Gold standard and Austrian economics
After I mentioned the gold standard in my last post on three centuries of UK interest rates, I received a number of comments relating to the gold standard and Austrian economics.
Mahesh asks about the advantages and disadvantages of going from a paper currency to the gold standard. I do not think of the gold standard as something to do with the physical commodity called gold; I think of it in terms of targeting the price level rather than the inflation rate.
Nowadays central banks target the inflation rate, not the price level. Suppose the initial price level was 100, the inflation target was 2% and actual inflation is 5%, then the central bank writes a suitably remorseful letter to the government explaining its failure to meet the target. In most cases, the government might accept and even endorse the explanation, though in the worst case, it may replace the head of the central bank. In either case, the inflation target for the next year would remain at 2%; the implied target for the price level at the end of the second year would be roughly 107 (105 plus 2% inflation).
Under the gold standard, essentially you are (implicitly) targeting the price level. In the above example, with desired annual inflation of 2%, the target price level at the end of two years is roughly 104. Since the price level at the end of the first year is already 105, implicitly the inflation target for the second year is -1%. High inflation in one year has to be compensated by deflation the next year. This is what we see during the gold standard era in the inflation graphs in my earlier post. During periods of war, there may be inflation for a few years, but this is acceptable if people believe that it will all be reversed in due course. You can even go off the gold standard temporarily if people believe you will come back to it.
Ideally in such a world, the detrended price level is a stationary process in econometric terms. In modern inflation targeting, the price level is a non stationary random walk (unit root process). For long term decisions, the reduction in volatility achieved by eradicating the unit root is huge.
The gold standard in practice also involved much lower inflation rates – most multi-decadal inflation rates are in the range of -½% to +½%. On a hedonic adjusted basis, this almost certainly implies persistent deflation, probably related to the inability of gold supply to keep pace with the growth of the global economy. I am not convinced that the trend rate of growth of the price level is hugely important so long as the detrended price level is a stationary process. If you worry about menu costs and money illusion, you may be less sanguine than I am.
In my view, the benefits of the gold standard had nothing to do with gold itself. I tend to regard gold as a (rational?) speculative bubble that has lasted five thousand years. The demonetization of silver in the late nineteenth century led to a collapse of the equally long lived (and equally rational?) silver price bubble. There is an ever present risk that the same could happen to gold one day. If the bimetallic ratio of 5-8 between gold and silver prices that prevailed for several millenia before the nineteenth century reflects the relative intrinsic worth of the two metals, gold could fall catastrophically. Of course, this might not happen in my lifetime nor in yours; that is why the bubble could be a rational speculative bubble.
Pravin asks whether inflation during the gold standard was due mainly to wars or government actions. Inflation could result not only from fiscal expansions but also from private sector credit expansions. Generically, I like to think of inflation in any one country under the gold standard as a deviation from purchasing power parity (PPP). Inflation would cause a departure from PPP, but since PPP asserts itself only over a period of a few years, this departure could persist for a short period, but in the medium to long term, the price level mean reverts to its old level.
Another complication is that even in a land with metallic money, one needs detailed historical evidence to determine whether the coins were accepted “by tale” or “by weight”. Until the nineteenth century, it was probably true that debased currency was accepted “by tale”, and therefore what appears to be silver (or gold) currency is actually fiat money.
As far as Austrian economics is concerned, I find Hayek, Schumpeter and Minsky to be most in accordance with my tastes. The gold standard is not to my mind among the more important ideas in Austrian economics. But then I am not an economist. I find that I am able to hold Keynesian, monetarist and Austrian ideas in my head almost simultaneously without getting a severe headache.
Posted at 1:23 pm IST on Tue, 13 Jan 2009 permanent link
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