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The Constraints of a Gold Standard

Are they a good thing or a bad thing...?

"First they ignore you. Then they laugh at you. Then they fight you. Then you win." 

–Mahatma Gandhi

CHAIRMAN of the Federal Reserve Ben Bernanke did something odd this week. He made some meaningful comments about the gold standard system, which is the only sensible alternative to the Ben-Bernanke-makes-it-up system we have today, writes Nathan Lewis at New World Economics.

He did this, I would say, because of increasing pressure, especially from the conservative grassroots in the US, which is translating into constant criticism of Bernanke's super-easy-money actions at the Fed from US conservative politicians.

I would say that we are well beyond the "ignore you" stage, and are in fact somewhere between the "laugh at you" and "fight you" stage.

Unfortunately, Bernanke's comments launched a stream of the usual incomprehensible argle-bargle from gold standard advocates that has characterized their efforts for the past forty years. If you want to get beyond the "laugh at you" stage, you are going to have to do a little better than this.

Let's see what Bernanke said, at his talk to college students at George Washington University (Transcript here):

Bernanke leads with a fairly good description of the original purpose of central banks – to provide short-term "elasticity" in the supply of base money, in response to short-term changes in demand. This "19th century central banking" is entirely compatible with the gold standard system, and indeed Bernanke traces this as far back as 1668 in Sweden. Considering that the world gold standard system existed in some form until 1971, we can see that central banks and the gold standard coexisted together for centuries.

Bernanke: "One of them was the effect of a gold standard on the money supply. Since the gold standard determines the money supply, there's not much scope for the central bank to use monetary policy just to stabilize the economy. And in particular, under a gold standard, typically the money supply goes up and interest rates go down in periods of strong economic activity. So that's the reverse of what a central bank would normally do today."

I have to admit that this is perhaps the first time I've heard this argument – that a gold standard system errs by providing too much money during boom times! That a gold standard produces interest rates that are too low! Of course, an expanding economy tends to be correlated with increasing money demand. Lower interest rates are typically an indicator of confidence in monetary policy and the main point is that a gold standard prevents a central bank from manipulating the economy via currency jiggering. This is one of the primary goals of a gold standard system – and it is this predictability which in turn leads to confidence in monetary and economic stability which forms the foundation of expanding economies and low interest rates. The Keynesians don't see it that way, of course. They have forever been anxious to manipulate the economy by playing with the currency.

Bernanke: "Yet another issue with the gold standard has to do with speculative attack. Now normally, a central bank with a gold standard only keeps a fraction of the gold necessary to back the entire money supply. Indeed, the Bank of England was famous for keeping, as Keynes called it, a thin film of gold. The British Central Bank only kept a small amount of gold, and they relied on their credibility to stand by the gold standard under all circumstances to–so that nobody ever challenged them about that issue. But if for whatever reason, if markets lose confidence in your willingness and your commitment to maintaining that gold standard relationship, you can get a speculative attack."

One of the main reasons that people "lose confidence" in your currency is that the currency managers start to talk about Keynesian notions of interest rate manipulation and currency devaluation – which is exactly what happened to the Bank of England in 1931. To deal with downward pressure on the pound, the Bank of England would have had to reduce the base money supply via open market operations. This would have likely led to a rise in short-term interest rates, which those at the helm were adverse to on Keynesian grounds. (The head of the Bank, Montagu Norman, was on vacation at the time, leaving matters in the hands of underlings with more "modern" views.) Thus, the Bank did nothing, with a devaluation the inevitable conclusion. The value of the pound plummeted, and the Bank of England had to respond with open market operations and higher interest rates just a few weeks later anyway, to keep the pound from collapsing into oblivion.

However, another problem is that central bankers like Bernanke don't actually know how to manage a proper currency peg today. The reason that the US Dollar left the gold standard in 1971 was primarily that the Federal Reserve did not properly understand that the response to a weakening currency is to reduce the monetary base, through open market operations in either gold bullion or government debt. The Fed did exactly the opposite, expanding the monetary base in the late 1960s when they should have been contracting. We see the same problem today in the dozens of currency blowups throughout the world since 1970, all of which were avoidable if central bankers knew how to do their jobs correctly. Thus, this fear of "speculative attack" is a genuine one, but it stems from central banker incompetence, not anything inherent to the gold standard.

Bernanke: "And the reason is that in a gold standard, the amount of money in the economy varies according to things like gold strikes. So for example, if United States, if gold was discovered in California and the amount of gold in the economy goes up, that will cause an inflation, whereas if the economy is growing faster and there's a shortage of gold, that will cause a deflation."

This is baloney. The important thing is the value of gold, not how much of it is mined here or there. A gold standard is a value peg, as Bernanke describes correctly. Gold is the same value everywhere, and the ups and downs of mining production doesn't change that value very much. Bernanke was just explaining that the Bank of England in fact didn't hold much gold at all!

Bernanke: "But you can see that from 1930 to 1933, the economy contracted by very large amounts every year. So it was an enormous contraction of GDP close to the third overall, between 1929 and 1933. At the same time, the economy was experiencing deflation. Deflation is falling prices."

The "deflation" that Bernanke talks about was really an economic collapse which had nothing to do with a failure of the gold standard system to do its job of maintaining a stable currency value. This is not just my opinion, but the consensus of people at the time as well. Even Keynes never blamed the gold standard for the Depression. He simply wanted to be able to manipulate interest rates and devalue the currency in response to the economic problems of the day. Bernanke doesn't blame the gold standard for the Depression in this speech, but instead takes Keynes' stance that the Fed should have been more proactive in responding to the problems with currency manipulation.

Student: "I have a question on the gold standard. Given everything that we know about monetary policy now and about the modern economy, why is there still an argument–some argument, for returning to the gold standard, and is it even possible?"

Chairman Bernanke: "So the argument I think has two parts. One is the desire to maintain 'the value of the Dollar.' I mean basically it's a desire to have very long run price stability. So, the argument is that paper money is inherently inflationary, so we have a gold standard tool, you won't have deflation. And as I said, that's true to some extent over long periods of time. But from a year to year basis, it's not true and so looking at history is helpful there."

The Consumer Price Index was not created until 1940. Between 1913 and 1940, we have the Bureau of Labor Statistics Wholesale Price Index, which is something like a broad commodity index. Previous to 1913, people generally refer to the Warren-Pearson Index, which is a straight commodity price index, with about a 50% weighting in farm products and a 30% weighting in energy. A lot of this supposed "instability of prices" during the 19th century up to 1940 is due to the fact that people are looking at commodity price indices and assuming that they are comparable to today's CPI. A 4% decline, in the course of a year, in today's CPI would be indicative of a major economic event. A 4% decline in the CRB Continuous Commodities Index in the course of a week is just market noise.

Bernanke: "The other reason, I think that gold standard advocates want to see return to gold, is that it removes discretion, it doesn't allow the Central Bank to respond with monetary policy, for example to booms and busts, and the advocates of the gold standard say it's better not to give that flexibility to a central bank. So those are basically the arguments."


Bernanke: "I think though that the gold standard would not be feasible for both practical reasons and policy reasons. On the practical side, it is just a simple fact there is not enough gold to meet the needs of a global gold standard and achieving that much gold would be very expensive, cost a lot of resources. But more fundamentally than that is that the world was changed, so the reason the Bank of England could maintain the gold standard even though it had very small number, amount of gold reserves was that everybody knew that they were going to–their first, second, third and fourth priority was staying on gold and that they had no interest in any other policy objective. But once there was concern that Bank of England might–you know, might not be fully committed, then there was a speculative attack that drove him off gold."

Here Bernanke manages to contradict himself in one paragraph. He says that "there is not enough gold" and then mentions that the Bank of England, the manager of the world's premier gold-linked international currency, didn't actually hold much gold. From 1860 to 1914, the Bank of England held an average of only about 1.5% of total aboveground gold. In 1910, the Bank of England held about 7 million ounces. Is 1.5% of the gold in the world "too much"? The US still holds about 5% of aboveground gold today, or 262 million ounces, which is about thirty seven times more than the Bank of England in 1910.

Bernanke: "So in a modern world, the commitment to the gold standard would mean that we are swearing that under no circumstances, no matter how bad unemployment gets, are we going to do anything about it using monetary policy. And if investors had 1 percent doubt that we would follow that promise, then they will have varying incentive to bring their cash and take out gold in this and in fact it will be a self-fulfilling prophecy. And we've seen that problem with various kinds of fix exchange rates that have come under attack during financial crisis."

Of course it is going to be problematic to maintain a peg if you constantly give hints that you would rather have a floating currency.

All in all, I thought Bernanke's comments were quite even-handed, and certainly much easier to understand than the baffling blah-blah that many gold standard advocates like to indulge in. He says some self-contradictory things, but that is just a repetition of the conventional wisdom he was taught, without having thought about it much.

Bernanke's views are clear: that a gold standard system prevents monetary jiggering, and that this is a bad thing. Funny how a guy in the money-jiggering business would say that. I say it is a good thing. Unemployment is still a problem which should be dealt with aggressively, but we should address it with real fundamental reforms and improvements, not currency twiddling. In the end, the Keynesian tricks don't amount to anything more than currency devaluation.

You still can't devalue yourself to prosperity. For 182 years, until 1971, the United States adhered to the principle of a gold standard, and became the wealthiest, most powerful, most innovative, and most advanced country the world has ever seen. After forty years of Keynesian floating currencies since 1971, even by the government's own unnaturally-rosy statistics, the average worker is making less than in 1970, after adjusting for currency devaluation. The reality is that we are poorer than forty years ago. The United States is in a slow decline, and will likely remain in one until we return to the principle that made us great: the gold standard system.

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Formerly a chief economist providing advice to institutional investors, Nathan Lewis now runs a private investing partnership in New York state. Published in the Financial Times, Asian Wall Street Journal, Huffington Post, Daily Yomiuri, The Daily Reckoning, Pravda, Forbes magazine, and by Dow Jones Newswires, he is also the author – with Addison Wiggin – of Gold: The Once and Future Money (John Wiley & Sons, 2007), as well as the essays and thoughts at New World Economics.

See the full archive of Nathan Lewis articles.

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