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.
ML/NJ
Don’t forget to read the article, at least look at the pictures...
Let every country keep its own fiat currency. As long as no fiat currency has reserve status, no country can afford to run a printing press.
When the dollar devalues by 80% sometime this year, the world will learn a useful lesson about the limits of fiat. They will continue to use it: they may however learn not to abuse it. And people who own Gold and Silver will get to buy some serious real-estate.
I'm not taking sides here, but I think ML has a point if you extend it to:
The only thing stupider than a gold standard is a paper standard backed by political promises based on unrealistic expectations of any economic system.
I think an inflationary fiat monetary policy, and socialist security ponzi schemes for the USA might have worked somewhat given a non-decreasing growth in productivity...workers actually working.
But when such a system from the 50s turns into the sloth consumerism of the 21st century so far, it can't be sustained....no matter what the monetary system.
Because gold is a real asset and real estate isn't?
Amen. The one thing the gold standard does for our money is at least provide a floor. These Fed worshiping fools will see how bad it will get when bond markets fully collapse.
The whole point, basically, was that gold too can be abused by central banks and governments.
Because after the devaluation Gold and Silver will hit their peak levels for this cycle.
However - domestic real estate will be at a deep low due to the problems with issuing mortgages in an uncertain inflationary environment. At that point people who can buy houses with a lump sum will do well.
Right, what we might call a 'disinterested partisan'. That's OK, gold sometimes has a dazzling psychedelic affect.
Devalues with respect to what, the Euro?
The gold standard was a major source of grief all during the 1700s and 1800s. It will destroy any nation stupid enough to re-implement it at this juncture.
*
“Because gold is a real asset and real estate isn’t?”
No; because gold is the benchmark of liquidity and real estate is dusty dry.
Gold is "abused" by central banks? Central banks have no control over gold. In fact that is one of its beauties. If the United States goes the way of the Roman Empire and takes the Federal Reserve along with it, all those gold coins that were minted a century ago will go along being worth more or less what they have been worth over the years. Little pictures of dead politicians will be worthless historical curiosities.
The only function the US Government had with respect to gold (and silver) was to coin it, which is to say the formed it into little discs of recognizable weight and purity. The metal was brought to the mint(s) by miners who had to pay a fee (seigniorage is the term) to the government for this service. The government didn't create money. The private sector did, which is why it was so much more honest.
ML/NJ
Some 60% of USD reserves are held outside of the US. When the buying power of those USD reserves contracts by 80%, a lot of fiat currencies backed by USD reserves will devalue sharply as well. Currencies backed by hard assets (e.g. the Canadian Dollar, maybe the Rouble(!)) will do better but I wouldn't like to be in them when the storm comes.
The net result is that the middle class across the world and especially America will lose a great deal of buying power - unless they move to hard assets before D-month.
” Devalues with respect to what, the Euro? “
A bit closer to real-world home, how about ‘devalues in terms of the purchasing power of Joe Six-Pack’s pocket money’.....
Contrary to the apparently heartfelt belief of many on these forums, most of us don’t, as a First Principle, think in terms of arbitrage....
Yes, but the article: 1. confused the problems of the gold standard with the problems of central banking and 2. failed to justify quantitatively its conclusions that the difficulties of the gold standard are as bad as those of the Keynesian fiat money system he appears to like.
You are confusing gold and government, although I admit that they both begin with “g”.
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