As Good As Gold

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					                                   SUSAN                                              REP.                           REGULATION
                                   EISENHOWER                                         PAUL RYAN                      Richard Epstein
                                   The                                                Repeal AMT.                    defends
                                   end of                                             Overhaul                       intellectual
                                   NATO?                                              the tax code.                  property
                                   PAGE 4                                             PAGE 11                        PAGE 3

March/ April 2008                                                                                                           Vol. XXX No. 2

As Good
As Gold?
         or the first time in many

F        years, the monetary arrange-
         ments of the United States
         have become an issue in the
         2008 presidential race. The
subprime crisis and the decline in
the foreign exchange value of the
dollar have raised questions about
the performance of the Federal
Reserve Board. One candidate has
proposed ending the post-1971
experiment with an unanchored fiat
dollar issued by the Federal Reserve
and returning to a gold standard
with private money issue. Critics
have raised a number of theoretical
and historical objections to the gold
standard. Some have called the gold
standard a “crazy” idea.
   The gold standard is not a flaw-
less monetary system. Neither is the                                     ato vice president for international programs Tom G.
fiat money alternative. In light of
historical evidence about the com-
parative magnitude of these flaws,
the gold standard is not a crazy idea.
                                                                    C    Palmer spoke at universities and think tanks in Shanghai,
                                                                         Ningbo, Beijing, Guangzhou, Shenzhen, Chengdu, and
                                                                    other cities during a three-week lecture tour of China in Decem-
CONT’D ON PAGE 8                                                    ber. Here he visits a statue of Adam Smith on the campus of
LAWRENCE H. WHITE is the F. A. Hayek Professor of Economic          the University of Finance and Economics in Chengdu along-
History at the University of Missouri–St. Louis and an adjunct
scholar of the Cato Institute. He is the author of Competition
                                                                    side Diqing Jiang, editor of Cato’s Chinese project,
and Currency, Free Banking in Britain, and The Theory of Monetary
Institutions. A longer, footnoted version of this article can be
                                                                    and Aili Huang of the Beijing-based Cathay Institute for Pub-
found at                                              lic Affairs. PAGE 6
                                                      “ Growth in
                                                     the stock of gold
                                                      has been slower
Continued from page 1
                                                      and steadier in                          under gold and silver standards. Specifically,
    The “gold standard” generically means a        practice than growth                        they reported, “The average inflation rate
monetary system in which a certain mass               in the stock of                          for the fiat standard observations is 9.17
of gold defines the monetary unit (e.g., the            fiat money.                            percent per year; the average inflation rate
“dollar”) and serves as the ultimate medi-
um of redemption. For example, during
the “classical” gold standard period
(1879–1914), the U.S. dollar was defined as
0.048 troy oz. of pure gold. Inverting the
                                               the cyanide process—were responses to pre-
                                               vious increases in demand and the pur-
                                               chasing power of gold and thus helped to
                                                                                               for the commodity standard observations
                                                                                               is 1.75 percent per year.”
                                                                                                   This result was not driven by a few
                                                                                               extreme cases; in fact, in computing the
                                                                                               average rates of inflation Rolnick and
defined ratio, 1 ounce of pure gold was        stabilize the purchasing power of gold over     Weber deliberately omitted cases of hyper-
equivalent to US$20.67. Gold coins need        the long run. Other increases resulted from     inflation (which occurred only under fiat
not, and historically did not, form the pre-   accidental discoveries. The largest such        money). Still, “every country in our sample
dominant medium of exchange in a finan-        “supply shock” in the 19th century was the      experienced a higher rate of inflation in the
cially sophisticated economy. Issuers of       1848 discovery of gold in California. The       period during which it was operating
paper currency and checkable deposits, nor-    outpouring of gold from California              under a fiat standard than in the period
mally private commercial banks but also a      reduced the purchasing power of gold            during which it was operating under a
government central bank if one exists, make    around the world, or in other words, gener-     commodity standard.” Peter Bernholz of
their notes redeemable for gold and hold       ated an inflation of the price level. But how   the University of Basel adds that “a study of
gold coins and bullion as reserves for meet-   large an inflation? The magnitude was sur-      about 30 currencies shows that there has
ing redemption demands. Because of the         prisingly small. Even over the most infla-      not been a single case of a currency freely
banks’ contractual obligation to redeem in     tionary interval, the general price index for   manipulated by its government or central
gold, the volume of paper currency and         the United States rose from 5.71 in 1849 to     bank since 1700 which enjoyed price stabil-
deposits—the everyday means of payment—        6.42 in 1857 (year 2000=100), an increase       ity for at least 30 years running.”
is geared to the volume of gold.               of 12.4 percent spread over eight years. The        The evidence thus indicates that growth
    So what are the key objections to the      compound annual price inflation rate over       in the stock of gold has been slower and
gold standard?                                 those eight years was slightly less than 1.5    steadier in practice than growth in the
                                               percent. Twenty-two years later, when the       stock of fiat money. Of course, U.S. infla-
“A gold standard leaves the quantity of        gold standard was finally restored follow-      tion is thankfully not as high as 9 percent
money to be determined by accidental           ing its suspension during the Civil War, the    today, but at 4.3 percent (CPI, year-over-
forces.”                                       purchasing power of gold had actually           year) it is currently more than twice as high
   There is a germ of truth to this concern.   risen slightly (the price level was slightly    as Rolnick and Weber’s figure for com-
A gold standard does leave the quantity        lower).                                         modity standards. Under a gold standard,
and purchasing power of money to be                The economic historian Hugh Rockoff,        the price level can be trusted not to wander
determined by the forces of supply and         in an examination of the output of gold,        far over the next 30 years because it is con-
demand in the market for gold. There can       concluded that “it is fair to describe the      strained by impersonal market forces.
be “accidental” shifts in the supply and       fluctuations in the supply of gold under        Under a fiat standard, the future price level
demand curves to which the quantity and        the classical standard as small and well-       depends on the personalities of yet-to-be-
purchasing power of money will respond.        timed.” He found that supply of fiat money      appointed monetary authorities and is
Our current fiat standard, by contrast,        in the postwar United States (1949–79), by      thus anybody’s guess.
leaves the supply of money to the decisions    contrast to the behavior of gold under the          The blogger Megan McArdle gets things
of a committee (namely, the Federal Open       classical gold standard, had both higher        almost exactly backward when she writes,
Market Committee of the Federal Reserve        annual rates of growth and a higher stan-       “The gold standard cannot do what a well-
System). The practical question is: under      dard deviation of annual growth rates           run fiat currency can do, which is tailor the
which system are the quantity and pur-         around decade averages.                         money supply to the economy’s demand
chasing power of money better behaved?             In a study covering many decades in         for money.” Under the gold standard, mar-
   As is well known, the stock of gold did     a large sample of countries, the Federal        ket forces do in fact automatically tailor the
not grow at a perfectly steady rate during     Reserve Bank of Minneapolis economists          money supply to the economy’s demand
the era of the historical gold standard.       Arthur Rolnick and Warren Weber similar-        for money. The economics of gold mining
Some increases in gold output—such as the      ly found that “money growth and inflation       operates to match world supply with world
Yukon discoveries and the development of       are higher” under fiat standards than           demand at a stable price level (though

8 • Cato Policy Report March/April 2008
                                                        “A gradual
                                                   anticipated deflation
                                                  does not discourage in-
admittedly large demand shocks can take
                                                  vestment, especially not                       dard—for example Canada—had no bank-
years to be accommodated), and the                when productivity gains                        ing panic in 1929–33 (nor did Canada have
“price-specie-flow mechanism” quickly              are driving growth in                         panics in the late 19th century), so the gold
brings gold from the rest of the world into            the first place.                          standard couldn’t have been responsible
any single country where demand for
money has grown. We can only imagine a
well-run fiat-currency-issuing central bank
trying to match these properties. We can-
not observe any central bank that has actu-
                                                 of gold. Prices particularly fell for those
                                                 goods whose production enjoyed great
                                                 technological improvement (for example
                                                                                                 for the panics. Rather the panics were due
                                                                                                 to completely avoidable legal restrictions
                                                                                                 (namely the ban on branch banking, and
                                                                                                 compulsory bond collateral requirements
                                                                                                 making the supply of banknotes “inelastic”)
ally managed it.                                 oil and steel after 1880). Strong growth of     that weakened the U.S. banking system.
                                                 real output, for particular goods or in gen-
“A gold standard would be a source of            eral, cannot be considered harmful.             “The benefit of a gold standard (restrain-
harmful deflation.”                                  It would be possible for the central bank   ing inflation) is attainable at less cost by
    The inflation rate under the gold stan-      under a fiat money standard to offset pro-      properly controlling the supply of a fiat
dard averaged close to zero over genera-         ductivity-driven declines in some prices by     money.”
tions, being sometimes slightly positive         expanding the quantity of money in order            Although growth in the stock of fiat
and sometimes slightly negative over indi-       to drive others prices upward, thus elimi-      money could in principle be as slow as (or
vidual decades. Rolnick and Weber, as            nating deflation “on average.” But there is     slower than) growth in the stock of gold
quoted above, found an average inflation         no social benefit in doing so. Falling costs    under a gold standard, it has not been so in
rate of 1.75 percent over the sample of gold     of production in steel (i.e., productivity      practice, as already noted. Alan Greenspan
and silver episodes reported in the pub-         gains) do not discourage investment in          actually used to recommend controlling
lished version of their paper; an earlier ver-   steel. A gradual anticipated deflation does     the fiat money supply to mimic the price-
sion using a different sample arrived at an      not discourage investment, especially not       level behavior of a gold standard. In
average rate of -0.5 percent. In 1879 the        when productivity gains are driving growth      response to questioning at a 2001 con-
United States resumed gold redemption            in the first place.                             gressional hearing, Greenspan said: “Mr.
for the U.S. dollar, which had been sus-             Nor does a deflation penalize debtors       Chairman, so long as you have fiat curren-
pended since the Civil War. Between 1880         once it comes to be anticipated, because        cy, which is a statutory issue, a central bank
and 1900 the United States experienced           nominal interest rates adjust downward to       properly functioning will endeavor to, in
one of the most prolonged periods of             reflect anticipated repayment in dollars of     many cases, replicate what a gold standard
deflation on record. The price level trended     higher purchasing power.                        would itself generate.”
more or less steadily downward, beginning                                                            Fiat money regimes have not, however,
at 6.10 and ending at 5.49 (GDP deflator,        “The gold standard was responsible for          accomplished price stability as fully as the
base year 2000=100). That works out to a         the U.S. banking panics of the late 19th        gold standard did. Although inflation is
total decline of 10 percent stretched over 20    century and the monetary contraction            less severe today than it was 30 years ago,
years. The deflationary period was no dis-       of 1929–33 and thereby for the Great            experienced inflation rates, and the expec-
aster for the real economy. Real output per      Depression.”                                    tations of future inflation rates embodied
capita began the period at $3,379 and                 The U.S. monetary contraction of           in long-term interest rates, have remained
ended it at $4,943 (both in 2000 dollars).       1929–33 is the prime example of a harmful       higher than corresponding rates under the
Total real per capita growth was thus a          deflation. It should be noted that it hap-      classical gold standard.
more-than-healthy 46 percent. (Real GDP          pened on the Federal Reserve’s watch. The
itself more than doubled.)                       episode should be blamed not on the gold        “A gold standard is no restraint at all, be-
    Monetary economists distinguish a            standard, but on the combination of a           cause government can devalue or suspend
benign deflation (due to the output of           weak banking system and a befuddled cen-        gold redemption whenever it wants.”
goods growing rapidly while the stock of         tral bank. The U.S. banking system was             A similar claim could be made about
money grows slowly, as in the 1880–1900          prone to runs and panics in the late 19th       any other restraint in the Constitution.
period) from a harmful deflation (due to         century, and continued to be so through         And yet constitutional rules are useful. By
unanticipated shrinkage in the money             the 1929–33 episode in which the Fed            authorizing only a limited set of govern-
stock). The gold standard was a source of        stood by and did not supply replacement         ment activities, ruling others simply out of
mild benign deflation in periods when the        reserves to keep the money stock from con-      bounds, they save the public the trouble of
output of goods grew faster than the stock       tracting. Other countries on the gold stan-     trying to weigh every potential activity on a

                                                                                                           March/April 2008 Cato Policy Report • 9
cost-benefit basis.
                                                    “   Growth in the
                                                      stock of money is
                                                     governed by market                             Conclusion
   An important problem in fiat money               forces rather than by                               Under the gold standard the issue of
regimes, as famously identified by Finn
                                                      government fiat.                              common money by banks is restrained by

Kydland and Edward C. Prescott, is the lack                                                         the cost of acquiring gold, which is deter-
of an enforceable commitment not to use                                                             mined by impersonal supply-and-demand
surprise monetary expansion and resulting        United States with Canada in the 19th centu-       forces in the gold mining market. Because
inflation as a temporary stimulus to the         ry). In the rare cases such a lender might be      of the issuers’ contractual obligations to
economy. When the public knows that the          needed, bank clearinghouses can play the role.     redeem in gold and the corresponding pru-
central bank would be tempted to use sur-                                                           dential need to hold gold reserves, the dol-
prise inflation, the public rationally expects    “The gold standard is an example of price         lar volume of paper currency and
higher-than-optimal inflation. The central       fixing by government.”                             deposits—the stock of money—is geared to
bank has to deliver higher-than-optimal              The gold standard doesn’t fix a price          the volume of gold. Growth in the stock of
inflation to avoid a negative surprise. An       between dollars and gold any more than the tra-    money is governed by market forces rather
unfortunate standoff is reached at a higher-     ditional British measurement system fixes a        than by government fiat. A gold standard
than-optimal inflation rate (which, being        price between pints and quarts. The fixed rela-    does not guarantee perfect steadiness in
fully anticipated, provides no economic          tionship is a matter of definition. A gold stan-   the growth of the money supply, but his-
stimulus). A gold standard avoids this trap.     dard defines the dollar (or whatever the name      torical comparison shows that it has pro-
Like tying Ulysses to the mast, it achieves      of the monetary unit) as a specified mass of       vided more moderate and steadier money
better results by removing the option (to use    gold. Dollars are not a separate good from gold.   growth in practice than the present-day
surprise inflation) that leads to ruin. Of                                                          alternative, politically empowering a cen-
course, a gold standard is not the only possi-    “The United States can’t recreate the clas-       tral banking committee to determine
ble rule for constraining the creation of        sical international gold standard by               growth in the stock of fiat money. From
money. Alternatives include a Friedman-          itself.”                                           the perspective of limiting money growth
type money-growth rule or an inflation-tar-          I have saved for last what I think is the      appropriately, the gold standard is far from
geting rule. But the gold standard has a         strongest objection to unilateral return to the    a crazy idea.
longer history and is the only historically      gold standard. The United States would not             Historical problems of U.S. banking
tested rule that does not presuppose a cen-      enjoy the benefits of being on an internation-     instability, sometimes blamed on the gold
tral bank.                                       al gold standard if it were the first and only     standard, turn out on closer inspection
   Leaving money issue in the hands of pri-      country whose currency was linked to gold.         to have had been rooted in banking reg-
vate banks rather than a government insti-       At least two major benefits would be missing:      ulations that inadvertently weakened U.S.
tution, as the United States did before 1913,    (1) the United States would not enjoy fixed        banks. Gold standard countries like
removes the option to use surprise mone-         exchange rates with the rest of the world (of      Canada that avoided the peculiar banking
tary expansion one step further. It remains      course, we’re already living with that disad-      restrictions of the United States also avoid-
true that government can suspend the gold        vantage today), and (2) the purchasing power       ed the instability. As we discovered in the
standard in an emergency, as both sides did      of gold would not be as stable. The purchas-       greatest banking panic, that of 1929–33,
during the U. S. Civil War, but the spirit of    ing power (or relative price) of today’s demon-    having a Federal Reserve System capable of
the gold standard calls for returning to the     etized gold has been much less stable than         overriding the gold standard did not elimi-
parity afterward, as the United States did.      that of gold under the 19th century’s global       nate the problem of weakness in the U.S.
Judging by long-term interest rates and the      gold standard, because the demand to hold          banking system.
thick market for long-term bonds under the       gold today is largely a speculative rather than        Other supposed historical problems,
post-bellum classical gold standard, the risk    a transactions demand. With only one econo-        like price deflation due to goods produc-
of permanent devaluation or suspension           my on gold—albeit a large economy—mone-            tion outgrowing gold production, turn out
was considered small.                            tary use of gold would likely remain the tail      not to have been actual problems.
                                                 rather than the dog. Thus even in the unlike-          A gold standard does entail resource
“Fiat money is necessary so that a lender        ly event that the United States were to elect      costs of mining the gold that is lodged in
of last resort can meet liquidity needs of       a president committed to a pro-gold policy,        bank vaults. But so too does a fiat standard
the banking system.”                             that president would be prudent to try to cul-     entail resource costs, primarily in the form
   History shows that a lender of last resort    tivate similar commitments from the govern-        of the deadweight costs of inflation. All in
would hardly be needed with a stable mone-       ments of the other leading economies of the        all, because the costs of a gold standard are
tary regime and a sound banking system           world before taking the United States down         reasonably small in relation to its benefits,
(again it is instructive to contrast the         the yellow brick road alone.                       the gold standard is not a crazy idea.

10 • Cato Policy Report March/April 2008

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Description: Discusses Gold Standard vs. Fiat Currency as alternatives and why the Gold Standard is not a panacea to our economic woes.
Amir Medovoi Amir Medovoi Sole Proprieter None
About This Alien is a Shrewd Practitioner and Relentless Student of Global Capital Markets and Real Estate.