“For every complex problem there is an answer that is clear, simple, and wrong.” – H.L. Mencken.
After the 2008 financial crisis and the subsequent bank bailouts, renewed interest sprang up for having every dollar in circulation backed by a fixed amount of gold. Those calling for gold have one thing right: our current standard of fiat fractional reserve money has proven to be a most dangerous error. However, it must be understood that gold is not the answer.
In the modern era, gold has been largely dismissed by the academic economic establishment as a “barbarous relic.” This is because gold as a number of vices as a monetary standard:
1. The supply of gold is inelastic – that is, it cannot expand or contract in response to changing economic conditions. In a context of a growing economy this means that gold is consistently deflationary. As economic growth proceeds over time, gold backed currency steadily increases in value, which encourages people to hoard currency that otherwise would be invested or spent. The more rapid the growth in economic output, the more rapid the appreciation of the currency.
The net result is that economic growth triggers a monetary feedback loop which undermines further economic growth. Everyone prefers to hold the appreciating currency instead of buying goods – as those goods become ever cheaper – and with declining prices comes declining profits. Declining profits leads to cost cutting (including laying people off work) and the economy grinds to a halt. In extreme cases deflation causes aggregate demand to collapse leading to a full blown Depression.
2. Gold is subject to supply disruptions. Historically, supplies of gold have changed significantly over relatively short periods of time. Major new finds, such as those in California in 1848 and in Alaska and South America in the late 19th century, resulted in abrupt increases in gold supply.
Technological developments like the introduction of cyanide based extraction also significantly increased gold production. While major new finds may be unlikely (at least until we begin mining asteroids), sudden technological breakthroughs cannot be discounted. Ideas that sound like science fictions today – extraction from seawater via nanotechnology or robotic mining – have to be taken serious in the context of a monetary regime meant to endure for many decades.
3. Gold is subject to demand disruptions. On the demand side we must account for the productive uses of gold. The preponderance of current gold production is used for jewelry and industrial applications. Under a gold standard any changes in those markets would directly impact the value of currency.
Any new industrial processes requiring gold as input could dramatically increase demand (and prices) on world markets. Conversely, it is estimated that Indian women hold more gold (in the form of jewelry) than does the federal reserve. If improved socioeconomic status leads Indian women to replace gold (as a store of value) with modern financial devices, that would undermine a predominant source of current demand (and could potentially release a flood of supply).
The supporters of a gold standard recognize these vices, but argue that gold has a cardinal virtue that overcomes them. As Ludwig Von Mises said in his Theory of Money and Credit,
“The excellence of the gold standard is to be seen in the fact that it renders the determination of the monetary unit’s purchasing power independent of the policies of governments and political parties. Furthermore, it prevents rulers from eluding the financial and budgetary prerogatives of the representative assemblies.”
This virtue responds to the foundational argument of those who propose gold: that man cannot be trusted to govern his own currency.
There is significant insight in this thesis. Time and again governments have abused the power of the printing press – to the impoverishment of their citizens and even the collapse of their economies. Yet the proposed solution of anchoring political prerogatives to gold fails in the last analysis. And so, consequently, does the merit of a gold standard.
The first failure of gold is that it proves to be a most ineffectual anchor. History shows us that when faced with extremity (or opportunity) governments can and will manipulate, modify or altogether remove their relationship to gold. Rather than the aegis to state power imagined by proponents, gold consistently proves merely an inconvenience to political exigency.
While this might appear at least an adequate virtue, protecting the fidelity of money during all but the times of most urgency; it is, in fact, a fundamental error. This is because the gold standard lures us into complacency and distracts us from an even deeper truth: “Man cannot be released from his responsibility for governing his own currency”. Gold offers the false security of a Sovereign, who, it is supposed, can better govern us than we can ourselves. For centuries, this argument was made in defense of Monarchy and it was no more true of Kings than it is of the Kingly metal.
It is the case that man cannot be trusted to govern his own currency. Nonetheless, it is his responsibility. One that cannot be shirked or avoided. Consequently, the best and only protection is vigilance and transparency. This is true, of course, of all politics. Given adequate opportunity, the schemers and advantage-takers will deprive you of your rights just as quickly as they will attempt to deprive you of your money. The price of liberty is eternal vigilance — no other coin will do.
While we can debate the true consequences of deflation or the mysterious history of the Great Depression, these arguments are ancillary. Once it is recognized that the security of gold is an illusion and worse than that a seduction, the argument is over. Gold, no more than fractional reserve banking, cannot serve as the foundation and security of our money.
Fortunately, the current fiat money system and the gold standard are not the only options available. A third possibility emerges once we realize that both conventional options are handicapped by their attempt to serve too many masters.
Money is generally regarded as having three functions:
- store of value
- medium of exchange
- unit of account
The role of money (like any other social technology) evolves over time. In the past money was critical for all three functions. However, in modern developed economies the storage of value is increasingly accomplished through non-monetary investment assets. That leaves currency primarily responsible for only the latter two functions.
Returning to the gold standard would turn the clock backwards, re-emphasizing storage of value. The alternative is to give up the fiction that money must have some intrinsic value. The social utility of money derives not from its formal asset backing but rather from its facility in acquiring goods and services on the open market.
The facilitation of trade requires only a pure medium of exchange; one that maintains a predictable value by increasing in quantity–according to transparent rules–at roughly the same rate as economic growth (as proposed by Milton Friedman almost 30 years ago in A Program For Monetary Stability).
For the modern economy, organized predominantly and increasingly around flows of value, a pure medium of exchange is the next logical evolutionary step. Gold could then continue to fill the role to which it is best suited – storing value as an investment asset.