Monetary standards

[Emsworth]

Under the gold standard, all currency is backed by gold. Under the bimetallic standard, currency is backed by two metals (usually gold and silver). Fiat money or paper money is not backed by anything.

For more in-depth analyses, see: gold standard, bimetallic standard, and fiat money.

I vote for option 1.

[Emsworth]

The gold standard promises deflation. If that's what you want, why not do it with fiat money?

I do not support the gold standard because I support deflation. The deflationary nature of the gold standard is not the basis of my argument. I oppose governmental control of the money supply because I believe that it can lead to severe economic problems.

In a free market, interest rates would be determined on the basis of the actual supply of and demand for loanable money. Interest is, effectively, the price of a loan. Interest rates can be determined by free market forces in the same way as the price of any other goods or services.

Businesses often make investment decisions on the basis of interest rates. If rates are low, businesses tend to invest more; if they are high, they tend to invest less. In a free market, rates of interest will naturally respond to business activity, keeping it in check. If business investment starts rising, then demand for loans will also start rising. If demand for loans starts rising, then interest rates will start rising (in accordance with the law of demand). And if interest rates start rising, then borrowing and investment will eventually fall. Thus, business investment will always be kept in check; it will not be allowed to rise uncontrollably.

Central banks, however, disrupt this process by interfering with the size of the money supply and by lowering interest rates. Artificially low interest rates, combined with an inflated money supply, will lead to more investment than would have occurred in a free market. In many cases, companies will invest in projects they might have avoided had the interest rate been at its natural level. This, in turn, leads to an inflationary boom--and eventually, a bust.

This might seem like an argument against central banks, rather than an argument in favor of the gold standard. If it were possible to use fiat money but simultaneously keep the size of the money supply constant, I would agree with this criticism. However, the fact of the matter is, it is altogether too easy for the government to inflate the supply of paper money. On the other hand, the government cannot inflate the supply of gold.

The gold standard alone would not be enough. It must be coupled with free banking in order to be effective.

[Emsworth]

I don't see why it should distort anything. I mean, the inflation is not exactly a secret.

The very basis of monetary policy is the idea that the government should expand or contract the money supply in order to artificially encourage or discourage investment. Any artificial stimulus is a distortion of the free market.

If the government increases taxes, then it is artificially depressing investment. And if the government increases the money supply, then it is artificially stimulating investment. Neither the tax nor the inflation is secret, but both are distortions.

[Emsworth]

I voted 'bimetallic' but I mean 'trimetallic' - Gold, Silver, Platinum.

A bimetallic or trimetallic standard would certainly have some of the virtues of the gold standard: in particular, the government would lose its control over the money supply.

However, I think that there is one important problem with this approach. Under a trimetallic scheme, the relative prices of gold, silver, and platinum would not be allowed to fluctuate in accordance with market forces. Rather, their relative prices would be fixed. As a result, the official value of a metal would be different from its true free market value, which in turn leads to shortages of undervalued metals.

For example, consider what happened when the United States operated on a bimetallic standard. Under this standard, sixteen ounces of silver were equal to one ounce of gold. However, the true free-market value of gold was much higher. As predicted by Gresham's Law, people started hoarding away gold but using only silver. This eventually results in a surplus of circulating silver and a shortage of circulating gold.

[Emsworth]

Deflation is more of a problem than mild inflation.

If a reduction in prices is caused naturally by free market forces, then I don't think that there would be any problem at all. In fact, I think that it would be more problematic if the government disrupts free market forces to artificially stop prices from falling.

[Emsworth]

Most of my family went through Hell as a result of the moronic decision to bring Britain back into the Gold Standard in 1925.

In my opinion, the problem was not the return to the gold standard per se, but the way in which the standard was defined. Winston Churchill decided to define the gold standard based on the pre-WWI gold price. However, the free market price of gold had actually increased significantly since the war. Thus, the deflation caused by the return to the gold standard was much greater than it should have been.

There is, you just have to value the dollar low enough. I think one ounce of gold should have to equivalent to about $4000 in order to take in acount all Federal Reserve Liabilities.

Murray Rothbard wrote an interesting article, "The Case for a Genuine Gold Dollar." He calculated that, in 1981, one ounce of gold would have to be defined as equal to $676 in order to cover Federal Reserve liabilities. I don't know how much the definition has changed since then, however.

[Emsworth]

Yea but that value is for what the liabilities were in 1981. Someone in a forum I know just calculated that for current(well a year ago's) values, and the dollar would have to be worth 0.00025 ounces of gold.

That seems approximately right. I've done my own calculation (source):

a. Total value of gold stock = $11.041 billion
b. Official value of gold = $42.22 per oz.
c. Total Federal Reserve liabilities = $824.341 billion

d. Total size of gold stock = a/b = 261.5 million oz.
e. New value of gold = c/d = $3152.36 per oz.
f. New definition of dollar = 1/e = 0.00032 oz. of gold

[Emsworth]

But why would the business community think there was a larger pool of savings?

Interest rates will fall if the money supply is inflated. Interest rates will also fall if savings increase. Thus, the effect in each case is the same. When the business community looks at the effect--the increase in the interest rate--it would tend to presume that there was an increase in savings.

You might say, because entrepreneurs are rational, they would know that the decline in interest rates was caused by money supply inflation rather than an increase in savings. Well, this would only be partly true. It must be remembered that economic agents never have complete information; they must rely on incomplete and imperfect data. Even though a business might know that the money supply has been inflated, it might still be misled by the rise in interest rates. A business might erroneously suppose that the inflation of the money supply was only partly responsible for the increase, and that an increase in savings was also partly responsible. After all, there is no way to perform an exact calculation to determine the effect of the inflation: economic acitivity cannot be modeled by equations.

And what about the gold of other nations?

Good point--I'm not sure exactly how much of the gold stock belongs to other nations.

[Emsworth]

I would pursue a zero-inflation target with fiat money.

In order to pursue such a target, the central bank would have to be able to gauge the economy appropriately. I would argue that the government is incapable of determining the most appropriate general price level, just as it is incapable of determining the most appropriate price of any particular product. A zero-inflation target strikes me as a form of general price control.

[Emsworth]

The prices of goods and services remain open to market competition.

They remain open to market competition only as long as the "average" price of these goods and services remains at some arbitrary constant level. I would argue that it is optimal to allow the price of the dollar to float freely, in accordance with the dictates of market forces.

Mild deflation that naturally results from the free market is certainly not bad for the economy.

[Emsworth]

By engaging in inflationary or deflationary policy, the government essentially taxes lenders or borrowers.

By tampering with the money supply, the government causes businesses to either overinvest or underinvest, as I argued above. I think that it is much better to allow the market to take its own natural course, rather than attempting to correct its tendencies in any way. (I understand that this conclusion is not necessarily shared by the non-Austrians.)

The argument against the gold standard, i.e., the argument against deflation, seems to be that deflation "robs" borrowers. This problem can very easily be avoided if the lender and borrower agree to index their loan to changes in the price of the dollar.

[Emsworth]

I suppose under the Austrian theory, if enough gold was discovered, we would also have these distortions in the economy.

No monetary system is perfect. The potential for distortions would certainly exist, even if fiat money is replaced by the gold standard.

The question to be asked is, what monetary standard would the free market naturally tend toward? Presumably, businesses would prefer to avoid economic distortions. At the same time, businesses would prefer for the medium of exchange to be convenient, durable, and portable. Rationally weighing the potential for distortion against convenience, the free market will tend toward a monetary system based on a certain commodity. That commodity--it might vary from society to society--should then be adopted as the medium of exchange.

Historically, precious metals--especially gold--have been the preferred medium of exchange wherever available, indicating that the free market naturally tends to prefer them. The government should not attempt to second-guess the natural tendency of the market by speculating about the possible risk for distortion in the future. The free market has already weighed that risk before settling upon precious metals as the preferred medium of exchange.

If it became possible to mass-produce gold, then I suppose that one would have to switch to a different standard.

[Emsworth]

I don't agree that an increase or decrease in the money supply necessarily creates distortions.

I suppose that we will have to agree to disagree on that point, then.

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When spurred by government activity, yes. When spurred by natural free market forces, no.