Thursday, January 30, 2014

Monometallism as the Winner's Curse (My Latest Working Paper)

I will be presenting this paper at this year's Policy History Conference.
By the middle of the 19th century major western nations began to adopt the gold standard. Britain was first to do so with its resumption of the gold standard in 1821. It was followed a half-century later by Germany in 1871 and the Latin Monetary Union – made up of France, Belgium, Italy, and Switzerland – in 1873, both of which also demonetized silver. The United States followed suit with the Coinage Act of 1873 which put the U.S. on a de jure gold standard when it resumed redemption in 1879. Before this, the price of gold remained relatively stable as countries on a bimetallic standard ensured that the exchange rate between silver and gold did not vary greatly. Thus, if one metal became scarce, a nation might adopt the other, by law or by practice, so as to alleviate a shortage of base money. By adopting the gold standard, governments disallowed the employment of substitutes for gold – i.e., silver – as base money and therefore made the demand for gold more inelastic. This made the monetary system more fragile. As a result of the demonetization of silver, shifts in demand for gold exercised increased influence over the price level. 
This was an inevitable consequence of the adoption of gold backed legal tender. Any change in the monetary gold stock, in GDP, or in the velocity of gold exercised greater influence on prices after the switch. Changes in the Sauerbeck-Statist index, a measure of wholesale prices, after 1873 reflect the downward pressure on prices as the index reached a peak in 1873 and followed a strong downward trend until after 1896. The problem was amplified as gold reserves were centralized under central banks. Combined with an already decreased elasticity of demand, suspension and later readoption of the gold standard promoted instability in gold denominated prices during WWI and the interwar era. As central banks increased or decreased the volume of gold held on reserve, prices moved in the opposite direction. 
This paper investigates the above problem by identifying the direction of changes in the elasticity of the price level in terms of gold with respect to changes in the monetary gold stock, GDP, and the velocity of gold, the latter of which is also known as the inverse of portfolio demand for gold. Of greatest concern is the last of these. The velocity of gold during the period cannot be measured directly. The model employed here estimates it indirectly and show that it exhibited tremendous downward pressure on prices once the gold standard was adopted and that the consolidation of gold at central banks greatly increased the sensitivity of prices to changes in GDP, the monetary gold stock, and the velocity of gold.
*Thanks to Carlos Ramirez for our many discussions about modeling.
HT Phil Magness

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