Wednesday, 17 February 2010

Monetary Stability and the Case for Gold Standard (University paper)

I. Introduction

My aim in this research paper is to investigate whether the current monetary arrangement has achieved the promised stability, and if not, what other options can we look to solve the problem from an Austrian School perspective. We can summarize the current monetary arrangement as an interdependent relationship between the central bank, fractional-reserve banks and fiat money. Even though this kind of arrangement was originally put forward by independent influential bankers, its contemporary adherents mainly come from the camps of Keynesianism and that of Chicago’s monetarists. Both schools believe the free market is incapable of properly handling the supply and demand for money, and therefore they say, the management of money should be centralized under the control of a monopoly institution with direct ties to the state.

In United States, for example, the said monetary arrangement has come into place in 1913 when the Federal Reserve system was created. Before the Fed, America had two central banks which were later abolished. What persisted, however, was a proto fractional-reserve banking system instituted in 1837 to start a period known as the “Free Banking” era which lasted until 1862. During that period, banks were free to issue notes against their specie, while the states regulated their reserve requirements as well as interest rates for loans and deposits. This changed in 1864 with the National Banking Act, one of the purposes of which was to create a uniform currency, forcing banks to accept each other’s currencies at par value, as well as finance the American Civil War that was going on. This system was characterized with expansions and contractions which led to several economic slumps. None was more serious, however, than the Panic of 1907. During this recession, the government allowed the banks to suspend their specie payments temporarily as it had done before. The crisis was a strong consolidation of previous claims from businessmen and politicians alike to create a European-style central bank to serve as “a lender of last resort” (Rothbard, 2002, p. 240). Its function would be to provide the fractional-reserve banking system with the desired liquidity in order to prevent any future crises such as that of 1907. In 1910, representatives of influential bankers, those of the J.P. Morgan and the Rockefeller families, gathered in a secret meeting in Jekyll Island, New York. They drafted an agreement, later known as the Federal Reserve Act, which was presented in Senate through their representatives and friends, culminating in the Fed that we know today. Supporters of the central bank believed that recessions came as a result of liquidity shortage needed to supply the banks who engaged in fractional-reserve banking. To them, the creation of the Fed meant that those problems were solved because whenever banks were in short of cash, Fed would be there to print it.

II. Has Monetary Stability Been Achieved?

Since the creation of the Fed in 1913, the U.S. alone has experienced 19 recessions (National Bureau of Economic Research, 2008). The most recent one which started in 2007 is being compared to the Great Depression. After many insolvencies, especially on part of the banks, the unemployment rate continues to rise despite the Fed’s endeavors to mitigate the crisis. The Fed chairman Ben Bernanke has decreased interest rates to almost 0% for the first time in the U.S. history, yet many say that the recession is far from over. Fearing that the economy has fallen in “the liquidity trap,” the U.S. government pressured Congress into accepting the $700bn stimulus plan as part of the fiscal policy to revive the economy. The stimulus along with the previous monetary policy actions haven’t showed any considerable signs of improvement, and so far lending in particular remains depressed. Now maybe it’s unfair to criticize the Fed, as one may argue that if it wasn’t for them the recession would have been even worse, and the total number of recessions after its creation would surpass 19. Some may argue that Bernanke & co. need more time to get the economy going, so people have to be patient and trust them. These arguments, however, appear dim in the light that there is already a school of economic thinking that has presented strong theories in contradiction with the aims and practices of centralizing the monetary system. Meet the Austrian School of economics.

Austrian School economists say that Fed’s attempts to restore “price stability” are in vain. According to them, attempts to achieve such a thing are based on flawed understanding of money. At the root of price stability is the idea that money is “neutral” (Shostak, 2003). By neutral, it is meant that changes in the quantity of money have no effects whatsoever in the real economy. Proponents of the idea of neutral money believe that changes in the quantity of money only affect its purchasing power, and do so proportionately. What is ignored, however, is the importance of relative prices of goods (Mises, 1938). For example, if a tomato’s exchange rate is two apples, then one apple is half of a tomato. Let’s say the price of tomato is $1, making the price of apple $0.5. Now if the quantity of money is doubled, prices will increase by 50%, making tomato cost $2 whereas the apple $1. According to this view of thinking, the increase in the money supply didn’t alter the fact that the trader can still exchange apples to tomatoes at a ratio of 2:1. However, this does not reflect the reality, for when the Fed increases or decreases the money supply, prices don’t change uniformly but rather fluctuate in different ways. It is therefore important to realize that the effects of supply and demand for goods are intertwined with the effects of supply and demand for money when it comes to prices. These effects cannot be separated, because if the price of tomatoes increases by 10% and those of apples by 2%, knowing the overall increase in the quantity of money will not help to single out these isolated effects (Shostak, 2003). This makes price stability simply futile, and any attempt to achieve it will only distort the capital production structure by misleading economic agents into misallocating resources.

Economy is in a continuous perpetual change, in which human action exposes preferences concerning money in the same way that it affects the demand and supply for other goods. The quantification of prices by adding different goods together and then dividing that number by the number of goods can only lead to arbitrary assumptions about any “level” of prices. Goods such as shirts or TV sets cannot be added together, because human judgment is subjective in evaluating goods that are even homogenous. Secondly, there is no “level” of prices which changes proportionately, because in reality, goods of prices change in different ways both absolutely and relatively. This kind of flawed thinking is in contrast with the definition of price itself; which is the units of currency paid for a particular unit of good or service at a definite point in time, at a definite place.

In this the great Austrian scholar Ludwig von Mises said, Human action originates change. As far as there is human action there is no stability, but ceaseless alteration” (1996, p. 223). Therefore, the Fed’s goal of achieving price stability is impossible because in a changing, dynamic world, money cannot remain neutral. What made the concept of “price stability” important among economists who support this monetary arrangement are only the shortcomings of the centralized monetary system. It is the failure of managing money that historically caused massive fluctuations in prices and therefore spawned the need for “stability” (Mises, 1996, p. 219).

III. The Case for Gold Standard

If the current monetary arrangement hasn’t achieved stability, what options are there to provide it? The classical gold standard has garnered as many advocates in its favor as much as it has turned people away from it. Some see it as an imperative for the stability of the currency system; others see it as the cause of Great Depression.

Austrian School economists support the concept of sound money. First, sound money is the ethical position that people ought to be free to choose their desired medium of exchange, devoid of any coercion or regulation such as the contemporary legal tender laws. In this Mises claimed, It is impossible to grasp the meaning of the idea of sound money if one does not realize that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part of governments. Ideologically it belongs in the same class with political constitutions and bills of right” (1981, p. 454).

Second, sound money implies the recognition of the fact that when people are free, they tend to choose commodity money as a medium of exchange, such as gold or silver, just like they have done for centuries. Economists have tried to explain the reason why money has value (purchasing power) and why people use it, mainly through either the idea of government decree forcing people to use it or through “social convention” (Varian, 2004). However, in order to understand the benefits of a gold standard as Austrian economists maintain, it is important to understand the origins of money first.

The first to explain the origins of money in Austrian circles was Carl Menger, the alleged founder of the School. Other economists, particularly W. Stanley Jevons, contributed to the debate of origins too. Many questions regarding the value of money, however, were still left unanswered and what surfaced was merely circular reasoning. “Money has value because it is accepted. And why is it accepted? Because it is accepted!” (Shostak, 2004). This was the case until 1912, when Mises introduced the famous regression theorem in his book The Theory of Money and Credit. In order to understand regression theorem, it is important to make a distinction between the value of money and that of other goods. Using the subjective theory of value, Austrian economists maintain that people make different evaluations of goods based on the goods’ abilities to satisfy peoples’ unique demands. In the case of money, the only demand is its purchasing power, but since that is the issue in question, explaining the value of money through “its value” is merely circular reasoning. In turn, Mises implies, money has value today based on the purchasing power it had yesterday. And money had value yesterday, based on its value of 2 days ago. In this time dimension, one can regress the value of money until it reaches a specific point. That specific point is the moment where money was linked to a commodity, such as the dollar which was essentially only a unit of measure for gold. When we reach the point of a commodity, then its value can be explained by the simple law of supply and demand, i.e. in a barter economy (1996, p. 409). In this, Rothbard elaborates, In contrast to directly used consumers' or producers' goods, money must have pre-existing prices on which to ground a demand. But the only way this can happen is by beginning with a useful commodity under barter, and then adding demand for a medium to the previous demand for direct use (e.g., for ornaments, in the case of gold)” (1990, p. 13).

Having clarified the origins of money, we can see that there’s an established natural link between people’s desire to hold some pieces of paper and their inevitable link to some commodity at some point in time. It is in this breath that we can determine that a stable currency system can only stem from this natural link with commodities that human behavior has established throughout centuries. Any escape from this reality will only throw us into the realm of the current monetary arrangement, a sea of ceaseless fluctuations in the value of money, yielded by the lack of capacity to manage it. People have used gold for thousands of years, voluntarily, and ironically; the only reason that they use government-mandated paper-money today is because that very money once upon a time had a direct link to gold. In addition to protection from the flawed monetary policies of the central bank, the gold standard would also protect from the fractional-reserve banking system, inhibiting banks from expanding beyond their means. In middle ages, when no central bank existed and a proto free-market banking scenario was in place, banks were unable to expand their credit beyond the specie in their deposits, or else they’d go bankrupt. Establishing a 100-percent gold standard today would provide the same guarantee and secure people’s deposits as well as overwhelmingly reduce bank insolvencies. However, it is important to reflect on the properties of something by inviting others to express their criticisms, and then see whether that something can be justified.

IV. Its Critique and Austrian School Responses

In order to see whether the gold standard is useful or not, it’s important to answer to its critics in an attempt to justify it. The critics of gold standard are usually the Keynesians, who lament it for inhibiting the government from using the tools of monetary and fiscal policy to correct the “inefficiencies” of the market. On the other side, Chicago’s monetarists directly blame the gold standard for the Great Depression as well as its restrictions on what they believe should be a fixed, steady, monetary growth rate.

One critique is that if the gold standard had been useful, it would have been in place today. And because it was abolished, there’s strong evidence that in general people were against it. To answer to this critique, it’s crucial to realize when the gold standard was repealed. Countries went on and off gold standard in different periods throughout their history, but they never did it as uniformly and as massively as in World War I. It is this period that is usually marked in history as a point in which the governments abandoned their monetary ties to any commodity. But was gold’s ineffectiveness the problem? No. The problem was war. Governments’ military campaigns soon drained their funding, which could only be supplemented by further taxes or borrowing. Since wars generally bring economic turmoil, governments knew that raising taxes to shore up the budget was out of question. Borrowing was also not a viable option since many governments were involved in the war themselves, so there were only a very reluctant few willing to lend. The only option left was inflation, and in gold standard, that wasn’t possible. It was therefore the political need to maintain such a destructive war that brought about the end of the gold standard. On this, Mises recalls, The gold standard did not collapse. Governments abolished it in order to pave the way for inflation. The whole grim apparatus of oppression and coercion, policemen, customs guards, penal courts, prisons, in some countries even executioners, had to be put into action in order to destroy the gold standard” (1981, p. 461).

Another critique is that the increases in the quantity of gold will have the same effect on prices as increases in the quantity of money. Though, critics maintain, this won’t be as severe as in an unbacked-money system, it will still cause fluctuations. Mises explains that an increase in the quantity of gold doesn’t necessarily mean an increase in the riches of the owners of the mines. For them, the annual output of the mines does not mean an increase in riches and does not impel them to offer higher prices. They will continue to live at the standard at which they used to live before” (Mises, 1996, p. 414). According to him, the incoming of gold in the market cannot start up a process of depreciation, as this new quantity is neutral with regard to prices, and if anything, prices have a general tendency to fall over time. In addition, the average increases of gold per annum range only from 1 to 2% (Blumen, 2009). Compare this to the increases in the paper money supply. Only from February 2008 up to December 2008, Fed’s yearly-rate growth of its balance sheet jumped to 153% (Shostak, 2009).

Another critique of the gold standard comes from Milton Friedman, but this time not because it overrides his “3% rule for the Fed,” but because using gold “requires the use of real resource to add to the stock of money” (1962, p. 40). He said that people have to “work hard to dig the gold out,” and that this “establishes a strong incentive for people to find ways to achieve the same result without employing these resources” (1962, p. 40). It is, therefore, Friedman’s fear of economic waste that makes the use of real resources for money inadequate. Preceding this statement, Friedman had cherished the importance of gold before, saying, The (classical) liberal is suspicious of assigning to government any functions that can be per formed through the market, both because this substitutes coercion for voluntary cooperation in the area in question and because by giving government an increased role, it threatens freedom in other areas” (1999, p. 17). This shows considerable acknowledgement on his part for the importance of gold in the liberty of individuals. However, when you take these two claims for comparison, you realize that Friedman is implying that there is a tradeoff between liberty and efficiency. In addition, Austrian School economist Walter Block raised another counter-argument by asking “why did then people use gold as money if it was resource costly?” (Block, 1999, p. 17). The rest of Friedman’s argument is a bit confusing, however, when one considers his statement made on the same subject, If people will accept as money pieces of paper on which is printed ‘I promise to pay - units of the commodity standard,’ these pieces of paper can perform the same function as the physical pieces of gold or silver, and they require very much less in resources to produce.” (1962, p. 40). It is unclear how that paper money will perform the same action as the commodity-backed money, unless what Friedman meant was that paper money would be used physically in transactions, whereas that couldn’t be the case with gold. The proponents of gold standard don’t advocate the use of gold physically in transactions; they simply say that all the paper money in circulation should be backed by a market-chosen commodity (it doesn’t have to be gold necessarily). Nevertheless, the usage of gold in everyday transactions is inconvenient.

There are other arguments against the gold standard, but there are other responses on its defense too. Discussing them, as well as other consequences of using or not using gold, would drive us into many different fields of economics. It is therefore impossible to cover more of them in this paper.

V. Conclusion

After conducting the research, I concluded that there is vast evidence that the current monetary arrangement has failed to achieve the stability it promised us. This may be partly because of the flawed understanding of money by the bureaucrats managing it, and partly because what can’t be known (or understood), can’t be managed. In consideration with other viable options, the gold standard remains a candidate with satisfactory results from the past as well as good economic theories in its defense.

The more that individuals leave to the government, the less they get to decide for themselves, so implicitly they centralize decisions on the hands of a few. In addition, government has a rich history of abuses by special interests at the expense of the people it was conceived to protect. Maybe the time has come for radical changes, especially in the monetary system. Congressman from Texas, Dr. Ron Paul, recently wrote a book titled End the Fed, claiming that the Fed has failed Americans and that it should be abolished if the economy wants to pursuit a path of stability. For those who agree and have been direct victims of the government’s manipulation of currency, their motto may well be “FED up!”

Reference List

Block, Walter. (1999). The Gold Standard: A critique of Friedman, Mundell, Hayek and Greenspan from the free enterprise perspective. Ludwig von Mises Institute, 17.

Blumen, Robert. (2009). Does gold mining matter? Mises Daily.

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Friedman, Milton. (1962). Capitalism and freedom. The University of Chicago Press, 40.

Mises, Ludwig. (1938). The non-neutrality of money. Springer.

Mises, Ludwig. (1996). Human action. Fox & Wilkes, 223. 219. 409. 414.

Mises, Ludwig. (1981). Theory of money and credit. Liberty Press, 454. 461.

National Bureau of Economic Research. (2008). List of business cycles.

Retrieved Dec. 6, 2009, from

Rothbard, Murray. (2002). A history of money and banking in United States. Ludwig von Mises Institute, 240.

Rothbard, Murray. (1990). What has the government done to our money? Ludwig von Mises Institute, 13.

Varian, Hal. (2004). Why is that dollar in your pocket worth anything? New York Times.

Retrieved Dec. 5, 2009, from 15.html

Shostak, Frank. (2004). How does money acquire its value? Mises Daily.

Retrieved Dec. 7, 2009, from

Shostak, Frank. (2003). The myth of price stability. Mises Daily.

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Shostak, Frank. (2009). Where is the U.S. economy heading? Mises Daily.

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