02 July 2009

Is a deflationary gold standard bad?

I've never really got why a gradual deflationary bias was a problem. Consumers know, for example, that just about any electronic good (computers, plasma screens etc) will get cheaper in the future, yet this does not seem to stop them from being made and bought. The fact that only those people who really really want the good will buy it and those are no so enthused will wait until it gets cheaper does not seem to stop business from making money.

If it was conspicuous consumption fueled by debt (and an inflationary bias) that got us into this mess, then would not a system with a deflationary bias be the solution? It has a built in frugality: your money will have more purchasing power in the future, so only buy today what you actually need. People would also only want to take on debt if they were actually going to be productive/efficient rather than just trying to bubble up asset prices. Now maybe if we can convince Greenies that a Gold Standard would work against consumerism and thus be good for the planet, we've got a chance.

The above thoughts were prompted by these comments left at this article Gold Standard ... Debunked or Another Bubble?:

Dirk, on November 24, 2008 at 12:58 pm, said:

I’m happy someone gets it- that constraining global economic activity based on a single metal that doesn’t really correlate to economic activity makes no sense.

Clearly, the gold standard is deflationary in absence of either major gold finds, or major negative economic shocks. More goods and services chasing a fixed money pool will create massive downward pressure on prices. And downward pressure on prices and assets equals lower incentives for investment, more difficulty paying off debt, and a negative wealth effect that creates real economic stagnation.

Inflation, on the other hand, creates pressure to invest money- not hoard it. As long as a currency promises a future redemptive power, it will keep its value. Perhaps fixing currency values to a “total energy” metric- the sum of all oil, coal, gas, solar, nuclear, etc. reserves- would allow for both economic growth and a guarantee of some future redemptive power for something really useful.

16 Stanley Pinchak, on November 25, 2008 at 2:03 pm, said:

Wow so much muddled thinking in one place. It is amazing that my browser didn’t pop up a warning.

1) Any stock of money sufficient to be accepted by the public as a money and selected as the medium of exchange is capable of serving as money. There is no need to grow the stock of money. Despite this false criticism, the gold stock does grow at a predictable (by mining engineers) and low rate between 1% and 3% per year.

2) The purchasing power of a money is related to the stock of money and the demand for money. Its purchasing power is also related to the supply and demand for all other goods in society for which it is exchanged. Thus as productivity increases, the purchasing power of a stable or slowly increasing money will increase. This has the effect of making daily expenses of those with debts easier to bear.

The only time a debt would become harder to pay off would be if the debtor was in a field of employment where his pay decreased in line with the increase in purchasing power of money. This might be a possibility, but at the same time that human actors today judge their debt burdens based on future expectations of income, those operating under a regime of increasing purchasing power of money would be capable of determining their expected future debt load capabilities. Those who guess wrong in such a situation are no different than those who bite off more debt than they can chew under our inflationary regime.

The biggest improvement that increasing purchasing power has is for savers and those on fixed incomes. Savers would earn interest + the difference in purchasing power between when they started saving and when they start consuming. This is the opposite of today where the difference in purchasing power subtracts from the interest and reduces the incentive to save. This will have the effect of greatly encouraging saving and the stock of loanable funds, driving interest rates to natural and sustainable low levels. This will benefit the saver/consumer in the future as well as the entrepreneur and the durable good consumer in the present.

Inflation on the other hand encourages debt based financing. It favors instant gratification, but since there are fewer savers since debt is the preferred method of financing, the purchases of today are not sustainable. The increase in consumption fueled by new money is not fully offset by the preferences of a ever shrinking class of savers who abstain from present consumption. This results in a business cycle like we see continuously under a system of bank credit expansion (ex nihlo). Inflation encourages capital consumption and not investment as Dirk claims. Empirical evidence of this is present in the dilapidated factories and rotting machinery of the American Rust Belt.

3) All business cycles (as in repeated and not caused by something like war or famine) are the result of fractional reserve banking and its concomitant ex nihlo credit expansion. There can be no stable and sustained economic growth under a fractional reserve banking regime. There will always be over-expansion combined with malinvestment, and and then retrenchment as the bad investments are liquidated. Attempting to tie a money to a commodity standard while maintaining a fractional reserve banking system is unsustainable. There will inevitably be calls for the creation of a central bank and lender of last resort as the bust causes bank runs.

The only viable solution is to realize that fractional reserve banking on demand deposit money is clearly a case of conflicting views of a contract and thus an untenable and invalid contract. How can a depositor demand a physical object which the banker (rightly?) assumes is lent to him for his purposes. A physical object must have a clear owner and can not be subject to control simultaneously by two parties of differing opinion under which direction to place the object. Thus demand deposits must be maintained in a warehouse fashion with 100% reserve maintained at all time. This eliminates the possibility of a bank run (in the historical sense and in the practical sense of potential damage to the depositor). Furthermore by limiting bank loans to funds deposited in time accounts (i.e. true saving) there will cease to be a business cycle.

4) The idea of a world central bank is superfluous with a free monetary system and 100% reserve banking. The main purposes of the central bank are to ease governmental expansion and to act as a lender of last resort. A world central bank will only lead to world bureaucracy. If banking is on a firm economic and legal foundation, there is no need for a lender of last resort. A world central bank is only an excuse for the establishment of world government. It can not prevent world wide business cycles while maintaining a fractional reserve banking system. Furthermore, if it maintained a 100% reserve banking system, it would still be subject to political considerations in open market operation and would still cause misallocations of resources, though not of the intertemporal kind as explained by the business cycle theory. The misallocations would result in privileged borrowers being able to bid resources from those who obtain the increase in the money supply last.

5) The myth that a gold standard would limit growth is preposterous. One of the greatest periods of economic (and population) expansion was obtained under a gold standard and under a period of increasing purchasing power of money (Cf. the 19th century). There is no theoretical nor physical restriction on the growth of economy based on a sound monetary system besides the subjective actions of individuals to save which allows for the implementation of longer and more productive production techniques.

The claim that unemployment is higher under a gold standard is also ridiculous. All non voluntary unemployment is the result of artificial restrictions on the movement of labor or its price. One must be careful not to make the mistake of comparing the unemployment rates of a central bank and fractional reserve banking boom period to an average or bust phase unemployment rate under the fractional reserve banking system which has persisted in the United States prior to its inception. Under a free market, all labor wishing to be employed will be. All state intervention attempting to reduce the ranks of the unemployed can only be obtained by reducing the well being of other actors in the economy. As such interventionist attempts to reduce unemployment, though they may increase productivity (doubtful), will not be optimal as compared ex ante in terms of the satisfaction of wants of all economic actors. On utilitarian and natural rights grounds, state intervention in the labor market is counterproductive, misguided, and should be avoided.

6) The idea that there is not enough gold to back all of the fiat currencies of the world is the most foolish statement of all. Logically one can take the stock of gold available and divide it by the weighted sum (by exchange rate) of the currencies of the world. This could provide backing for every single dollar, ruble, yen, etc. However, this is a bad policy, for the market should be left free to choose its own money, it should not be instituted from on high via state decree or central bank policy.

All that needs to be done is to eliminate legal tender laws and taxes on market selected monies. Since we have several thousand years of history showing that Gold and Silver are typically selected as money, we should start by eliminating taxes on them. If there is a push for a different medium of exchange, it should be treated in the same fashion. At the same time, all fractional reserve demand deposit banking must be subjected to traditional legal principles regarding property rights.

This means a reversion to 100% reserve banking. From these two changes, the market will perform the transition to a sound money with the minimum disruption and transfer cost. A state imposed system can only result in higher costs, as well as a retention of particular privileges for the state, most commonly in the form of a central bank, liable to interfere in the money supply through open market operations and subject to the political whims of demagogues.


  1. The 19th century was a stable nirvana? Not hardly:

    The Panic of 1873 was the start of the Long Depression, a severe nationwide economic depression in the United States that lasted until 1879. It was precipitated by the bankruptcy of the Philadelphia banking firm Jay Cooke & Company on September 18, 1873, following the crash on May 9, 1873 of the Vienna Stock Exchange in Austria (the so-called or “founders' crash”). It was one of a series of economic crises in the 19th and early 20th centuries.

  2. Agreed, no period is ever stable and so trying to use that as proof for or against ones position is poor debating.

  3. So for the non-economist, where can I find a nice side-by-side comparison of the arguments for and against centralized fractional reserve banking? As a citizen who want to be able instruct his representatives and senators, and who is witnessing increasing demands for a Federal Reserve Audit and/or its elimination, how can an ordinary citizen come to an informed opinion without getting a PhD in economics? So far I have come to understand that there are two major camps; the Austrian School and the Keynesian School. I'm assuming both schools publish in academic peer reviewed journals. Who keeps score and where can I find it? :)

  4. I don't know of any side-by-side comparison. As for academic peer reviewed journals, these two http://www.professorfekete.com/ and http://www.debtdeflation.com/blogs would assert that it is all one way and that there is no healthly debate (part of the reason most economists did not see this coming).

  5. Thanks for the links. I did as search on Wikipedia which gave some nice comparisons. Apparently, the Austrian School doesn't use a lot of math as they believe the simplifications necessary to make the problem tractable invalidate it's use. The Keynesians criticize the Austrian School as not being rigorous. I can now see why Austrian School papers don't get published in journals dominated by Keneysian reviewers. So they have their own journals. Still leaves me unable to ascertain who is more likely to be right. :(

  6. You don't get why steady deflation is a bad thing? I guess you don't own your own home.

  7. In a deflationary environment there wouldn't be speculation in houses so the overall prices would be much lower, resulting in housing becoming a consumption good.