When Even the Fed Is Confused About Gold, We Still Have Some Work To Do
January 30, 2015
(This item originally appeared at Forbes.com on January 30, 2015.)
I sometimes read things like college textbooks because, when the author is presenting basic ideas to a general audience, their most foundational misconceptions are on clear display. Recently, the Federal Reserve put out a brief description of a gold standard system – the policy used, in principle, by the United States from 1789 to 1971, and also by the Federal Reserve itself from its founding in 1913 to 1971. It’s a nice way to understand today’s conventional wisdom on the topic, including all the errors inherent.
A gold standard system is very simple. The goal is to maintain the value of the currency equivalent to some defined amount of gold. In the past, the value parity for the dollar was 1/20.67th of an ounce of gold, and later 1/35th of an ounce. Thus, it is a variety of a fixed-value policy. Today, fixed-value policies are very common, but are typically used with a major international currency, like the euro, as the “standard of value” instead of gold. I count at least fifty-five countries with some variant of a fixed-value policy with the euro today.
Once you have a goal, you need a way to attain that goal. Just having a press conference doesn’t do it. Also, storing a bunch of metal in a box doesn’t do it. The most effective way to obtain the fixed-value link is something that resembles a currency board, such as the currency board systems linked to the euro today. I would argue that successful historic gold standard systems, such as those in use by the Bank of England or hundreds of smaller note-issuing banks in the United States in the late 19th century, resembled a currency board in their basic operation although their outward forms were somewhat different. (There are a lot of wrong ways to do it too – don’t do those.)
Once we see that a gold standard system is a fixed-value policy, we also know what it is not. It is not, for example, a system that has any relationship to imports and exports of gold bullion, because the value of gold bullion is the same everywhere whether you import it or not. The amount of gold in a vault has no direct importance, because the value of gold is the same whether there is a lot of it in a vault or a little. There is no “price-specie flow” mechanism (assuming free trade in bullion), because whatever the “price level” and whatever the “specie flow,” the value of gold is the same everywhere.
In practice, historical gold standard systems were almost never “100% reserve” systems, where there are bullion reserve holdings equivalent to 100% of currency (base money) outstanding. In U.S. history, bullion reserve holdings were typically around 20% during the 19th century. Some countries (Russia and France) had a tendency to hold a lot of bullion, and others (Britain and Germany) did not. Their gold standard systems worked either way.
We can see that it doesn’t matter whether there is a “current account deficit” or “current account surplus,” or any other “balance of payments” issue, because the value of gold is the same either way. Mining production might have some small effect on gold’s value, but since existing aboveground gold is about fifty times greater than annual mining production, it doesn’t make much difference whether mines have a good year or not. In the past 150 years, mining supply has varied between about 1.50% and 3.0% of global aboveground gold supply, and it typically takes many years or decades to go from one extreme to the other.
You can also have all the short-term “elasticity” or longer-term expansion in the money supply that is appropriate — and historically, monetary bases did vary by quite a bit during the gold standard era, in both the short and long term – as long as it is compatible with the fixed-value policy. (The term “elasticity” actually comes from discussions during the late 19th century regarding the short-term operations of the Bank of England – obviously, compatible with the gold standard policy.)
It’s not really that complicated.
For a longer discussion of these topics, including all the historical statistics, you can read my books Gold: the Monetary Polaris (available in free eBook format), Gold: the Once and Future Money, the website newworldeconomics.com, and – for the audiovisually inclined – a thirty-minute presentation on YouTube.
Now, let’s see what the Fed has to say:
With a gold standard, the value of a country’s money is tied to its stock of gold reserves. That is, each unit of currency (e.g., a dollar) is tied to a specific amount of gold and is redeemable for that specific amount of gold. The government’s ability to increase the money supply is then restrained by its gold reserves. And since gold is naturally limited and the global gold supply grows relatively slowly, this system seemingly protects against high rates of inflation.
While there is a thread of truth here, I think it is appropriate to call a spade a spade; or, to say that this is a bunch of hooey. In the U.S. example, the total currency supply grew by 163 times between 1775 and 1900, while the global gold supply grew by about 3.4 times due to mining production.
If I am not quite clear, let me simplify: 163 is not the same as 3.4.
Nevertheless, the value of the dollar was basically the same during that period. (There was a small adjustment in 1834.) So, we see that a gold standard system can accommodate any degree of expansion that is appropriate, while also maintaining the fixed-value parity policy.
And what were the gold imports, exports, domestic or world mining production, balance of payments, investment flows, bullion reserve coverage ratios and so forth for the United States during this 125-year period? They were this, that and the other – during that period of time, most everything that could happen did happen. None of it mattered. The dollar was still worth $20.67/oz., its fixed-value parity until 1933.
Between 1775 and 1900, Britain had a completely different pattern of bullion imports, exports, mining production, current account balances, reserve holdings and changes in the monetary base. Yet, the British pound nevertheless maintained its own fixed-value gold parity, at 3 pounds 17 shillings 10 pence per ounce.
If you have managed to read this far (966 words, by the way), you now know more about how the world managed its monetary affairs pre-1971 than the majority of academic specialists, and also the Federal Reserve. I know you don’t believe me when I say that, but later you will look back and agree that it is true.
The reason we don’t have a gold standard policy today is not because it doesn’t work – the last twenty years of the gold standard era, the 1950s and 1960s, were the most prosperous of the last century – but because people forgot what it was for, and how it operated. The world gold standard era didn’t end because it was producing bad results, but because it was left in the hands of people who blew it up out of sheer ignorance and stupidity.
Don’t believe me? Just read what the Federal Reserve itself has to say about the topic, while citing recent academic work. Obviously, these people are clueless. Clueless people break things, and then point fingers elsewhere.
I think there has been a bit of disinformation over the years. It serves some people’s interests if people don’t understand the most basic concepts of gold-based money. In any case, if we are to create a viable alternative to today’s floating-fiat madness, we need to have a strong foundation regarding these core principles.
At least at the Federal Reserve, that foundation is not yet in place.