Don't Crucify Our Economy on a Cross of Bad Economics

Creighton Harrington
Aug 27, 2012 at 6:18 PM

I ran across this article by Matthew O'Brien of The Atlantic where he goes on a predictable tirade against the evils of the gold standard. Why, if we disallowed central monetary planning, then we'll be leaving market decisions to the market. God forbid!

This article reeks of the arrogance of mainstream economists who can pull the statistical blanket over their eyes, ignore fundamental economic principles, and consolidate all the variables of life into one graph (in this case, "2 charts"). 

First and foremost is this paragraph,

Why would anyone want to go back to the bad old days? The gold standard limited central banks from printing money when economies needed central banks to print money, and limited governments from running deficits when economies needed governments to run deficits. It was a devilish device for turning recessions into depressions.

I hate to be the person that has to point this out to O'Brien, but the period between 1800 and 1900 experienced, not only in America, but the entire world, the greatest economic growth in the history of mankind.  This period was also a time when America was on a gold standard of some form.  Indeed, for a large part of it, the money in circulation was not merely paper backed by gold, but literally the gold itself.  In light of this, the fact that central banks were restricted in monetary expansion and governments were restricted in deficit financing hardly seems to be the historical point that bears repeating.  Indeed, if anything, O'Brien is undercutting his own argument if it is promoting loose fiscal and monetary policy.

O'Brien is coming from the mainstream macroeconomic perspective that the solution to economic downturns is to boost aggregate demand.  The specifics of how people are spending money, or why the depression even occurred, is irrelevant, the only thing that is important is that the government and the Fed do whatever they can to boost aggregate demand.

Essentially he is arguing that economics recessions are a product of natural free market economies.  The only solution is to artificially make up for the fact that these downturns will occur and this must be done through monopoly control of money and massive amounts of spending with money that no one has.

Recessions are not natural by-products of free markets.  They are a result of interest rate manipulation in an effort to boost economic growth in the first place.  Sheldon Richman, in a recent Reason article, explains,

...central-bank inflationary policies that artificially depress interest rates encourage longer-term production activities that wouldn’t have been undertaken otherwise, given the level of real saving. When the boom ends, the malinvestment of labor and resources is revealed. Labor, equipment, and land that had been attracted to production inconsistent with true consumer demand must now be rearranged. The misshapen economy must be permitted to assume a more appropriate shape. But that takes entrepreneurial risk, time, and money (savings). If the correction is to occur quickly and with minimum hardship, the government must get out of the way. In particular, it must not keep interest rates artificially low (discouraging saving) or create uncertainty about the future regulatory and tax regimes. The world is uncertain enough; to the extent government increases uncertainty about regulation and taxation, investors will be encouraged to run in place and not make grand new commitments. This prevents the needed effort to align labor and resources with what consumers want (or will want in the future). 

Government spending may stimulate the use [of] idle resources, but that’s not good enough. We don’t want just any use of [resources]—they’re scarce, after all. We want uses that consumers would approve of. Politicians, whose decisions face no market test, are clueless in that regard.

In other words, the very solutions that O'Brien claims the gold bugs wish to deny an economy to use are the underlying cause of the recession in the first place.

A Flawed Conception of Inflation

Part of O'Brien's argument, the straw man that gold bugs don't care about recessions qua recessions, but that the larger evil they fear is inflation, is "refuted" through his use of historical CPI data.


If gold bugs merely want to escape inflation, then this graphic is damning isn't it?  Even more so when equally coupled with this graphic:


Hold your horses.

Inflation is not merely a rise in the price level or, using CPI data, the rise in the price level of a basket of goods. Inflation is the increase in the supply of money.  Rising prices are a result of this increase.

This is a fatal flaw in the use of the CPI as a measure of price increases in that should the CPI be unchanged, the supply of money can be increasing.  Murray Rothbard, in his excellent work America's Great Depression, pointed out that, prior to the depression itself, the level of prices remained relatively stable while the supply of money was increasing.

The important thing to remember is that prices do not exist merely to make middle-aged housewives have to cut coupons, they serve the purpose of directing the flow of resources among the infinite array of possible uses that a modern economy can make of them.  More than that, they must direct the flow resources across time, which is achieved through the interest rate.

Ceterus paribus (meaning absent manipulation of the supply of money), a decrease in the price of consumption goods (or goods in the present) is a result of a decrease in time preferences or an increase in the demand for goods in the future.  This shifting in the structure of supply and demand should tell resources to move away from consumer goods industries and, instead, be focused on capital goods industries.

However, and this is where the CPI is at a loss, should the underlying valuations of consumers be in such a shape, an increase in the money supply would cause prices that should be declining to remain relatively stable.

Recessions are a reaction.  The cause is artificial economic booms.  Both of these, booms and busts, do their work through movements in prices.  Booms result from artificial interest rate manipulation and cause resources to go towards ends that are impossible to sustain.  The resulting crash is the market trying to reallocate resources, through price changes, along lines that actual supply and demand are trying to dictate them to go.

Think about what total price stability means.  Consumer valuations are changing all the time.  The demand for any particular good fluctuates radically in the period of a day, let alone decades.  Price stability, absent money supply manipulation, would mean that consumers experienced no change in their valuations.  They would become robots, the world would merely repeat itself in one endless round of production to satisfy the same ends over and over.  No new products could be created to upset the even rotation.  No increases in the standard of living.  Nothing.  The world would have to become static.

Rather than be afraid of price increases, gold bugs, if that is what we want to call people who want to restrict the Feds ability to manipulate the supply of money, would rather that the Fed, and mainstream economists, be the ones who get over their fear of inflation.  Let prices do their job and allocate resources.  If that means they have to increase, then they have to increase.

Ultimately, money, whether tied to gold, copper, platinum, or cows, should be result of the market, not Washington.  It should do its job of easing the trade of goods.  It should not be assumed to be able to be manipulated and magically create wealth as a result.

O'Brien doesn't want us to "crucify our economy on a cross of gold."  He'd rather we "crucified" it on a cross of bad economics and the Federal Reserve.

Milton Friedman warned that a return to the gold standard must be accompanied by a 100% reserve requirement or at least a really high reserve ratio. From my reading, a lot of Austrian economists agree. I wonder...should we first try to raise reserve requirements first, before focusing on a return to a gold standard?

Prescience500's picture

I'd say the best solution would be to remove legal tender laws and allow the market to choose the money.

If we are looking to have the gold standard be a way to hinder the Fed's ability to just print money out of thin air and the government's ability to borrow without limit, then the reserve requirement isn't necessarily important (in this context).  By that I mean that tying the dollar to any commodity will cause the Fed to have to turn off the presses to some extent.

It won't cause them to stop completely and I would like to see a 100% reserve ratio, but that is not going to happen any time soon.

Creighton Harrington's picture

I sort of agree, but the gold standard we used to have didn't work either, even before the Fed. Banks print too much money and every so often there would be a bank run and following depression. Thanks to the relatively free market that doesn't exist today, they didn't last as long as modern downturns. Also, the gold standard combined with the fed was one of the major factors in the Great Depression. The gold standard of the Bretton Woods system failed because the federal reserve wouldn't stop printing money. The result was a near monetary collapse, stagflation, and a move to fiat currency.

I have two ideas. We could deregulate the banks in a big way while raising reserve requirements in such a way that that the total act would be neutral. The banks wouldn't be any more or less profitable. The second idea is that we could also make banks publish and even advertise their total reserve ratio and the reserve ratio for each account. Banks will raise their actual reserve ratio so that people don't freak out when they see how low it is. My second idea would not only neuter some of the federal reserve's ability to affect the economy, but it could work well with any commodity standard, should the government decide to return the dollar to it.

Prescience500's picture

I do think that inflation has made basic units of currency ever more meaningless. However, to return to the gold standard can be more difficult than one might imagine. First, in order to value all goods and services in terms of vaulted gold one will need to chain weight all prices to a previous value and try to peg the dollar to a specific gold value per ounce. Thus, either you inflate the already uncomfortably expensive gold or you try to increase its supply which is very hard to do. I would not ignore that the pegged standard can be beneficial, but it might be difficult to put in place and it will throw the economy in a short-run chaos. Also, inflation, if kept at a minimum, can help soothe out the business cycle and its effect on the populace will be faster. However, it will help limit the confusion between real growth and price hikes

ramosmercado's picture