Golden stability versus fiat chaos (Part I)Sep 11, 2012·Felix Moreno de la Cova Solis
The gold standard is slowly becoming a mainstream discussion point again. This is in part thanks to recent calls from US Republicans for another congressional “gold commission” to examine the idea of restoring some form of gold-backing to the US dollar.
The reaction from mainstream economists, especially those with the fanciest awards and largest loudspeakers, has been predictable: they hate the idea with a passion. However, we will ignore the insults, misleading charts, strawman fallacies and data abuse practised by some, and instead examine more legitimate objections to gold money.
Let us also ignore that lazy and often-repeated argument that “there is not enough gold” for a gold standard to work nowadays. Anybody with a minimum understanding of how supply, demand and prices work can refute this objection.
The most legitimate doubts cast by academic economists on gold hinge on the question of stability. After all, central banks and other money management institutions were ostensibly created to fight instability and economic cycles. They cite “price stability” as one of their key objectives.
Set aside for a moment the question of whether price stability itself is actually a desirable goal, since it can be argued that prices should change, as their purpose is to convey information about real world conditions – which are not exactly immutable. In fact steadily dropping prices can be a sure sign of increasing productivity and a healthy economy. Consider the computer and electronics industry as an illustrator of this point. Has the fact that, in both real and nominal terms, prices for these goods have been steadily falling put people off buying these items, or hindered investment and productivity in this sector? Of course not.
So is gold more stable than fiat money? Does gold maintain purchasing power better than, for example, the fiat dollar? Are prices under a gold standard a better reflection of underlying economic fundamentals than is the case under a fiat regime?
The answer to all of the points is undoubtedly yes. Currencies can and do disappear, yet gold has remained recognised as money for thousands of years. We shall look at the historical and empirical evidence (there is plenty) shortly, but first let’s look at the logical argument.
Gold is a finite and scarce element. There is a limited amount and it is costly and difficult to extract. Gold production typically adds 1-2% annually to the existing gold stock; even in the largest gold rushes, such as mid-19th century California, global gold production never exceeded an annual range of 3-4%.
In contrast, the fiat electronic dollar can be created out of thin air in unlimited quantities and at almost infinite speed. Electronic dollars can be destroyed just as fast. There are no physical, logistical, real world limits to how fast or how many dollars can be created. So even before policy, political will and central bankers’ whims are considered, the reality is that the money supply has the potential to expand much more rapidly under a pure fiat currency system.
Then there is the added consideration that since our present monetary system requires that money be created as debt, and that total debt always exceeds total money, the fiat money supply needs to expand at an increasing pace to avoid a collapse. The political pressure for constant expansion is huge. Even if the Federal Reserve chairman wanted to keep the money supply stable, he would be under immense pressure not to do so.
But this Fed chairman, and almost all of his predecessors, are explicit in not wanting a stable money supply. Remember Ben Bernanke’s infamous speech: “Deflation: making sure it doesn’t happen here”.
The logical reasons why fiat currency loses value are clear, but what does experience show? What is the empirical evidence?
First of all compare a chart of US money supply to this chart of the world’s gold reserves.
The former trends exponential, while the latter shows steady, linear growth. However, much more important is this simple fact: there is not one single example of fiat money, a currency backed only by government decree, that has survived 50 years without losing over half its value. There is not a single example of a fiat currency that has even lasted 100 years without being totally debased.
“Ah yes”, some might say: “but fiat money is relatively new while gold has been around much longer, so it’s unfair to compare”. Not really. History brings us examples of unbacked paper money from as far back as the Yuan dynasty (circa 10th century). Paper money advocates have had over 1,000 years to get it right in countless attempts, with all types of variations, cultures and historical context. We are still waiting for one experiment to succeed in the long-term.
On the other hand we have examples of gold money all the way back to ancient Lydia (around 600 BC) and those coins are still worth a great deal, even if we melted them down and destroyed their historical value, the gold would still hold great purchasing power. Some collectible fiat bank notes from distant times might also have substantial value as antiques, but the paper – or whatever material they were made with – would not have incredible value in of itself. In the case of electronic dollars, the contrast is even starker. This is perhaps the key material difference in value between gold and fiat money.
Here is a side-by-side comparison of inflation and economic growth in the United Kingdom during the gold standard era and during the fiat money era.
The contrast is staggering, and should raise serious doubts about the conventional economic wisdom – championed by Keynesians and Monetarists – that a growing money supply (and hence, rising prices) is a necessary precondition of economic growth, and that deflation is always bad.
The American experience was similar to the British one during this period. Just compare price levels before and after 1913 – excluding the periods of the Continental and the Greenback dollars, both fiat currency and both in the end worthless – with the acceleration that ensued after 1971 when the last (weak) link to gold was finally severed (see this infographic on world monetary regimes for more details). If you delve into the historical record from France, Germany, the Netherlands, China and many other countries, you will see very similar experiences.
I could go on endlessly; there are hundreds of years’ worth of evidence and data from multiple countries. The only way economists can mislead the public or themselves into thinking that empirical evidence shows gold-based systems to be inferior is by focusing on narrow time periods and well-chosen charts.
The gold standard, especially a real gold standard in which all can redeem their notes and deposits in gold on demand – not just governments and a privileged few – is a powerful ally of savers. Whereas fiat currency is guaranteed to lose its value steadily year by year, over long periods gold holds its value, and protects people’s purchasing power.
The late Professor Roy Jastram best documented this phenomenon in his 1977 book The Golden Constant (an updated version of this book with new commentary from the World Gold Council’s Jill Leyland was published in 2009). As Jastram acknowledged, long-term purchasing power consistency is one thing, but the gold standard is no promise of year-to-year price stability. There is also no guarantee that if governments decide to return to sound money they will actually keep their promises.
However, the probabilities of economic disaster are greatly diminished by fiscal prudence. Thrift increases the chances of solvency. A gold standard, however imperfect, is what man eventually ends up returning to, time after time, when fiat currency regimes inevitably fail.
In Part II of Golden stability vs fiat chaos (to be published shortly) I will examine how the gold standard affects the boom and bust cycle.