Let me say at the outset that I am bullish on gold in the long run. US demographics, politics, debt levels, harder-to-extract energy, peaking of globalization’s labor supply shock: all these point to inflation in the long run. And central bankers have not exactly covered themselves in glory lately.

That being said, going back on the gold standard makes exactly as much sense as going back to horses and buggies.

Here’s why.


Gold enthusiasts point out that a good suit cost about an ounce of gold in Roman times, Revolutionary times, and (at least until the recent bull market) modern times.

An observation, and then a question. From Roman times until the early 1800s, growth was low, then both populations and per-capita GDPs soared. Q: If the world was still on the gold standard, would gold be worth more, or less than it is?

The answer is, a hell of a lot more. The dollars people now hold would need to be gold equivalents, and gold demand would be far higher. Back of the envelope estimates: since 1820 world real GDP has gone up by a factor of something like 60. The world’s inventory of gold has gone up 15 times (from the oft-quoted saw that 90% of the world’s gold has been mined since 1848).

Therefore, if the relationship of gold supply to real GDP had stayed the same, the price of the suit in gold would have had to have drop to about 1/4.

Simple math: if the amount of gold added to the world’s inventory is something like 1.5% a year, and if world real GDP grows at a 2.5% rate, prices have to fall 1% annually to keep the amount of gold relative to nominal GDP the same.

In a modern economy, price deflation is death. Suppose you’re an investor and an entrepreneur comes to you with a proposal to build a factory, and the business plan shows next year the factory will cost 1% less to build, and the products will sell 1% cheaper. Why build a factory today if you can get a 1% a year increase in purchasing power just by keeping gold in your mattress? You would need a very big or very certain return to lend it out or invest it.

The upshot is, under the gold standard fewer factories will be built, real interest rates will be higher, and entrepreneurs and established companies are not going to get access to the cheap capital which generates high rates of growth. Falling prices and strong growth tend to be mutually exclusive. (Inflation and taxes force entrepreneurs to invest, take risks, and basically run to stay in place – as long as they’re not so high and unpredictable they defeat the purpose of running.)

When you get strong growth globally and a fixed amount of gold, you end up with not enough money to go around, and a banking crisis. People don’t cut prices and wages when times are good. In fact behavioral economics (and long experience) shows they avoid doing so even when times are bad. Growing GDP and fixed money supply means interest rates go up. Banks get creative about trying to lend as much as possible with limited capital. Eventually, the countries that are losing gold suffer bank runs and financial panic. They might devalue their currency, screwing the people who hold it, exactly as the gold-standard advocates hope to avoid. Planet-wide the supply of gold is fixed, so the panics roll around from country to country, until depression brings economic activity and prices back in line with the gold supply that can support them. (To true gold afficionados, this is a feature, not a bug.)

I was once at a dinner honoring Paul Volcker, and a bolder acquaintance asked him what he thought about Ron Paul and the gold standard. His answer was in the old days, the gold standard was a millstone around central bankers’ necks and they were quite glad to be rid of it.

The crux is, you need a certain amount of money, determined by the size of the economy, and the price level, and the technical efficiency with which you can use it for transactions. Too much money, you get inflation. Too little, you get high interest rates, panic and depression. In a fiat money system, the central bank decides how much money there should be. In a gold standard, the amount is fixed, except for mining. The gold standard is like having a hard core central banker who grows reserves according to an ultra-strict rule.

Consider these monetary regimes: 1) a fiat system where central bankers determine the money supply; 2) a strict monetary growth rule where money is allowed to grow in line with GDP; 3) a commodity basket regime, where monetary growth is managed to keep the price of the basket relatively constant over time; 4) a gold standard, where the basket is reduced to 1, and the supply of money grows in line with the quantity of gold, not the price.

The utter pointlessness of the gold standard argument is seen by the fact that a typical response to a panic, or war, was to suspend convertibility, provide paper liquidity, and then later go back on the gold standard at a devalued rate. If you do this often enough, it’s not very different from never being on the gold standard in the first place. It’s a fiat currency, intermittently managed to keep it in line with gold as long as times are good.

Under the less hardcore monetary regimes like 2) and 3), in extremis, bankers can adjust the parameters of the monetary rule. When push comes to shove, bankers always do what they want. It follows that in the long run, whatever anyone decides, the supply of money ultimately depends on the judgment of central bankers. Even the great Volcker went back from 2) to 1).

Far from being persuaded by people who think the gold standard is the only stable system, it seems clear to me that a flexible economy needs a flexible currency and fiat money is the only stable equilibrium.

The US dollar might totter as it is seen as a less reliable store of value, but the Fed always just has to go up the ladder of target credibility (and pay the economic piper) to restore it. The only thing the USA has to do to keep the fiat money system going is 1) not disappear from the face of the earth and 2) go up the hard-money ladder quickly enough to avoid hyperinflation.

In other words, not completely screw up.

In the next few years or maybe decades, I suspect there will be ample opportunity to screw up. The US will be less important in the world economy, the dollar will be less acceptable, everyone already has too many, and for various reasons alluded to above, we will move down the credibility ladder, closer to Argentina than Switzerland. So I’m a dollar bear and a gold bull. But if you think fiat currencies are going away, then you have succumbed to gold buggery.

You might be a gold bug… if you think ‘manipulation’ is keeping the price of precious metals low; if you think yellow metal is the only way to own gold because ETFs and futures etc. are backed by nonexistent inventories (warehouses and auditors notwithstanding); if you chart stocks by their value in gold as a measure of ontological reality instead of a thought experiment; if you deflate anything by the monetary base; if you think inflation and taxation are theft and represent the worst possible outcome in an economy, but if all the banks had been allowed to collapse in an old-style panic, the effect would have been good for the soul in the long run.

From The Reformed Broker, some other signs you might be a gold bug.