Saturday, November 2, 2013

If Shifts in Velocity Can Alter Relative Prices, What About Changes in Gold Holdings by Central Banks?

I am currently busy working on a new project which has kept me away from blogging over the last week. In researching I have stumbled upon a fact that is revealing of late Hayek. It seems that he never came to terms with absolute inability of government adhere whatsoever to any fixed standard. In Denationalization of Money, he writes:
One might hope to prevent the violent fluctuations in the value of money in recent years by returning to the gold standard or some regime of fixed exchanges. I still believe that, so long as the management of money is in the hands of government, the gold standard with all its imperfections is the only tolerably safe system.
To be fair, I must acknowledge that Hayek does admit “the undeniable truth that the gold standard has serious defects.” He also places constraints on his support for the gold standard, saying:
It [gold] certainly could not bear the strain if the majority of countries tried to run their own gold standard. There just is not enough gold about. An international gold standard could today mean only that a few countries maintained a gold standard while the other hung on to them through a gold exchange standard.
Confusing, no? The gold exchange standard was the system that bred mistrust and monetary catastrophe. It was certainly no second best option. As has been revealed through my study of Hayek as a common theme, any time he mentions a policy that is in some respect compromised, specifically if it is backward looking, it comes across as awkward. To clarify, for Hayek gold is not preferable as a currency, but it is the only appropriate choice of government chooses control currency. If that happens, countries will have to adopt a gold exchange standard with only a few holding the actual gold reserves.

Take a deep breath, as I am done confusing you for now, and prepare for Hayek’s scarcely adulterated wisdom. Oddly, his analysis of gold under a free banking standard reveals precisely the problem that it carried under a managed standard. He writes:
It may be that, with free competition between different kinds of money, gold coins might at first prove to be the most popular. But this very fact, the increasing demand for gold, would probably lead to such a rise (and perhaps also violent fluctuations) of the price of gold that, though it might still be widely used for hoarding, it would soon cease to be convenient as the unit for business transactions and accounting.
Increased demand for gold under the gold standard increased its value just the same as might occur in a world of private currencies. That was the very reason why it failed. Changes in the price of gold, in other words the gold price level, created two sorts of price distortion. First it altered relative prices of goods so that the plans of entrepreneurs were upset by a technically unnecessary adjustment. Second, the inflation and deflation associated with the interwar gold standard altered the terms of credit so that creditors were benefitted under deflation and debtors were benefitted under inflation. Of course when price movements are extreme, the benefits for either party are likely outweighed by the cost of a shrinking volume of economic activity. Also, the further divergence of relative prices only compounds the problem. Hayek clearly understood this in regard to changes in velocity of domestic currency:
It can be maintained that the analyses in terms of the demand for cash balances and the use of the concept of velocity of circulation by the quantity theory are formally equivalent. The difference is important. The cash balance approach directs attention to the crucial causal factor, the individual’s desire for holdings of stocks of money. The velocity of circulation refers to a resultant statistical magnitude which experience may show to be fairly constant over the fairly long periods for which we have useful data – thus providing some justification for claiming a simple connection between ‘the’ quantity of money and ‘the’ price level – but which is often misleading because it becomes so easily associated with the erroneous belief that monetary changes affect only the general level of prices. [Monetary changes] are then often regarded as harmful chiefly for this reason, as if they raised or lowered all prices simultaneously and by the same percentage. Yet the real harm they do is due to the differential effect on different prices, which change successively in a very irregular order and to a very different degree, so that as a result the whole structure of relative prices becomes distorted and misguides production into the wrong directions.
The very same difficulty occurs when central banks hoard gold. Hayek somehow never specifically outlines that problem. He was not the only one to let this pass. This problem is pervasive in the literature. Those who more fully understood the dangers of price level volatility due to shifting demand for gold by central banks did not consider the problem of distortions in relative price. Their lack of concern for "noise" from relative price changes may be one reason why some were content with simple price level stabilization which ignores changes in real output. 

The merits of both views must be considered. The fusion between an Austrian perspective on prices and a monetarist perspective on gold can reveal much. More to be said on that next time as I consider other arguments and spell out the problem with more technical language.


  1. I really liked this post, I was actually thinking about the effects of the gold market on relative prices, David Glasner following Hawtrey in his book about free banking makes this point several times through the book; the fact that the international market for Gold specially among European nations to seek to reestablish old parities led to a sudden demand shock in the gold market that led to a international deflation and a problems of liquidation of assets in the financial system, this led me to think (since I wrote a paper on minimizing monetary effects on relative prices) this led me to think about how epistemology unstable it might be a free banking regime with a commodity reedimibility such as Gold, Glasner as a matter of fact argues for a free banking with a labor standard; would you say that a free banking system without central banks with a system of gold reedimibility brings unnecessary alterations to relative prices? if so is there any way of eliminating those real market factors? at least there are no monetary factors, I would love to know your thought on this, thanks!

  2. This is much of what my article on SSRN is about . Central banks became primary holders of gold in a world where other options were generally prohibited by legal tender laws. By limiting consumer choices in regard to money, governments made the monetary system less robust and more fragile. In a gold standard regime, gold is the only option. Under a free-banking regime, if a money's value moves too high, speculators can push the price down by selling - profit taking - and moving their wealth to other assets (one might argue that we currently live in a quasi-free-banking regime where the dollar is the unit of account). This limits the magnitude of relative price shifts under a free-banking standard.

    I have looked a little bit into Glasner's labor standard. It seems to overlap Selgin's productivity norm. I can't say much else than that as my interests take me elsewhere at the moment.

    I've started reading your paper, but I am not finished. I believe my first paragraph speaks to some of your concerns.