Pundit's Perspectives – Fri 15 Apr, 2016

Paul Krugman vs the Gold Standard

I found this article to be very interesting. The debate of will we ever go back to a gold standard and would a gold standard solve some of the financial problems will rage on forever. Our current financial system is very far away from the gold standard and the banks want to keep it that way. I believe that if we are ever going to a gold standard it will be because another strong country adopts it first and forces the rest of the world to follow. Many people disagree with me but this is still a long way off.

As for the article below the author takes us through a recent comment made by Paul Krugman arguing that Ted Cruz is more dangerous than Donald Trump. To that argument he dives into what a gold standard would look like and if it would be as dangerous as Mr Krugman thinks.

Click here to visit the original posting site over at UneasyMoney.com.

What’s so Bad about the Gold Standard?

Last week Paul Krugman argued that Ted Cruz is more dangerous than Donald Trump, because Trump is merely a protectionist while Cruz wants to restore the gold standard. I’m not going to weigh in on the relative merits of Cruz and Trump, but I have previously suggested that Krugman may be too dismissive of the possibility that the Smoot-Hawley tariff did indeed play a significant, though certainly secondary, role in the Great Depression. In warning about the danger of a return to the gold standard, Krugman is certainly right that the gold standard was and could again be profoundly destabilizing to the world economy, but I don’t think he did such a good job of explaining why, largely because, like Ben Bernanke and, I am afraid, most other economists, Krugman isn’t totally clear on how the gold standard really worked.

Here’s what Krugman says:

[P]rotectionism didn’t cause the Great Depression. It was a consequence, not a cause – and much less severe in countries that had the good sense to leave the gold standard.

That’s basically right. But I note for the record, to spell out the my point made in the post I alluded to in the opening paragraph that protectionism might indeed have played a role in exacerbating the Great Depression, making it harder for Germany and other indebted countries to pay off their debts by making it more difficult for them to exports required to discharge their obligations, thereby making their IOUs, widely held by European and American banks, worthless or nearly so, undermining the solvency of many of those banks. It also increased the demand for the gold required to discharge debts, adding to the deflationary forces that had been unleashed by the Bank of France and the Fed, thereby triggering the debt-deflation mechanism described by Irving Fisher in his famous article.

Which brings us to Cruz, who is enthusiastic about the gold standard – which did play a major role in spreading the Depression.

Well, that’s half — or maybe a quarter — right. The gold standard did play a major role in spreading the Depression. But the role was not just major; it was dominant. And the role of the gold standard in the Great Depression was not just to spread it; the role was, as Hawtrey and Cassel warned a decade before it happened, to cause it. The causal mechanism was that in restoring the gold standard, the various central banks linking their currencies to gold would increase their demands for gold reserves so substantially that the value of gold would rise back to its value before World War I, which was about double what it was after the war. It was to avoid such a catastrophic increase in the value of gold that Hawtrey drafted the resolutions adopted at the 1922 Genoa monetary conference calling for central-bank cooperation to minimize the increase in the monetary demand for gold associated with restoring the gold standard. Unfortunately, when France officially restored the gold standard in 1928, it went on a gold-buying spree, joined in by the Fed in 1929 when it raised interest rates to suppress Wall Street stock speculation. The huge accumulation of gold by France and the US in 1929 led directly to the deflation that started in the second half of 1929, which continued unabated till 1933. The Great Depression was caused by a 50% increase in the value of gold that was the direct result of the restoration of the gold standard. In principle, if the Genoa Resolutions had been followed, the restoration of the gold standard could have been accomplished with no increase in the value of gold. But, obviously, the gold standard was a catastrophe waiting to happen.

The problem with gold is, first of all, that it removes flexibility. Given an adverse shock to demand, it rules out any offsetting loosening of monetary policy.

That’s not quite right; the problem with gold is, first of all, that it does not guarantee that value of gold will be stable. The problem is exacerbated when central banks hold substantial gold reserves, which means that significant changes in the demand of central banks for gold reserves can have dramatic repercussions on the value of gold. Far from being a guarantee of price stability, the gold standard can be the source of price-level instability, depending on the policies adopted by individual central banks. The Great Depression was not caused by an adverse shock to demand; it was caused by a policy-induced shock to the value of gold. There was nothing inherent in the gold standard that would have prevented a loosening of monetary policy – a decline in the gold reserves held by central banks – to reverse the deflationary effects of the rapid accumulation of gold reserves, but, the insane Bank of France was not inclined to reverse its policy, perversely viewing the increase in its gold reserves as evidence of the success of its catastrophic policy. However, once some central banks are accumulating gold reserves, other central banks inevitably feel that they must take steps to at least maintain their current levels of reserves, lest markets begin to lose confidence that convertibility into gold will be preserved. Bad policy tends to spread. Krugman seems to have this possibility in mind when he continues:

Worse, relying on gold can easily have the effect of forcing a tightening of monetary policy at precisely the wrong moment. In a crisis, people get worried about banks and seek cash, increasing the demand for the monetary base – but you can’t expand the monetary base to meet this demand, because it’s tied to gold.

But Krugman is being a little sloppy here. If the demand for the monetary base – meaning, presumably, currency plus reserves at the central bank — is increasing, then the public simply wants to increase their holdings of currency, not spend the added holdings. So what stops the the central bank accommodate that demand? Krugman says that “it” – meaning, presumably, the monetary base – is tied to gold. What does it mean for the monetary base to be “tied” to gold? Under the gold standard, the “tie” to gold is a promise to convert the monetary base, on demand, at a specified conversion rate.

Question: why would that promise to convert have prevented the central bank from increasing the monetary base? Answer: it would not and did not. Since, by assumption, the public is demanding more currency to hold, there is no reason why the central bank could not safely accommodate that demand. Of course, there would be a problem if the public feared that the central bank might not continue to honor its convertibility commitment and that the price of gold would rise. Then there would be an internal drain on the central bank’s gold reserves. But that is not — or doesn’t seem to be — the case that Krugman has in mind. Rather, what he seems to mean is that the quantity of base money is limited by a reserve ratio between the gold reserves held by the central bank and the monetary base. But if the tie between the monetary base and gold that Krugman is referring to is a legal reserve requirement, then he is confusing the legal reserve requirement with the gold standard, and the two are simply not the same, it being entirely possible, and actually desirable, for the gold standard to function with no legal reserve requirement – certainly not a marginal reserve requirement.

On top of that, a slump drives interest rates down, increasing the demand for real assets perceived as safe — like gold — which is why gold prices rose after the 2008 crisis. But if you’re on a gold standard, nominal gold prices can’t rise; the only way real prices can rise is a fall in the prices of everything else. Hello, deflation!

Note the implicit assumption here: that the slump just happens for some unknown reason. I don’t deny that such events are possible, but in the context of this discussion about the gold standard and its destabilizing properties, the historically relevant scenario is when the slump occurred because of a deliberate decision to raise interest rates, as the Fed did in 1929 to suppress stock-market speculation and as the Bank of England did for most of the 1920s, to restore and maintain the prewar sterling parity against the dollar. Under those circumstances, it was the increase in the interest rate set by the central bank that amounted to an increase in the monetary demand for gold which is what caused gold appreciation and deflation.


Comments:
  1. On April 15, 2016 at 1:22 pm,
    OOTB..................... CCF says:

    Just another mouthpiece for the BANKSTERS/FED

  2. On April 15, 2016 at 1:31 pm,
    Bonzo Barzini says:

    Liberals hate gold the way vampires hate the sun. When the fiat dollar collapses we will go back to a gold backed dollar.

    • On April 15, 2016 at 4:21 pm,
      Wayne says:

      Liberals hate gold . . . in the hands of others. We have a gold standard, it’s just that many private citizens don’t know it exists . . . but the nations know it exists.

      • On April 15, 2016 at 4:54 pm,
        Chartster says:

        You’re right, Wayne. People that know finance know we have a gold standard already. I’m sure the public will know pretty soon. ( as seen on TV )

  3. On April 15, 2016 at 2:25 pm,
    Marty says:

    Great interview @ TF metals podcast with John Butler, from an American in London perspective.

  4. On April 15, 2016 at 4:35 pm,
    Matthew says:

    Krugman is so completely not worthy of consideration that there had to be a website dedicated to correcting everything he says.

    http://contrakrugman.com/

    • On April 15, 2016 at 5:18 pm,
      Skeeta says:

      ha ha ha….that’s hilarious !

  5. On April 15, 2016 at 5:23 pm,
    Ron says:

    Asset backed currency: or
    How to fix the private Fractional Federal Reserve System:
    Our Fractional Federal Reserve and fiat currency is the cause of the disastrous steady economic decline in this country over the last 100 years.
    A stable currency, one that does not cause inflation or deflation boon and busts will eliminate most of the problem.
    A stable asset backed currency is much simpler to achieve than most people realize. It also has many advantages over a gold or partial gold backed currency. In fact it only takes three simple rules to implement a stable asset backed currency. I will list these rules in order of importance starting with the most important.
    1. Outlaw derivatives and naked shorts.
    2. Change the fractional reserve requirement from 1/10 to 1/1
    3. Require collateral on all loans.

    When the FED prints money out of thin air and lends it to purchase an asset with the asset used as collateral, then the money is backed by a hard asset with real value. I learned this from C. Edward Griffin. When I first heard it I was shocked then I realized that it was obviously true.

    Changing the fractional reserve requirement from 1/10 to 1/1 will prevent the banks from creating money that is not backed by hard assets. Currently the national debt is 18 Trillion dollars. When the government borrows 18 trillion dollars and deposits it in the national bank. The banks can now loan out 10 times that amount or 180 Trillion Dollars. The banks get 10 dollars for every dollar for the government. If the fractional reserve requirement is changed to 1 to 1 then the banks can create 0 dollars that are not backed by hard assets. The money that the government borrows is backed by the hard assets of the government.

    Derivatives also create money out of thin air that is not backed by anything.
    The current derivatives market is 1.2 Quadrillian or 20 times world GDP or 80 times US GDP or 66 times US government debt. The fractional reserver creates money at 10 time the debt, but the derivatives market creats money at 20 to 100 times debt. This is why the absolute most important immediate reform to our monitory system is to Outlaw Derivatives which were illegle up untill 1995.

  6. On April 15, 2016 at 6:44 pm,
    Chartster says:

    Spot on, Ron! However, with a gold standard there still will be fractional reserve banking. But not 10-1 of zero backed crap.

  7. On April 15, 2016 at 7:18 pm,
    Chartster says:

    http://www.zerohedge.com/news/2016-04-15/investigating-deutsche-bank%E2%80%99s-%E2%82%AC21-trillion-derivative-casino-wake-admission-it-rigge

    And the JPM chart looks worse than DB..!

    Reminds me of a Van Halen song: Woah oh oh… Jamie’s cryin…

    • On April 16, 2016 at 7:08 am,
      OOTB..................... CCF says:

      ALL the TBTF banks have ugly charts………..

  8. On April 15, 2016 at 7:52 pm,
    Ebolan says:

    If Krudman doesn’t make you barf something is seriously wrong with you.

    And you boys see this?

    Blistering Demand For 30Y Paper: Indirects Second Highest Ever
    http://www.freedomsphoenix.com/News/195125-2016-04-15-blistering-demand-for-30y-paper-indirects-second-highest-ever.htm

    I wonder what Mr. Big Al Korelin has to say about that.

  9. On April 16, 2016 at 9:17 am,
    Kyle says:

    It is because the banking system demands that they be able to have their cake and eat it too that we don’t have a gold standard. They want to be able to lever themselves up, make risky bets, and reap their bonuses, and have the Fed and taxpayer bailout when they inevitably become insolvent.