Is the Gold Standard a ‘Crazy’ Idea?

Larry White says “no.”

UPDATE: Tyler Cowen agrees that the gold standard isn’t a ‘crazy’ idea, but nevertheless rejects a return to commodity-backed currency. Meanwhile, a commenter on the post at MR writes:

The purchasing power of gold has varied over a factor of ten since the 70s. Hardly a standard of value.

This is a very misleading statement. Since the 1970s, gold has been de-monetized. As Larry White explains, under the gold standard, the demand for gold is largely transactions-based and therefore the fluctuations in its purchasing power remain quite stable. When gold is de-monetized, however, its purchasing power tends to fluctuate a great deal.

UPDATE II: Larry White responds to Tyler Cowen.

The Gold Standard and the Great Depression

Pete Boettke discusses the gold standard and the depression. My thoughts are in the comments.

UPDATE: Steve Horwitz chimes in with a follow-up post.

Frum, Again

Avid readers may recall that I had to correct David Frum in regards to the gold standard and the Great Depression. Frum is once again attacking the gold standard, but this time with an ad hominem attack of its main proponent in the political arena, Rep. Ron Paul:

But [Rep. Paul’s] core supporters also thrill to his self-taught monetary views, which amount to a rejection of everything taught by modern economists from Alfred Marshall to Milton Friedman.

While I am certainly no advocate of the gold standard, I am quite leery of with regards to discretionary monetary policy. It is my view that the purpose of the central bank should be to limit inflation and I would prefer that this be done through an explicit inflation target. In this respect, my view is quite similar to Milton Friedman’s and thus I am quite puzzled at David Frum’s assertions. Rep. Paul’s main reason for advocating the gold standard, at least to my knowledge, is a strong disregard for discretionary monetary policy and the inflation and distortions that it can create. In this way, Paul is very similar to the likes of Milton Friedman, despite the fact that Friedman did not advocate the gold standard (for more on this, see Peter Boettke’s stellar post on Frum).

The essential point is that the debate is not so much about the gold standard as it is about monetary policy carried out by individuals and thus the potential for error. Many influential economists including Friedman, F.A. Hayek, and Ludwig von Mises expressed strong doubts about the desirability of a central bank with discretionary power over monetary policy. Hayek’s Prices and Production explains in detail the distortions that can take place due to discretionary monetary policy. In addition, Friedman advocated monetary policy rules as favorable to individuals at a central bank. So perhaps such views aren’t as out of the mainstream as Frum would have you believe.

The Gold Standard

The gold standard has been gaining a great deal of attention recently, largely from Rep. Ron Paul who has main a return to gold-backed currency a major theme of his campaign. While I am hardly an advocate of the gold standard, it is unfortunate that much of the discussion of the gold standard has been riddled with inaccuracies and false causation.

Most recently, David Frum decided to tackle the issue:

Since permanently abandoning gold convertibility in 1933, the US economy has experienced far less economic volatility. Recessions are fewer and shallower (if sometimes longer).

Frum mentions the Great Depression as a byproduct of the gold standard. While this is somewhat correct, it is entirely misleading. It is not the gold standard in and of itself that led to the depression, but rather a mismanagement of the gold standard that created a deflationary bias (for a much more detailed analysis, see Bernanke and James).

This deflationary bias was created by two major factors:

1.) Asymmetrical monetary responsiveness to changes in gold flows. Under the rules of the gold standard, when one experiences an inflow of gold they are to increase the money supply accordingly and when one experiences outflows, they are to decrease the money supply accordingly. During the interwar period, those countries experiencing gold outflows were following suit by reducing the money supply. However, the United States and France, the two countries with the greatest inflow of gold, had little incentive to avoid gold accumulation (relative to currency). Prior to this period, everything had centered around the Bank of England, which had no incentive to accumulate gold and thus ensured convertibility. This lack of incentive for the United States and Franc during the interwar period, however, led to a deflationary bias.

2.) Weak central banks. During this time period, central banks had limited power over the money supply. This was largely as a result large restrictions on open market operations (the simplest way to increase the money supply). This was done following the first World War to prevent monetization of deficits by central banks. However, this limitation led to a deflationary bias.

With the major gold inflow into France, one would have expected the French to inflate their currency. However, due in large part to the strong restrictions on open market operations, France did not follow suit and actually experienced double digit deflation.

Meanwhile, in the United States, the Federal Reserve was keen on limiting stock market speculation and thus tightened monetary policy (Hamilton), despite the inflow of gold. This led to deflationary pressure and the eventual decline of the overall price level in 1929.

While this post is in no way an attempt to justify or defend the gold standard, it is especially important to note is that the gold standard is not directly the cause of the Great Depression. As Bernanke and James note, the was a “self-inflicted wound.” The central banks had little or no reason to avoid gold accumulation relative to the domestic currency and their weak powers coupled with policies that ran counter to the rules of the gold standard created the deflationary pressure that created the depression. In other words, the two countries that experienced the most pronounced inflows of gold had central banks who either chose not to adhere to the rules of the gold standard because of other policy objectives or were ill-equipped to handle such inflows due to heavy restrictions on their powers.