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Seeking Monetary Stability: The Elusive Gold Standard

I am not so much opposed to the gold standard itself as I am underwhelmed by arguments asserting the uniqueness of its benefits. My “meh” derives from two propositions: 1) Any policy benefit from a gold standard can be replicated by a set of rules governing the supply of fiat money; 2) the political will necessary to implement a set of rules that mimic the effects of a gold standard would never be greater, and almost surely would be less, than the political will necessary to implement a gold standard. Therefore, it would be better for advocates of sound money to support a set of rules by which the supply of money increases at a set rate—ideally, a rate that would, on average, result in zero inflation.

Advocates of the gold standard—entirely correctly—argue it is a commitment mechanism by which the government’s ability to manipulate the money supply, and so the value of money, would be constrained. The thing is, as we all know by experience, the strength of a policy commitment to a gold standard is no greater than any other statutory (or constitutional) commitment.

The question is, what’s the best way back to stable money?

What’s important about the gold standard is the discipline it provides to support price stability. A rule-based monetary system can provide as great a commitment to price stability—perhaps even more—but would be much easier to implement.

Most economists, including Milton Friedman, argue as long as the rate of inflation or deflation is stable—that is, is fully anticipated—then costs to inflation or deflation are minimal. I would go a bit further, arguing there is no justification for non-zero inflation.

Friedman writes in the opening chapter in his book The Optimum Quantity of Money,

Anticipated inflations or deflations produce no transfers from debtors to creditors which raise questions of equity; the interest rate on claims valued in nominal terms adjusts to allow for the anticipated rate of inflation. Anticipated inflations or deflations need involve no frictions in adjusting to changing prices. Every individual can take the anticipated change in the price level into account in setting prices for future trades. Finally, anticipated inflations or deflations involve no tradeoffs between inflation and employment.

The only reason to set the inflation rate consistently greater than zero is the belief that decreasing the interest rate in response to a recession can reduce the length and severity of the recession. Of course, to the extent that response is anticipated, then Friedman’s analysis above—anticipating the rational expectations revolution in macroeconomics of the 1970s—suggests an interest rate change will have no real effect. (New Keynesian economists have produced models showing sticky prices could result in real economic effects even for anticipated changes in the money supply. But that is a matter for another day.)

Friedman develops a case for a policy of modest, sustained deflation in his book. Friedman argues (modest) deflation—set at the same percentage as the nominal interest rate—would create real returns for holding money. Individuals and firms would therefore minimize transaction costs they otherwise incur when they take monetary transactions to secure positive returns for the funds they would otherwise hold as money.

Overall savings from reducing transaction costs would be modest. And Friedman concedes the “practical consideration . . . that the optimum rate of price decline will change from time to time” means that it would be “unwise to recommend as a policy objective a policy of deflation of final-product prices sufficient to yield a full optimum in the sense of this paper.”

With no compelling reason for a policy of planned, sustained inflation, and no practical reason for a policy of planned, sustained deflation, a policy of stable money—zero planned inflation—would seem at least weakly optimal.

Whether money is denominated as gold or as fiat money, zero inflation requires the supply of money to increase at the same rate as production increases. If the economy produces three percent more goods and services, then the inflation would be zero only if the supply of money also increases by three percent.

But discretion is the problem, and economic measures lag what actually happens in the economy. So the goal would be a non-discretionary increase in the money supply equal to the anticipated average increase in production over a given time span. This would take no more political will, and probably much less, than a return to the gold standard.

Of interest, given variance in the price of gold as supply and demand for gold change, it is entirely possible a rule-based system of fiat money would generate more price stability than a gold standard. To wit, a dollar of fiat currency would be backed by the basket of commodities (including gold, by the way) represented by the entire U.S. economy rather than backed by just one commodity. Hence, the variation of the value of a dollar backed by the basket of commodities reflected in the entire U.S. economy would almost always be less than the variation in the value of a dollar backed solely by gold.

The critical factor, whether for gold or for a rule-based monetary policy, is the commitment to maintain the regime, whether gold or the rule. The political will it would take to get a rule-based change in Federal Reserve policies through Congress would certainly be less than persuading Congress to re-adopt a gold standard.

On the other hand, even if Congress were to re-adopt the gold standard, it would be no more difficult to repeal a gold standard than it would be to repeal a rule-based policy for the Fed. A rule-based policy shares all of the virtues of a gold standard, yet, as a practical matter, would be politically easier to enact or adopt than a gold standard.

Reader Discussion

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on March 20, 2019 at 10:43:25 am

"Therefore, it would be better for advocates of sound money to support a set of rules by which the supply of money increases at a set rate—ideally, a rate that would, on average, result in zero inflation.

This comment reflects a flawed understanding of money and inflation.

Inflation is ANY increase in the supply of money, whether or not it is ever reflected in increases in consumer prices. The US money supply could be frozen at today's supply and the US would have enough money for any future level of economic activity. The money supply does NOT determine the level of economic activity in an unhampered economy, production does.

Moreover, the natural course in an unhampered economy is for prices to gradually fall over time due to productivity gains. Increases in purchasing power is a goal of economic activity, not a flaw! A policy of continuous monetary expansion so as to achieve "zero inflation" (aka keeping prices stable) is counterproductive theoretically, and historically shown to lead to economic disaster (see the US monetary policy of the 1920s). Targeting stable prices is actually an inflationary monetary policy.

The advantage of a commodity money like gold is that market forces determine the supply and price. Production of (say) gold occurs only when the price for it as money or as a production input exceeds its production costs. There is no "brighter mind" in charge of deciding supply.

The author starts from a flawed economic premise and goes downhill from there...

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Image of OH Anarcho-Capitalist
OH Anarcho-Capitalist
on March 20, 2019 at 11:41:35 am

The Libertarian Party (UK) has just adopted a policy to end discretionary monetary policy at the Bank of England (I don't think the B of E will be too concerned at the moment as the Party is very small)
Members were given the choice of NGDP Targeting, Milton Friedman's K-percent rule or a Gold standard with direct convertibility. Guess it was no surprise from a load of crusty libertarians that they went for the Gold standard.
I was fairly neutral on the outcome being more or a free banking and bitcoin advocate.
One advantage of gold apart from the market determining supply with the convertibility aspect helping to keep it honest is that it limits the ability of a central bank to manipulate the figures somewhat. Either the gold is there or not.
With NGDP targeting who is measuring inflation or GDP?
Maybe the author is correct that something like NGDP or a rule on a fixed increase in the supply of money would be an easier sell. It would also arguably be easier to flout.

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Image of Brian Vickery
Brian Vickery
on March 20, 2019 at 15:12:20 pm

The problem is you have to define what "zero inflation" means. Inflation is measured in the value of a bundle of goods over time. But what goods to measure? The gold standard picks gold as the standard to measure against. The nice thing about gold is that it is hard to create (being an element requires substantial and costly nuclear reactions), mine (a lot of gold is already mined), or otherwise acquire. This means it is a relatively fixed quantity in circulation at any given point in time. There are other precious medals that have these qualities (silver, platinum, and palladium), and you could pick any one of them or a mixture of them or other things. But something has to be picked to measure how much inflation is occurring that cannot be easily gamed.

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Image of Devin Watkins
Devin Watkins
on March 22, 2019 at 05:47:12 am

[…] more money to fund projects for their favored supporters. Savings then lose value as prices are driven up by inflation. Citizens become less certain of money as a store of value and economic growth suffers. Government […]

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Image of Fiat Money and the Promise of Cryptocurrency
Fiat Money and the Promise of Cryptocurrency
on March 23, 2019 at 08:34:57 am

[…] more money to fund projects for their favored supporters. Savings then lose value as prices are driven up by inflation. Citizens become less certain of money as a store of value and economic growth suffers. Government […]

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Image of Fiat Money and the Promise of Cryptocurrency – Building Blocks for Liberty
Fiat Money and the Promise of Cryptocurrency – Building Blocks for Liberty
on April 18, 2019 at 12:08:59 pm

Contrary to Prof. Rogers's assumption, the United States government is not free to choose between a metallic system and a fiat currency. The Constitution requires a metallic system and forbids a fiat currency:

1. The basic unit of account is the 'dollar,' a silver coin (defined by reference to the Spanish milled dollar) containing 371.25 grains of pure silver or 416 grains of standard silver. There was no such thing as a 'United States dollar' before 1793. To change the definition (i.e., the metallic content) of a 'dollar' would require a constitutional amendment.

2. Neither Congress nor the states may make anything but gold or silver coins, or currency backed by the same, legal tender.

3. Neither Congress nor the states may issue fiat money ('bills of credit').

4. The foregoing prohibitions regarding legal tender and bills of credit apply not just to the states but also to the federal government via the Ninth and Tenth Amendments.

5. Congress's power to 'regulate the value' of domestic and foreign coin is not an unlimited power to redefine the value of the dollar however it pleases, but rather a limited power to adjust the weight and fineness of gold coins to ensure gold and silver coins both remain in circulation (counteract Gresham's Law).

The foregoing constitutional constraints are legally binding, even when, as now, Congress ignores them.

For more information, see:

1. https://deanclancy.com/the-constitutions-seven-money-clauses/

2. https://www.lawliberty.org/liberty-forum/issuing-an-existential-challenge-to-the-federal-reserve/

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Dean

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