Posted on 03/15/2011 5:54:12 AM PDT by expat_panama
The gold standard is a Holy Grail of otherworldly purity for which monetary knights perpetually quest. After all the stomach-churning, post-meltdown improvisations by central banks and governments worldwide—the Troubled Asset Relief Program, quantitative easing, and mortal entanglements with insolvent mega-debtors—it's natural to long for nobler days. Thus World Bank President Robert Zoellick argues for returning to gold as a monetary reference point. And in the credit market, guru James Grant yearns again to pull the Excalibur of the classical gold standard from the stone. While the current run-up in gold is a signal (whether of inflation expectations, credit problems, or lemming-like investor behavior remains to be determined), 800 years of Western monetary history shows that bullion-based systems offer no benefits over paper-based systems. Like all technocratic fixes, their rigidity can make things worse.
During the heyday of the classical gold standard, 1880-1914, claims Grant, "Central banks had the single public function of exchanging gold for paper or paper for gold." In theory, the monetary base smoothly adjusted, automatically contracting to protect the reserve when credit or inflation problems led to gold outflow, expanding when gold was turned in for central bank notes. In reality, central banks in bullion-based systems created money, engaged in open-market operations, and managed repeated crises as lenders of last resort—just as they do today. It is misleading to select a single stable 35-year period with no major wars and the giant boom of the Second Industrial Revolution—both the result of decades-long trends—and credit it to the classical gold standard.
Bullion-based systems have two major problems. First, supply is ordinarily fixed in the short term, creating deflationary pressure when economic activity expands: there is not enough coin to go around. As far back as the Middle Ages, bullion stocks were insufficient for commerce, not to mention costly to transport and safeguard. Before central banking, this led to currency debasement. As Carmen Reinhart and Kenneth Rogoff have documented, over centuries, the proportion of silver (the original European monetary base) in coinage inexorably dropped to a small fraction; by the 19th century it was quasi-fiat money.1
Given the limits of bullion, private bankers, such as the Medici, created money in the form of negotiable bills of exchange. In theory, these bills were convertible to bullion, creating an incentive for sufficient bank bullion reserves; in reality, they were backed by the quality of all the issuer's assets. Bills of exchange operated as cash and were rarely redeemed: as in any banking system, circulating currency was a small part of the monetary base, at least for major transactions. (Think M1 and M2 today, which include currency, demand deposits, and money market funds.) Then as now, no bank had enough reserves to immediately pay 100 percent of its obligations during a run. Major houses that wrecked their credit with bad sovereign loans, such as the Peruzzi and Bardi2 banks, went bankrupt.
Bullion production was uneven, creating a second major problem: huge swings in the monetary base unrelated to the rate of economic growth and the size of economies. Large discoveries triggered massive expansion and inflation, but when mines played out, sudden production drop-offs caused contractions—the opposite of Milton Friedman's prescription for a constant rate of monetary base growth. Early modern Spain is the poster boy: after its conquest of South America, the giant Potosí silver mountain fuelled inflation and imperial overstretch in a series of Reformation-era wars, followed by multiple bankruptcies when production decelerated around 1590, then declined in the 17th century.3 Similarly, the silver supply surge created by the mid-19th century discovery of Nevada's Comstock Lode generated Japanese inflation that helped topple the Tokugawa Shogunate.4
The first modern central bank, the Bank of Amsterdam (founded 1609, early in the Dutch Republic's Golden Age of economic dominance), devised proto-modern solutions for stabilizing its silver monetary base. As 17th-century Latin American silver production dropped, debtors flooded the Dutch economy with debased foreign silver coinage, creating a stagflation risk. The Bank experimented with a bullion standard, converting different coins to paper at fixed exchange rates, but it could never get the rates right for long, triggering Gresham’s Law events where bad money drove out good. The Bank eventually adopted the Bretton Woods-like solution of ending silver convertibility for its reserves in significant commercial transactions, issuing publicly traded notes, and regulating the supply of silver and interest rates through open-market operations. The Dutch florin became Europe’s stable reserve currency from about 1680-1780.5
The Bank of England (founded in 1694 to fund the world war against France’s absolutist Louis XIV) moved to a gold standard in 1717 when Master of the Mint Sir Isaac Newton drove silver off the market by accidentally overvaluing gold.6 Although nominally on a bullion standard, the Bank suspended it during the world war crises of 1696 and 1797 (anticipating the suspension of the classical gold standard with the onset of World War I in 1914). In some of the eight crises in between the early suspensions, the bank's merchant and trader creditors voluntarily agreed to take paper instead of bullion.7 The first print reference to The Old Lady of Threadneedle Street, a 1797 post-suspension cartoon, shows her in a dress made of banknotes, crying rape as the handsome Prime Minister, William Pitt the Younger, seduces her while shaking gold guineas out of her pockets.
The late stages of the Napoleonic Wars triggered severe inflation.9 In response, politicians fetishized the gold standard. The Bank resisted a return, fearing deflation and an inability to provide liquidity in crises. Subsequent events showed that the Bank was right, with parallels to both Britain's catastrophic post-World War I gold standard resumption of 1926, which helped trigger the Great Depression, and to post-2008 improvisations.
Parliament, spurred by economist David Ricardo, passed a gold standard resumption bill in 1819. In response, prices dropped by 36 percent over the next three years. This triggered worker unrest, which the government quelled with the Peterloo Massacre in Manchester (1819), killing 11 and injuring hundreds.10 (Like many brilliant economists to come, Ricardo insisted that the problem was not with his plan, but with the incompetents executing it. He was rumored to have recanted on his deathbed in 1823.11) By 1822, the Prime Minister, Lord Liverpool, who had backed the 1819 resumption bill, was threatening legislation to force the Bank to pump money into the system so that the government could fund proto-Keynesian poor relief payments.12
The economy recovered by 1824, thanks to an emerging markets boom in newly independent South American nations—and the Bank's gold reserves fell by 74 percent, starting a new crisis. In 1825, the Bank abruptly tightened credit to defend the gold standard, causing 64 banks to fail, but the run continued, even as the government demanded that the Bank "pay out to the last penny." (One government member helpfully suggested that if the Bank's "gold was exhausted, they should place a paper against their door stating that they had not gold to pay with, but might expect to have gold to recommence payment in a short period." 13) In the end, Nathan Rothschild arranged a last-minute gold facility from France.14 Although Grant’s flinty lender of last resort restricts itself to “emergency lending against good collateral at a high rate of interest,” in 1825, the Bank of England worked overtime to print new notes, then literally turned its agents into traveling salesmen of liquidity, flooding the country with paper in exchange for a wild agglomeration of assets. It tripled its discounts in a few weeks from ₤5 to ₤15 million. "[W]e were not on some occasions over nice," Bank Director Jeremiah Harman told Parliament,15 channeling Federal Reserve Chairman Ben Bernanke.
The crisis abated, but an automatic, smoothly adjusting gold standard failed to take hold. An 1839 crisis required another emergency French gold facility. With the enactment of Robert Peel's Bank Charter Act of 1844, Parliament mandated a statutory exchange rate and what turned out to be excessive reserves. The Act forced the Bank, operating on a "thin film of gold,"16 into a giant pro-cyclical credit contraction in the agricultural/railway crisis of 1847. Asked about providing emergency liquidity, Bank Governor James Morris effectively said "it's not my job": "[W]hether Her Majesty's Government might have any political Reasons, such as Fear of Mills being stopped, or Riots in the Country, was a Question for them to decide, and one which we could not answer."17
The Government finally caved in, suspending the Act in 1847 (Peel, like Ricardo, blamed the incompetent Bank rather than his law) and during subsequent crises in 1857 and 1866;18 the 1890 Barings crisis was resolved with a third French gold facility.19 Despite the 1844 Act's attempt to create a statutory straitjacket, Walter Bagehot in Lombard Street (1873) dismissed it as "only a subordinate matter in the money market."20
The 1866 crisis was followed by a deflationary expansion in the UK, as the Second Industrial Revolution took off and the post-Civil War American South returned to world cotton markets. The adoption of the post-1880 classical gold standard—59 countries hewed to convertibility by the start of World War I 21—followed rather than caused these structural changes. Much of the classical gold standard's success came from increased supply: deflation increased the real price of gold, which over a period of decades triggered additional exploration and technological innovation.22 Huge gold discoveries in California and Australia surged into the world monetary system in the decade after 1849, then diminished. The ensuing post-1870 deflation raised the real price of gold, ultimately incentivizing the huge discoveries in South Africa's Witwatersrand in 1886 and Canada's Klondike in 1896 and triggering another round of reflation. (The Klondike gold strike abruptly ended the debtor currency agitation that had roiled the rapidly growing, chronically bullion-short United States from the 1870s Greenback Party through William Jennings Bryan's 1896 Cross of Gold speech.)
Far from creating smooth, automatic adjustments, the huge new gold supply led to money market manipulations. Britain fought the 1899-1902 Boer War, in part, to keep South African gold supplies under British control. South African gold ore was shipped exclusively to the United Kingdom for refining in regular quantities, and the Bank of England bought any unsold gold at the official price.23 (During World War I, when one South African mining company wanted to sell in the United States to take advantage of higher prices, the government stopped it.24) Fearing excessive expansion from the increased gold flow, the Bank of England added to its gold reserves and set an above-market Bank Rate.25
The following chart illustrates that from 1821 (after the passage of the resumption bill, though before resumption itself) through 1913,26 decade-over-decade gold production growth of less than 50 percent was associated with deflation, while gold supply production growth in excess of roughly 100 percent was associated with reflation.27 (Because it took time for changes in gold production to work their way into the economy, changes in gold production are lagged by ten years, so that the 1811-1820 change is graphed under 1821-1830. Price levels are reported in a ten-year moving average.)
Bullion-based standards never produced a seamless, automatically adjusting mechanism—only a series of crises. Central bankers constantly manipulated to balance exchange-rate stability, price stability, and economic growth. Sometimes they failed: Reinhart and Rogoff show that the free capital flows of the classical gold standard era were associated with an increase in banking crises.28 
In more recent times, the "Greenspan-Bernanke Put" promised a similar technocratic fix. The godlike Greenspan had supposedly replaced the business cycle with a "Great Moderation"—until it blew up. Since the 17th century, whether under the silver standard, gold standard, or fiat money, central banks have imperfectly improvised in the financial markets as they are, not as gold standard theory wishes they were.
Image by Rob Green/Bergman Group.
Footnotes
1.Carmen M. Reinhart & Kenneth S. Rogoff, This Time is Different: Eight Centuries of Financial Folly (Princeton U. Press 2009), p. 178.
2.Reinhart & Rogoff pp. 69-70.
3.Richard L. Garner, Long-Term Silver Mining Trends in Spanish America: A Comparative Analysis of Peru and Mexico, American Historical Review, Vol. 93 Issue 4, pp.898-935 (October 1988), p. 900.
4.Global Price and History Group, Japan 1710-1871 (Mitsui Bunko), at http://gpih.ucdavis.edu/Datafilelist.htm <visited Mar. 11, 2011>, based on Mitsui Bunko, "Trends of Major Prices in Early Modern Japan" (University of Tokyo Press 1989).
5.Stephen Quinn & William Roberds, "An Economic Explanation of the Early Bank of Amsterdam, Debasement, Bills of Exchange, and the Emergence of the First Central Bank," Federal Reserve Bank of Atlanta Working Paper 2006-13 (Sept. 2006); Stephen Quinn & William Roberds, "How Amsterdam Got Fiat Money," Federal Reserve Bank of Atlanta Working Paper 2010-17 (Dec. 2010).
6.Michael D. Bordo and Finn E. Kydland, "The Gold Standard as a Commitment Mechanism," in Tamim Bayoumi, Barry Eichengreen & Mark P. Taylor, eds., Modern Perspectives on the Gold Standard, Cambridge U. Press 1996, p.65. Newton, at heart an alchemist, effectively turned gold into a fiat currency relative to silver.
7.John H. Wood, A History of Central Banking in Great Britain and the United States (Cambridge U. Press Studies in Macroeconomic History 2005), pp. 42-43.
8.http://legacy.www.nypl.org/research/chss/spe/art/print/exhibits/gillray/captions/image52.html
9.Wood pp. 47-49,
10.Wood p. 59 n.72.
11.Wood p. 57.
12.Wood pp. 62-63.
13.Wood p. 66.
14.David Kynaston, "The Bank of England and the Government," in Richard Roberts and David Kynaston, eds., The Bank of England: Money, Power and Influence 1694-1994 (Oxford Clarendon Press 1995), p.21.
15.Wood p. 66.
16.R.S. Sayers, "The Development of Central Banking after Bagehot," Economic History Review, No. 2, 1951, pp. 109-116, quoted in Wood 115.
17.Rudiger Dornbusch & Jacob A. Frenkel, The Gold Standard and the Bank of England in the Crisis of 1847, in Michael D. Bordo & Anna J. Schwartz, eds., A Retrospective on the Classical Gold Standard, 1821-1831 (U. of Chicago Press 1984), p. 252 (quoting T.E. Gregory, ed., Select Statutes, Documents, Reports Relating to British Banking, 1832-1928, London: Oxford U. Press, 1929).
18.Wood pp. 112-113.
19.Robert Pringle, Key Events in Central Banking 1609-2001 (Central Banking Publications 2001), p. 22.
20.Wood p. 93.
21.Russell Ally, "War and Gold -- The Bank of England, the London Gold market and South Africa's Gold, 1914-19," Journal of Southern African Studies, Vol. 17 Issue 2, pp. 221-238 (June 1991), text at n.5.
22.Hugh Rockoff, "Some Evidence on the Real Price of Gold, Its Costs of Production, and Commodity Prices," in Bordo & Schwartz (1984)., pp. 620-636.
23.Ally text at n.24.
24.Ally text at ns. 31-33.
25.Wood, pp. 109, 115.
26.Gold production data is for changes in average annual production each decade, which smoothes out year-to-year swings, particularly for the mid-decade discoveries in South Africa and the Klondike. Rockoff in Bordo & Schwartz (1984), p. 624, Table 14.2.
27.UK Office for National Statistics, Table 3.6, Composite Price Index and annual change 1800 to 2008, CDKO: Long term indicator of prices of consumer g&s (Jan. 1974=100).
28.Reinhart & Rogoff p. 156.
We don’t have to worry about imposing a Gold standard.
As long as there is a free market for Gold and no desperate Government attempt to control its price or confiscate it then the market will drive the price of Gold to mirror the world’s money supply.
People can then take their fiat and exchange it for gold. Bingo! Instant gold standard, without any of the pitfalls of central banking.
This free market in Gold exists now - but is not completely aware of the crushing debts that burden the World’s Reserve fiat currency, the dollar.
But after D-month, everyone will be only too aware that Gold is ~15000 dollars an ounce and that the dollar has shrunk to a small multiple of its calorific value. Then the market will not only be free, but well-informed.
Central banks have no control over gold.
Really? Tell that to the conspiracy theorists who claim central banks are manipulating the price of gold.
Gold simply is: it outlasts governments: it outlasts metal-leasing scams, 'paper' forms of Gold and IOU accounting.
Whatever governments do, Gold eventually accounts for the fiat money supply by rising sharply in price.
Very well done expat_panama! Information is power and this was a very powerful article. Maybe a few of the Ron Paul fanatics will get a little actual Economic science education...but, somehow I doubt they will...they like the fantasy world Ron Paul lives in.
What is REALLY stupid is that every time we raise the price on something, we think we are making more money, even earnings.
The TRUTH is, every time the value is raised, the DOLLAR value DECREASES.
Greed is what has destroyed all of our values.
--and into the 1900's to. My dad was a small child back then on a failing farm. He told me about how it got so bad that keeping the family fed meant the pigs went hungry. People tend to forget what double digit deflation can means.
“First, supply is ordinarily fixed in the short term, creating deflationary pressure when economic activity expands: there is not enough coin to go around.”
And the reason falling prices is bad is what? Doesn’t that mean every dollar we earn can purchase more than it did last year? Exactly why is this a problem? I’m trying to remember the last time people complained about falling computer prices.
Sounds like you’re saying that inflation is the destruction of American values. During the ‘30’s we had massive deflation and at the time there were no religious leaders celebrating any resurgence of American values.
You're in good company not knowing why deflation is poison, but I'll tell you how it's gone in the past.
Starting a business means getting labor and capital, and before the labor can be hired the capital has to be rented --as a 'loan' (OK sure we got religious nuts on these threads that want to cut off bankers' hands but they're crazy). This means business activity starts with a loan based what's known at the time, and if right after the loan's made we get hit with a surprise inflation swing then payments have to be met with slashed earnings.
Last time was in the 1930's with 45% non-farm unemployment. Really ugly. Never again.
I know very little of the 30’s. I do know that when wives incomes were included in families borrowing power, back in the 70’s, prices started rising. More spendable income meant higher prices.
At first it was fine, families could get that bigger/newer house they needed. Then, the investors and “flippers” took over. Not only were houses quickly sold for a large profit, but old houses were “beautified” and sold for larger profits.
As this pyramid grew, more buyers were needed at the bottom. So, we brought in those who would not even qualify for a loan, normally.
We need to help each other, instead of looking for the quick buck. This country has created more millionaires than ever before, but what is their true value? What is the true worth of the dollar?
Very little compared to what it once was, at least in the last fifty years.
Because, as the article notes, mined metals are subject to discovery of new deposits and exhaustion of old ones. Real estate, on the other hand, is a known quantity and they’re not making any more of it (a tiny number of doomed megaengineering projects aside).
BTW: the problem with returning to a gold standard now is it would require Fort Knox holding 20% of all gold ever mined.
You're saying you're absolutely certain that inflation will reach "80% sometime this year".
Thanks, I get the picture now.
It's much worse than that. If the dollar "devalues" by 80%, inflation would be 400%!
I hope you didn’t hurt yourself making that stretch to tar me with your broad brush —
Sheesh....
You've noticed it too. My take is once again proof there is a God. No other reasonable explanation.
Everyone who holds USD will share in the pain of an 80% devaluation event sometime later this year: I predict between the end of June and the end of December.
It will be a sharp devaluation taking place over a few weeks. Anyone in cash will be wiped out.
This is simply what must happen when the USD finally loses reserve currency status. The US has no other way of meeting its crushing debts and is not currently taking steps to increase its GDP or to deal seriously with debt (rather the reverse in fact).
Once D-month is over, I predict that the dollar will continue to (slowly) lose buying power until you guys elect a Conservative President. Then it will rise again.
I may prove to be wrong about the timing. But the scale of the devaluation is about right. This is going to be the largest movement of wealth in human history, because your government has amassed the most enormous debt in human history.
The whole point if the article is to tell you that the floor is stated for naive people like you who believe in it. The exchange rate can be as easily manipulated and as arbitrary as Central Bank's money supply targets. And those rates were manipulated at will to suit circumstances.
The author does not mention, unfortunately, that Roosevelt and Morgenthau would chose the exchange rate of gold on weekly meetings, each time in accordance with numbers that Roosevelt considered lucky for him. That's your gold standard in reality.
If you disagree, isn't it helpful to understand, at least, what you are arguing against. Please reread the article.
“This means business activity starts with a loan based what’s known at the time”
I understand that, but so long as steady deflation is ‘expected’ under a gold standard, I don’t understand the big deal. It merely changes the terms of what constitutes a sensible loan in light of these expectations. It’s much more of a big deal if the central bank intervenes to create unexpected inflation or otherwise screw up economic fundamentals in a way no rational businessman could have predicted.
Put another way, deflation has been an enduring feature of markets for computers and other electronic gadgetry, yet I haven’t seen any evidence that these industries lack for borrowed capital.
What am I missing?
As said earlier: you don't need to return to a Gold Standard. In a way it will find you. The price of Gold is going to rise sharply until it accounts for the money supply.
When this happens the US could indeed return to a Gold Standard. But - in common with the thread poster - I believe a classical Gold Standard is a bad idea. Banks really can't handle being chained to money (that acts as a store of value) rather than to currency. The problem becomes insuperable with foreign banks buying that true money with their paper.
Just keep one fiat currency per country and let Gold float. Fiscal sanity is naturally enforced upon all fiat-issuing nations that don't have reserve currency status (also: that don't get to piggyback on the German economy - looking at you Greece).
America's return to fiscal sanity will begin when it awakens sometime this year with the worse devaluation hangover ever.
Ok, I’ll confess that I’m trying to understand the concepts being promoted here and have so far failed to do so.
Based on the 80% devaluation scenario, should I cash out my mutual funds, IRA, etc. and purchase metals [gold, silver, lead] and wait for a recovery/stabilization or just hold on to the cash?
I’m not that well versed or educated in this type of thing so I welcome informative/insightful comments.
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