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September 2012 Policy Study, Number 12-9

   

A Short History of Economic Theory

   

The Gold Standard: Medium, Measure, Standard, and Store

   

 

Gold. Wars have been fought, alliances betrayed, and empires forged over this malleable metal. Over the millennia, gold has been a source of fascination for mankind and central to the economics profession ever since Adam Smith wrote The Wealth of Nations. The question of whether a gold standard is beneficial has been debated since the mercantilists first proposed that gold equals wealth. The gold standard offers the advantages of a good currency, resistance to central control, and a predictable expansion rate, but can hobble an economy and impose high resource costs.

 

As the old rhyme goes, “Money is a matter of functions four: medium, measure, standard, and store.” In The Wealth of Nations, Adam Smith looks at how gold meets these requirements for a “good” currency. As a medium of exchange, gold is highly useful because it allows different producers to trade their goods and services in small, manageable pieces.[161] In a market where thousands of goods and services are worth different amounts, it is natural to settle on a precious metal as a measure of value.[162] Obviously, gold is an excellent standard for producers to use when exchanging the product of their labor for the product of another.[163] Finally, because gold is highly durable and portable, it is an excellent way to store value over time.[164] While Smith focused on the physical advantages of a gold standard, Milton Friedman looked to the intangible ability of gold to protect liberty.

 

Friedman, long a proponent of 18th century classical liberalism, initially supported the gold standard in Capitalism and Freedom as a means to curtail centralized authority. In their study of the abandonment of the gold standard by the U.S., Halwood, MacDonald, and Marsh noted that the Great Depression might have been caused by the Federal Reserve’s mismanagement of monetary policy.[165] Friedman certainly agreed with this position, and believed that the poor monetary policy of highly leveraged debt fueled the stock crash of 1929.[166] Above all, Friedman had a fundamental fear of concentrated governmental power, especially over the economy.[167] Although a commodity standard is natural, Friedman asserted that it would automatically bring fiduciary money with it.[168] Since fiduciary money entails government control, Friedman was in favor of standard money, such as gold.[169] The advantage of limited central control over gold was coupled with a predictable expansion rate in its supply.

 

Stability, one of the most important parts of a successful economy, was seen by many to reside in the gold standard. Because of gold’s relative scarcity, the supply tends to rise at a rate of 1-3 percent per year.[170] This means that the extremes of high deflation or inflation are not likely under a pure gold standard.[171] Even the “supply shocks” brought about by gold rushes are short-lived, returning the market to equilibrium in short order.[172] An automatic gold standard is therefore highly predictable and lends stability to an economy.[173] Having examined the advantages of the gold standard, it is now necessary to look at the shortcomings of such a system.

 

The relatively slow growth rate of the gold supply means that a pure, 100 percent gold standard results in deflation. Although the steady expansion of the supply of gold seems to provide stability, it has an unexpected side effect.[174] A healthy economy grows at a faster rate than the slow, 1-3 percent expansion in the gold supply, and the difference between the growth of a purely gold monetary supply and the economy would lead to deflation. Although Friedman saw the advantages of a gold standard, he realized that it would not be technically feasible, so he advocated a fiat currency tied to gold.[175] However, he did not want the Federal Reserve to control the supply, and instead preferred an automatic, targeted rate of 3-5 percent, to keep up with economic growth.[176] This compromise avoided centralized control of monetary policy and the naturally slow growth of the gold supply.[177] In addition to the slow growth in the supply of gold, it suffers from high resource costs for mining, transport, and minting.

 

Gold requires immense resources to bring to market as a currency, consuming large, productive parts of the economy. Even the indefatigable Friedman saw the folly of expending resources to dig up gold and then interring it at Fort Knox.[178] The resources consumed in producing gold leads to an attempt to have the product (money) without the work, i.e., a fiat currency.[179] It was estimated that a theoretical maximum of 4 percent of GDP would be required to bring a gold currency to market.[180] However, it has also been posited that this may be an unavoidable cost, regardless of whether or not a gold standard is in place.[181] Ultimately, Friedman rejected the gold standard due to its deflationary effects, not its resource costs.[182]

 

Because of its high resource costs and low expansion rate, the gold standard’s advantages of predictability, resistance to central control, and status as a good currency are not as solid as they appear. When the question of a “pure” gold standard was raised, the father of monetary policy, Milton Friedman, admitted that it was neither practical nor desirable. He correctly saw the problem presented by the gold standard. In Capitalism and Freedom, he wrote that, “Our task…is to steer a course between two views, neither of which is acceptable though both have their attractions. The Scylla is the belief that a purely automatic gold standard is both feasible and desirable…The Charybdis is the belief that the need to adapt to unforeseen circumstances requires the assignment of wide discretionary powers to a group of technicians…Neither has proved a satisfactory solution in the past; and neither is likely to in the future.”[183]

 

   

 

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