Wednesday, January 15, 2014

Hawtrey on the Weakness of the Gold Standard: Gold, per se, was not the Problem

As I continue my study of the Ralph Hawtrey's analysis of the classical gold standard in The Gold Standard in Theory and Practice, I notice that he sets forward in his narrative an argument that implies the problem that I am currently extrapolating upon in an upcoming paper. (I hope to get it up on SSRN in the next week or two.) He writes:
The immediate effect of the suspension of the free coinage of silver in Europe was to concentrate the whole demand for additional metallic currency upon the gold supply of the world.
As I have argued before, the establishment of the gold standard eliminated metallic substitutes for gold as base money. By definition, this made demand for gold more inelastic, thus creating an environment that encouraged price volatility.

As the price of any good becomes more expensive, individuals tend to substitute away from it. By preventing the employment of substitutes for gold, gold standard countries – meaning, in practice, all western nations after 1879 – made more fragile the international monetary system. This is a fact too little appreciated in the literature concerning the gold standard - with the exception research from Bordo and Reddish that I posted recently, and probably David Glasner, Scott Sumner, and other interested market monetarists. The restraint provided by the classical gold standard appears to garner support for it among libertarian leaning economists. As a result, the effects of intervention in the classical gold standard have gone on generally ignored as arguments concerning it have become polarized. i.e., in debate gold becomes either a barbarous relic or a beacon of growth and economic stability. 

Researchers should be asking: “How did the gold standard change when silver was demonetized?” and “Why did it fail?” Hawtrey baldly explains the problem:
Since there is nothing in the circumstances of either metal [gold or silver] to make it more stable in value than the other, are we to be driven to the conclusion that the precious metals are inherently defective for that purpose? That would be a mistake. The true moral of the nineteenth-century monetary experience is rather that the defects in gold and silver as standards of value have been attributed to causes within human control. Governments have been too prone to modify their currency systems without regard to the reactions they might cause in the world markets for the precious metals, and therefore in the currency systems of their neighbors.
Conflicting policies from independent central banks destroyed the stability provided by the gold standard. Hawtrey preferred that central banks might cooperate to avoid the problems associated with the monometallic standard, but such hopes were dashed by political reality.

Arguments concerning the gold standard in history too often devolve into a fight about the merits of the gold standard per se. Consider George Selgin’s “The Rise and Fall of the Gold Standard in the United States” (which, despite my qualms, I still recommend for anyone attempting to gain familiarity with the gold standard. His discussion of silver demonetization quite informative!). Although he clarifies that a gold standard does not depend on “’legal tender’ status”, the complications associated with the adoption of a monometallic standard under a legal tender regime breeds complications that are ignored. In defending the gold standard against the claim that it is inherently deflationary and therefore suppresses economic growth, he writes:
…actual statistics for the [deflationary] interval in question reveal healthy average growth rates for both total and per capita real income … with declining prices reflecting, not flagging demand (as they did in the 1930s) but robust growth.”
The gold standard itself was not itself exceptionally deflationary, but a monometallic regime enforced by law was deflationary. This was not due to an increase in production. The growth of the gold stock could not keep pace with demand for gold after silver was demonetized. Deflation was more a result of the elimination of metallic substitutes than of increases in production. (See my earlier post.) It is for this reason that we see a strong downtrend in gold denominated prices between 1873, around the time that most major nations demonetized silver, and 1896.

Surely the debate can be improved. If the gold standard was destroyed by “causes within human control,” by governments that were “too prone to modify their currency systems without regard to the reactions they might cause,” then the interesting story to be told concerns political economy. In this story, the gold standard is more of a bystander than a system of instability or inherent promoter of deflation. 

While researchers like Barry Eichengreen and Peter Temin suggest that the gold standard was overly constrained monetary policy, I suggest that the classical gold standard overly constrained markets. The limitations of a monometallic legal tender monopoly impeded the formation of expectations in regard to future prices as substitution away from gold could no longer limit swings in prices. (For insight, see Barsky and De Long on inflation expectations under the classical gold standard.) If we are to discuss the gold standard, we must first ask "before or after silver was demonetized?"

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