The purpose of this post is to show that it is technically possible to implement a gold standard today. Many criticisms against the gold standard claim that it is not possible to shift to a gold standard. These criticisms range from – the money supply will fall, there will be chaos if many agencies control money supply, there is not enough gold in the world to shift to a gold standard. These criticisms are baseless and betray an understanding of what money really is.
I would be grateful for comments/feedback on my below understanding of the gold standard.
What is so special about gold?
First and foremost, the Austrian economists do not support the gold standard because it has some mystical properties. As our economy moved from barter to exchange based on money, gold came to be widely accepted as the best medium of exchange. This was because gold satisfied the many qualities of a good medium of exchange, like acceptability, durability, portability, homogeneity, scarcity.
Murray Rothbard in his book, What has the government done to our money, says
Historically, many different goods have been used as media (medium of exchange): tobacco in colonial Virginia, sugar in the West Indies, salt in Abyssinia, cattle in ancient Greece, nails in Scotland, copper in ancient Egypt, and grain, beads, tea, cowrie shells, and fishhooks. Through the centuries, two commodities, gold and silver, have emerged as money in the free competition of the market, and have displaced the other commodities.
Thus, the Austrians support the gold standard as gold is what the market accepted as money before the government monopolized the money supply. It is not for any economist to decide what commodity should be used as money. Our monetary history suggests that gold was established by the market as the best form of money. In case some other commodity had been established as money, we would have been arguing for a monetary system based on a different commodity.
What is the Gold Standard?
Simply put, a gold standard means a monetary system based on the commodity gold. Does this mean you will have to carry gold bars in trucks to make payment for buying real estate? No. You can make payments in paper receipts which will be redeemable in gold. Who has the obligation to redeem the paper receipts for gold? Obviously, the entity who has issued the receipts; which brings us to a very contentious question – who has the right to issue such redeemable paper receipts?
In a gold standard, anybody who has gold can issue such receipts. Suppose the government has gold reserves of 1 tonne. It can issue its own paper receipts, say the ‘dollar’ and define it as equal to 1 gram of gold. This will allow the government to issue 1 million dollars. Similarly, anyone can take out their own paper receipts. If you have 1 tonne of gold, you can take out your own receipts, and label it ‘rupiya’ and define it as 1 kg of gold. This will allow you to print 1000 rupiya. You can take this rupiya to the market and buy goods and services.
Will the market accept your rupiyas as payment? That will depend on your credibility in the market. Say you went to purchase a car and it costs 1 kg gold. You can use your one rupiya to buy the car. The car dealer can later knock at your door and ask you to redeem your one rupiya for 1 kg gold. If you do not redeem your rupiya, your credibility declines, and in the future, market participants may refuse to accept rupiyas.
Does this mean you will starve to death with nobody willing to sell you food? Of course not. Even if the credibility of your rupiya has gone for a toss, you can always turn in your gold to the government and receive dollar in exchange. Or you could turn over your gold to a bank whose currency is widely accepted by the public. Or, you could simply melt your gold into smaller units and use it directly for exchange.
The point I am trying to make here is that in a free market gold standard, the market will decide the paper receipts or currency that will be used. Will there be multitude currencies and chaos? No. History suggests that the market will eventually settle to a few different types of paper receipts. Maybe, only dollars will be used or maybe, currencies issued by certain trust worthy banks will be used. (It may be mentioned here that currency issued by different banks will not be a problem, just as having savings account at different banks is not a problem. Inter bank transactions can take place through a clearing house, as is presently done.)
Paper currency issued by different participants in the gold standard are simply receipts for a claim towards gold. As gold is the real money in a gold standard, we stumble on an important question. Who has the right to mine gold? Well, no points for guessing, but obviously the Austrian reply to this question will be – its a free market, everybody has the right to mine gold.
Suppose you want to buy a car, which costs 1 kg gold. You have two choices – either you can mine 1 kg gold and pay for your car, or you can choose to work somewhere and get 1 kg of gold as wages. Which option you choose depends on which activity will demand the least effort from your side – this is similar to saying which activity is profitable to you. Similary, a mining company will mine gold till the time it is profitable for it to do so. It may seem that in a gold standard, private mining companies will earn super normal profits and will become masters of the universe. This is not true.
An example will clarify.
Assume a mining company can hire laborers for 1 kg gold per day to work on its gold mines, and each laborers can mine 5 kg of gold per day. Can such a situation arise in a free market? Of course not. Why would anyone accept 1 kg gold in payment for extracting 5 kg of gold? One can argue here that independently (without machinery of the mining company), the laborer will be unable to mine gold, and hence he may accept a lower payment that the value of gold he produces. Even then, what prohibits another company which can buy machinery and hire laborers to start mining operations? Eventually, as long as mining gold remains a profitable activity, the supply of gold will keep on increasing, adding to the existing supply of gold stock in the economy. Eventually, the “price” of gold (in terms of its purchasing power in buying goods and services) will fall to match the cost of extracting gold and we reach a sort of “steady state” supply of gold.
As we can see above, the supply of gold, which is to say the supply of money in a gold standard, is determined by the market. It is important to mention here that the initial stock of gold, as well as the addition to gold stock through mining, are irrelevant from the point of view of operation of the gold standard.
We can take a stylized example of an economy to understand the above point.
Assume an economy which produces only one good – say 1000 units of X. Assume the initial stock of gold in this economy is 1000 kgs and gold is the accepted medium of exchange. This 1000 kgs of gold is split between two market participants, say A and B, equally – 500 kgs each. What will be the price of one unit of X in this economy? X will cost 1 kg gold, and both A and B can buy 500 units each of X. Now, in the same example, assume that the initial stock of gold, which is split evenly between X and Y, is 1 kg. The price of one unit of X will be 1 gm and A and B can both still buy 500 units each of X. Now assume that because of a certain technological innovation, it has become easier to mine gold and the stock of gold in the economy increases to 2000 kgs. Ceteris paribus, the price of one unit of X increases to 2 kgs of gold and A and B can both still buy 500 units of each.
In a fiat money economy, the way to think about this is to imagine that one morning when you wake up, you are told that an extra “zero” has been added to all monetary denominations. So Rs 10 is now Rs 100. What used to cost Rs 10 before will now cost Rs 100. Similarly, if you were earning Rs 10 before, you will now earn Rs 100. In real terms, nothing changes. By adding an extra zero, we have increased the monetary base in an economy ten times. If the initial stock of money in an economy was Rs 10 lakh, it is now Rs 100 lakh. In real terms, nothing changes. In nominal terms, the purchasing power of rupee has fallen – what you could previously buy with Rs 10 will now cost Rs 100.
What is important is real consumption of goods and services. Money is simply used to exchange goods and services. If there is a huge initial pile of gold, prices will be quoted in tonnes or million tonnes. If we have very limited supply of gold, prices will be quoted in grams or milligrams. We can use any unit we want, it couldn’t matter less.
Can we shift to a Gold standard today?
Yes we can. Most of the criticisms against the gold standard have already been addressed above. We saw how in a free market gold standard, even though everybody has the right to issue currency, there is no chaos or dooms day. The market will choose as currency the paper receipts which have the highest credibility for redemption in gold. In fact, the term ‘dollar’ originated from minting of coins by The Count of Schlick, whose coins earned a reputation for their quality. Even though anybody could mint coins, the ‘dollar’ minted by The Count emerged as universal acceptance.
The dollar began as the generally applied name of an ounce weight of silver coined by a Bohemian Count named Schlick, in the sixteenth century. The Count of Schlick lived in Joachim’s Valley or Jaochimsthal. The Count’s coins earned a great reputation for their uniformity and fineness, and they were widely called “Joachim’s thalers,” or, finally, “thaler.” The name “dollar” eventually emerged from “thaler.”
We also saw how the initial stock of gold or increase/decrease in supply of gold pose no difficulties in the technical operation of the gold standard. These are not merely assertions but facts that can be verified by studying monetary history.
Though we have implicitly addressed the criticism that there is not enough gold to shift to a gold standard, lets discuss this again through an example.
Assume an economy is running on gold standard. The gold reserves in this economy is 1000 kg and a dollar is defined as 10 kg of gold. Thus, there are 100 dollars in this economy. Now, the government abolishes the gold standard and monopolizes the function of issuing currency in the economy. With the link between the dollar and gold reserves broken, the government is now free to print dollars without any corresponding increase in gold reserves. Ten years later, the supply of dollars in the economy has increased to 1000 dollars.
If the government wants to re-introduce the gold standard, with the initial stock of gold reserves (1000 kg ) and the inflated supply of 1000 dollars, the dollar will have to redefined from being equal to 10 kg of gold to 1 kg of gold. We can shift back to the gold standard with the same initial gold reserves but an inflated paper money supply. The question of insufficient gold reserves does not arise. Ludwig Von Mises had remarked that an ounce of gold is sufficient to run a gold standard. I think we can appreciate the significance of this quote in the context of the above example.
We now need to address a final point before closing this post. Lets continue with the above example.
Before the government redefines the dollar as being equal to 1 kg of gold, the “price” of gold observed in the fiat economy will be lower than this rate, i.e., the dollar will be overvalued and gold undervalued. This is to be expected as under a fiat money system, the supply of dollars increase as a much faster rate than the supply of gold reserves. Gold has to be mined from the depths of the earth while money can be printed in bulk effortlessly. In our example, assume the price of gold in the fiat economy is half a dollar for 1 kg of gold. This creates a confusion that we need 2000 kgs of gold to convert the 1000 dollars into gold and shift to a gold standard. Since the gold reserves are only 1000 kgs, there must be “insufficient gold.” As we have seen, this betrays an understanding that money is not an independent entity, but a unit of account. The dollar simply has to be redefined to “equate” the available gold reserves with the existing supply of paper money.
When the government redefines the dollar as 1 kg of gold, immediately we see that gold has “appreciated” and the dollar has “depreciated.” 1 kg of gold previously used to fetch you half a dollar. After the introduction of the gold standard and the redefined dollar, 1 kg of gold will fetch you 1 dollar.
If you are a gold mining company (or individual) and were previously selling a kg of gold for half a dollar, you can now exchange the same for one dollar. If it was profitable to sell a kg of gold at half a dollar, its two times more profitable to sell a kg of gold for a dollar. This will lead to more companies (or individuals) engaging in gold mining. This process will continue until rampant mining bids up the cost of gold mining to such an extent that the profit return on gold mining falls to the return observed in other industries. The laws of normal profit which apply to any other industry in a free market economy will apply in the mining industry too.
Why did the Gold standard collapse?
If indeed the gold standard is a workable solution, why did it collapse? To answer this question, we will have to take a voyage through the monetary history of the world. We can keep this topic for a future blog post. Suffice it is to say here that the gold standard did not meet its demise because of any inherent flaws.
Indeed, the gold standard did not collapse – it was abandoned by the government.
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This disucssion is a modified version of the post on my blog http://informedinvestors.wordpress.com/
Welcome, Ravi. I'll update this post with some feedback when I get a chance to go through your post.
Hi James
I am quite a newcomer to the Austrian perspective on economics. I find mises.org a great place to hone my understanding on the Austrian school of economics. I had my education in India and find it surprising that in my 5 years of economics training (under grad and post grad), there was not a single prescribed reading/coursework on the Austrian school.
I was having a horrific time explaing to my friends that the gold standard is not a relic from the past and its a workable solution. I wrote this post on my blog to make my friends understand how a gold standard will work. I am posting in here to get further comments or corrections in case I have misunderstood something.
Thanks
Well welcome! You've certainly come to the right place. It's great to have you. It looks like you're decently along in your studies.
Be sure to check out The Ultimate Beginner meta-thread to get the lay of the land, and answers to some common questions. (The welcome link there will offer forum tips and how-tos). Feel free to open a thread if you have any questions (but definitely check in at that link to see if any threads have already been started on your topic.) Also, definitely take advantage of the search function (although it seems to only be returning results from posts made in just the last few days lately...that is, it doesn't seem to be searching the whole forum, just posts within the last few days.) So don't get discouraged if you aren't getting many hits. If you don't find what you're looking for, feel free to PM me (or anyone else, I guess). We might be able to remember if (and where) a topic is. But I'm pretty sure most of the common ones are covered in that meta-thread.
Also don't worry about bumping an old one if you want to re-open a subject. It's usually better to do that, unless you have a very specific question and the older thread is really long. (They can get that way sometimes.)
You might find it surprising you were never introduced to these scholars in your studies, but sadly that's not uncommon. As I was saying here and here, I know of university professors of economics...who have never even heard of Hayek. But of course, that's basically the reason for the mission of the Mises Institute ;)
As for your piece here, you've done a pretty nice job. It's actually kind of coincidental that you would post this now, as I actually just read a nice short description of the money concept from Tom Woods, which I just posted here.
I think you might actually want to include that link, or incorporate some of that language about how a money comes about. I think it will help your explanation by helping people grasp what money actually is and what it's for.
You do a good job of covering a lot of bases. When you introduce a scenario, I instantly think of all the different hypotheticals someone might raise...but you quickly address them. (Not many people have the prescience to do this.)
One thing you don't mention though, that I think would be useful is the relative ease with which transactions could take place today under a gold standard. How many cash-less transactions already take place everyday? People always raise the issue of gold being too cumbersome and heavy to carry around, or too valuable for practical everyday use (i.e. even a piece of gold as small as a gram is worth $50...and most everyday transactions require smaller denominations). But with today's technology, you could easily have credit cards that simply account in gold. That way you could easily numerically divide the gold down as small as you want. In fact, Peter Schiff's company Euro Pacific Bank actually offers such a card (although due to ridiculous regulations in the US it's only available for non-US residents).
A bit later you state "Which option you choose depends on which activity will demand the least effort from your side – this is similar to saying which activity is profitable to you." While there's not anything technically wrong with that statement, you might consider rewording it, as it might lead someone to start thinking of profit in terms of effort. You might say something like "Which option you choose depends on which activity you are better suited to and/or are more interested in doing – this is similar to saying which activity is preferrable to you."
Your fiat example reminded me of this post, which you might find useful to draw on for ideas. You might also get some use out of this one.
When you talk about where the name "dollar" came from, if you're going to quote Rothbard, there's no real need to basically paraphrase him right before you quote it. Either paraphrase it yourself, or just quote it. You might just say:
In fact, the term ‘dollar’ originated from coins which earned a reputation for their quality:
Murray Rothbard in his book, What Has Government Done to Our Money?: [the quote you used]
I'm not so sure I would use the premise of "redefining the dollar". While correct in a technical sense, I think this will lose a lot of your audience. It is a bit difficult for a novice to follow, and is not really the most practical method, as simply dictating by fiat that a piece of paper is worth a certain amount is bad enough...but when it already has an established market value...and literally billions of people already hold them, there's really no way to do such a thing.
The real solution is to simply remove more and more of the legal tender laws and the restrictions on currency, until you have a free market for money in which competition can exist freely. Competing currencies will develop their own values and, as you said, there will be a constant move toward a single money.
Finally, I would choose a more telling term than to say the gold standard was "abandoned" by government. "Abandoned" implies it was simply not good enough, or something better was developed. Obviously the reality is the gold standard was removed because it was restraining government growth, and powerful people both in government and special banking interests with ties to government needed a manipulatable money system to more easily maintain their dominance and grow their power. Of course The Creature from Jekyll Island is one of the best resources on this. (Others can be found here.)
I would say something more along the lines of the gold standard was "abolished" by private banking interests.
Minor corrections:
"Similary, a mining company will mine gold till the time it is profitable for it to do so."...I think you mean unprofitable.
"each laborers" should be "each laborer"
Also, you might wish to hyperlink the title of Rothbard's book directly to the text itself...either the document page with all the links to the text, or the wiki page (which also includes a link to the document page) or the HTML or PDF itself.
Other sources can be found here:
Argumentation:Gold
Money and How it Works
Money & Banking
Overall you've got a pretty nice writeup here. I think if you look through the links provided here and incorporate some of those points, and provide the rest in a "resources" section or something like that for people interested in more information, you'll have a great post.
Once again, welcome!
James, thanks a lot for your feedback and comments. I will incorporate the same in my write up to my friends. I have flagged your ultimate beginner's guide and will be havign a look at that. Presenlty, I am going through Robert Wenzel's 30 day reading challenge that I came across on Tom Wood's blog.
It would be great if you could clarify further on this point,
I understand the argument may be difficult for a novice to follow as in a fiat monetary system if think of terms like 'dollar' as an independent entitty and not a unit of account. However, is it facutally incorrect? I based my point on redefining the dollar from what I read in Rothbard's 'The case for a 100 percent gold standard':
Since we have many times the number of dollars as we have gold dollars at the present fixed weight of the dollar, we have essentially two alternative, polar routes toward 100 percent gold: either to force a deflation of the supply of dollars down to the currently valued gold stock, or to “raise the price of gold” (to lower the definition of the dollar’s weight) to make the total stock of gold dollars 100 percent equal to the total supply of dollars in the society. Or we can choose some combination of the two routes. (emphasis mine)
"What is important is real consumption of goods and services. Money is simply used to exchange goods and services. If there is a huge initial pile of gold, prices will be quoted in tonnes or million tonnes. If we have very limited supply of gold, prices will be quoted in grams or milligrams. We can use any unit we want, it couldn’t matter less."
Doesnt that mean that also just liek with paper money, a high amount of gold bars in existence will lower its purchasing power, if so then how is gold advantageous to paper fiat?
Ive always thought that the advantage to a gold standard is that gold is useful. In industry, this can offset inflationary trends (since the gold used for computers, teeth, etc will not be used as a medium of exchange).
“Since people are concerned that ‘X’ will not be provided, ‘X’ will naturally be provided by those who are concerned by its absence.""The sweetest of minds can harbor the harshest of men.”
http://voluntaryistreader.wordpress.org
Kelvin, the context behind those lines was to show that the initial stock of gold does not matter. If there is a huge pile up of gold, its purchasing power will be less. This holds for a paper money system also, as more is the supply of paper money, less will be their purchasing power. However, the advantage of a gold standard is that the government does not control the money supply and monopolizes the legal tender. Under a fiat economy, the government can print money arbitrarily and imposes an 'inflation tax' on people. Such inflationary printing of money also has distributional effects, in the sense that some sections of the society (generally the ones favoured by the government) benefit from rising prices while others are hurt.
I did not understand what you mean to say by the below,
Could you kindly elaborate further?
As far as the industry thing, since it has a useful use for something, it might drive up its value. Also if there is a piece of gold acting as a tooth, or a microchip circuit board, it will not be used as money. People assume that all the miners that mine for gold in a gold standard will inflate the economy, while in fact some gold miners actually mine for a certain use.
That is why it became money, it had a use, looks pretty, and is overall pretty rare.
What if a huge gold mine was discovered, wouldnt this inflate a gold standard?
Im not opposed to a gold currency, im just trying to figure out more about it.
Hi Kelvin
If were to replace today's fiat money system with a gold standard, the price of gold would increase in terms of monetary units like "dollar". So yes, gold for industrial uses will become expensive. This will be a one time adjustement for such industries.
With regard to your second question,
I have addressed this question in my write up. If a huge gold mine was discovered, then the supply of gold will increase (and assuming no change in output), each unit of gold will buy less of real goods and services. So yes, this is "inflation." Prices will adjust to reflect the new stock of gold. If you were taking a walk in a forest and were to stumble on a pot of gold, and then start buying commodity X with your new found wealth, the price of commodity X will increase. Why should it be any other way? This is exactly how a free market gold standard economy is supposed to function. Nobody is saying that under a gold standard, the prices of goods and services will be forever constant.
I hope this answers your questions.
Basic question: is this "gold standard" voluntary or imposed by government? If it is the latter then it is not sustainable and will not work.
The gold standard is a voluntary monetary system. It orginated from the barter system as the preferred system of monetary transactions. The paper money system was "imposed" by the government to outst the gold standard. Today's paper money system is forced upon people as government has put it in law that only federal reserve bank notes can serve as legal tender.
The problem is really simple. If people who advocate the paper money system are confident that the society has chosen the paper money system as the preferred system of monetary transactions, then why is there a law mandating that only dollars can serve the purpose the legal tender? If indeed the paper money system is the best, why does it need to be forced upon the people by outlawing any other forms of money?