The Gold Standard a Defense

James Hamilton at Econbrowser wrote a post on the gold standard and the Great Depression, that needs an answer. Since I studied economics in college and am an advocate of commodity money, I’ll take a swing at it.

The first problem with Mr. Hamilton’s argument is that he defines the gold standard in only one of its historical forms, the government run bank note system at the end of the thousands of year long history of commodity money. But most advocates of the gold standard are not in favor of such a system, precisely because of the problems it creates some of which James then goes on to outline. He defines that system as follows.

“Under a pure gold standard, the government would stand ready to trade dollars for gold at a fixed rate.”

But the problem is, this definition leaves unanswered one of the most important questions, does the government have the gold or other commodity to meet all of its obligations. To be technical goes the government run a fractional reserve gold standard or a 100% reserve gold standard. In layman’s terms if the government promises to give an ounce of gold for every thousand dollars does it have gold to pay out one thousandth of an ounce of gold for every dollar in circulation

If it doesn’t have the gold to pay off all its obligations then it is operating a fractional reserve system which is indeed vulnerable to attacks by speculators. This is because the value of the gold the government is willing to pay for its notes is greater than the value of the notes. The government in such a situation is in fact systemically bankrupt, it does not have the gold to meet its obligations and it has no prospect of getting enough gold to pay off its obligations. That such a system is highly unstable goes without saying. The government or other issuer under such a system is in the same position as the government of Argentina under its dollar peg.

If on the other hand, the government or other issuer does have enough gold to meet its obligations and it will not issue additional dollars unless it receives enough gold to fully back the new notes, it is operating a 100% gold reserve standard. Such a system is in no way open to speculative attack. On the contrary all that would happen if people came to the central bank or other issuer and demanded gold is that they would have a sack of gold coin or bullion bars instead of an easier to carry around wad of notes. Under such a situation, the notes would have a value equal to or greater than the gold because of the convenience of the notes for large quantities of money.

As for the question of the country leaving the gold standard that is of course possible, but it applies as an argument against any better system of doing things. (i.e. Person A “I think we should build huts instead of living in a cave.” Person B “But we might stop building huts in which case we would have to go back to living in caves.”) To remove the temptation for the government to steal peoples gold by going off the gold standard, we could just have privately issued notes or electronic currency and the government could just perform its usual and proper function of preventing fraud and enforcing contracts. I personally think this is the better option. In fact, e-gold runs just such a system. You take them gold, silver, platinum or palladium bullion, and they account for the bullion and allow you to transfer it from one account to another to make payments.

Mr. Hamilton’s most important argument is that a gold standard causes instability because investors doubt the ability of the government to meet its obligations and redeem all of its notes. He puts his argument this way.

“I argued in a paper titled, "The Role of the International Gold Standard in Propagating the Great Depression," published in Contemporary Policy Issues in 1988, that counting on a gold standard to enforce monetary and fiscal discipline in an environment in which speculators had great doubts about governments' ability to adhere to that discipline was a recipe for disaster. International capital flows became more erratic, not less, as doubts were raised about whether first the pound would be devalued and then the dollar. Britain gave in to the speculative attacks and abandoned gold in 1931, whereas the U.S. toughed it out by deliberately raising interest rates in 1931 at a time when the economy was already near free fall.”

This is true, but only of a fractional reserve system. The problem is as I have said, a government operating a fractional reserve gold standard is in fact bankrupt, it is promising something it can’t deliver. It is in a state of perpetual crisis. If the Fed were to declare a gold standard today at $525 an ounce I would oppose it. It could be a nothing other than a disaster. For a gold standard to work the issuer must have enough gold to cover its obligations. At present that means a dollar gold price of $2,000 an ounce or greater.

James continues his argument,

“Because of this uncertainty, there was a big increase in demand for gold, the one safe asset in this setting, which meant the relative price of gold must rise. If everybody is trying to hoard more gold, you're going to have to pay more potatoes to get an ounce of gold. Since the U.S. insisted on holding the dollar price of gold fixed, this meant that the dollar price of potatoes had to fall. The longer a country stayed on the gold standard, the more overall deflation it experienced. Many of us are persuaded that this deflation greatly added to the economic difficulties of those countries that insisted on sticking with a fixed value of their currency in terms of gold.”

Again, this is true, but only of fractional reserve systems. Under a 100% system, there would be no reason to hoard money in this way because the system would be highly liquid. If banks and the government had enough gold to pay their demand obligations, the redemption of notes and withdrawal of money from bank accounts could not cause a liquidity crisis.

The real truth is that a fractional reserve gold standard is not really a system of commodity money, it is a system of fiduciary money. As long as the central bank is allowed to create debts in excess of its ability to pay them, the money system will be unstable. Even if there was no crisis, the continued issuance of uncovered obligations would mean that the same amount of gold would back an ever increasing quantity of notes eventually this would mean virtually no gold backing the notes, i.e. no gold standard.

If James is interested in continuing this discussion, I would be willing to write about how I would handle the transition and how such a system would-could work so he could respond to that.