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Going for gold: perils of entering the goldzone

By Lorenzo

Who would want the global monetary system to be at the mercy of the Bank of China?  Not conservative, free market types in the United States and elsewhere, one guesses.

Actually, it turns out lots of them do; all the people who support some sort of return to the gold standard, who think that the US (and other countries) should recreate the goldzone. Let me explain.

Gold shines
Some folk are quite impressed by the way the price of gold has shot up in recent years (all gold statistics are from the World Gold Council website).

Gold price in US$: on the up and up

As the price has shot up, so has gold’s attraction as an investment. It is a striking illustration of the mystique of gold that folk who, if any other asset quadrupled in price in 6 years, would call “bubble”, see the surge in the gold price as saying something profound about the global economic situation and monetary system.

Mined and recycled gold increasingly flows into (private) vaults

While industrial and dental use of gold has remained fairly constant, there has been a strong shift from demand for gold being dominated by jewellery to increasing interest in coins and bullion. With investment hitting 40% of mined and recycled gold, it is likely at about the levels that flowed into monetary gold at the height of the gold standard; movement between monetary and non-monetary uses of gold being an important feature (pdf) of the 1873-1914 gold standard.

After surging in price in 1979-80, gold was actually losing value as an investment in real terms until 2005, when it began a price surge which has seen it storm past its 1980 highpoint: but low real interest rates make gold a better investment (pdf). While Asian demand had tended to dominate the market, the striking change in demand for gold as an investment has been the dramatic European (particularly German) embrace of gold from 2008 onwards.

Investment gold, in tonnes

A certain Euro-nervousness perhaps.  Looking at jewellery and investment demand together, the way Asian demand dominates the gold market is clear.

Big in Asia: demand for gold for jewellery and investment in 2011, in tonnes.

India has long been a strong market for gold and, as they and the Chinese are getting richer; this (along with the aforementioned Euro-nervousness) is reflected in the demand for gold. For all the (largely American) goldbug chatter, Americans are not nearly as in love with gold as others are.

Still, there are voices calling for us all to enter the goldzone, to “go back to gold” as the basis for the international monetary system. But doing so would have implications they may not have considered fully.

Entering the goldzone
Money is a transaction good: the value of money is what it can be swapped for. In a monetary exchange economy, the price level (P) is the average swap value of money in circulation for goods and services. Using the Fisher-Friedman equation of exchange (money stock x rate of turnover of money for goods and services = prices x output: i.e. MV = Py), then P = MV/y.

The cost of production of money is merely a minimum constraint on its supply. For notes, this clearly not much of a constraint. (For coins, some premium over metal value for transaction utility can also be a factor.) In the case of a monopoly provider of non-convertible notes, there is no other constraint on its supply except that adopted by the monopoly provider. In economist George Selgin’s words:

The disadvantage of fiat money [.i.e. non-convertible money], relative to commodity money, rests precisely in the fact that its scarcity, being thus contrived, is also contingent. A matter of deliberate policy only, it is subject to adjustment at the will of the monetary authorities or, if those authorities are bound by a monetary rule, at that of the legislature. Consequently, although a fiat money can be managed so as to not only preserve its purchasing power over time, but also so as to achieve the greatest possible degree of overall macroeconomic stability, there is no guarantee that it will be so managed, and market forces themselves offer no effective check against its arbitrary mismanagement.

Hence the appeal of money being convertible, to provide an anchor for monetary stability not dependant on the monetary authorities (or, more accurately, that constrains them in specific ways). The money is then backed by whatever it is the money can be redeemed for (in the case of the gold standard, a set amount of gold).

That money can be “swapped out” by being redeemed in its set gold value means that the supply of convertible notes can be increased or decreased in line with shifts in propensity to hold notes, with no effect on the price level, and tend to do so in an equilibrating way, due to the constraint of people being able to swap out notes for gold. Cover ratios, a required ratio of notes to gold reserves, can be set but are not a necessary feature. The constraint is the right to redeem, not the number of notes.

Under the gold standard, since the price of gold in terms of money is fixed, increases in the demand for gold greater than the supply thereof (which would otherwise mean higher money prices for gold) can only manifest through lower prices for goods and services. To put it another way, under the gold standard, the price of gold is inverse to the price level; they move in opposite directions. (Though there is no price of gold except as registered in the price level; there is just the fixed rate of exchange of money for gold.).

If, as was the case in the 1873-1895 period, countries are entering the gold standard faster than the gold supply could match, the increased demand for monetised gold puts downward pressure on the price of goods and services. As the supply of monetised gold was not keeping up with the demand for monetised gold, this pushed the overall price level downwards (the only way the increased price of gold could register). Hence, output of goods and services expanding faster than the level of gold tended to have the effect of pushing down prices, just as the supply of gold increasing faster than output of goods and services tended to have the effect of pushing up prices.

Similarly, with the return to the gold standard after WWI, since the wartime surge in price levels were not compensated for by setting higher money prices for gold (i.e. more monetary units to purchase a given amount of gold), unless the demand for gold was restrained, there was going to be downward pressure on prices for goods and services (the only way upward movement in the price of gold could register). A problem exacerbated as countries re-entered the goldzone.

Demand for gold could be restrained by abandoning gold coins, by using gold-convertible foreign exchange as reserves (both of which were done) and by being willing to relax cover ratios (ratio of notes to gold reserves), which was not. The deflationary pressures registered in the falling commodity prices which were a feature of the 1920s.

When the Bank of France began to dramatically increase its cover ratio from 1928 onwards by continually raising its gold reserves without monetising the extra gold holdings, it dramatically increased the demand for gold, setting off (along with similar action by the Fed) a disastrous fall in prices throughout the goldzone, the only way the increased price of gold could register. As prices fell, output fell, spending fell, incomes fell and debt burdens surged, leading to a wave of credit crises and bank failures; the catastrophic slump (collapse in transactions/glut of goods and services) known as The Great Depression. The solution was to leave the goldzone; as countries did, they began to recover.

All in it together
For that is the thing about the goldzone; you cannot stop other countries entering. But it is worse than that; for you cannot stop them driving up the demand for gold. And the point of the system is to provide a fixed “swap value” for money, a fungible anchor for the value of money. Hence driving up the price of gold means driving down the price level for every country in the goldzone. (Remembering that, if you are in the goldzone, then you have a fixed exchange rate with gold and with every other currency in the goldzone.)

So, what it means to be in the goldzone is to be at the mercy of, not only your central bank, but every other central bank in the goldzone, entry into which cannot be blocked.  The danger is not even the average level of goldzone central bank incompetence, but the outlier level of central bank incompetence.

Indeed, a central bank outside the goldzone but able to affect the gold price could have much the same effect (as the failure of Franco-German monetary cooperation as Germany went off the silver standard helped destabilise the silver standard in the 1870s). Though being in the goldzone gives much greater ability to “suck in” gold. Simply undervalue your currency in terms of gold, so gold is overvalued–as the franc was when France went back on the gold standard in 1928–then gold buys more in your country and so will flow towards you. While it would be possible for other central banks to counteract such behaviour by releasing their own gold reserves, that would obviously have limits–not to mention creating a perverse incentive.

The European Central Bank is even currently giving us an object lesson in how stupid a central bank can be. (As Nobel laureate Thomas Sargent says, the euro is basically an artificial gold standard–remember that point about fixed exchange rates.)

So, how many central banks do you trust?

Which brings me back to where I came in–do you want an international monetary system where the price level in your country is at the mercy of the Bank of China? (Or, come to that, the Bank of Iran?) And what chances do you think there are of any set of national policy makers deciding that would be a good idea?

It is not as if this is remotely a made-up scenario. It was precisely because the interwar goldzone was at the mercy of the Bank of France and its insane policy (abetted by the stupid policies of the Fed) that the goldzone of the time was driven into that disastrous deflation and collapse in incomes we call The Great Depression. But, if you don’t notice the role of the Bank of France in precipitating the massive deflation–perhaps because you are obsessing over the alleged inflationary boom of the 1920s (which wasn’t an inflationary boom in any useful sense)–then this problem will likely not occur to you.

Even Friedrich Hayek who, in his Denationalisation of Money (pdf), declares that:

as long as the management of money is in the hands of government, the gold standard with all its imperfections is the only tolerable safe system

Also notes

the undeniable truth that the gold standard also has serious defects

and

Though gold is an anchor–and any anchor is better than a money left to the discretion of government–it is a very wobbly anchor. It certainly could not bear the strain if a majority of countries tried to run their own gold standard. There is just not enough gold about. … the increasing demand for gold, would probably lead to a rise (and perhaps also violent fluctuations) of the price of gold that, although might still be widely used for hoarding, it would soon cease to be convenient as the unit for business transactions and accounting

(Hayek also has an enthusiasm for fixed exchange rates I do not share; not only has a floating exchange rate been an excellent “shock absorber” for Australia, but the wider evidence is rather against them.)

It is all very well to want to have a gold standard without central banks, but that is not the way it would work. After all, your country can decide not to have a central bank, but what about any other country that enters the goldzone? Wanting a gold standard to replace or restrain central bank discretion turns out to be making your situation much more vulnerable to the discretion of many central banks.

Golden delusions
Some of what is going on in such golden hankerings–apart from an understandable wish for monetary stability (but have a look at that gold price graph again)–is an odd (and very ahistorical) notion that somehow thousands of years of monetary history was all naturally leading up to a gold standard which, in its classical form, lasted 40 years. (A blessed state we have since lapsed from.)

Admittedly, the UK was on the gold standard much longer than 40 years (roughly 200 in fact). But that had been a fully British–largely Bank of England–managed system. The 1873-1914 international gold standard was also largely managed by the Bank of England; in a sense, a pound sterling for everyone, just as the eurozone is a deutschmark for everyone.

On eurozone as goldzone redux, take a wild guess at which countries were forced back off the C19th gold standard during its 1873-1895 deflationary period. If you guessed Italy, Spain, Portugal, and Greece (amongst others), well done.  These words about the painful strictures of the gold standard when it was deflationary may sound strangely familiar:

Deflation forced a difficult choice between deteriorating borrowing conditions and painful adjustments. Countries starting with relatively low debt levels could compromise, letting their debt drift slightly and making only partial fiscal adjustments. But for those that already had fairly high debt levels, such as the southern European countries, the adjustment cost required for continued participation in the gold standard could be very large, especially since the market mechanism implied that a sustained deterioration in public debts meant accelerating premia for new loans. The opportunity cost of being part of the gold standard was becoming very substantial, increasing the pressure to switch to seignorage finance, and go on inconvertible paper to escape gold deflation.

Conversely, the US Federal Reserve–which dominated gold reserve holdings after WWI, and still does–failed to manage the interwar gold standard, particularly after the death of Benjamin Strong.

The notion that the C19th gold standard could be a pound-sterling-for-everyone was the same delusion as the euro-as-deutschmark-for-everyone; that money can be just money. But there is no such thing as just money. Not merely in that money is a multidimensional phenomenon but because money operates within webs of institutions and presumptions; adopting a monetary system does not bring those institutions and presumptions with it, the transacting parties using money bring their presumptions and social placements with them.

If you see money as some naturally evolved specific thing, or even as just a tool, you will be misled. Austrian school economist William Garrison puts the notion of the gold standard as a natural evolution clearly:

(1) Left to its own devices, a market economy will give rise to medium of exchange.(2) The commodity that emerges as the medium of exchange will be one that possesses a certain set of characteristics. (3) This set of characteristics has its clearest and most pronounced manifestation in gold. So conceived, the gold standard—at least in its purest form—neither requires nor permits the State to exercise control over the money supply. …. The proponents of gold are not suggesting that irresponsible tinkering is inevitable—whatever the nature of the monetary system; they are instead making the sharp distinction between a designed institution and an evolved institution.

Yet even the UK entered the gold standard by accident. Historically, silver has been a much more important monetary metal than gold. (The pound sterling was originally a weight of silver.) Across the centuries, there was a shifting ratio between gold and silver, depending on the ebb and flow of discoveries and sources for each, though generally not too far from the 1:17 gold/silver ratio in the Earth’s crust. (The Wizard of Oz is a political allegory on [pdf] the silver-gold debates of the late C19th in the US that sparked one of the great political speeches.) In 1717, the then Master of the Mint, a person with some prominence in intellectual history, set a ratio between gold and silver coins that overvalued gold and undervalued silver, so gold bought more in Britain and silver bought more overseas. Naturally, gold flowed into Britain and silver flowed out, effectively (and accidentally) putting Britain on the gold standard. Which it was then on continually, apart from wartime suspensions in 1797-1821 and 1914-1925, until 1931.

As for the 1873 breakdown of the highly functional system of a gold bloc (led by Britain), a (mostly Asian-Germanic) silver bloc and a bimetallism bloc (led by France), in economic historian Marc Flandreau’s words (pdf):

far from being preordained for structural, technological or political reasons, the making of the gold standard was an accident of history.

A result of the breakdown in international monetary cooperation between France and Germany after the Franco-Prussian War and the German imposition on a defeated France of a huge war indemnity (equal to about a third of French GNP; the French paid it off in three years–puts German whining about post-WWI reparations in perspective).

When one examines the actual history of money, as distinct from Just So stories about money, the most important factor in monetary history has been that rulers and states being–as a consequence of their coercive power, and so the scale of their expropriations and spending–the largest transactors, they have therefore had the biggest stake in, and the most power over, monetary systems. The history of money has been a long history of the interaction between the power of rulers and the exigencies of transacting, with monetary innovations often being the response to past abuses. (Coins have regular bumps on their edges, reeded edges, to prevent clipping, for example; though rulers have been the main source of monetary abuses, a history of abuse that greatly predates central banking.)

It is a profound delusion, this notion that the gold standard would protect us from the failures of central banks; only remotely plausible if you think that somehow inflation is all you have worry about central banks inflicting on us. Sadly, they have many more ways of screwing up than merely inflating.

Personally, I don’t fancy being in a monetary system at the mercy of the Bank of Iran. How about you?

[UPDATE: In Chapter 7 of his Monetary Mischief: Episodes in Monetary History, Milton Friedman details how US silver purchases under FDR--in order to get support from Senators of silver mining States for his New Deal legislation--drove China offer the silver standard.  Another example of how being on a metal commodity standard can make one's monetary system, and so economy, highly vulnerable to the actions of other governments.]

54 Comments

  1. TerjeP
    Posted July 17, 2012 at 12:44 pm | Permalink

    The deflationary post the US civil war in the US and post WWI in Britian and commonwealth nations linked to the pound needs to be properly understood. The deflation was a product of the way the gold standard was implemented in both instances. If the fix price had been in line with the previous market price the deflation would have been avoided.

  2. Posted July 17, 2012 at 12:50 pm | Permalink

    Yes, if you do not overvalue your currency (and thus undervalue gold), then that will not create deflationary pressure due to the price of gold rising/price level rising.

    But the 1928-onwards deflation was quite a different problem, as was the 1873-1895 deflation, both of which were general throughout the goldzone.

  3. TerjeP
    Posted July 18, 2012 at 8:13 pm | Permalink

    In 1925 pretty much the whole British commonwealth of nations goes onto the gold standard at a horrendously low gold price. You’re asserting that other gold standard nations, not on the pound standard, suffered deflation as a consequence of gold demand. Some examples and some explaination of their monetary policy circumstances would be helpful in making your case.

  4. JC
    Posted July 18, 2012 at 8:29 pm | Permalink

    Personally, I don’t fancy being in a monetary system at the mercy of the Bank of Iran. How about you?

    Huh? Why the bank of Iran? I don’t see your point there?

  5. Posted July 19, 2012 at 6:57 am | Permalink

    JC@4 Just using it as an example of a possible rogue central bank.

    TP@3 As Britain had the necessary gold reserves to cover going back onto gold, the deflationary effect was mostly limited to the UK, since its price level was most “out of whack”. There is a reason the General Strike was in 1926.

    Since the pound was overvalued (so gold was undervalued), gold flowed out of Britain to where it bought more.

    It was not until the undervalued franc went back on the gold standard (so gold flowed into France, where it bought more) AND the Bank of France used the gold inflow to continuously run up its cover ratios (effectively taking gold out of the monetary system, so driving up its price) that deflation was imposed on the entire goldzone (fixed exchange rates and only one world price for gold).

    That the Fed was also “sterilising” gold inflows exacerbated the effect.

    Douglas Irwin’s paper, that I linked to in the text, has the details.

  6. JC
    Posted July 19, 2012 at 9:28 am | Permalink

    lorenzo

    You don’t seem to be distinguishing between the various gold systems. The gold “standard” around after the war was really a system of fixed exchange rates. Everyone knew that and when the French came knocking on the US gold window in 1971 the were told to get lost and the US floated that weekend.

    I think blaming the gold standard for the problems in the early 30′s is ignoring the fact that both Hoover and FDR essentially froze wages along with goods and services markets.

    There are huge differences between a classic gold standard and the other systems set up such as the ones in the 30′s and then after WW2.

    There are huge problems with going back to gold now and wouldn’t work as domestic markets are not flexible enough.. wages and goods. NGDP would work best.

    JC@4 Just using it as an example of a possible rogue central bank.

    Yes I know. However why is there a difference in the Bank of Iran holding Dollar reserves or gold in your mind? I don’t quite get why the Bank of Iran would be more of a rogue with gold or should be feared more.

    Lastly monetary union is nothing like a fixed or pegged exchange rate. There is a huge difference between Hong Kong’s dollar peg/ Britain and Scoltland’s monetary union.

    It doesn’t work in the Europe because the euroweenies never bothered to harmonize that labor and goods market along with welfare. That’s why it’s cracked.

  7. derrida derider
    Posted July 19, 2012 at 10:43 am | Permalink

    MV=Py should be MV≡Py. It’s the Fischer-Friedman identity, not equation. This matters because identities are purely logical propositions. “The propositions of logic are all tautologies” (Wittgenstein) – they flow from the definitions of the terms and so tell you nothing about the state of the world. Policy implications can only flow from the empiric, not logical, relations between those terms.

    Sorry for the Phil101 rant, but this was a crucial point in the old arguments about monetarism, and I suspect it is a crucial point in arguments about commodity-based money. We can only assume M=PV/y in a model where P, V and y are independent of each other. But we know that in fact V and y are causally linked to each other. And unless you’re an RBC type who assumes superneutrality of money P and y are too, at least in the short run.

  8. Posted July 19, 2012 at 11:11 am | Permalink

    DD@7 I prefer words and graphs: maths is not my favourite language at all.

    Actually, I had a niggle about how to think about what is constraining what and your comment has brought it up again, thanks.

  9. kvd
    Posted July 19, 2012 at 1:36 pm | Permalink

    dd@7 that is one of the most useful comments I’ve read on this much quoted ‘equation’ – except then you went and b-ggered it up by restating it incorrectly (sh. be M=Py/V) ;)

    Anyway, thanks. Mathematical equations should/must operate consistently over all ranges of factor values and can be re-stated to produce any unknown factor, whereas logical propositions – yes, I think I’m now a little more along the line to understanding some of Lorenzo’s points, thanks to you.

  10. kvd
    Posted July 19, 2012 at 1:38 pm | Permalink

    And then 6 becomes 7, magically…

  11. Posted July 19, 2012 at 1:44 pm | Permalink

    JC@6 I have let your comment out for this thread because you raise some reasonable questions; if you don’t play nice you go right back in.

    I think blaming the gold standard for the problems in the early 30′s is ignoring the fact that both Hoover and FDR essentially froze wages along with goods and services markets.

    Since they were responding to the enormous collapse in income and economic activity that had already happened, they could hardly be causing it. Particularly not it being serious right across the goldzone.

    As soon as FDR took the US off the gold standard, the US had its fastest ever recorded recovery in industrial production. Then brought to a screeching halt by the passing of NIRA, but that is another story.

    As for differences between gold standards, the post WWII Bretton Woods system is such a different beast, I did not discuss it at all. Since it also presided over mass global surge in prosperity, its differences would appear to be to its advantage.

    There are huge differences between a classic gold standard and the other systems set up such as the ones in the 30′s and

    People went back on the gold standard in the 1920s. And, absent the differences (lack of gold coins, increased use of convertible foreign exchange as reserves) the problems would have hit much quicker by driving up the demand for gold much sooner. The changes were necessary to make it workable at all.

    However why is there a difference in the Bank of Iran holding Dollar reserves or gold in your mind? I don’t quite get why the Bank of Iran would be more of a rogue with gold or should be feared more.

    Nothing Iran can do with dollars would force deflation on the US. Being on gold creates a far greater degree of vulnerability.

    Lastly monetary union is nothing like a fixed or pegged exchange rate. There is a huge difference between Hong Kong’s dollar peg/ Britain and Scoltland’s monetary union.

    But those differences are largely non-monetary. Such as fiscal union, labour mobility, common risk pool. The goldzone was very like the eurozone in that it is a fixed exchange rate across institutionally varied countries without fiscal union, significant labour mobility or a common risk pool.

  12. Posted July 19, 2012 at 1:46 pm | Permalink

    kvd@10 And then, through the miracles of moderation, it is fixed :)

  13. kvd
    Posted July 19, 2012 at 1:54 pm | Permalink

    Hey thanks Lorenzo! What a clever moderator you are!

    I think I remember my first or second ever comment on this blog was casting suspicion upon SL for her efforts in tidying up another commenter’s mess. My, how water flows under the bridge.

  14. TerjeP
    Posted July 19, 2012 at 7:19 pm | Permalink

    The gold standard was a key factor behind the Great Depression, but why did it produce such an intense worldwide deflation and associated economic contraction? While the tightening of U.S. monetary policy in 1928 is often blamed for having initiated the downturn, France increased its share of world gold reserves from 7 percent to 27 percent between 1927 and 1932 and effectively sterilized most of this accumulation. This “gold hoarding” created an artificial shortage of reserves and put other countries under enormous deflationary pressure.

    Lorenzo – the quote above is from your link. Thanks for this bit of monetary history as it isn’t something I was previously familiar with.

    How did France accumulate all this gold without flooding the world with Franks? And if they did flood the world with Franks, that were as good as gold, then it is not as if they were reducing global liquidity, just changing it’s form. Other nations would surely only have suffered deflation in so far as they insisted on backing their currencies literally with gold. However the only requirement of a gold standard is a fixed exchange rate with gold not how much physical gold you have. A nation can be on a gold standard and own no gold at all. As such it seems to me that deflation was still a policy choice.

  15. Posted July 19, 2012 at 8:16 pm | Permalink

    TP@14

    How did France accumulate all this gold without flooding the world with Franks?

    By continually increasing its cover ratio. So the gold inflow was “sterilised”.

    Yes, deflation was a policy choice: imposed on the rest of the goldzone by the Bank of France and the Fed.

  16. TerjeP
    Posted July 20, 2012 at 3:49 am | Permalink

    Okay but how did it sterilise? If it used stocks of pounds sterling to buy back those Franks then obviously that would be leading to an increase in sterling on the markets. What did it actually use to sterilise. Was it bonds, sterling, dollars, silver?

  17. Posted July 20, 2012 at 4:49 am | Permalink

    TP@16 At no point were the francs in circulating increased. So gold flowed in, the Bank sold foreign exchange and then did not increase circulation of francs.

    Remember, under the gold standard, the level of notes or other monetary assets in circulations is not the constraint, it is the price of gold which is the constraint. If you are taking gold out of the system but not increasing monetary assets, you are effectively driving up the price of gold.

  18. JC
    Posted July 20, 2012 at 12:44 pm | Permalink

    Since they were responding to the enormous collapse in income and economic activity that had already happened, they could hardly be causing it. Particularly not it being serious right across the goldzone.

    I’m referring to the American experience, as you know. When the crash occurred, Hoover in his wisdom began to take action by attempting to freeze wages and prices. FDR essentially became the second Hoover administration in all but name and began to do the same things thereby not allowing markets to clear.

    Remember that in their ignorance, they were not concerned with aggregate income but keeping wages high which in a slowdown is impossible. If they were concerned with aggregate income they would have allowed wages to settle.

    Combine that with what essentially was a fixed exchange rate and result ends up absolutely toxic. That’s 30′s America. The US did not experience one Depression, but a rolling number of recessions and depressions as one rotten policy was introduced after another.

    Now was the de-linking to gold, or the devaluation part of the solution? Of course it was. However the damage had been caused by the absolute toxic nature of their policies.

    Look, there is no free lunch, either the liquidation (adjustment) took place through a domestic devaluation.. ie.. a allowing the domestic price level to adjust to new realities or let it go through the exchange rate which in this case was monetary policy.

    As soon as FDR took the US off the gold standard, the US had its fastest ever recorded recovery in industrial production.

    Well yes and it also shouldn’t be surprising. However lets not kid ourselves or not bring to light the damage that was caused by those two administrations fucking around and interfering. Aren’t we seeing that now- a supply shock caused by this administration’s appalling suite of polices?

    As for differences between gold standards, the post WWII Bretton Woods system is such a different beast, I did not discuss it at all. Since it also presided over mass global surge in prosperity, its differences would appear to be to its advantage.

    However when discussing gold standard it is important to describe exactly what we’re talking about. Bretton Woods was not a gold standard. In fact it was an illiberal disgusting array of connected policies that I believe actually slowed the recovery from the war onwards. We would all have been wealthier without the structure of Bretton Woods. Americans were not allowed to buy gold. Australians had to freaking apply to the RBA for approval to buy foreign exchange even for an overseas vacation. these are jsut small examples.

    Bretton Woods was actually an attempt to slow down globalization and Keynes was smart enough to know that the system he helped put in place could only survive with the constraints he placed around it.

    We should not be under any illusions just how hampering Bretton woods was to welfare.

    Now back to the discussion about gold. I’m with you, I don’t think gold would work. However I don’t think gold would work because we don’t have economic systems with enough flexibility particularly in the labor markets.Consequently I back Sumner’s idea to the hilt.

    However lets not kid ourselves. The system that Scott is advocating is not one that promotes internal market flexibility. It’s simply the best option in the horrible system of mixed economies and government interference. It actually allows leftism to claim victory in our economic settings. That’s not a good thing.

  19. Posted July 20, 2012 at 3:30 pm | Permalink

    JC@18 One of the problems with seriously contractionary monetary policy is that it promotes bad policy and extreme politics. Without the first, Hoover and FDR would not have gone off on their frolics.

    Since the Bretton Woods system presided over the fastest rates of economic growth in human history, arguing the counter-factual that it made things worse is difficult.

    I have come to agree with supporters of the gold standard that central banks destroyed it. They do not seem, however, to “get” the corollary–that the problem with the gold standard is precisely how vulnerable it (or any fixed exchange regime) is to central bank malfeasance.

    And yes, if you have a central bank then it should be required to take responsibility both for price stability and income growth, which means NGDP targeting or some close analogue.

  20. kvd
    Posted July 20, 2012 at 4:00 pm | Permalink

    A ‘gold standard’ will never be allowed because it means that central authority would have to cede to ‘common people’ the right to pursue their own valuations as to the economic worth of their individual activities. Even in a democracy, that cannot be allowed to happen. /sarc

    I think JC makes a lot of sense on this, but can I ask either him or Lorenzo why it was that ‘many countries’ pegged to gold, rather than simply one – and then all others ‘relating’ to that? Don’t particularly care if it was US, GB or even Iran – one part of the friction seems to me to have been caused by having to reconcile ‘competing bases’.

    I’ve got a sense that the answer is political, not economic. Anyway, thanks for an inteesting discussion.

  21. Posted July 20, 2012 at 4:09 pm | Permalink

    kvd@20 The monetary monopoly has generated huge difficulties. The argument that it is a necessary element in good public policy is actually very thin and mainly gets by because it is just assumed. The more I study money and monetary history, the more sceptical about it I become. (And, if you think it is a necessary element in good public policy, that is no excuse for not analysing it for the monopoly it is.)

    why it was that ‘many countries’ pegged to gold, rather than simply one – and then all others ‘relating’ to that? Don’t particularly care if it was US, GB or even Iran – one part of the friction seems to me to have been caused by having to reconcile ‘competing bases’.

    I am not sure I entirely understand the question. But, it was possible for have one currency pegged to gold and then everyone else pegged to it. (Bretton Woods roughly worked like that.) But that is not a full gold standard. It is a fixed exchange rate system with a gold element.

    The key element in a gold standard is redeemability for gold. It is having a fixed price to gold which then generates all the other fixed exchange rates.

  22. JC
    Posted July 20, 2012 at 4:28 pm | Permalink

    JC@18 One of the problems with seriously contractionary monetary policy is that it promotes bad policy and extreme politics. Without the first, Hoover and FDR would not have gone off on their frolics.

    I’m not exactly sure you need changes in monetary policy if the domestic market is really flexible. I think it’s inflexibility that creates it.

    Since the Bretton Woods system presided over the fastest rates of economic growth in human history, arguing the counter-factual that it made things worse is difficult.

    You’d hope you had those sorts of growth rates after that level of devastation. But also lets remember that Europe was also blessed with a three decent people in leadership positions in Germany, France and Italy who produced some pretty decent supply reforms.

    I think the potential would have been much better with another system other than Bretton Woods. BW was anti-globalization as Keynes made sure capital movements were restricted or at least gave governments at the time the wherewithal to restrict them.

    Were growth rates good? Yea sure. However they could have been much much better.

    I have come to agree with supporters of the gold standard that central banks destroyed it. They do not seem, however, to “get” the corollary–that the problem with the gold standard is precisely how vulnerable it (or any fixed exchange regime) is to central bank malfeasance.

    You don’t need a central bank when there is a convertible gold ratio. You just need a gold window, that’s all.

    Again I’m not advocating a return.

    And yes, if you have a central bank then it should be required to take responsibility both for price stability and income growth, which means NGDP targeting or some close analogue.

    As I said I’m supporter, however I’m under no illusions that the reason we require NGDP is because of the inflexibility created by these fucked up mixed economies. We don’t need it for other reasons.

    In a fully flexible domestic market with little impediments you could even go back to a system where money has a store of value. Not now though.

  23. kvd
    Posted July 20, 2012 at 4:30 pm | Permalink

    The key element in a gold standard is redeemability for gold

    Lorenzo I read that, but then you previously went on to talk about France’s efforts at building up its store of gold – placing strains upon the system.

    I suppose what I still don’t ‘get’ about the disdain for a ‘gold standard’ is this unease about one country rather than another having more physical backing for a so-called standard which basically presumes ALL currencies have physical interexchangeability (a new word I invented!) with some inert substance called gold.

    I mean – either you do back it up, or you sell the story that you will back it up, if pressed. And most people won’t believe you.

  24. JC
    Posted July 20, 2012 at 4:42 pm | Permalink

    I think JC makes a lot of sense on this, but can I ask either him or Lorenzo why it was that ‘many countries’ pegged to gold, rather than simply one – and then all others ‘relating’ to that? Don’t particularly care if it was US, GB or even Iran – one part of the friction seems to me to have been caused by having to reconcile ‘competing bases’.

    The biggie(s) had to be pegged to gold. That is the US etc. If the biggest economy wasn’t it wouldn’t work. However the US was on a pretend peg as they never released their gold to those that had a claim on them at the official 35 bucks an ounce. It was very funny as the frogs litterally went over to see Nixon on a Friday and told the Americans they wanted immediate conversion of their US dollar holdings to gold and that weekend the Americans floated the dollar… ie.. no conversion. They screwed the Frogs, which was well deserved to but still kinda dishonest.

    The way the thing worked from memory was that the US pegged to gold that then everyone’s currency was on a defacto peg because their currencies had a small 2.5% band to trade in against the US Dollar, which Keynes thought was enough flexibility.

    Small currencies can’t peg to gold as they don’t have the ability to manage the peg. Can you imagine Australia for instance being able to hold the peg from when gold was around 300 an ounce to now where it’s trading at $1585? It would be impossible for us. It wouldn’t be impossible but we would be at the mercy of the gold market. Hence why the big ones would have to peg first.

  25. kvd
    Posted July 20, 2012 at 7:19 pm | Permalink

    JC@24 thanks. I will have to read up about that Nixon period, and I accept at least one ‘big one’ needs to peg first.

    But if you’ll accept an honest question about your Australian example: fine to accept Aus in isolation would have troubles in a movement from $300 to $1500+ – but that’s taking Aus in isolation, whereas presumably in that scenario, all her trading partners would be subject to the same movement?

    Hence relativity maintained, hence my question – what’s so ‘bad’ about that?

  26. kvd
    Posted July 20, 2012 at 7:34 pm | Permalink

    JC I have a comment in mod which I hope you or Lorenzo might answer, but I’m now 20 hours past last sleep, so don’t think lack of any immediate response is lack of interest. Fair enough?

  27. Posted July 20, 2012 at 8:41 pm | Permalink

    JC@22

    if the domestic market is really flexible

    Monetary policy has to be run for countries as they are, not as they ought to be. Wages, for example, are “sticky”. And no about of labour market liberalisation is going to eliminate that.

    You don’t need a central bank when there is a convertible gold ratio. You just need a gold window, that’s all.

    You don’t, but you are still at the mercy of someone else’s rogue central bank.

    kvd@23

    I suppose what I still don’t ‘get’ about the disdain for a ‘gold standard’ is this unease about one country rather than another having more physical backing for a so-called standard which basically presumes ALL currencies have physical interexchangeability (a new word I invented!) with some inert substance called gold.

    If your currency is not redeemable for gold, it is not on the gold standard. If it is redeemable for currency which is on gold, then you are on the gold exchange standard, but that is not quite the same beast. If the former, you need a certain amount of actual gold backing. If the latter, you need sufficient reserves in the relevant currency(ies).

    The point about the Bank of France was that it was effectively driving up the price of gold which could only register by driving down the price level in goldzone countries.

    On the issue of a biggie would have to peg first, we could go back to the pre1873 system of gold, silver and bimetallism. Looking at the economic stats, that was actually more stable.

    People talk about the gold standard lasting a long time, but it didn’t. Sure, the UK was on it for about 200 years, but a lot of other countries only jumped on board in the 1870s or after.

  28. JC
    Posted July 20, 2012 at 9:05 pm | Permalink

    But if you’ll accept an honest question about your Australian example: fine to accept Aus in isolation would have troubles in a movement from $300 to $1500+ – but that’s taking Aus in isolation, whereas presumably in that scenario, all her trading partners would be subject to the same movement?

    Hence relativity maintained, hence my question – what’s so ‘bad’ about that?

    Think of it like this. Say Australia went unilateral and pegged when gold was was US$300 an ounce. The Aussie US at the time was 55 cents. As we’re linked to gold, it means the exchange rate is:

    (Gold is now US$1,576 per ounce)

    $1,576 – $300 / 300 = 4.2533 X .55 = 2.33

    So our exchange rate would be 2.33 to the US Dollar.

    In other words we’d be dead economically.

    I’m not sure small countries going together would make much of a difference either.

    You need the 3 large economies pegging to gold. It could never work with the small ones. It would require the US China EU and perhaps Japan.

  29. JC
    Posted July 20, 2012 at 11:23 pm | Permalink

    Monetary policy has to be run for countries as they are, not as they ought to be. Wages, for example, are “sticky”. And no about of labour market liberalisation is going to eliminate that.

    Well I think they’re sticky and that’s true by and large. It would be interesting to see how sticky they were in history and by history i mean prior to the Depression.

    I’m not sure they were that sticky in the 1920/21 depression which saw the US economy take a hair raising dip and 18 months later was growing smartly again.

    However the point is well taken which I suggested earlier too in that we’re not flexible enough to be able to adopt hardened currencies.

    Wage flexibility could also come about by making part of wages as part of a year end bonus system. In banking/trading we had a very high degree of compensation variability which by and large was accepted and understood.

    Even the public sector could be “variabilized” by some formula such as GDP growth or whatever.

    I’m not sure the stickiness couldn’t be ironed out or in this case washed out.

  30. kvd
    Posted July 21, 2012 at 4:29 am | Permalink

    Thanks@28, particularly for the simple equation. I see what you mean re USD-AUD, but that leaves unanswered how our relativity would look against our other major trading partners (assuming those were also locked onto a USD, gold-backed exch. rate)?

    I found this tool which enables historical comparison of up to five currencies to a base, and I plugged in our top 5 trading partners – and then my head ‘sploded ;)

    So I’ll try not to mention gold ever again.

  31. Posted July 21, 2012 at 5:14 am | Permalink

    JC@29 They seemed to have been fairly “sticky” during the 1890s Depresson, when US unemployment apparently hit 18% and stayed high for a few years. The 1920/1 downturn was coming off the surge in wartime inflation, which may have made a difference.

    I have suggested in the past that part of the recent flexibility of the Oz economy is that more people are in employment situations (self-employment, labour hire, casual work) where they can take an income hit without losing their jobs.

  32. JC
    Posted July 21, 2012 at 6:17 am | Permalink

    You’ve criticized banking comp in the past Lorenzo, however being able to variablize incomes with a smaller fixed salary and a higher end of year bonus structure allow firms to cut fixed costs.

    Large changes were found acceptable by the workers.

    I always thought that principle ought to be transferred to many other sectors. Qantas would be a prime candidate.

  33. Posted July 21, 2012 at 7:55 am | Permalink

    JC@32 I have never criticised competition in banking. I have criticised various forms of government intervention and their consequences, not the same thing.

    Large changes in income with a pre-specified bonus structure may be acceptable, but I note that there was still a fixed lower bound.

  34. Tim Quilty
    Posted July 21, 2012 at 1:36 pm | Permalink

    Comp as in compensation, not competition…

  35. TerjeP
    Posted July 21, 2012 at 2:04 pm | Permalink

    TP@16 At no point were the francs in circulating increased. So gold flowed in, the Bank sold foreign exchange and then did not increase circulation of francs.

    Say the French did this using pound sterling for simplicity. The effect will be to push up the value of gold and push down the value of sterling. If the Brits want to stay fixed to gold in this situation they will need to buy pounds and sell gold. It’s not clear at all that this would be a source of deflation.

    Mining is done against a cost curve. To be sure there is a time lag but anything that pushes up the value of gold in real terms will bring online new gold mines. And likewise if the real value of gold falls gold mines will close. I’m not saying that the real value can never change but there are a lot of inbuilt stabilisers when most of the world is using a gold standard.

    I’m interested by your French example but I can’t say I’m convinced. The narrative fits the facts you presented but that does not mean the narrative is accurate. Still I’m grateful for the extra data point.

  36. Posted July 21, 2012 at 9:58 pm | Permalink

    TP@35 The Brits did sell gold, gold outflows from the UK were a significant problem. Which meant the UK price level had to fall to stop the pound being overvalued in gold, which is a direct source of deflation.

    And gold production was never going to cope which such a rate of withdrawal of gold from the monetary system (by the French and the Fed), since stocks so dominate over new production. (Gold would not be much of an anchor, otherwise.)

  37. Posted July 21, 2012 at 10:00 pm | Permalink

    TQ@34 Ah, the mis-recognised abbreviation problem …

  38. TerjeP
    Posted July 22, 2012 at 8:16 am | Permalink

    Lorenzo – my reflection on this suggests an alternate narrative to yours.

    1925 Britian adopts the gold standard. Rather than valuing the pound at the current market price relative to gold they adopt the pre WWI price. This unleashes deflationary forces that begin to snake their way through the economy.

    1927 France figures this British game of deflation may not last. Let’s offload the British pounds we have for actual gold.

    1929 Britian sticks with the exchange rate set in 1925. But Australia has had enough and breaks the long standing fFix between the Australian pound and the British pound.

  39. TerjeP
    Posted July 22, 2012 at 8:17 am | Permalink

    p.s. Under my narrative above the French behaviour is a response to British deflationary monetary policy not a cause. This make more intuitive sense to me.

  40. Posted July 22, 2012 at 8:34 am | Permalink

    TP@38 The problem with your analysis is that (1) deflationary pressures from the British overvaluation were overwhelmingly concentrated in the UK. (2) France did not have to “do” anything to get a gold inflow beyond their initial undervaluation of the france; a gold outflow was a natural response to the overvalued pound, a gold inflow was a natural response to the undervalued franc (which also insulated France from deflationary pressures).
    (3) The Bank of France’s increasing their cover ratio so systematically and dramatically went way beyond any “response” to the British act.
    (4) The actions of the Fed ditto.

  41. TerjeP
    Posted July 22, 2012 at 2:59 pm | Permalink

    (1) deflationary pressures from the British overvaluation were overwhelmingly concentrated in the UK.

    I don’t accept this. Much of the commonwealth including countries such as Australia were on a pound standard not a true gold standard. If the British pound was over valued and deflationary then so were these various other currencies.

    As for Frances actions they seem logical to me. They could keep their pounds or swap them for gold. They were notionally of equal value. However the odds of a British devaluation would have seemed reasonable. Certainly there were voices calling for it. As such the French would be wise to swap any pounds they held for gold as a hedge against a possible devaluation of the pound down the track. They would seem to have been responding in a quite rational way to the overvaluation of the pound. To sell an overvalued asset for an equally liquid alternate asset that is not overvalued is quite sensible.

  42. TerjeP
    Posted July 22, 2012 at 3:01 pm | Permalink

    In short I think the key source of the British monetary problem was the monetary error made by the British in 1925.

  43. Posted July 22, 2012 at 6:03 pm | Permalink

    TP@41 I will accept “overwhelmingly concentrated in the sterling zone”. I meant that it was not impacting France and the US.

    The French raising their cover ratio so dramatically and continually was deeply stupid. No one expected them to turn back the gold. But the system relied on equilibration by folk not pulling gold out of the monetary system entirely as its price was rising, which is what the French were effectively doing. They were, in effect, seeking to not face the consequences of undervaluing the franc, thereby driving the entire system to destruction. There was nothing “sensible” about it. Particularly as their policies were directly responsible for bringing Hitler to power, and wasn’t that a winner for them.

    All this aided and abetted by the Fed, of course.

    In the 1870s, the French had destroyed the bimetallist bloc they had been the leaders of by failing to engage in minimal international monetary cooperation (pdf). They had a history of problematic monetary policy.

  44. TerjeP
    Posted July 23, 2012 at 7:07 am | Permalink

    Particularly as their policies were directly responsible for bringing Hitler to power, and wasn’t that a winner for them.

    That’s a big claim.

  45. Posted July 23, 2012 at 1:19 pm | Permalink

    TP@44 Have a look at the data in Irwin’s paper. The Bank of France hugely increased its gold reserves without increasing francs issued. That was massively deflatory in the goldzone. That deflation was at the heart of the Great Depression. The deflationary spiral of the Great Depression brought Hitler to power. It is a simple sequence of events.

  46. Mel
    Posted July 23, 2012 at 6:38 pm | Permalink

    Lorenzo, you’ve previously said this:

    “Countries whose labour movement were not seriously influenced by Marxism were much more effective in remaining democratic and not developing major fascist movements.

    ….

    The strength of fascism, Nazism etc was usually directly proportional to the scale/intensity of local revolutionary Marxist parties.”

    Have you changed your mind?

  47. Posted July 23, 2012 at 8:39 pm | Permalink

    M@46 No, it is clearly the case that the power of Nazi, fascist etc movements was directly proportional to the intensity of local left-revolutionary parties. What contractionary deflationary spirals did was increase extremist politics generally–both the KPD and the NSDAP increased their vote dramatically during the Depression.

    But if the revolutionary left was tiny and lacked influence (as in the Anglosphere) then radical right politics increased somewhat (Mosley, New Guard), but did not take off.

    If it was substantial, then radical right politics did much better. Germany was at the other end of the spectrum from the Anglosphere, France was an intermediate case (it had a significant Communist Party, but its influence in the wider Left was more marginal–in particular, in not alienating rural voters). Italy had gone Fascist after a previous deflationary spiral and upsurge in revolutionary socialism.

  48. TerjeP
    Posted July 23, 2012 at 10:05 pm | Permalink

    Lorenzo,

    Causality and responsibility are not the same thing. However even if you had simply claimed that French monetary policy caused the great depression which caused the rise of Hitler I would still regard your position as being absurd. Hitler was a product of many factors.

    And in any case I don’t buy your concerns regarding French monetary policy. If the French were dumping sterling for gold it was caused by the British monetary policy of overvaluing sterling. And on that basis but applying your logic we would almost end up saying that Winston Churchill caused world war II because it was he that over valued the pound. Although to be fair to Churchill the notion that the Great Depression was cause by monetary phenomena in the first instance is also dubious in my view.

  49. JC
    Posted July 23, 2012 at 11:50 pm | Permalink

    So you’re basically saying that the monetary policy being conducted by Britain or France wouldn’t destabilize the other trading partner? That’s interesting.

    Although to be fair to Churchill the notion that the Great Depression was cause by monetary phenomena in the first instance is also dubious in my view.

    Now explain why, Terje. Tell everyone you think it was caused by Smoot Hawley because you read it in Jude Waniski’s book, “How the world works”. Go on.

  50. Posted July 24, 2012 at 6:54 am | Permalink

    TP@48 I will accept “led to”. Hitler was marginal politically before the Great Depression.

    And you keep ignoring the scale of French reserve increases, their failure to maintain cover ratios (which increased dramatically) and the franc being undervalued (which would have, and did, lead to gold inflows on its own).

  51. Posted July 24, 2012 at 7:33 am | Permalink

    TP@48

    Although to be fair to Churchill the notion that the Great Depression was cause by monetary phenomena in the first instance is also dubious in my view.

    Then you are against the view which has been dominant in the economic profession since Friedman and Schwartz published A Monetary History of the United States. The work since has been mainly filling in the details.

  52. Posted July 24, 2012 at 10:53 am | Permalink

    If the French were dumping sterling for gold it was caused by the British monetary policy of overvaluing sterling.

    Can you rule out that they might have been performing a speculative attack on the British gold reserves?

  53. Mel
    Posted July 27, 2012 at 12:07 pm | Permalink

    Lrrenzo @47:

    “M@46 No, it is clearly the case that the power of Nazi, fascist etc movements was directly proportional to the intensity of local left-revolutionary parties.”

    The reality is more complicated than that and you are overlaying a pattern on data that will not support it. It is easy to find counter-examples, for examples the Communists in Finland polled more than the Communists in Germany ever did without having a major, history-changing fascist movement. Ditto the post WWII Euro-Communists. Conversely Austria’s communist party was not strong but its fascist movement thrived regardless.

    Your hatred of Marxism has clouded your judgement.

    It is no coincidence that the share of income going to Capital and corporate elite has increased with the collapse of fears of a revolutionary Left. It is also no coincidence that in America, where the revolutionary left has been weak almost to the point of irrelevance, that the corporate honchos at Corporation X can take home more loot than a pillaging Mongolian Khan while the company’s janitor lives in a run down trailer park.

    There is a pattern, but it doesn’t support your argument.

  54. Posted July 27, 2012 at 3:23 pm | Permalink

    M@53 The issue isn’t Marxism–the SPD was Marxist, the only relevance that had was it led the SPD to write off rural voters (an error that the broad Left in France and Northern Europe did not make).

    The issue is Leninism (including Stalinism as a subset thereof). And Finland is obviously a special case, given its war of independence from Russia and consequent civil war.

    Anything that happened after WWII is completely irrelevant, given how thoroughly Fascism and Nazism were discredited by their defeat and various revelations.

    Also, the outbreak of mass prosperity and the success of the liberal capitalist Anglosphere rejuvenated liberal democratic movements (in the broad sense). It was not as if anti-communism wasn’t a major element in postwar politics; effective anti-communism was part of mainstream democratic politics.

    As for increase in capital’s share of GDP, that has a lot more to do with the breakdown of Bretton Woods and “the great factor price equalisation” and consequent financial deregulations than anything to do with revolutionary politics.

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