Wednesday, August 29, 2012

The Republicans and the gold standard

by Michael Roberts

A row has broken out over the decision of the US Republican party to set up a commission to investigate the possibility of the US returning to the gold standard.  Under a gold standard a unit of national currency is defined in terms of unchanging weights of gold.  There is a gold bar standard—where currency is redeemed in the form of bullion—or a gold coin standard—where the currency is redeemed in the form of full-weight gold coins.

Under a gold bar standard, only large amounts of currency are convertible into gold bars of considerable weight.  After World War I, governments (with the exception of the U.S. government, which maintained a gold coin standard) adopted a gold bar standard and the coinage of gold largely ceased as the central banks attempted to conserve the gold bullion in their vaults.  Governments came off the gold standard during the Great Depression and it was only re-established in a limited form in 1944 when the US dollar was pegged to a fixed price of gold under the Bretton Woods agreement, a gold bullion version.

Doyen of the Keynesian school and hammer of the Republicans, Paul Krugman was almost apoplectic at the news that the Republicans were considering a return to the gold standard to fix the value of the dollar.  By returning to what Krugman has called a ‘barbaric metal’ to fix the value of currencies and trade, Krugman reckons that the Republicans are basically mad.  However, the Republicans see it differently: “There is a growing recognition within the Republican party and in America more generally that we’re not going to be able to print our way to prosperity,” said Sean Fieler, chairman of the American Principles Project, a conservative group that has pushed for a return to the gold standard.  Supporters of the gold standard see it as a way of keeping the dollar strong, controlling inflation and ending the power of the Federal Reserve to control the money supply.
But Krugman claims that the argument that allowing the Fed to ‘print money’ and having a flexible currency is a recipe for runaway inflation is “wrong, wrong, wrong.”  After all, inflation remains low and exchange rate flexibility has “been crucial to most of the success stories of the crisis, from Poland to Sweden to Iceland” (unfortunately, he can only cite just a small number of Northern European economies as ‘success’ stories).
Even if exchange-rate flexibility has had limited success, the idea of returning to the gold standard would put the “clock back two centuries, not just one.” says Krugman. That’s because the Republicans are not only considering returning to the gold standard by pegging the value of the dollar to the gold price, but even fixing the amount of dollars in the economy to the amount of gold in the vaults of the Federal Reserve, something not done since the 18th century.
Some form of gold standard for the dollar was in operation, with occasional interruptions, from 1789 until 1971.  And there was a long period when the US had no central bank. The US abolished its central bank in 1836 and did not revive it until 1914.  And licensed banks were able to print their own paper currency from 1789 until 1862.

Did it work?  Well, the price level stayed pretty static from 1780 to 1933.  That suggests it did.  There was just one problem.  The US economy still experienced wild swings in the business cycle with depressions occurring in every decade. Some of these depressions were nearly as bad as the Great Depression.  So all was not well under the gold standard, just as it has not been without it.
Ben Bernanke, the chairman of the Federal Reserve, made his name as an economist in deriving the cause of the Great Depression as being due to wrongheaded monetary policy, in particular, the decision of the Republican government of the day to stick to a ‘rigid’ gold standard when other countries had left it and devalued their currencies to boost exports and economic growth.  In a speech in 2004, Bernanke reiterated his view of the gold standard as the main cause of the Great Depression (see Money, Gold and the Great Depression, Federal Reserve Board, 2 March 2004).

Such a conclusion is vehemently rejected by those economists who belong to the Austrian school and to whom the Republican leaders now turn for theoretical support.  Murray N Rothbard is the modern guru of Austrian economics, the successor to Von Mises and Hayek.  In a paper entitled, Economic Depressions: their causes and cure (see, Rothbard presents the Austrian case very clearly.  But the very first premise of Austrian economics as presented by Rothbard means that it falls at the first fence.  Rothbard says “General economic theory teaches us that supply and demand always tend to equilibrium in the market and therefore prices of products as well of the factors that contribute to production are always tending toward some equilibrium point”.  Starting from that false premise, you are on a hiding to nothing, as Steve Keen’s excellent refutation of ‘equilibrium’ supply and demand economics shows (see his latest edition of Debunking Economics – Revised and Expanded Edition: The Naked Emperor Dethroned?).

But Rothbard contrasts what he religiously believes to be the evident truth that free markets tend towards equilibrium with that of Karl Marx who reckoned that “business cycles were an inherent feature of the capitalist market economy”.   Rothbard argues that there “is nothing in the general theory of the market system that would account for regular and recurring boom and bust phases of the business cycle”.   That’s right – there is nothing in mainstream economics to explain crises.  But Rothbard sees this as good news, not bad.  According to him, “the market economy is a profit and loss economy (that’s true), in which the acumen of and ability of business entrepreneurs is gauged by the profit and loss they reap (except bankers, it seems).  The market economy continues a built-in mechanism, a kind of natural selection, that ensures the survival and flourishing of the superior forecaster and weeding out inferior ones. So we would not expect the market economy to show losses.”

Then Rothbard poses the big question: if, in theory, the market economy should avoid depressions and losses, how come the capitalist economy regularly experiences “steep depressions” and “severe losses”?  The problem is the nature of banking.  Rothbard turns to the classical economist David Ricardo who argued that banks had capacity to expand credit and the money supply without being fixed to the amount of deposits they took in.  Thus they opened up the possibility of excessive credit.  By expanding credit beyond the cash deposits or gold reserves they had, banks could create a credit bubble that would burst when they did not have enough deposits or reserves (in gold) to cover obligations.  So the boom would then turn to slump.

But, says Rothbard, this does not mean that the ‘free market’ is the culprit of crises after all.  You see, in the free market, proper competition between the banks would quickly force those lending too much or lending too little to reverse policies and so stop any bubbles or depressions lasting long.  Competition would force them in line.  A problem only arose when ‘a governmental bank’ is set up with a monopoly over the money supply and government borrowing.  This central bank can keep driving up credit without the ‘free market’ in banking being able to stop it.  Then banking system assets get way out of line with liabilities (deposits and gold reserves).  So “the business cycle is brought about, not by any mysterious failing of the free market economy, but by quite the opposite: by systematic intervention by government in the market process.”

Even worse, this government-driven credit expansion drives down the rate of interest for borrowing to invest to artificially low levels and thus causes ‘over-investment’ in the productive sectors.  Eventually, available savings (profits) are not sufficient to meet these investment commitments and a crisis or slump ensues.  Thus, for the Austrians, all blame is at the door of government.  A free market would bring investment into line with savings and all would be well.

From this flows the policy prescription that the Austrians advocate when an economy is in a recession or depression.  Rothbard puts it baldly: “what the government should do is absolutely nothing”.  The Austrian prescription is “the exact opposite of the Keynesians: it is for government to keep absolute hands off the economy and confine itself to stopping its own functions and to cutting its budget”.
This is the theoretical connection between the Republican idea of a return to the gold standard and implementing ‘Austerian’ policies on government spending.  The Austrians argue that the Great Recession was the result of excessive credit expansion engendered by the Federal Reserve, as was the Great Depression.  The answer is not to let the Fed create yet more money or for the government to borrow yet more money, to be funded by Fed QE programmes.  No, it is the opposite: cut Fed monetary support for the banks and the economy and ride out any bank failures and sky-high unemployment until the proper relation between savings (profits) and investment are restored.

And in the future, the Fed should be abolished and private banks should set their own interest rates and print their own money.  Bank reserves should be fixed in value to the price of gold and better still made up of only gold bullion or coin.  So the gold standard should be a proper one, not a halfway house.  A gold standard that just applies to international transactions (as Bretton Woods did from 1944 to 1971) is inadequate; it must be applied to domestic transactions within an economy without interference from a central bank or government.  Then the ‘free market’ can set prices and the value of currencies ‘automatically’.  And as free market prices ‘tend to equilibrium’, contrary to Marx’s view, this will end boom and slumps in the economy.

Actually Marx would agree to some extent with this.  Marx explained that, under capitalist commodity production, money must be a commodity before it can become money. This means that in order to function as money, the money commodity must have value in capitalist production. Fixing the value of money by fiat cannot work, while leaving production to the anarchy of the profit system. He criticised the 19th century Currency School that claimed a forced contraction of gold supply would lead to a drop in general prices and vice versa.  On the contrary, Marx reckoned the general conditions of production set prices and the demand for money (gold).  Trying to fix the quantity or price of gold by dictat would only exacerbate booms and slumps.

But what would the imposition of a gold standard mean in practice right now?  Well, a troy ounce of gold is currently worth roughly $1650.  So for the US to return to a gold standard, Congress would have to pass a law which fixes that price in perpetuity.  To maintain that fix, the Fed/Treasury or private banks would have to acquire enough gold to “back” the currency. Banks or the Fed would have to stand ready to exchange gold for money and money for gold at the fixed price in unlimited quantities at any time.  They would have to be prepared to stem a run on the dollar (a “gold drain”) by raising dollar interest rates and reducing the dollar money supply until banks are induced to buy dollars with gold at the fixed price, even if that requires a major and prolonged deflation/depression.

The foreign exchange value of the dollar would be entirely subject to the price of gold.
The problem is that the price of gold would not be stable but dependent on its own supply and demand, in other words on the productivity of gold mining and the reserves held by national governments.   And history shows that this is not stable.  The graph below shows the gold price relative to US inflation – not much stability there!  The price of gold is eight times the real value of the dollar.  So the dollar is historically weak in terms of gold.  If the Republicans fixed the dollar to the current price of gold, they would be ensuring a very competitive dollar in world markets – something other capitalist governments may not appreciate.  If they fixed the dollar at a lower gold price, they would strengthen the dollar for years ahead, probably damaging exports and depressing production and prices.

Barry Eichengreen is a mainstream Keynesian economist.  In an article last year, A Critique of Pure Gold, in the journal, The National Interest, (Sept-Oct 2011 issue), Eichengreen made a critique of the Austrian view. What worries Eichengreen, as it did Keynes, is that the Austrian policy prescription of ‘inaction’ threatens to provoke social revolt and instability: “pain would be meted out to the innocent as well as the guilty, with workers thrown out of their jobs in resulting recessions as well as financiers who see their portfolios shrink”.  Anyway, inaction is unnecessary because “we have learned how to prevent a financial crisis precipitating a depression through the use of monetary and fiscal stimuli”.
But have we?  That is just what the Austrians are denying.  Look at the failure to reduce high unemployment in the last four years despite fiscal stimulus, bank bailouts, quantitative easing and interest rates near zero.  Eichengeen says the reason for the failure of Keynesian policies is that they have not been applied sufficiently.  We need to double government borrowing and QE measures!  All we have done so far is “prevented the financial system from collapsing, the economy from falling off a cliff and the Great Recession not turning into a Great Depression”.

But even that is in doubt.  The Long Depression we are now in is measured by low economic growth, high unemployment and falling real incomes.  So where is the recovery?  Is it just another bout of fiscal stimulus and QE away (as Eichengreen argues)?  Or does it require the massive deleveraging of debt and the devaluation of dead capital (as the Austrians might even agree with the Marxists)?
The gold standard idea has the merit of recognising that, unless money becomes a commodity, it has no anchor to value.  If dollars can be ‘created out of thin air’ and their number bear no relation to the value of production in the economy, then credit becomes ‘fictitious’ and will only increase the burden of the devaluation of capital when a slump arrives.  But Eichengreen can score against the Austrians on the gold standard.  A return to the gold standard that deliberately aims to reduce credit induced ‘inflation’ by forcing up the value of the dollar at the expense of more unemployment and bankruptcies in industry is just as damaging as runaway inflation: “the distributional effects of deflation are no happier than those of inflation.  In this case, the debtors with obligations in nominal terms (that’s most of us) are unable to protect themselves.” When the US returned to the gold standard after the post civil war boom of 1864-79, what followed was the Great Depression of 1880s and farmers were driven into bankruptcy by falling prices.  Of course, like Bernanke, Eichengreen puts the depression down to the introduction of the gold standard and not to the overaccumulation of capital in the productive sectors, that took place from the mid-1870s.

Eichengreen argues that the “proponents of the gold standard thus face a Goldilocks problem; the porridge must neither be too hot nor too cold but just right” otherwise the dollar-gold price could cause deflation or inflation.  In response, Hayek, Von Mises or Rothbard would say that the ‘free market’ would ensure the equilibrium necessary (this is nonsense, of course).  And the Goldilocks argument also applies to Keynesian prescriptions: just how much fiscal and monetary easing will boost the economy without inflation and when should stimulus be replaced by restraint?  How can we get it right under the anarchic system of capitalism?

But Eichengreen continues: “There were repeated booms and slumps, frequently culminating in financial crises, especially in the US in periods when there was a gold standard and no central bank.”  Why? Following Hyman Minsky, Eichengreen says it was because the banking system allowed too much credit to be created.  There is an intrinsic instability caused by ‘fractional banking’ where credit outstrips deposits and reserves.  Fractional banking only works as long as there is ‘confidence’ in the banking system.  To protect against a loss of confidence, the banking system needs the backing of government through a central bank as a ‘lender of last resort’.

In a way, Austrians and Keynesians agree: the cause of booms and slumps under capitalism is not to be found in its mode of production for profit, but in the inherent instability of the banking sector.  The answer to this for the Austrians is a ‘free market’ in banking, doing away with any central bank fixing interest rates or the value of the currency.  Allow banks to print their own money and compete while national currencies are fixed to the flow of gold between national economies.  The answer of the Keynesians is less ‘free market’ in banking and more control of banking through government and a central bank, while allowing currencies to change without being fixed to any commodity with real value. Keynesians reckon the role of a central bank will be beneficient because it will ameliorate the booms or slumps of the capitalist economy by changing the price of money (interest rates) or the quantity.  The Austrians reckon that central bank action is damaging and actually causes boom and slumps.

The reality is that both are wrong.  As I explained in a previous post (Paul Krugman, Steve Keen and mysticism of Keynesian economics, 21 April 2012), money is ‘endogenous’ to a capitalist economy.  In other words, central banks do not control the supply and cost of money.  It is a result of the demand for money in the whole economy.  The boys and girls of Modern Monetary Theory recognise this, except they think the demand for money is set by some psychological process of ‘confidence’ or ‘animal spirits, or because of Minskyian-type ‘instability’ in finance.  Marxists reckon the demand for money or credit is related to the accumulation of capital in production and that ultimately depends on profitability.  Profits call the tune (see my post, 26 June 2012).

Eichengreen is keen to tell us that even Hayek concluded that the gold standard was no solution to avoiding booms and slumps. He quotes Hayek that “there could be violent fluctuations in the price of gold if it were again to become the principal means of payments and store of value, since the demand for it would change dramatically, owing to shifts the state of confidence or general economic conditions.”  Exactly, as Hayek admits, it is the “general economic conditions’ that matter, not trying to hold the banking system to some fixed standard of value.  And these general economic conditions will vary according to the laws of motion of capitalism, particularly the law of profitability, something both the Keynesian and Austrians ignore.

Of course, for Hayek, those general economic conditions “tend to equilibrium”, so all we need to do is let private banking print their own dollars and market competition will ensure it does not get out of hand.  So we are back full circle to religious belief of the Austrians and mainstream economic theory that a ‘completely free market’ (a religious dream) would deliver a growing and prosperous economy without booms and slumps.

It is an irony that it was a Republican president that ditched the US gold standard back in 1971.  And, despite the talk, the Republicans now will not readopt the gold standard and abolish the Federal Reserve, despite the encouragement of the Tea Party, Ron Paul and the Austrians.  First, they are in the pockets of finance capital and the likes of Goldman Sachs, Bank America, JP Morgan and Citicorp have a cosy arrangement with the Treasury and the Fed.  Government saved them from bankruptcy and is there to protect them from any future cock-ups and preserve their oligopolistic status.

Also, the US is no longer the hegemonic capitalist power in the world that it was in 1944 when it fixed the dollar price of gold and forced other capitalist economies to recognise a strong dollar.  That hegemony was broken in 1971.  The US remains the largest single gold holder and that still gives the dollar the edge over other currencies, but the Eurozone has even more gold and the likes of China, India and Russia are increasing the gold reserves fast.

The Republicans will have to continue with the ‘half-baked’ prescriptions of Keynes and Milton Friedman.

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