for now). If the price of gold is fixed, then the value of your money is also fixed over time and can't change - but we'll assume that no other country is on the gold standard (because it's a dumb idea and they're not ruled by the Republican Party), so their currencies aren't fixed to the value of your currency. You might think this arrangement is a good thing, but it's not. Prices of some things relative to other things change all the time - the prices of oil v. gold, of different foods v. oil or gold, of finished goods like computers v. oil or gold, of services v. oil or gold, etc. But, these products and services aren't just produced and consumed domestically - you can trade food for oil with Saudi Arabia, or food for cars with Japan, etc. If the value of a country's currency is fixed, then relative prices and wages can only adjust between each other and between other countries by increasing or decreasing - but the problem is that both wages and prices are "sticky;" that is, businesses don't like to constantly revise their price lists (because that's expensive), and workers HATE to receive less nominal pay (because it makes them feel like they've lost something). Therefore, every single person in your country experiences a lot of pain under a gold standard system, because both prices and wages have to constantly change, as shown by the first chart above. Furthermore, if you're on a gold standard and other countries aren't, you've put yourself at a competitive disadvantage, because when economic trouble comes, they can devalue their currency, making their goods cheaper than your goods - so they sell more than you and recover, while all you do is increase your holdings of (somewhat cheaper) foreign fiat money, as your consumers buy cheaper goods from abroad.

For an extremely timely case study on what happens to a country in economic trouble under (a monetary regime very similar to) the gold standard, see Greece.

But enough of my poor explanations - what do the experts think? According to a recent poll of leading economists found that exactly zero economists (conservative, liberal, freshwater, saltwater, or other) agreed with the statement, "If the US replaced its discretionary monetary policy regime with a gold standard, defining a 'dollar' as a specific number of ounces of gold, the price-stability and employment outcomes would be better for the average American."

One might think that the Republican Party would look at the data and experts' opinions and think, "Hey, I guess we were wrong about that whole inflation / gold standard stuff," but no, they look like they're going to double-down on their misguided economic ideology rather than adapt to what reality is showing them.

What baffles me most, however, is that the Republican Party doesn't even seem to feel the need to explain WHY they think returning to the gold standard is a good idea, other than "OMG, gold has gotten expensive." Is it a bigger problem that the price of gold is more volatile, or would it be a bigger problem if the whole economy was more volatile and unemployment was permanently higher?

Then again, I haven't followed the advice of right-wing pundits and sunk all my money into gold - perhaps if I had, I'd be more excited about exchanging permanent economic volatility and higher unemployment for a more stable gold price.

But, for practically everyone in the U.S. (including most businesses), a return to the gold standard would be a personally catastrophic economic event, and it would greatly increase the frequency of destabilizing periods of both higher inflation and grinding deflation, as well as permanently increasing unemployment.

Personally, I question the rationality of any party or person who looks at the above charts and concludes that, for society on the whole, the gold standard will lead to a better outcome than fiat currency.


  1. I had an interesting back-and-forth about this post on Facebook, so I'll post it here for posterity:

    DB: I am certainly no economist but it would seem to me that the reason for a gold standard is to have a standard. Science is not possible without agreed upon standards. How can the results of an economic experiment be judged if there is no agreed upon standard? Is an hour of labor today worth more or less than in 1898? A loaf of bread in 1923? A pair of shoes in 1621?

    This is the reason the science of economics is ruled by magicians, thieves, and politicians. Despite all the advances of modern science and the wonders it has brought, we live in the Dark Ages ruled by men of greed.

    The Angry Bureaucrat: Interesting question - I'd say an hour of labor is worth a lot more today than in 1898. For example, in an hour in my job, I can send and receive 50 pieces of correspondence to various people around the world, run data analyses to tell me exactly what the demographic distribution of the country is and will likely be for the next 100 years, and print off a book for me to read later. And that's taking it easy. It would take many days (if not weeks) to accomplish the same amount of work in 1898, because technology has advanced so far. By the same token, both bread and shoes are cheaper now, since they cost so much less labor to make than they did in 1923 and 1621. I'm not sure how that informs the second part of your post, but I'd say that yes, labor is worth more and bread/shoes are worth less now than in the past.

    DB: I would agree. This nation has gone from 90% of us being farmers to 2% of us being able to grow more than we can eat. I don't even like shoes but I have a half dozen pairs. Yet millions have no shoes and die from lack of a loaf of bread to eat. How can this be possible?

    The financial institutions of the world lives in fear that it would be possible to bury your money in a mason jar and have it be worth the same amount 20 years later. Without "mild inflation" (to use the Federal Reserve parlance) *saving* money makes sense. Instead, anyone with any common sense knows you must *invest*your money or inflation will eat away at your savings. Once invested in the financial system, the magicians are free to use your money to create financial innovations based on capital reserves, fractional lending, and re-hypothecation. Their best trick this time was to pawn off the risk they created on other *sophisticated* investors through securitization.

    Inflation has many causes but its historical cause is a government printing press. More recently the Federal Reserve has done away with even the cost of printing (coining costing more than the smallest denominations are worth now) and just creates zeros and ones on its balance sheet. A gold standard might be a barbaric practice of the stone age, but the participants at Brenton Woods thought it had some value. I for one prefer the thinking of the Bretton Woods participants to the modern day money changers. Having seen the cost and horror of war and having the memory of what caused it fresh in their minds, they thought gold made pretty good sense.

    1. Continued:

      The Angry Bureaucrat: ‎"The financial institutions of the world lives in fear that it would be possible to bury your money in a mason jar and have it be worth the same amount 20 years later" - that is certainly true, and I will not be one to defend modern-day Wall Street - I certainly think it would be better for everyone if banking was a boring, tightly regulated business, like it was for most of the 20th century. But, returning to the gold standard as a way to reign in the bankers is, at best, misguided - it would be far more efficient (and less catastrophic) to reign in the bankers directly.

      It comes down to what is most important to you/your country when designing/choosing money - is it more important that money be a constant store of value over time, or is it more important that it facilitate commerce? It can do both, of course, but one function will necessarily overshadow the other. I would argue that it is more important for money to facilitate commerce than to be a constant store of value over the decades/centuries. As you point out, the gold standard enables the hoarding of cash - all this really enables is for people to delay consumption from one time period to the next. This can actively discourage investment and economic growth, as hoarding cash is almost always bad for the economy (see http://en.wikipedia.org/wiki/Paradox_of_thrift).

      Fiat money, however, if functioning as a reasonably good store of value in the short-term but subject to mild inflation, encourages commerce, economic activity, and economic growth rather than cash-hoarding - fiat money encourages people to put money into interest-bearing accounts at (ideally tightly-regulated) banks, and those banks can then (ideally conservatively) loan that capital out to people and businesses who want to invest that capital in enterprises that are more productive than hoarding cash in a jar. Furthermore, if some people want to hoard constant stores of value, they are free to do so - they can buy gold or whatever else with their fiat money, and then hoard those constant stores of value instead of money.

      So, I'm totally with you with the need to reign in today's financial institutions - I just don't want to do so by crippling our financial system, which would be the likely outcome of returning to a gold standard. It would make much more sense to reign in the big banks and other financial institutions directly.

      DB: I am well aware of the paradox of thrift. I see it in action every day as evidenced by the $2 trillion in cash sitting on American corporate balance sheets and a negative rate of return on Swiss bonds.

      As I stated in my first reply, I'm no economist. I'm just a dumb redneck from SC. From what little I have read though it appears that fiat currency is always tied to the inability of a country to fund its wars. I can't help but think the two are linked and we are headed once again towards disaster.

      Thanks for taking the time to respond. I enjoy hearing opposing points of view. Who knows, at some point down the road I might even admit I'm wrong. Unlike politicians, its not a fatal mistake if I do.


      If you want to keep up with discussions like the above, "like" The Angry Bureaucrat on Facebook (link on the right of the page).

  2. Angry Bureaucrat,

    I'm so glad you posted this because I haven't seen much dissent against the gold standard presented concisely and backed by numbers. However, I think the premise "the gold standard will stabilize prices" is incorrect. I'm sure pundits have claimed this, but many people in my circles and I who are for the gold standard agree that hard money is good for a different reason altogether: to reduce the amount of wealth held by banks and increase the amount of wealth held by people in society.

    Before the gold standard was abolished in the USA, banks were not as big of a business as they are today. Fiat currencies naturally feed the banking industry since they collect the minute, but compounded interest rates over the years. The main idea of hard money is the banking system would be reduced to just their main purpose: to hold money for people and lend to businesses. The banks would not have enough wealth to play in the stock, commodity, and forex markets like they do today. Then, most of the wealth held by banks that is used to trade securities and debt instruments would be returned to society for businesses, roads, schools, homes, etc.

    I agree with you that a hard money system backed completely by gold would not stabilize prices like fiat money does. 100% agree with you there. However, a hard money system backed by a mixture of gold, silver, oil, and man-hours would be less volatile.

    And of course most economists would not like a switch to the gold standard. First of all, that would require major change, which nobody likes to do. Second, most economists are taught Keynesian economics, which in theory is fantastic! In reality, the side effect is wealth being siphoned into the banking industry slowly over time from the printing of fiat currencies of every major country in the world. In reality, hard money will produce more volatile prices, but society will hold most of the wealth, and it won't erode over time.

    But hey, hard money or fiat money... either system works until the people get tired of it and revolt, right? For me, I like hard money personally because I know I can handle price changes more easily than most (I've got an "always prepared" mindset). So I like the benefit of having wealth in society's hands since price volatility is not a downside for me.

    Thanks for the post. Cheers.


    1. M: Thanks for your thoughts. See the above comments to see why I disagree with you - I think there are far easier ways to reign in banks (i.e. by just regulating them directly) than to return to the gold standard. [Semantic note - I'll note that the U.S. dollar is still "hard currency" even though it's fiat money - see https://en.wikipedia.org/wiki/Hard_currency.]

      For the reasons I outline above, it's likely that returning to a gold standard would actually mean there would be LESS money available to society, not more. It goes back to what the primary (but note sole) purpose of money is - as a store of value, or as a means to promote commerce. There are lots of potential stores of value, but fiat money is by far the best way we've yet invented to promote commerce.

      -The Angry Bureaucrat