One of the articles I read in graduate school that persuaded me that a gold standard would be inefficient was Milton Friedman’s “Commodity-Reserve Currency,” published in the Journal of Political Economy in 1951 and later reprinted in his Essays in Positive Economics.
Back in 1999, Lawrence H. White had an excellent critique of Friedman’s point. The bottom line is that Friedman is way, way off.
In summarizing both Friedman’s point and his own critique of Friedman, Larry writes today:
Milton Friedman (1951, 1960) provided influential back-of-the-envelope estimates of the costs devoted to extracting gold under what he called a “strict” gold standard. I have criticized those estimates elsewhere (White 1999, pp. 42-48) for exaggerating the volume of gold reserves used by actual gold-standard economies, and thus exaggerating the resource cost. Friedman’s estimates assumed a 100 percent gold reserve ratio against demand deposits (1951) or against all bank deposits (1960), whereas sophisticated banking systems in gold-standard economies historically operated on small prudential reserve ratios (as he elsewhere recognized). Plugging a historically observed 2 percent reserve ratio against all the bank liabilities in the broad monetary aggregate M2, rather than Friedman’s 100 percent, yields a resource cost estimate one-fiftieth of his 1960 figure, namely 0.05 percent rather than 2.5 percent of national income.
This is from his “The Resource Costs of Fiat Money Are Now Higher Than Those of a Gold Standard,” Alt-M, December 17, 2019.
It gets worse. Larry goes on to point out that the fear of inflation generated by a fiat money system leads people to hold a lot of gold. How much gold? He continues:
Recent data on gold production from the World Gold Council (2019) allow us to revisit the question with something better than casual empiricism, and to reach a conclusion.[1] Plugging recent numbers from the World Gold Council into Friedman’s own model, it is fairly clear that gold coins and bullion in recent years have been produced in greater volumes than would have been the case under a gold standard with reasonable prudential reserve ratios, and thus gold-extraction resource costs have been higher under fiat money in practice. Note that this accounting effort provides an underestimate of the total resource costs induced by fiat money, because it neglects the costs incurred in acquiring silver, collectibles, cryptocurrencies, and other inflation hedges.
In the rest of the article, Larry gives the numbers that back his claims. He sums up:
These estimates indicate that the historical switch from gold to fiat standards, contrary to the sincere hopes of Milton Friedman and other advocates of the switch, has increased the resource costs associated with the production of gold coins and bullion. Perhaps this was avoidable. The establishment of trustworthy non-inflationary fiat money systems (as Friedman of course prominently advocated) might have given private citizens no reason to invest in gold coins and bars, and might have brought a resource cost saving over the gold standard. But that experiment has not been run.
One small numerate criticism. Larry writes:
When President Richard Nixon “closed the gold window” to end what remained of gold redemption of the US dollar on August 15, 1971, the official par value was $35 per ounce, while the market price had floated to $44.60. In the last half of 2019, with fiat standards prevailing around the world, the price of gold has hovered above $1450 per ounce. The ratio of $1450 to $44.60 means that the dollar price of gold has risen more than 32-fold since August 1971.
But the increase is not a “more than 32-fold increase.” It’s more than a 31-fold increase.
READER COMMENTS
AJ
Dec 17 2019 at 4:44pm
Why is it ‘more than a 31-fold increase’ and not 32? Larry’s number seems to make more sense…
robc
Dec 17 2019 at 7:06pm
Doubling is a 1 fold increase, tripling a 2 fold. 32upling is thus a 31 fold increase.
artifex
Dec 18 2019 at 1:45am
The increase is actually more than a 32-fold increase, in the most common sense (for example, see Wiktionary’s usage note about the -fold suffix, or Merriam-Webster’s online website). So Larry is not wrong. Since it is ambiguous, though, best to avoid using it when qualifying an increase.
Rob Rawlings
Dec 18 2019 at 9:39am
Yes, I agree. There seems to be general consensus that there is no such things as a ‘one-fold’ increase and Webster’s agrees (https://www.merriam-webster.com/dictionary/twofold) that a two-fold means to double.
David Henderson
Dec 18 2019 at 6:23pm
Actually, your Merriam-Webster link doesn’t at all say what you say it says. It doesn’t even address the issue of what a two-fold increase means. Take a closer look.
Rob Rawlings
Dec 19 2019 at 12:22pm
One of the definitions given is ‘being twice as great or as many’ and one of their examples of usage is ‘a twofold increase in spending’. I am missing why this fails to address ‘the issue of what a two-fold increase means’.
David Henderson
Dec 19 2019 at 3:09pm
Rob, The dictionary gives as an example of the use of the word in a sentence, “a twofold increase in spending.” It doesn’t even hint that means that spending doubled.
Rob Rawlings
Dec 19 2019 at 6:10pm
I agree that the definition given does readily lead one to conclude that spending doubled in the sample they give but I’m not sure that is relevant.
Your quibble is with the following sentence:
‘The ratio of $1450 to $44.60 means that the dollar price of gold has risen more than 32-fold since August 1971.’
Suppose in year 1 the price had increased to $89.20 and someone had written ‘ the dollar price has risen to a level two-fold its previous level’. You would presumably have quibbled this as in fact only a one-fold increase?
OK, then taking the dictionary definition for two-fold as ‘twice as great [as]’ and plugging into this sentence one gets ‘The dollar price has risen to level twice as great as its previous level’.
I do not see how (given the definition from Merriam-Webster) one could not concede this can only mean a doubling (and trebling) of price.
Rob Rawlings
Dec 19 2019 at 6:11pm
‘I do not see how (given the definition from Merriam-Webster) one could not concede this can only mean a doubling (NOT trebling) of price.
David Henderson
Dec 19 2019 at 7:34pm
Rob, I think we’re converging.
You wrote:
No, I wouldn’t have “quibbled” at all. It rose to a level that is tw0-fold its previous level and it’s a one-fold increase.
You wrote:
Exactly. We’re agreed.
Rob Rawlings
Dec 19 2019 at 10:17pm
Thanks.
Turns out there is a wikipedia page on the subject (https://en.wikipedia.org/wiki/Fold_change).
From what I gather referring to a doubling of something as either ‘a two-fold change’ or a ‘one-fold change’ are BOTH correct but the latter apparently ‘has generally fallen out of use’.
Thaomas
Dec 17 2019 at 7:41pm
And why might people not hold gold because they feared that the gold standard might me abandoned or the gold reserve rations lowered in favor of a system in which the monetary authority targeted a super-optimal rate of increase in the price level? History certainly has plenty of examples of corrupt commodity standards (country going on and off the standard, varying the ratios in bimetallic standards, etc.)
Matthias Goergens
Dec 18 2019 at 12:47am
The people at Alt-M would favour something like a private gold standard, where there’s no monetary authority. It’s just private contracts enforced by courts (and reputation). Those private contracts are harder to change by government fiat than government policy and commitments.
Most of the writers at Alt-M explicitly don’t like the interwar gold standard that has more of the problems you write about. There were systems before WWI in some parts of the world that better approximate that private ideal.
Such a private system for example doesn’t have an official reserve ratio. Banks that emit notes just decide on how many reserves they need. (Look into the Canadian and Scottish free banking episodes for how that looked like. Or the English private token coinage that George Selgin wrote about in Good Money.) That’s also where the 2% figure comes from.
As an historic aside, the 2% (voluntary!) reserve ratio is much smaller than the 10% eg the Fed demands. But those Scottish banks voluntarily chose to hold roughly 30% equity on their balance sheets. That’s much more than the ~8%-ish the regulators demand today, and that the banks spent a lot of effort and brainpower on working around.
IMHO, a thick capital cushion is more important in a bank than reserves. That way your money is essentially backed by the productive capital of the economy that the banks lend against; not by gold or cash in vaults (or numbers at the Fed).
Warren Platts
Dec 17 2019 at 8:50pm
Very interesting post. That increase in the price of gold reflects the decline in purchasing power of the USD (that is supposedly overvalued!) But, I guess they want a certain amount of inflation at about 2% per year. For reasons I don’t understand. But as a geologist, I can say it would be very difficult to dig up enough gold to support 2% inflation per year…
Thaomas
Dec 18 2019 at 7:38am
The 2% target is based on the idea that some prices are difficult to adjust downward so that a certain amount of general inflation allows more flexibility in relative prices than zero inflation.
Warren Platts
Dec 24 2019 at 4:08am
Hmm.. You mean like wages? People don’t like accepting wage reductions, thus a bit of inflation allows wage suppression without people even realising what is going on. Yes, that makes sense. Indeed I recall reading something in Mankiw that said something like that..
Todd Ramsey
Dec 18 2019 at 9:43am
The analysis is marred because it ignores the desire of individuals in rapidly growing countries, like China and India, for example, to hold gold as an easy-to-hide store of value.
The analysis itself highlights the vastly increased share of gold production going to private investment holdings.
It’s likely that individuals in these countries are holding gold not as an inflation hedge, but rather as protection against government seizure.
For the same reason, Bitcoin production and holding have increased massively over the same time period. Surely White doesn’t think Chinese individuals are holding Bitcoin as an inflation hedge.
Alexander Turok
Dec 18 2019 at 1:12pm
This assumes that there will be no fears of inflation under a gold standard. But inflation is clearly possible, and many examples can be seen historically, such as the discovery/looting of the Americas. People will fear gold discoveries or shifts in demand in gold because it goes in and out of fashion for jewelry, shifts in demand because countries go on or off the gold standard, ect.
Nick
Dec 20 2019 at 8:07am
Strict gold standard means central bank is willing, in up to practically infinite size (bank has either bought all the gold, or has taken in all the money), to exchange money for gold in either direction (perhaps with some spread) ?
The idea that owning only 2% of the monetary base as gold would satisfy this seems implausible (100% seems certainly enough). as a result it would seem the bank would have to set the price of gold extremely high such that it was a much higher fraction of the monetary base and then no one would have a desire for gold (or they accumulated enough gold).
A side effect of that would be huge private resource spent on gold mining. if the only purpose of the gold mining is to increase the store of gold at the central bank then huge resource is spent on something that is essentially unproductive.
only once you truly trusted that it was credible would the amount of gold reserves required be very low, however if it was truly trusted you wouldn’t need the reserves at all.
David Seltzer
Dec 21 2019 at 2:53pm
I suspect the resource costs of cryptocurrencies are less than fiat money and an established gold standard.
Warren Platts
Dec 24 2019 at 4:01am
Actually it is the opposite: surprisingly perhaps, bitcoin, at least, actually burns up more energy than gold mining does these days!
https://www.weforum.org/agenda/2018/11/study-reveals-that-bitcoin-mining-uses-as-much-energy-as-mining-for-gold/
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