Home > finance, FogOfWar, rant > Guest post: The gold standard

Guest post: The gold standard

September 7, 2011

FogOfWar kindly wrote a guest post for me while I was on vacation:

First off, for anyone who hasn’t seen the first or second round of “Keynes vs. Hayek” in hip-hop style, please check them out, they’re hilarious.

There’s an economic crisis going on around us, and periodically one hears people suggesting that we go back to the gold standard. It’s a pretty complicated issue, and I don’t really have an answer to the “gold standard debate”–just probing questions and a lingering feeling that the chattering class has been dismissive when they should be seriously inquisitive. I think this dismissiveness is driven by the fact that Ron Paul is the leading political proponent of the gold standard and competing currencies, and he’s (1) a traditional conservative libertarian (a bit in the Goldwater vein); and (2) a bit of a wingnut.

Aristotle would be ashamed— the validity of an argument does not depend upon the person making the argument, but upon whether the ideas contained are valid or invalid. Andrew Sullivan recently linked to this article by Barry Eichengreen, claiming that it’s “a lucid explanation of why calls to go back to the gold standard are so misguided.”  In fact, it’s a fairly serious examination of the gold standard (ultimately coming down “nay”), which is a welcome relief from the flippant and arrogant dismissiveness one usually sees from economic pundits.

As with many edited articles, I recommend skipping the first page and a half (begin from the paragraph starting “For this libertarian infatuation with the gold standard…”).  Here’s how I think the article should have begun:

[T]he period leading up to the 2008 crisis displayed a number of specific characteristics associated with the Austrian theory of the business cycle. The engine of instability, according to members of the Austrian School, is the procyclical behavior of the banking system. In boom times, exuberant bankers aggressively expand their balance sheets, more so when an accommodating central bank, unrestrained by the disciplines of the gold standard, funds their investments at low cost. Their excessive credit creation encourages reckless consumption and investment, fueling inflation and asset-price bubbles. It distorts the makeup of spending toward interest-rate-sensitive items like housing.

But the longer the asset-price inflation in question is allowed to run, the more likely it becomes that the stock of sound investment projects is depleted and that significant amounts of finance come to be allocated in unsound ways. At some point, inevitably, those unsound investments are revealed as such. Euphoria then gives way to panic. Leveraging gives way to deleveraging. The entire financial edifice comes crashing down.

This schema bears more than a passing to the events of the last two decades.

First, I would reword that last sentence as follows: This schema bear a striking resemblance to the events of the last two decades. Moreover, I would add, in light of this data, one might ask not why fringe candidate Ron Paul is calling for examination of a return to the gold standard, but rather why this view is considered to be on the fringe rather than at the center of debate. There are a number of reasons to believe that a return to the gold standard might not have the desired effect, although that certainly begs the question of what can be done to prevent future crisis on the order of 2008.

I’d place myself in the camp of “not convinced that the gold standard is the answer, but think it would be really hard to fuck up the economy as bad as the Fed did over the last 20 years even if you were trying, so maybe it’s an idea that deserves some real thought.”

Here’s another key paragraph:

Society, in its wisdom, has concluded that inflicting intense pain upon innocent bystanders through a long period of high unemployment [by allowing bubbles to work themselves out as Austrians advocate] is not the best way of discouraging irrational exuberance in financial markets. Nor is precipitating a depression the most expeditious way of cleansing bank and corporate balance sheets. Better is to stabilize the level of economic activity and encourage the strong expansion of the economy. This enables banks and firms to grow out from under their bad debts. In this way, the mistaken investments of the past eventually become inconsequential. While there may indeed be a problem of moral hazard, it is best left for the future, when it can be addressed by imposing more rigorous regulatory restraints on the banking and financial systems.

This gets to the crux of Eichengreen’s argument, but consider the following points:

  1. The “help” proposed by Keynsians in fact might make things worse in the long term (not out of malice, but the road to hell is paved with good intentions) by dragging out the inevitable consequences of misallocation during the bubble.  In essence, this is a ‘rip the band-aid’ off argument.  I think I’ve seen some historical analysis that the total damage done from a bank-solvency driven recession is, in fact, worse over time if extended rather than allowing banks to fail and recapitalize (Sweden vs. Japan).
  2. “… nor is precipitating a depression…” It’s taken as an article of faith that we would have been in a depression if not for the stimulus package, but I’m skeptical.  This is and will always be a theoretical “what if” analysis, conducted by economists who have a cognitive bias in favor of a certain answer (and, for those working in government, a President who needs to juke the stats to get reelected).
  3. “While there may indeed be a problem of moral hazard it is best left for the future, when it can be addressed by imposing more rigorous regulatory restraints on the banking and financial system.” Whaaaaaaaaat? This is where Keynesians lose me.  The sentence is so hopelessly naïve that it undermines the entire argument.  Take your nose out of your input-driven models for a minute and take a look around and ask yourself how good a track record bank regulators have at imposing “more rigorous regulatory restraints” during boom times; major new regulatory changes only have political will during a crisis (Securities Act of ’33, Exchange Act of ’34, Glass-Steagall in ’34).  I’m not going to argue the relative benefits of economic models when the theory is premised on a factual event that’s very likely not going to happen.

Here’s a paragraph I liked:

Bank lending was strongly procyclical in the late nineteenth and early twentieth centuries, gold convertibility or not. There were repeated booms and busts, not infrequently culminating in financial crises. Indeed, such crises were especially prevalent in the United States, which was not only on the gold standard but didn’t yet have a central bank to organize bailouts.

The problem, then as now, was the intrinsic instability of fractional-reserve banking.

This is a really good point; I don’t have an answer and it ties in to a lot of deep questions about the structure of the banking system and “what is money”. I do like that it’s being discussed, and I’d love to hear views (educated and layman alike) on “so if the gold standard won’t work and the Fed fucked things up so bad, what do you suggest?”

Lastly, here’s the end of the piece:

For a solution to this instability, Hayek himself ultimately looked not to the gold standard but to the rise of private monies that might compete with the government’s own. Private issuers, he argued, would have an interest in keeping the purchasing power of their monies stable, for otherwise there would be no market for them. The central bank would then have no option but to do likewise, since private parties now had alternatives guaranteed to hold their value.

Abstract and idealistic, one might say. On the other hand, maybe the Tea Party should look for monetary salvation not to the gold standard but to private monies like Bitcoin.

Um, for the record that’s long been the position of Paul.  See for example this. Moreover, I think the author isn’t aware that there may be significant legal obstacles to create a competing currency.

I don’t have an answer to the many questions raised here, but they’ve been on my mind a lot. Any thoughts?


Categories: finance, FogOfWar, rant
  1. Robert Smart
    September 7, 2011 at 9:02 pm

    Money tries to do 2 jobs: (1) Be a medium of exchange and comparing values; and (2) Be a repository of value. Maybe we need 2 currencies: highly convertible but a market driven rate. Might I suggest that the backup for the “repository of value” money should be stuff of real value: non-perishable commodities in proportion to there actual consumption. E.g. oil, metal, etc. As a side benefit we have stockpiles that might be valuable in an emergency.

  2. majordomo
    September 8, 2011 at 9:15 am

    I too used to think Ron Paul was a wingnut (and I still think many of his supporters are) until I watched a YouTube clip of Ron Paul predicting the 2008 housing crisis and financial meltdown as early as 2003. Watch the clip if you don’t believe me:

    When asked why the mainstream didn’t see the financial meltdown coming, he said it was because most of them are members of the Keynesian school of economics, and have never heard of the Austrian School, the followers of whom (e.g. Peter Schiff) knew about the impending meltdown years before it occurred.

    • human mathematics
      September 9, 2011 at 1:53 am

      I think it’s RP’s non-economic views that make him a wingnut.

  3. September 8, 2011 at 9:47 am

    So long as more benefits of the boom accrue to the bankers (and associated professions including fund managers and insurers) than to other social strata, while the cost of the bust is distributed evenly through society, the bankers will have a vested interest in encouraging violent economic cycles.

    It reminds me of the way Eucalyptus trees start forest fires. The Eucalyptus trees have a higher rate of survival in a forest fire than their direct competitors. Therefore they drip highly flammable gum onto the forest floor, in effect encouraging such fires to start (Hence their common name ‘Australian Gum Tree). Afterwards the proportion of Eucalyptus in the forest has increased (of course if the fires get too fierce or frequent even the Eucalyptus burn, so it is a risky strategy).

    However, I do not see ‘the gold standard’ as being relevant to this problem: after all you can see similar bubbles and busts long before the gold standard was removed (indeed, they seem to be the normal market response to novel resources: Tulips, Louisiana, Railways, Internet…

    • FogOfWar
      September 8, 2011 at 9:09 pm

      This is my first centennial market crash, but I believe in prior crashes many of the bankers were wiped out. That’s one of the points that makes this crash (and, more to the point, the government response to it) so problematic IMHO.

      As to Ron Paul’s wingnut status, you can judge for yourself here:

      Also, Paul Krugman just wrote a blog post about the price of gold (not the gold standard directly) here:


      My favorite part of the post is a commentator who said “Actually there are 10 types of people in the world: those who understand binary and those who don’t.” Other than that, it’s an interesting thesis, although I’d say it’s classic one-factor modelling of a multifactor question (what drives the price of gold). No trader would use this kind of analysis in isolation–see, for a particularly striking example of another factor, this:


      What struck me about the Krugman post is that he sees everything in the world in light of the Keynes v Hayek debate. If Ron Paul is the most visible proponent of Hayek, Krugman is the most visible proponent of Keynes (neither is, I’m sure, the leading academic expert on the respective subjects). I’m pretty confident that the current price of gold doesn’t tell us much of anything about whether Keynes or Hayek are right–it mostly reflects the fact that an awful lot more people have been buying gold than selling it, and I can think of a lot of different reasons for that.


  4. Bindicap
    September 11, 2011 at 8:40 pm

    The conventional theory as I understand it is that monetary policy has a large effect on economic activity and you are in much better shape with the ability to control and tweak it independent of artificial constraints such as you have with a hard link between money and something like gold.

    Inflation, growth, and unemployment are all strongly connected to interest rates when things are not too far out of whack. I think the IS/LM model is the classic relationship http://en.wikipedia.org/wiki/IS/LM_model, although it’s not blindly accepted and there are many alternatives.

    From this you get to policy prescriptions such as raising rates if an economy seems overheated and may be growing too fast and generating inflation, or lowering rates if growth is too slow and unemployment is rising. A Taylor Rule (there are variations) prescribes an appropriate rate given economic parameters, http://en.wikipedia.org/wiki/Taylor_rule. The goal is sustained, stable growth that comes close to using all the economy’s resources, and avoids instabilities and periods of high inflation or deflation.

    In order to implement such a monetary policy, you need a body to make determinations, which is the Federal Reserve in the US, and a mechanism by which it can supply or withdraw money in order to tune interest rates — this is generally done through open market operations, wherein the Fed will enter repos or reverse-repos to exchange bonds for cash at rates around its target.

    There has always been a lot of interest in how well this all actually performs, and in particular there has been a lot of blame on the Fed under Greenspan for keeping rates too low, too long in the beginning of the 2000s.

    You simply cannot withdraw or inject gold the same way to fine-tune money supply when money is linked directly to gold. The supply will just grow at the rate that new gold enters the system, totally irrespective of what level of money is appropriate for the economy. Eg, if a nation is in a period of great innovation and a lot of immigration, it may want to grow money supply much faster than gold permits. This situation will mean gold/money becomes too scarce and too valuable relative to actual goods and services that people want and you enter a period of deflation which encourages hoarding of gold/money (because it will buy more if you wait) and choking normal flow and exchange in the economy.

    Outside of equilibrium situations, a gold standard also constrains how you can react to shocks. Eg, lowering rates to boost economic activity after a devastating hurricane, or raising rates in response to an asset bubble. The end of the gold standard came because it constrained expansionary monetary policy needed to restart growth in the wake of the great depression, and various studies have tied the recovery of various countries to when they finally gave up the gold standard.

    Nowadays we are not close to full economic activity but rates are already very low and cannot realistically go negative, so there have been unconventional ways to try to promote expansion through monetary policy such as quantitative easing. Probably fiscal policy would be more effective, but that is fraught with even more hairy politics.

    My understanding of advocacy of a gold standard is that the inability to tune monetary policy effectively under it is considered a feature and not a bug. When you disagree with rate policy or don’t like or trust the Fed, it seems a big improvement.

    My own judgment is that a lot of the criticism is not correct. (Eg, we have not seen hyper-inflation as is often predicted by gold standard proponents if we don’t change as they want.) And even if rate policy as we have it now can be wrong and generate problems, depending on how well the Fed does its job, we are still better off than under a constrained system where policy will in effect always be somewhat wrong, and perhaps hugely wrong at very inconvenient times (as when the gold standard was universally dropped in the wake of the great depression).

    • FogOfWar
      September 14, 2011 at 12:13 am

      Agree with much of what you said, and that’s a good overview of the conventional theory, although I come to tentatively different conclusions.

      To formulate the question a different way: “is what the Fed does in *reality*, not in theory, on balance helpful or harmful?” The Keynes camp is confident in the ability of the Fed to do its job well, the Hayek camp thinks the Keynesians are suffering from hubris.

      My view may be driven by recency bias (is a 20-year time span still considered recent? Certainly by historical standards it is). We’re now 3 years in to the bust of the sequential asset bubbles created by Alan Greenspan and the damage is profound and not showing signs of healing quickly. If this is the reality of Keynesianism (again, not the theory), I’m not sold.

      As an aside, inflation does not have to be hyperinflation to be damaging, and true inflation is significantly higher than the government-manipulated CPI statistic. See here: http://www.shadowstats.com/


  5. human mathematics
    September 14, 2011 at 2:54 am

    FogOfWar, I think there are at least two key problems with the gold-standard argument you presented.

    1) How would a gold standard have prevented the 2008 financial crash, or any of the other financial-market volatility of the past 20 years? If you naïvely divided the price of security X at time t by G_t, the price of gold at the same time, you would not have a stable time series. Nor is it immediately obvious that changes in the international value of say the US dollar would have prevented lying and cheating on the part of synthetic derivatives manufacturers. (Would it have stemmed hot money flows to SE Asia in 1998? Would it have prevented a Russian default in the same year? Etc.)

    One or more of these arguments has to be made before it’s clear that a gold standard would be better and not just different.

    2) As I understand it, the disadvantage of a gold standard as opposed to floating exchange rates is not that governments are deprived of monetary policy tools (@Bindicap’s IS-LM reference). The disadvantage is that private markets cannot argue over the value of a given currency.

    Consider this example: Australia has one wallop of gold in reserve. Their output increases by 11% and so the government needs to print 11% more Australian dollars to keep prices stable. But it takes 2 years for the government to accurately measure this productivity increase, whereas the market would have settled somewhere between 10% and 12% as the growth number based on free market magic, within 3 months.

  6. FogOfWar
    September 14, 2011 at 9:55 pm

    Yah–lot’s of good questions there.

    I think the core reason for this line of inquiry is that the lying and cheating is all there, but the backdrop and the incentive behind it was too much money flowing around the system chasing any asset that moved (every financial industry veteran in the mid-oughts saw this and many were shocked by it), and that definitely lands a very big chunk of the blame on the Fed.

    Thus, I’d like to see a lively debate in policy and public circles about how to prevent the Fed from doing the same thing again. As I said at the beginning, I’m not convinced the gold standard is the answer, but I do think the status quo is not OK…


    • human mathematics
      September 15, 2011 at 11:52 pm

      Experience is a harsh teacher. Economists will be dissecting these financial crises for some time to come. We may not have to worry as much about a repeat as about an error of another type.

      As far as taking away power from the Fed: it’s literally impossible to tie ourselves with a rope we can’t cut. Even if Congress dissolved the Fed, it would still have power over currency.

      • FogOfWar
        September 17, 2011 at 6:38 pm

        I’m not so reassured, perhaps because I work in the financial sector and I look around me and see banks engaging in almost exactly the same behavior as in, say, 2006 without any adult supervision or intervention. If we can’t even learn from recent history, how can we hope to have learned the lessons of 2008 when 2048 arrives?

        I like the ‘tie ourselves with a rope we can’t cut’ analogy–been in the back of my head as well. Congress could switch to a gold standard (or some other/better solution to limit the Fed), but then Congress would have the power to remove that constraint later. Exactly what happened with the passage of Glass-Steagall and the subsequent repeal of it 60 years later…

        Still no answers, only questions…


  7. human mathematics
    September 24, 2011 at 1:29 am

    FogOfWar, this is relevant from Janet Tavakoli:


    This is actually a story of Wall Street’s massive, wide-spread, multi-year fraud, including accounting fraud.

    I appeared on 60 Minutes (February 14) and said Wall Street’s dealings with mortgage lenders, securitizations, derivatives, and investors were a massive Ponzi scheme, the biggest crime ever against the American economy.

    Going to a gold standard would not reduce fraud. If that was indeed the central problem as Ms. Tavakoli says, going to gold wouldn’t help us.

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