The Fall and Rise of the Gold Standard
by Antal Fekete
October 20, 2005
Abstract
Our revisionist theory of the gold standard takes the bill market
and the discount rate into full account. Greater availability of
gold is no cause for inflation. The new gold flows to the bill market
lowering the discount rate, which quickly puts a greater variety
of consumer goods on the shelves of retail shops preventing prices
from rising. Nor is reduced availability of gold cause for deflation.
The gold is withdrawn from the bill market raising the discount rate,
which quickly eliminates marginal merchandise from the shelves, preventing
prices from falling. Rising prices are never the result of an abundance
of gold: they are always the result of scarcity of goods, such as
that caused by misguided credit policies of banks discounting financial
bills which are not backed by maturing consumer goods. Falling prices
are never the result of a scarcity of gold: they are always the result
of an overabundance of goods, such as that caused by misguided government
policies creating unemployment.
Unevenly rotating economy
The gold standard can only be understood in the context of its clearing
system, the bill market, trading real bills that move in a direction
opposite to the flow of maturing goods to the final gold-paying consumer.
Authors who are looking at the gold standard in isolation got the
wrong perspective. They have to invoke the quantity theory of money.
The trouble with it is that while it could explain linear changes,
it is helpless to explain non-linear phenomena such as dynamic changes.
Whenever Mises talked about an "evenly rotating economy," he had
to rule out dynamics. To this extent his opus is unfinished and can
only be completed by extending it to the "unevenly rotating" or dynamic
economy, wherein the quantity theory of money no longer applies.
The evenly rotating economy is strictly an abstraction that, by Mises'
own admission, nowhere exists in reality, not even as a first approximation.
Classical theory of the gold standard
There is a natural tendency to minimize gold flows across international
boundaries. Balances are settled, not through gold remittances, but
through arbitrage in real bills. Arbitrageurs buy bills in a country
running a deficit and sell an equivalent amount in a country running
a surplus, to take advantage of the favorable spread in the discount
rate. This arbitrage is particularly effective if one country acts
as a clearing house, as England did prior to World War I.
This observation invites the following critique of the classical
theory of the international gold standard, according to which gold
flows from a deficit to a surplus country inducing changes in the
relative price levels. In more details, as this theory would have
it, prices fall in the deficit country and rise in the surplus country.
Higher prices are supposed to have the effect of discouraging exports
while encouraging imports, with the opposite effect for lower prices.
This process purports to explain the adjustment mechanism of foreign
trade. However, this pernicious theory has never worked in practice
but caused a great deal of monetary mischief in the world after Milton
Friedman persuaded governments to "float" their currencies in the
early 1970's.
Revisionist theory of the gold standard
In reality, the price level hardly ever responds to trade imbalances.
Economists have been at a loss to explain persistent trade deficits
and blamed the gold standard for the anomaly. They should have blamed
themselves and their flawed theories.
As our more sophisticated theory shows, if the supply of gold increases
in one country, then the new gold first flows to the bill market
where it will bid up the price of real bills. This makes the discount
rate fall. Shopkeepers respond by filling their empty shelf-space
with marginal merchandise. By the time the new gold trickles down
to the rest of the economy in the form of higher wages and greater
dividend income, the extra merchandise will be in place waiting for
the increased consumer-spending to materialize. Social circulating
capital expands and soaks up the extra demand for consumer goods.
There is no inflation.
Conversely, if the supply of gold decreases in a country, then the
gold is withdrawn from the bill market. Real bills are sold. That
makes their prices fall. The discount rate jumps. Shopkeepers respond
by eliminating marginal merchandise form their shelves. Neither gold
outflow nor increased gold hoarding will squeeze prices. They cause
the social circulating capital to contract as propensity to consume
declines. Marginal merchandise is no longer available in every grocery
store. The consumer who still wants it must search for it in speciality
shops and be prepared to pay a higher price for it as moving these
items can no longer be financed at the discount rate; it must be
financed through a loan at the higher interest rate. There is no
deflation.
Karl Marx talked about the "anarchy of the market" under the capitalist
mode of production, suggesting that producers act blindly and they
inevitably glut the market in expanding production. But as our analysis
shows, assuming that the discount rate is not distorted by the banks
and the government, producers and distributors have a sensitive inner
communication system, the bill market. They know that by the time
the new product reaches the shelves of the shopkeeper, the sovereign
consumer will be looking for it. They get their signals, not from
the rate of interest, but from the nimble discount rate. Its fall
is signaling them the impending increase in consumer demand.
Fundamental principle of retail trade
This, then, is the fundamental principle of the retail trade: the
adjustment mechanism which brings into balance the amount of gold
in circulation with the supply of consumer goods works, not on
prices but on the discount rate. The law of supply and demand
is inoperative. An autonomous increase in demand has no inevitable
effect on the prices of consumer goods but will, instead, lower
the rate of marginal productivity of social circulating capital,
i.e., the discount rate. The lower discount rate automatically
makes the supply of consumer goods expand.
By the same token, an autonomous decrease in demand will raise the
rate of marginal productivity of social circulating capital, i.e.,
the discount rate. A higher discount rate automatically makes the
supply of consumer goods shrink. There is no such a thing as an autonomous
change of supply in the retail trade. Supply is closely regulated
by demand through the mechanism of the bill market and the discount
rate.
The vulgar supply/demand equilibrium analysis cannot describe the
process of supplying the consumer with urgently needed goods. It
could not explain why prices were stable under the gold standard
even in the face of changes in demand. In a previous article I have
explained this phenomenon in terms of increasing economic entropy.
Coping with natural disasters
If a country is stricken with a bad harvest or by some other natural
calamity destroying property and consumer goods, then there will
be an immediate increase in the discount rate. Retail prices of consumer
goods will not rise inevitably. The stricken country, thanks to its
high discount rate, is an attractive place on which to draw bills.
This translates into an immediate influx of short-term credit from
abroad in the form of the most urgently needed consumer goods. Compare
this with the present system of politically motivated foreign aid.
By the time the amount and kind of aid is agreed upon by the negotiators,
the need may well shift. The gold standard is by far the best system
for the international division of labor in good times as well as
in bad. Governments have exposed their subjects to unnecessary deprivations
when they first sabotaged and then destroyed the gold standard and
its clearing system, the international bill market. Peoples of various
countries help one another to the fullest possible extent in case
of calamities, provided that they are allowed to cooperate under
the aegis of the international gold standard. Without its umbrella
peoples are pitted against one another in a bitter competition which
often drives them to war.
Coping with a gold avalanche
By the same token, the international gold standard and its clearing
system the bill market allows nations to share the windfall or godsend
that occasionally benefits one nation or another. Assume that the
output of gold mines increases by leaps and bounds, or that foreign
gold invades one country. It need not cause an increase in prices,
as predicted by the vulgar theory. Instead, it will benefit all countries
adhering to the international gold standard through a general lowering
of the discount rate, which will first drop in the country hit by
the gold avalanche. Suppliers will start drawing bills on foreign
countries with a higher discount rate. The increase in imports will
repel the invasion of foreign gold and expel excess domestic gold.
Social circulating capital expands as a result of the lower discount
rate. The spinoff from higher incomes due to the greater availability
of gold will be met by an expanded offering on the shelves of the
shopkeepers, who are able to display a great variety of goods thanks
to the lower marginal productivity of social circulating capital.
As excess gold is expelled, other countries will also start to benefit.
Now suppose that all countries except one close their Mints to gold,
and all the monetary gold in the world descends upon that one country.
Even in this extreme case there is no need for the prices to rise.
The rate of marginal productivity of social circulating capital will
be approaching zero. Retail stores will run out of shelf space and
start using the side-walks to display marginal merchandise. The greater
availability of gold will, in this case as in any other, call out
an even greater abundance of merchandise. Price rises are always
the result of a scarcity of goods, never of a greater availability
of gold.
A bumper crop is often considered a disaster by producers who blame
it for the collapse of prices. But it need not happen under a gold
standard. The cash crop is part of the social circulating capital
and when available in great abundance, marginal productivity will
be lowered making the discount rate fall. This allows new products
made of the same old ingredient to appear on the shelves. Furthermore,
exporters take advantage of the low discount rate and draw bills
on shipments of the bumper crop to foreign destinations. Instead
of slashing prices, the gold standard will increase market share
through slashing the discount rate. Everybody benefits.
Legal tender bank notes
It is true that scarcity is usually brought about by the banks and
the government through their interference with the free flow of gold
to the bill market, or with the free flow of merchandise across international
boundaries. An example of this is the world-wide inflation of 1896-1914.
World gold production increased at a prodigal rate after the opening
of the gold mines in the Transvaal. This in itself would not have
caused price increases if bill markets around the world had been
allowed to absorb the new gold. They were not. The banks intercepted
the new gold flowing to the bill market in order to construct a credit
pyramid upon their newly expanded gold reserves.
The bank credit, however, was not healthy. It was not self-liquidating,
as it would have if it had been based on real bills drawn on consumer
goods moving fast to the gold-paying consumer. Furthermore, governments
discouraged gold coin circulation instead of encouraging it. They
drove the gold into the banks, and changed the laws that originally
forbade the bank of issue to discount financial and treasury bills.
The note issue of the Reichsbank of Germany was made legal tender
in 1909. This event was the salvo that heralded the impending destruction
of the bill market. Within five years, by the time the war broke
out, the portfolio of most banks of issue consisted of financial
and treasury bills, where previously only real bills were eligible
for serving as reserves for the note issue. The bill market was paralysed
and never since allowed to make a recovery.
A direct consequence of the unhealthy credit expansion was inflation
world-wide, even before the war. It was conveniently explained away
by the quantity theory of money, using gold as the whipping boy.
Nobody pointed out that the expansion of credit far outstripped the
increase in the stock of monetary gold. Still more serious was the
undermining of the international bill market that could no longer
prevent price rises through the discount rate mechanism after bank
reserves were diluted through the addition of fiduciary bills. The
fact remains that, in spite of government propaganda, it was not
the inflow of new gold but the subversion of the bill market that
caused the 1896-1914 inflation and price rises.
Plunder as the cause of inflation
Going further back in time we may observe that the great historic
tides of prices, blamed on the dispersal of gold, were really caused
by military conquest and plunder, making goods scarce. This was true
of the sack of Persepolis by Alexander the Great in 331 B.C., as
well as the sack of Cuzco by Pizzaro in 1533 A.D. The fact that looted
gold was the instrument whereby goods were made scarce in other parts
of the world does not change the validity of this observation. The
important thing is that it was not the greater availability of gold per
se that made prices to rise, but the scarcity of goods due to
plunder.
Fall of the gold standard
The fall of the gold standard can only be understood in the context
of the fall of the bill market. After World War I the victorious
governments that redrew international boundaries would not allow
the free circulation of real bills and consumer goods to resume.
They also wanted to deny the gold coin to "man's greedy little palms",
to use the phrase of Lord Keynes. The bill market was scuttled, and
governments assumed control of foreign trade in consumer goods which
was thereafter animated by political rather than economic considerations.
This turned out to be the most disastrous public decision in peacetime.
In an earlier article of this series I related how it led to the
collapse of the gold standard followed by unprecedented unemployment
world-wide, as predicted by Professor Heinrich Rittershausen of Germany
in 1930. It is a shameless lie that the gold standard collapsed due
to its inner contradictions, after spreading unemployment in the
world. The fact is that it was sabotaged, before the war by Germany
in making bank notes legal tender (an act that was duly aped by France
as well as other countries), and after the war by the victorious
governments in destroying the clearing system of the gold standard,
the bill market. The theory and history of the gold standard has
been distorted by governments and their hand-picked mouth-pieces
at the universities. It is time to set the record straight and state
the truth: mass unemployment in the 1930's was caused by the governments
themselves in destroying the wage fund, however inadvertently, along
with the bill market.
Detractors of real bills must logically applaud the government hatchet
job that destroyed the bill market while making preparations for
the war in 1909. They conveniently look at it as a needed "purification",
purging the gold standard as it were from its imperfections. Advocates
of the 100 percent gold standard are intellectual accomplices of
the greatest job destruction of history. They approve the abolition
of the wage fund in the consumer goods sector, a corollary of the
destruction of the bill market. You cannot have it both ways. If
you deny self-liquidating credit, then you also deny jobs financed
thereby.
In praise of gold hoarding
The most serious charge against the gold standard, made by Lord
Keynes, is that it is "contractionist" in that it encourages gold
hoarding and, through the contraction of the money supply, it creates
unemployment. The truth, however, is that gold hoarding in the early
1930's was maliciously instigated by the enemies of the gold standard,
first and foremost among them Lord Keynes himself. They started a
whispering campaign that the national currency should be devalued
to help the export industry. This was nothing short of advocating
sabotage.
In so far as gold hoarding/dishoarding as an economic phenomenon
are concerned, they are healthy and natural. In fact, gold hoarding
is an organic part of the mechanism that regulates the (floor of
the) rate of interest: it is the only way the public can stop the
banks from expanding credit by withdrawing bank reserves. Gold hoarding
of the marginal bondholder sets a limit to falling interest rates.
If the government tries to stop gold hoarding by confiscating it,
then the propensity to hoard, instead of working through a natural
conduit, gold, would find outlet in the hoarding of other marketable
merchandise, an unnatural conduit, which is fraught with the greatest
dangers, namely, that of generating a runaway vibrator through resonance
between price fluctuations and interest-rate fluctuations, such as
Kondratiev's long-wave inflation/deflation cycle.
Rise of the gold standard
The gold standard shall, like the mythological bird Phoenix, rise
from its ashes when the regime of irredeemable currency forced on
the peoples of the world will self-destruct, as the time-bomb of
ever-increasing unpayable debt, having reached critical mass, goes
off. The born-again international gold standard will be complete
with its natural clearing system, the international bill market.
Advocates of the so-called 100 percent gold standard display a most
profound ignorance of monetary science when they naively think that
the clearing system of the new gold standard will consist of fleets
of cargo planes flying gold around the world to satisfy their taste
for purity.
There is a great urgency to have a national debate on the burning
questions how to prepare for the cataclysmic collapse of the regime
of irredeemable currency that is now threatening the world. It is
inexcusable that some people are trying to smuggle in their own petty
agenda and derail the orderly discussion of the main issue, the study
of the operation of the gold standard in depth, including its clearing
system the bill market, and its signaling system the discount rate
(as distinct from the rate of interest).
The second coming of the gold standard and the bill market is inevitable,
despite the charlatanism of the opponents of real bills. Their 100
percent gold standard will be rejected 100 percent by events as they
unfold.
References:
Antal E. Fekete, Where
Mises Went Wrong, AFR.org, September 15, 2005
Antal E. Fekete, Unemployment:
Human Sacrifice on the Altar of Mammon, AFR.org, September
30, 2005
Antal E. Fekete, Economic
Entropy, AFR.org, October 9, 2005
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Antal E. Fekete is Professor Emeritus at Memorial University
in St. Johns, Newfoundland. Born and educated in Hungary, he emigrated
to Canada after the Hungarian Revolution in 1956 and taught for 35
years in the field of mathematics. Over the years, he has been a
visiting professor or Fellow at Columbia University, Princeton University,
and Trinity College of Dublin. He worked in the Washington office
of Congressman W.E. Dannemeyer on monetary and fiscal reform for
five years in the nineties; and in 1996, he won first prize in the
prestigious International Currency Essay contest sponsored by Bank
Lips Ltd. of Switzerland. He is the author of Gold and Interest and Monetary
Economics 101. In addition, his scholarly articles have appeared
on numerous Internet sites such as Financial Sense Online, Free-Market
News, Gold-Eagle, SafeHaven, and LeMetropoleCafe.
E-mail: aefekete@hotmail.com
