Milton Friedman on Gold Demand and the Price Level

In 1990, Milton Friedman published “Crime of 1873”, an article that comprised a chapter in his Money Mischief – a book that is generally underappreciated, though not by some of my favorite monetary theorists. Friedman’s thesis is that the Crime of 1873 was actually a crime, though perhaps not in the legal sense:

Whether or not a verdict of "guilty" would have been appropriate in a court of law for "the crime of '73," it is appropriate in the court of history. The omission of the fateful line [allowing for silver coinage] had momentous consequences for the subsequent monetary history of the United States and, indeed, to some extent, of the world… The act of 1873 cast the die for a gold standard, which explains its significance. Moreover, while the conventional view is Laughlin's, that "the act of 1873 was a piece of good fortune" ([1886] 1896, p. 93), my own view is that it was the opposite: a mistake that had highly adverse consequences.

The U.S. demonetized silver just as European nations joined the gold standard, and thus demonetized silver: Germany in 1871, France, Belgium, Italy, and Switzerland in 1873, “The Scandanavian Union (Denmark, Norway, and Sweden), the Netherlands, and Russia followed suit in 1875-76 and Austria in 1879.” This switch by all major Western nations led to a significant price deflation in gold terms between 1873 and 1896. This also coincided with other deflationary forces:

The increased world demand for gold for monetary purposes coincided with a slowing in the rate of increase of the world's stock of gold and a rising output of goods and services. These forces put downward pressure on the price level. Stated differently, with gold scarcer relative to output in general, the price of gold in terms of goods went up, which means that the nominal price level (under a gold standard, the price level in terms of gold) went down.

This painful deflation – painful at least for debtors – could have been avoided.

Gresham’s law states that under a legal tender monopoly, money whose actual value is higher than the face value offered by the mint is hoarded and the “cheaper money” is used for exchange (as the unit of account) while the hoarded money serves as a store of value. Had the U.S. maintained a bimetal standard, gold would have been hoarded as its value had risen due to slowing production and increased demand in Europe. Silver would have been used for exchange as the face value of silver coins and bullion would likely have been higher than the value of its silver content. This also would have served to stabilize the gold price of silver by guaranteeing a market for it. Despite its shortcomings, price stability was one significant advantage of bimetallism.

Friedman findings support this:

If my estimates are anywhere near correct, a bimetallic-or really silver-standard would have produced a considerably steadier price level than the gold standard that was adopted.

He supports this with a graph that is hard to argue with:

Friedman shows that the price ratio of gold and silver remained relatively stable throughout the 19^th century. It was not until all major nations demonetized silver in favor of gold that the ratio lost became unhinged. Friedman provides a counter-historical regression line to support his argument. It is estimated by multiplying the gold price of silver by 16 and dividing it by a hypothetical price of gold had the U.S. not joined the gold standard (see the article for more details). The outcome would have been different:

Friedman's predictor line suggests that the price ratio of gold and silver would still have risen, but that rise would have been short lived as the existence of a legal price of silver in the U.S. would have encouraged discouraged deviations that were far from the official ratio.

Friedman's argument is compelling. My only addition to it is that falling prices under a gold standard, and the later price volatility during and after World War I was the result of the elimination of precious metal substitutes for gold as outside money by gold standard countries. More on that in the future.