Sunday, December 1, 2013

Hawtrey's Narrative and My Critique of the Classical Gold Standard/Monometallism

I’ve been making my way through one of Ralph Hawtrey’s classic works, The Gold Standard in Theory and Practice. The book is both highly readable and insightful. Of interest today is Hawtrey’s narrative of the classical gold standard.

Gold and silver were both used for exchange in commerce throughout much of recorded history. It was not until the 1870s that the western world moved to a uniform gold standard. The foundations for this move were laid as a result of large gold discoveries in Australia and California during the middle of the 19th century. Gold had been the more highly valued money, which under bimetallism meant that it was hoarded and silver was used for exchange as official par overvalued it. After the gold discoveries, the reverse was true. The increase in the monetary gold stock brought down its value so that now silver traded at a premium under bimetal standards. Hawtrey notes that this was not without consequence:
The French franc from a silver unit became a gold unit. The two great financial centres of the world, London and Paris, were both gold centres.
At the time Germany employed a silver standard, and conditions were not favorable for such a position:
Germany no longer derived any advantage from the silver standard in her trade with Eastern Europe, because silver had there made way for inconvertible paper. The bimetallic currencies of Western Europe had passed from a state of fixity in terms of silver [i.e., a de facto silver standard under a bimetal regime], with a slight fluctuating premium on gold, to fixity in terms of gold, with a slight fluctuating premium on silver… Even if the ratio of gold to silver continued to be stabilized by the bimetallism of the Latin Union, the silver standard might be expected to be a disadvantage to the German financial centres.
After its war in 1871 Germany adopted the gold standard and suspended the free coinage of silver. With new demand for gold, this shifted the price ratio in favor of a de facto silver standard for bimetal regimes. [See my brief discussion of Gresham’s law from last post.] That is, had bimetal regimes operated as they had beforehand, silver would have been employed under those regimes. But at this time, “Russia Austria-Hungary, Italy and the United States were using depreciated paper” and France made her money inconvertible. With the suspension of redemption in traditionally bimetal regimes:
There was nothing to relieve the sudden scarcity of gold, and the price of silver in gold began to fall. But that meant that the currencies of silver-using countries began to depreciate… The only remedy was the suspension of coinage of silver.
Given the above described political situation, the general adoption of the gold standard appears to be an accident of history. What were the precise impacts of this "accident"?

An interesting, yet not broadly acknowledged, aspect of the adoption of the gold standard concerns its promotion of a relatively unstable price level. After the gold standard was adopted, the impact on the price level from a change in the monetary gold stock or in production appears to increase. Notice the change that occurs in 1873:

Notice that prices had stabilized from about 1856 to 1873. The gold standard era can be divided into an era of price deflation, 1873-1896, and of price inflation, 1896-1914. During 1914 most nations on the gold standard suspended redemption, but since gold was implicitly the only metallic standard - the return of redemption was anticipated after the war - price rose steeply as demand for gold fell. Precisely what one would expect given a lack of metallic money substitutes. 

I ran a series of regressions to investigate:

British GDP
Monetary Gold Stock

Sauerbeck-Statist Index

Sauerbeck-Statist Index

Sauerbeck-Statist Index

Standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1

I used an ARCH model to account for the clustering of price level volatility as changes in direction tend to occur for more than one year at a time. The coefficients (those numbers with *s next to them) estimate the percent impact of a one percent increase in the independent variables – GDP and Monetary Gold – on the Sauerbeck-Statist Index, a measure of the British wholesale prices. The effect of both about doubles across the entire time period after the gold standard is established. The effects decrease slightly when the time period is extended to 1913, likely due to the increase in production of gold that began to occur in the 1890s after the discovery of the cyanide process for extraction. This alleviated the impacts of an increase in demand for gold.

Bottom line, a monometallic standard is bad for price stability. Was this bad for production? It is hard to tell because the industrial revolution was in full bloom at the time of the change. Clearly the world economy was able to handle a less flexible monetary standard as the growth associated with the period was before unthinkable. And perhaps the move to a common standard decreased transactions costs enough to compensate for the inflexibility. The interesting question is: on net, did the gold standard hurt or help economic growth?

Late note: The use of ARCH does not seem to matter as I receive the same output with a simple regression with Newey-West HAC errors.

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