Guest Post: Paul Krugman’s Mis-Characterization Of The Gold Standard
Submitted by Tyler Durden on 08/30/2012 20:42 -0400
Submitted by James E. Miller of the Ludwig von Mises Institute of Canada,
With a price hovering around $1,600 an ounce and the prospect of “additional monetary accommodation” hinted to in the
latest meeting of the Federal Reserve’s Federal Open Market Committee,
gold is once again becoming a hot topic of discussion.
George Soros
made news recently
when a filing with the Securities and Exchange Commission revealed that
he had liquidated his position with major financial firms and had
loaded up on gold; approximately 884,000 shares worth. Jim Cramer, the
CNBC personality in constant search of growing business trends,
recommends putting at least 20% of one’s assets in gold. Following the Republican National Convention, the
party platform now proposes the establishment of a commission to study “the feasibility of a metallic basis for U.S. currency.”
Like the gold commission before it, this new interest in gold has
brought out the critics who regard the precious metal as nothing short
of, to borrow the infamous term coined by
John M. Keynes, a “barbarous relic.” Wesleyan University economist Richard Grossman writes in the
Los Angeles Times that the idea of a gold commission is a “waste of time and money” because the standard hasn’t “worked for 100 years.” In
The Atlantic, fiat currency enthusiast Matthew O’Brien calls the
gold standard a “terrible idea” and presents a few charts demonstrating that linking the dollar to gold failed to keep prices stable.
Economist and New York Times columnist Paul Krugman has praised O’Brien’s article on his blog and makes sure to point out that the price of gold has been highly volatile since 1968 by showing the following chart:
There is a remarkably widespread view
that at least gold has had stable purchasing power. But nothing could be
further from the truth.
Krugman points out that when interest rates are low the price of gold typically rises.
He claims that as interest rates tend to fall during recessions, gold’s
rise in price would lead to “a fall in the general price level.”
Lastly,
Krugman ridicules the notion that a true gold standard
would prevent asset bubbles and subsequent busts from occurring by
calling attention to the fact that America suffered from financial
panics “in 1873, 1884, 1890, 1893, 1907, 1930, 1931, 1932, and 1933.”
These criticisms, while containing empirical data, are grossly deceptive.
The information provided doesn’t support Krugman’s assertions
whatsoever. Instead of utilizing sound economic theory as an
interpreter of the data, Krugman and his Keynesian colleagues use it to
prove their claims. Their methodological positivism has lead them to
fallacious conclusions which just so happen to support their favored
policies of state domination over money. The reality is that not only
has gold held its value over time, those panics which Krugman refers to
occurred because of government intervention; not the gold standard.
Right off the bat, the Nobel Laureate makes the amateur mistake of conflating two different gold standards.
There was not one set standard throughout the 19th century up to the
Great Depression. Until the first World War, the United States and much
of the West was under the
classical gold standard.
This meant that the dollar was just a name for a set amount of gold;
generally 1/20 of an ounce. Following the massive inflation used to pay
for World War I and the Genoa Conference of 1922, the
gold exchange standard
was adopted by many Western countries including Britain. Though the
United States remained under an imperfect classical gold standard, other
Western countries stopped redeeming gold coins for national
currencies. Instead, they redeemed their currencies for dollars or
pounds which allowed for expanded fiscal policies because the constraint
of gold was not so prominent. At the same time, President of the New
York Federal Reserve, Benjamin Strong, conspired with the head of the
Bank of England, Montague Norman, to keep gold from flowing out of
Britain by having the Fed adopt “easy money conditions in the United
States” and “increase bank liquidity a great deal”
according to
economic historian Robert Higgs. This backroom deal was carried out as
England readopted the gold standard in 1926 at the pre-World War 1
parity despite the pound being devalued during the war. Because trade
unions and unemployment insurance made wage rates less flexible
downwards, the ensuing deflation was detrimental and combated through
further inflation aided and abetted by the Fed.
This new international agreement between central bankers may
have appeared to be a maintaining of the classical gold standard but it
was nothing of the sort. The inflationary boom in the later
half of the 1920s was a product of the monetary scheming of the Fed and
Bank of England. The final result was the stock market crash of 1929
which ushered in the Great Depression. Contrary to popular belief, the
Depression was not caused by the classical gold standard but because of
its rejection.
As for the other panics Krugman mentions, neither were caused
by the gold standard but by government intervention in the money market. As economist Joseph Salerno
explains, the pervasiveness of
fractional reserve banking,
or the expansion of credit unbacked by gold reserves, played a key role
in creating financial instability. The panics were caused primarily by
..the establishment of a quasi-central
banking cartel among seven privileged New York banks resulting in the
almost complete centralization of U.S. gold reserves in their vaults by
the National Bank acts of 1863-1864. This New York City banking cartel
was able to expand willy nilly the monetary base and the overall money
supply by expanding their own notes and deposits on top of gold
reserves. Their notes and deposits were then used as reserves by lower
tier banks (Reserve City Banks and Country Banks) on which to pyramid
their own notes and deposits.
Moreover, banks, especially the larger
ones, were encouraged in their inflationary credit creation by the
firmly entrenched expectation that they would be freed from fulfilling
their contractual obligations in times of difficulty by the legal
suspensions of cash payments to their depositors and note-holders that
recurred during panics throughout the 19th century.
In sum, an adherence to a real gold standard was not the main cause of all the financial panics Paul Krugman lists.
It was his favorite institution, the state, and the incessant fiddling
around with the economy by the political class that created an unstable
monetary system. It is also worth pointing out that the late 19th
century was a period of incredible economic growth for both the United
States and the rest of the world in spite of the flawed gold standard.
Though it is often alluded to as a time of robber barons, worker
starvation, and terrible deflation, the U.S. economy experienced its
highest rate of growth ever recorded as the 1800s drew to a close. As
Murray Rothbard documents in
The History of Money and Banking in the United States: The Colonial Era to World War II:
The record of 1879–1896 was very similar
to the first stage of the alleged great depression from 1873 to 1879.
Once again, we had a phenomenal expansion of American industry,
production, and real output per head. Real reproducible, tangible wealth
per capita rose at the decadal peak in American history in the 1880s,
at 3.8 percent per annum. Real net national product rose at the rate of
3.7 percent per year from 1879 to 1897, while per-capita net national
product increased by 1.5 percent per year…
Both consumer prices and nominal wages
fell by about 30 percent during the last decade of greenbacks. But from
1879–1889, while prices kept falling, wages rose 23 percent. So real
wages, after taking inflation—or the lack of it—into effect, soared.
No decade before or since produced such a sustainable rise in real wages.
From 1869 to 1879 the total number of
business establishments barely rose, but the next decade saw a
39.4-percent increase. Nor surprisingly, a decade of falling prices,
rising real income, and lucrative interest returns made for tremendous
capital investment, ensuring future gains in productivity.
When the United States maintained a gold standard to a fairly significant degree, the economy blossomed.
The relative absence of inflation ensured that the dollar acted as a
store of value in addition to facilitating transactions. Without the
threat of looming price increases, the public was more willing to put
off consumption and add to the supply of capital availability by
saving. The prudent technique of producing more than you consume
allowed for a greater number of entrepreneurs to put capital to work.
This set the foundation for mass production and giving consumers access
to an abundance of goods never thought possible just a century before.
To the Keynesians’ befuddlement, the economic renaissance of
the late 19th century occurred at a time where prices weren’t rising or
stable but actually falling. The fall in the general price
level occurred as the production capacity expanded at a faster rate than
the money supply. Today, economists of the Keynesian and monetarist
school remain convinced that a stable price level is good thing when
common sense dictates otherwise. Falling prices are a godsend for
consumers; not a catastrophe. As long as entrepreneurs are able to
utilize the inherent feedback mechanism of an undistorted pricing system
to forecast input costs, falling prices are only a minor problem. The
focus on price stability is why many economists
missed the Depression and the Fed-engineered boom of the 1920s. In a free market, the tendency is for prices to fall as production increases.
Krugman denies not only that sound money leads to economic
stability and growth, he does so while attempting to show that gold has
been incredibly volatile since Richard Nixon cuts the dollar’s tie to
the precious metal in 1971. But Krugman puts the proverbial
cart before the horse with his example as it hasn’t been the price of
gold that has fluctuated to a high degree but rather the dollar’s
value. As
Forbes editor John Tamny
pointed out in August of 2011
as Brookes calculated in his essential book The Economy In Mind,
“In 1970 an ounce of gold ($35) would buy 15 barrels of OPEC oil
($2.30/bbl). In May 1981 an ounce of gold ($480) still bought 15 barrels
of Saudi oil ($32/bbl).” Fast forward to the present, and an ounce of
gold ($1750) buys roughly 20 barrels of oil ($85)
Krugman also asserts that when interest rates fall, the price of gold increases [ZH - we discussed the various regime changes between interest rates and gold here in great detail].
But again he makes the same mistake of not recognizing the role dollar
manipulation plays in both measures. Interest rates haven’t been formed
by market forces since the Federal Reserve was established. In a free
market, interest rates are determined by the public’s collective time
preference or the discounting of future goods against present goods.
When more people are saving, and therefore putting off consumption,
there is a higher supply of loanable funds. This higher supply
translates to lower interest rates as the price of present capital
lowers. Under a fiat regime like the Fed which oversees a system of
fractional reserve banking, interests rates are manipulated by a few
central bankers instead of the market. These central planners increase
the supply of money in an effort to push down interest rates and induce
consumers into borrowing. This also has the effect of pushing up the
price of gold as investors lose confidence in the dollar’s value.
In his crusade to keep Keynesianism as a legitimate school of
thought, Krugman has yet again attempted to mischaracterize gold and
blame it for crises caused solely by government intervention. What Keynesianism amounts to is a theory of state worship and the virtue of hedonism. Its leading proponents declare
there is such thing as a free lunch
and that it is served directly by the printing of money. In other
words, it is based on backwards logic and remains distant from reality.
The Keynesians admit there was a housing bubble then fret over an “output gap.”
They blame market exuberance for recessions but then prescribe the
exact same policies that lead to exuberance to begin with. This
irrationality was best displayed with a remarkable quote by former
Treasury Secretary and former director of President Obama’s National
Economic Council Lawrence Summers who wrote in an
editorial for the Washington Post:
The central irony of a financial crisis
is that while it is caused by too much confidence, borrowing and
lending, and spending, it can be resolved only with more confidence,
borrowing and lending, and spending.
Keynesians have no pure economic theory; they are totally ad hoc in their approach.
Any data point which fits their view is trumpeted. Any theory that
presents a challenge to the idea that the economy can be finely tuned
like a child’s trinket is dismissed as right-wing propaganda.
Keynesians ultimately reject the golden rule of economics: savings
represents deferred consumption and producing more than is consumed.
Real savings in the form of capital goods (factories, equipment,
machinery, etc.) are the backbone of any economy. Government only
squanders these scarce resources through its constant pillaging of
wealth.
Keynes himself was contemptuous of the middle class throughout his professional career. This is perhaps why he held such disdain for gold.
Gold is the market’s choice for money; not the statist ruling class
dependent on spending virtually unlimited sums of tax dollars. Because a
true gold standard prevents runaway inflation and budget deficits from
occurring in perpetuity, Keynesians will do all they can to discredit
gold as a workable form of currency. Their allegiance lies with the
state and paper money; not the natural choices of the common man.
