Is a Gold Standard Deflationary?

Is a Gold Standard Deflationary?
July 22, 2011

(This item originally appeared at on July 22, 2011.)

Typically, when you start to talk about gold standard systems, someone stands up and says that it is “deflationary.”

Well, is it? The United States had a gold standard system for 182 years, from 1789 to 1971. We did the experiment. We should know the answer, right?

First of all, what does “deflationary” mean? It is one of those words like “liquidity,” which means everything, and nothing at all.

I would say that there are two main nuances to the word “deflationary.” One is the notion of a rising currency value–essentially the opposite of “inflationary,” denoting a falling currency. The other is economic contraction in general, which leads to “air going out of the balloon” metaphors and often a tendency for prices to decline as a result of recession.

A gold standard is not supposed to produce a rising currency value. It is supposed to produce a currency of stable value – one that neither rises nor falls. The World Gold Council has produced a paper which studies long-term price trends, called “Gold as a Store of Value: Research Study No. 22,” by Stephen Harmston. It has data from 1596 to 1971 in Britain. These are basically commodity price indexes, because those are the only price series that we have going back to 1596.

What it shows is basically a flat line. From end to end, commodity prices (compared to gold) actually go up a little bit over the time period, denoting an inflationary rather than deflationary long-term trend.

However, the difference is so small that it can be considered statistical noise. In essence, the price data shows that gold is indeed stable in value, as much as anything can be over a four-century period. Sometimes people say that economies have a “deflationary trend” with a gold standard. What they seem to mean by this is that many goods and services become cheaper in price over time. For example, computers are much cheaper today than they were thirty years ago. This is due to advances in technology and processes, not any sort of monetary distortion. At the same time, other things–notably urban real estate and wages–tend to go up in value over time, reflecting the increasing societal wealth that tends to happen with a gold standard system. Both are natural occurrences when you have a currency that is stable in value.

The second notion is that a gold standard system causes economic contraction and decline. Well, does it? After 182 years of a gold standard system, did the United States have a larger, or smaller economy?

In 1790, the population of the United States was 3.9 million, and there were thirteen states with an economy based on subsistence farming. In 1970, the population was 203 million, with 50 states and the most advanced, wealthiest industrial economy the world had ever seen.

If a gold standard causes contraction and decline, how did that happen? Obviously it is baloney. After 182 years of a gold standard system, the U.S. became the richest, most powerful, most influential country in the world.

What causes contraction and decline is not using a gold standard system. In the forty years since floating currencies began in 1971, the average American family has made no progress at all–even with two incomes, instead of one. If you measure income in terms of ounces of gold, we are back to early-1950s levels. Although there were many ups and downs over the last two centuries, including a Civil War and a Great Depression, this is perhaps the first time in U.S. history where the average family is worse off than it was forty years earlier.

However, during those two centuries, there have been times when a gold standard has been genuinely “deflationary.” This was typically after wars–the War of 1812, the Civil War, World War I, and World War II.

During the Civil War, the U.S. dollar floated and was devalued. This was the famous “greenback” period. At the end of the war, the dollar was worth about half of its prewar value. The decision was made to raise the value of the dollar back to its original parity, and peg it to gold again at $20.67/ounce. This took place over several years, and the U.S. returned to a gold standard in 1879. The other wars mentioned were also accompanied by sagging dollar value, although not as much as during the Civil War. After the wars ended, the dollar’s value was raised and returned to its prewar parity.

This choice to return to a gold standard system at prewar parity (instead of a new parity) involved a rising currency value, and thus was indeed “deflationary” as we defined it earlier. However, this was not due to the gold standard itself, but rather because the U.S. left the gold standard system during each of these wars.

During World War I, France also floated and devalued the franc. France returned to a gold standard system in 1926, but at a new parity that did not require a rising currency value. In effect, the currency was permanently devalued, and repegged to gold at the new rate. As a result of this, no deflation was necessary. However, by devaluing the currency, the terms of all contracts were altered, producing arbitrary winners and losers. Both policies – returning to a prewar parity, or using a new parity — have their benefits and complications.

The gold standard is also blamed for “deflation” during any recession. For as long as there have been gold standard systems, which is a very long time, there have been other people who have wanted to try to solve their economic problems with a currency devaluation or some sort of “easy money” policy.

“But as this Addition to the Money, will employ the People are now Idle, and these now employ’d to more Advantage: So the Product will be encreas’d, and Manufacture advanc’d. If the Consumption of the Nation continue as now, the Export will be greater, and a Ballance due to us …”

See? Just add more money, and all your problems are solved. Does that sound like QE2 today? This quote comes from a book called Money and Trade Considered: With a Proposal for Supplying the Nation with Money. It was published in 1705. The author was John Law.

Law continued: “Indeed, if lowness of Interest were the Consequence of a greater Quantity of Money, the Stock applied to Trade would be greater, and Merchants would Trade Cheaper, from the easiness of borrowing and the lower Interest of Money, without any Inconveniencies attending it.”

How could anyone refuse such a sensible proposal, especially one without any “inconveniencies” attending it?

Law must have been convincing, because by 1720 he was the Finance Minister of France. His inflationary “Mississippi Bubble” bankrupted most of the aristocracy of France, an Inconvenience that made Law rather unpopular there. Before the end of the year 1720, he fled the country dressed as a woman.

A gold standard prevents this sort of currency fiddling. Thus, the gold standard is called “deflationary” (recessionary) because it prevents the currency manipulators from supposedly solving the unemployment problem through the magic of the printing press.

I wonder how Ben Bernanke and his Keynesian pals would look in a dress? Maybe we will find out.