The Persistence of the Bizarre

The Persistence of the Bizarre
March 26, 2011

There’s a notion out there that, to establish a gold standard, you take the existing monetary base, divide it by the amount of gold the government has in storage, and then you end up with a price of gold.

This is so idiotic that for a long time I figured I’d just leave it alone. Do these people also think that babies are delivered by storks?

And yet, it is a testament to the extremely poor state of affairs these days that these sorts of arguments exist, and indeed have been around for decades apparently without anyone to call BS on them. When it got to the point that Dylan Grice, economist for Societe Generale, started citing this sort of baloney I thought maybe it was time to say something. Grice is actually a pretty good economist, willing to investigate matters in the spirit of curiosity (instead of a pre-existing agenda) and come to real conclusions, as opposed to the various barkers and shills of Wall Street known as “strategists.”

Unfortunately, these sorts of ideas were popularized by Murray Rothbard, in books like The Case Against the Fed. You can read the whole text here:

Read The Case Against the Fed.

Don’t take it too seriously.

The gold stock of the Fed should be revalued upward so that the gold can pay off all the Fed’s liabilities—largely Federal Reserve Notes and Federal Reserve deposits, at 100 cents to the dollar. This means that the gold stock should be revalued such that 260 million gold ounces will be able to pay off $404 billion in Fed liabilities. …

There is nothing sacred about any initial definition of the gold dollar, so long as we stick to it once we are on the gold standard. If we wish to revalue gold so that the 260 million gold ounces can pay off $404 billion in Fed liabilities, then the new fixed value of gold should be set at $404 billion divided by 260 million ounces, or $1555 per gold ounce. If we revalue the Fed gold stock at the “price” of $1555 per ounce, then its 260 million ounces will be worth $404 billion. Or, to put it another way, the “dollar” would then be defined as 1/1555 of an ounce.

There are a lot of problems with this. Let’s list a few:

1) Neither the British or U.S. gold standards of the last 300 years, nor many of the others around the world, worked like this. Rothbard is just making stuff up.

2) A gold standard is NOT dependent on the amount of bullion in a vault. We saw that this was never the case.

There were a few exceptions — China used silver bullion exclusively as money into the 20th century — but in the Western European world that was the rule.

3) “Defining the dollar” at $1555/oz. (from perhaps $350/oz. when Rothbard was writing) is a devaluation. It’s just the same as when Roosevelt “changed the definition of the dollar” from $20.67/oz. to $35/oz. in 1933. You would think this would be what Rothbard and the other hard money types would want to prevent. (In fact the result of this devaluation was to make the U.S.’s gold holdings worth more than the monetary base, for a little while.)

4) This “100% backing” would be very brief. The normal operation of a gold standard would soon cause base money to diverge from whatever the bullion inventory happened to be. If you kept base money stable, then its value would diverge from the gold target. You only get to target one thing, value or volume, and the other is a residual. A gold standard is a value target, not a bullion reserves/volume target.

5) Although a small country, like Fiji, could implement some sort of “100% backing” system, there isn’t enough gold in the world to do this on a global basis. That is why goverments tended toward “economizing on gold” for centuries. People who argue that it is possible that you could do it by “revaluing gold” fail to notice that this would be a devaluation. For example, let’s say you “revalued gold” at $14,000/oz. today. That would be a 10x devaluation of the dollar. Eventually, prices would rise by about 10x. Then, you would need ten times as many dollars to do your business. So, the amount of dollars in circulation would have to rise, which would mean that you wouldn’t have “100% backing” anymore.

6) What if the gold isn’t there anymore?

However, these specific items fail to really explain the problem with this proposal. The problem is that these people — apparently including Rothbard — have a fundamental lack of understanding of how monetary systems work. Let’s say you have a five year old child. You are complaining about the price of gasoline. The child says: why don’t you just put water in the tank? It looks about the same, a clear liquid. Cheaper too. A child would accept the explanation that “it just wouldn’t work,” but an adult is more stubborn. Especially an adult to already thinks they know the answers. Hey, they studied Rothbard for years. And there are all these people who agree with them. The Mises Institute. You would have to explain all the workings of an internal combustion engine, and why gasoline can be used as a fuel and water cannot. And during the whole time they would smile smugly and say you were wrong, water does indeed work, they are quite sure of it. (You can see why I tend to avoid these people.)

For example, by the time you get this far, usually there is some guy who claims that we can just revalue the real value of gold higher. I don’t mean that the dollar drops in value, but rather that gold rises in real value.

This is contrary to the most basic tenets of a gold standard system. It is also contrary to reality. Do you see what I mean about trying to run an automobile by putting water in the tank? There is a fundamental missing of the point involved here. The purpose of a gold standard system is to produce a currency that is stable in value. The means of accomplishing this is to link the value of the currency to gold. Why gold? Because gold is stable in value. Governments rise and collapse. Wars come and go. But gold is stable in value. Has been for 2500+ years. And even if it is not, perhaps, perfectly stable in value, it is close enough that we can treat it as such. We’ve been running this experiment for a long time. The Greeks used gold (and silver) as money. So did the Romans. So did the Chinese and Japanese. So did the Africans and Persians. So did the United States only a few decades ago. And when the Conquistadors crossed the ocean, in search of gold, they found that the Aztec kings hoarded gold just like the Spanish kings. At no point did anyone say: “well, we thought gold was stable in value, but we were wrong.” Gold is stable in value no matter what some blockhead says. It’s something we discovered by experimentation, just like any other fact of the physical world.

So you have to laugh when someone figures that they can change the value of gold, by some large amount, just by moving their mouth and saying something. This little ship of fantasy would be instantly crushed against the rock of reality. But it also shows that they missed the whole point of a gold standard. The whole point of a gold standard is that gold doesn’t change its value just because of some guy saying blah blah blah. Unlike the floating dollar today, which changes value due to Ben Bernanke’s latest press conference.

I often say that you should think of a gold standard like a “currency board linked to gold.” In fact all gold standards operate like this, whether you have a lot of gold in a vault somewhere or not.

March 11, 2011: A Currency Board Linked to Gold

It is on this principle that paper money circulates: the whole charge for paper money may be considered as seignorage. Though it has no intrinsic value, yet, by limiting its quantity, its value in exchange is as great as an equal denomination of [gold] coin, or of bullion in that coin. . . .

It will be seen that it is not necessary that the paper money should be payable in specie to secure its value; it is only necessary that its quantity should be regulated according to the value of the metal which is declared to be the standard.


David Ricardo, Principles of Political Economy and Taxation, 1817

The quantity should be regulated according to the value of the metal which is declared to be the standard. That is the currency-board-type mechanism I am talking about. Notice how Ricardo and I are on the same page about this. I am not making this stuff up. Ricardo did not say that the “quantity should depend on the amount of gold in a vault”, or imports and exports of bullion, or any other such quantitative measure. The proper target is value — namely the value of the standard, which means gold. (In Ricardo’s day it occasionally meant silver.) Specie (bullion) is not necessary. You might have it. You might not. It’s the quantity-regulation aspect that allows the value of paper bills to be linked to gold. Ricardo was the premier reference for monetary matters in England during the 19th century. In fact, he played a key role in re-establishing the gold standard in Britain in 1821, at the prewar parity, after a period of floating currencies.

In 1822, just after the gold standard was re-established, the Bank of England had £18.665m of banknotes outstanding and £11.057m of gold bullion. There was no “revaluation” to make them balance. A few years later, in 1837, the BoE had £18.165m of banknotes and £4.077m of bullion. There weren’t even close to being equal. So what. The amount of gold is largely irrelevant. The value of the pound remained pegged to gold until 1914.

And what of the U.S.? In 1855, a time of “free banking” in the U.S. which is much loved by libertarians (there was no Federal Reserve or even a standardized national currency) there was an estimated $394 million of banknotes outstanding, and $59 million of gold bullion held by issuing banks. In other words, a bullion/banknote ratio of 14%. Of course, all of these banknotes were pegged to gold. The U.S. left the gold standard during the Civil War, and returned to gold in 1879, at the prewar parity of $20.67/ounce. In 1880, there were about $746m of banknotes outstanding, and $139m of gold bullion held by issuing banks. The coverage ratio was 20%. There was no “revaluation.” There was no “100% reserve.” It didn’t matter. The whole Rothbard thing is a fairy tale.

So there are two examples of returning to a gold standard, from an extended (23 years in Britain, 19 years in the U.S.) period of floating currencies. Worked fine. No problem. It’s a piece of cake.

January 27, 2011: What Is a Gold Standard?

(By the way, a short-form version of January 27, 2011: What Is a Gold Standard? should be appearing in the print version of Forbes this week. Look for it!)

When people talk about “returning to a gold standard” today, they often mean, “doing what Rothbard and his hallelujah choir suggest.” This has nothing to do with any historical gold standard system. It is a sort of miasmic fantasia. But, if that is all that people have to offer today, then that is what “returning to a gold standard” would mean. It would mean instant failure and horrible economic turmoil as these ideas are proven to be laughably flawed in real-world implementation. The Bernankes, Krugmans and other Keynesians of the world are really not so hot, but the fact is that they would be better than the Rothbardian clown brigade. People sense this, which is one reason why they have stuck with the Keynesians for decades.

That is why we need a new group, of at least a dozen people or so, who have mastery of this material. How can you have a new gold standard if there is nobody — not one single person — who knows how to implement it? You can’t. Yes, I know there are hundreds who say they know how, but you aren’t fooling me.