Contra Bernanke on the gold standard

In his lecture at George Washington University on March 20, 2012, Federal Reserve chairman Ben Bernanke said that under a gold standard the authorities’ ability to address economic conditions is significantly curtailed. The Fed chairman holds that the gold standard prevents the central bank from engaging in policies aimed at stabilizing the economy after sudden shocks. This in turn, holds the Fed chairman, could lead to severe economic upheavals. According to Bernanke,

Since the gold standard determines the money supply, there’s not much scope for the central bank to use monetary policy to stabilize the economy.… Because you had a gold standard which tied the money supply to gold, there was no flexibility for the central bank to lower interest rates in recession or raise interest rates in an inflation.

This is precisely why the gold standard is so good: it prevents the authorities from engaging in reckless money pumping of the sort Bernanke has been engaging in since the end of 2007 by pushing over $2 trillion in new money into the banking system.

The Federal Reserve balance sheet jumped from $0.889 trillion in December 2007 to $2.247 trillion in December 2008. The yearly rate of growth of the balance sheet climbed from 2.6 percent in December 2007 to 152.8 percent by December 2008. Additionally the Fed has aggressively lowered the federal-funds rate target from 5.25 percent in August 2007 to almost nil by December 2008.

Consequently the yearly rate of growth of the AMS measure[3] of the US money supply climbed from 1.5 percent in April 2008 to 14.3 percent by August 2009.

Contrary to Bernanke and most mainstream thinkers, such pumping has inflicted severe damage to the process of real wealth generation. It has severely impoverished wealth generators and laid the foundation for serious economic troubles ahead.

Allowing the money supply to be determined by the production of gold leads to stability and not chaos as Bernanke suggests. In an environment where money is gold and no one is engaged in the act of money printing, economic swings, i.e., boom-bust cycles, cannot emerge. (Note that money printing sets in motion an exchange of nothing for something, i.e., an act of embezzlement.) Contrary to Bernanke, it is policies that aim at stabilizing the economy that result in instability and economic chaos.

Bernanke holds that another major negative of a gold standard is that it creates a system of fixed exchange rates between the currencies of countries that are on a gold standard. There is no variability as we have it today, he argues:

If there are shocks or changes in the money supply in one country and perhaps even a bad set of policies, other countries that are tied to the currency of that country will also experience some of the effects of that.

It seems that the Fed chairman is arguing in favor of a floating currency system. We suggest that Bernanke has overlooked the fact that in a free market money is a commodity, and a dollar or other similar currency as such is not an independent entity.

Prior to 1933, the name dollar was used to refer to a unit of gold that had a weight of 23.22 grains. Since there are 480 grains in one ounce, this means that the name dollar also stood for 0.048 ounce of gold. This in turn means that one ounce of gold referred to $20.67. Please note that $20.67 is not the price of one ounce of gold in terms of dollars as Bernanke and other experts are saying. “Dollar” was just a name for 0.048 ounce of gold. According to Rothbard,

No one prints dollars on the purely free market because there are, in fact, no dollars; there are only commodities, such as wheat, cars, and gold.[1]

Likewise, the names of other currencies stood for a fixed amount of gold. The habit of regarding these names as a separate entity from gold emerged with the enforcement of the paper standard. Over time, as paper money assumed a life of its own, it became acceptable to set the price of gold in terms of dollars, francs, pounds, etc. — the absurdity of all this reached new heights with the introduction of the floating currency system.

Contrary to Bernanke, in a free market, currencies do not float against each other. They are exchanged in accordance with a fixed definition. If the British pound stands for 0.25 ounces of gold and the dollar stands for 0.05 ounces of gold, then one British pound will be exchanged for five dollars. This rate of exchange is a result of the fact that 0.25 of an ounce is five times larger than 0.05 of an ounce.

A floating currency system of commodity money is no less absurd than the idea of a fluctuating market price for dollars in terms of cents. How many cents equal one dollar is not something that is subject to fluctuations. It is fixed forever.[2]

Once it is realized that in a free market money is a commodity, it is obvious that, in similarity to other goods and services, its exchange value cannot stay still but will vary in accordance with supply and demand.

Now, Bernanke argues that variability in the supply of gold could lead to instability. But why should this be the case? Does a change in the supply-demand conditions of various goods and services produce instability? All that we will have is a change in prices. Obviously, if the supply of gold were to increase strongly this will lead to an increase in prices in terms of gold. This increase in prices however, has nothing to do with inflation. (Inflation, an increase in money “out of thin air,” leads to an exchange of nothing for something — an act of embezzlement.) If the increase in the supply of gold were to persist, people would likely abandon gold as the medium of exchange and adopt another commodity.

According to the Fed chairman another problem with the gold standard is that it could trigger a speculative attack:

Now normally, a central bank with a gold standard only keeps a fraction of the gold necessary to back the entire money supply.… The British Central Bank only kept a small amount of gold, and they relied on their credibility to stand by the gold standard under all circumstances — so that nobody ever challenged them about the issue. But if for whatever reason, if markets lose confidence in your willingness and your commitment to maintaining that gold standard relationship, you can get a speculative attack.

A possible speculative attack is not a result of a gold standard but of the central bank abusing the gold standard by issuing paper money unbacked by gold. In short, the authorities were issuing unbacked-by-gold paper money, thereby undermining the gold standard.

Also in his speech Bernanke laments that a shortage of gold could lead to a general fall in prices, which could seriously damage the economy. For the Fed chairman, the fact that money is not growing is a disaster.

What matters is not the amount of money as such but its purchasing power. Hence with an expansion in real wealth the purchasing power of dollars will increase and every holder of dollars will be able to command more real wealth. A general fall in prices, which is labeled deflation, therefore permits more individuals to access an expanding pool of wealth.

Summary and Conclusion

Contrary to Bernanke, a gold standard that is not abused by the central bank generates stability. Boom-bust cycles are the outcome of central-bank policies that are aimed at stabilizing the economy. The alleged instability of economies during so-called gold standards in the past took place because the authorities were issuing unbacked-by-gold paper money, thereby undermining the gold standard.

This article was previously published at Mises.org.