Friday, August 24, 2012

The Gold Standard Is Still A STUPID IDEA THAT WON'T WORK

From the Financial Times:

The gold standard has returned to mainstream US politics for the first time in 30 years, with a “gold commission” set to become part of official Republican party policy.

Drafts of the party platform, which it will adopt at a convention in Tampa Bay, Florida, next week, call for an audit of Federal Reserve monetary policy and a commission to look at restoring the link between the dollar and gold.

First -- the Fed is already audited.  Here's a link to the Fed's complete audit page. If they want to audit monetary policy, well, that's done everyday by the financial press and economic bloggers all over the world.  

How these ideas that the Fed isn't audited get into mainstream political thought when they are so easily fact-checked (Google, anyone?) is absolutely amazing.  At best, it completely destroys the "rational expectations" garbage that's partially the basis of the University of Chicago school of thought.

But, more to the point.  In uncertain times people clutch at straws.  This is partially understandable considering the overall economic environment.  However, the gold standard -- which is seen by some as a silver bullet that will magically restore "sound money" -- is not the answer.   In fact, it's a really bad idea.  I wrote a piece in March that explained this in detail.

In a recent lecture, Bernanke explained why the gold standard is a bad idea.  He did so in a very convincing way, as highlighted by Joe Weisenthal and agreed to by Professor Brad DeLong.  (for background on this issue, please read Monetary Theory and Bretton Woods by Filippo Cesarano).  I would also encourage you to read Mr. Weisenthal's article. However, let me address Mish's love of the gold standard, or, more precisely, the fact he's never addressed the fundamental problems with the gold standard as expressed in the following identity:


Where M=the money supply (gold), V=velocity, P=price and Q = physical volume of all goods produced.  In a gold based monetary system, the above equation explains how balance of payment equilibrium is achieved.  As a country runs a trade deficit, M decreases.  In order for the identity to maintain balance something must decrease on the other side of the equation.  This is usually prices (P), which in turn makes the country's goods more competitive in international trade, thereby leading to equilibrium once again being achieved.  Sounds simple, right?

Not really, as there are several problems.  Like most economic models, this one assumes that prices move freely; or, put another way, prices are not sticky.  This is hardly the case in the real world, where prices can remain at unrealistic levels for some time.  This makes the adjustment mechanism anything but instantaneous.  Secondly, "classical economists took the volume of final output to be fixed at the full employment level in the long run." (International Economics by Robert Carbaugh, Kindle Reference 6753-55).  Considering the US economy has been operating far below the full employment level for the last three years (as have a fair number of other economies), this "magic equation" wouldn't apply very well to the current situation.  In addition, a decrease in the money supply created by a trade deficit leads to an increase in the cost of money -- namely, interest rates.  While these should theoretically make the deficit country a more attractive place to send money (thereby lowering the trade deficit), higher interest rates will also slow economic growth in the deficit running country, making it less attractive from a foreign investment position. This slows the correction process even more.  There is also the issue that the gold standard does not survive war spending, which is what led to it's fall in the first place after WWI.  Finally, there is the issue that no one can futz with the system -- that is, there can be no government intervention in the currency markets for this to work.  Raise you hand if you think that will last longer than a few years in the current environment; I have a bridge to sell you.

In reality, the golden age of the gold standard only lasted about 30 years from the end of the 1800s to WWI.  Several countries tried to get back on the gold standard after WWI but to little avail (as an aside, Britain tried to get back on the gold standard.  However, Churchill set the conversion rate too high, a policy move critiqued by Keynes).  All of this led to the Bretton Woods agreement after WWII. 

Let me add three other points.

From Mish:
Weisenthal: The gold standard ends up linking everyone's currencies.

Mish: So what? Look what happened after Nixon closed the gold window. We have had nothing but problems, temporarily masked over by printing more money until things blew sky high, culminating in bank bailouts at taxpayer expense, and those on fixed income crucified in the wake.
Actually, being that inter-lnked means all economies rise and fall together, preventing one economy from taking a different approach to a problem and helping to prevent an economic free fall from occurring.  For example, during the last recession both China and Germany engaged in stimulus spending, which essentially saved both economies and helped to avert disaster for the world as a whole.  Had we all been inter-linked, that couldn't have happened.  I should also add that this level of currency inter-linking is a big problem in Europe right now -- a situation which Mish has written about extensively.
Weisenthal: [A gold standard] creates deflation, as William Jennings Bryan noted. The meaning of the "cross of gold" speech: Because farmers had debts fixed in gold, loss of pricing power in commodities killed them.

Mish: Hello Joe. Please tell me how many in this country would not like to see lower prices at the gas pump, lower prices on food, lower rent prices, lower prices on clothes? The fact of the matter is price deflation is a good thing. The only reason why it seems otherwise is debt in deflation is harder to pay back. That is not a problem with deflation, that is a problem of banks foolishly lending more money than can possibly be paid back. Fractional reserve lending is the culprit.
Deflation does not mean just lower prices; it also means unemployment, caused by a deflationary spiral that goes like this: demand drops, leading to lower production, leading to lay-offs, leading to lower demand ... you get the idea.   The Great Depression is the classic example of this phenomena. 
Weisenthal: The economy was far more volatile under the gold standard (all the depressions and recessions back in the pre-Fed days).

Mish: Really? On what planet? Did the collapse in the housing bubble affect your ability to reason? Except for cases like Weimar, Mississippi Bubble, and for that matter all bubbles, gold provided stability. The bubbles (and the subsequent collapses) were caused by fractional reserve lending, not the gold standard.
Actually, Mish, on this planet.  An inquiring mind would seek out a book such as A Brief History of Panics,  which shows that in the 1800s there was nearly a panic every 10 years.  As professor James Hamilton pointed out:
The graph below records the behavior of short-term interest rates over 1857 to 1937. Over much of this period, the U.S. maintained a fixed dollar price for an ounce of gold, and prior to 1913 (indicated by a vertical line on the graph) there was no Federal Reserve System. The pre-Fed era was characterized by frequent episodes such as the Panic of 1857, Panic of 1873, Panic of 1893, Panic of 1896, and Panic of 1907 in which even the safest borrowers would suddenly find themselves needing to pay a very high rate of interest. Those events were associated with significant financial failures and business contraction. After establishment of the Federal Reserve, the U.S. short-term interest rate became much more stable and exhibited none of the sudden spiking behavior that used to be so common


The pre-Fed financial panics were also accompanied by long contractions in overall economic activity, as indicated by the NBER dates for economic recessions noted in the graph below. Although of course we still had recessions after the Federal Reserve was established in 1913, they tended to be less frequent and shorter in duration.
Here is the accompanying chart:


In short, the gold standard argument doesn't hold up after a modicum of scrutiny.  Frankly, the old Mish wouldn't have bought an argument this shallow.  However, the new and greatly unimproved Mish clearly has.  While I'm sure his numerous acolytes will nod their heads in agreement at the simplistic "gold standards are the magic panacea to all your ills" argument, I lament the loss of a great critical mind and hope for the day when he returns.