Saturday, January 5, 2013

Why a gold standard is a bad idea (III)

Regular readers know that I have stood against the idea of a gold standard (see my previous posts in 2008, 2010 and 2011). I have always regarded the hard money crowd as longing for a mythical time and place that never quite existed.

I came upon some analysis from Frances Woolley at Worthwhile Canadian Initiative that highlighted some of the points that I made about the inflexibility of a gold standard by analyzing a time and place that is mythical - Middle Earth [emphasis added]:
The full economic impact of [the dragon] Smaug [with his gold treasure hoard] can only be understood by recognizing that the dragon's arrival resulted in a severe monetary shock. On the left is shown Smaug's hoard. On the right, for purposes of comparison, are the gold reserves of the Bank of England. It is clear from a simple inspection of these two figures that the amount of gold coinage Smaug withdrew from circulation represents a significant volume of currency. This would, inevitably, lead to deflation and depressed economic activity.
Woolley is making the point that under the monetary model of the economy (PQ = MV), if you withdraw money supply from the system, lower economic activity would be the result. The question then becomes what the proper response if Middle Earth had a central bank using a more flexible monetary system using fiat money would be in the face of such a macroeconomic shock:
One has to ask whether or not a more innovative monetary policy framework could have ameliorated the impacts of the dragon-induced economic downturn. If the peoples of Middle Earth had abandoned their gold specie standard, and switched instead to a paper currency, they could have revived trade-flows without sacrificing so many lives. Unfortunately, the lack of a central bank, or indeed any but the most rudimentary monetary institutions, was a major obstacle to currency reform.

Dragons come. The question is how to respond to them.
The post is worth reading in its entirety. In particular, there are some interesting wonky responses in the comments, especially when you consider that Middle Earth is a mythical place. Here is just one amusing example here:
Considering that Smaug actually took over the castle some 150 years before "The Hobbit" takes place, would not price rigidities have resolved themselves and economic production returned to pre-Smaug levels?

On the other hand, I suppose if Smaug had continued to ravage the countryside year after year, perhaps the money supply was continually decreasing. Fully downwardly rigid nominal prices (like for debt, or if social standards hadn't adjusted, for wages) could then prevent economic adjustment.

But then again, just to continue the argument, it seems unlikely that prices would be very sticky at all in a feudal economy. The two stickiest prices, wages and debts, probably didn't exist. Most workers are subsistence farm owners and are not paid wages. The financial system is negligible - if it even exists - making debt contracts rare. While there certainly could be some sticky prices, those are adjusted over time with much more ease than wages or debts, no?

If this were the case Smaug's deflationary actions would be purely nominal and all his real effects would be through the "fiscal policy" you mention.
Bottom line: I am against the adoption of a gold standard because such a regime creates inflexibility that creates unnecessary volatility for an economic system, regardless of whether the system is real or mythical.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

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Gloeschi said...

Everybody is against the gold standard. And, as you correctly point out, it would restrain the growth of the monetary base (unless you decided to revalue the gold price from time to time). But once trust in fiat money has gone, a gold standard might be the only option to rebuild a functioning monetary system. So a gold standard will not be re-introduced because people "like" it, but because there is simply no other option.
If the gold standard was really out of question, why would the US keep 20,000 tonnes of the stuff under the guard of the military?

Frances Woolley said...

Thanks for the link. What motivated it, in part, was realizing just how little gold there is in the world - all of the gold that has ever been extracted could fit about a 20 m x 20 m x 20 m cube - so if Middle Earth has the same geological make-up as our world, Smaug's gold pile is wildly improbable. (b.t.w. it's "Woolley" not "wooley).