Friday, November 11, 2011

What's Wrong with the Gold Standard?

One question that was asked after my post about abolishing the Fed was "what is wrong the gold standard?"

I admit that my comment stating that gold is "ridiculous" was a bit harsh.  Gold production might be arbitrary in the sense that our government can't control it.  But that is precisely why gold bugs prefer it to the current system.  Consider the following graph of the consumer price index over the course of American history:


The United States completely abandoned the gold standard in 1971.  Before that, the nation experienced several bouts of inflation (usually associated with wars), but then underwent long periods of moderate deflation. Afterwards prices exploded.  In fact, they are growing exponentially.  The same thing happens to a bank account that accumulates a constant rate of interest.

The next graph shows the rate of inflation:


Aside from a period of pretty heavy inflation during the late 70's, we have had an average of about 3% inflation in prices each year. Clearly, the creation of the Federal Reserve and the abandonment of the gold standard has led to inflation.  So why argue that gold is ridiculous?  Because I believe that the economy operates better with a little bit of inflation.  I also believe that we should have higher than normal inflation during recessions that are caused by demand shocks (indicated by unemployment).

My main argument against gold is that the supply can't change in reaction to the needs of the economy.  So the argument really isn't about gold, it's about the money supply.  Should we have a small rate of baseline inflation?  Should we try and stimulate the economy when we experience a demand shock?

The reason I think we should have a small baseline inflation rate is basically the same reason many people don't like it: sticky wages.  Inflation erodes the wages of those whose wages aren't changing.  If you don't negotiate a raise with your employer every so often, your living standards will start to decline.  The reason people might not like this is obvious.  It threatens to slowly undermine your standard of living.  The reason I like it is that the economy is changing.  Some jobs are becoming less valuable and others are becoming more so.  Those jobs that are becoming more valuable will experience wage growth according to supply and demand.  But "stickiness" prevents a gradual decline in wages for those professions that are becoming less useful unless we have underlying inflation.

My reason for supporting an increase in inflation during a period of high unemployment is that I believe it results in a transfer of wealth from those with stable jobs to those with marginal jobs.  If we have low inflation (or worse, deflation) people with marginal jobs will be fired, and those who can almost get hired into marginal jobs won't be.  People with stable jobs might benefit from an increased standard of living, but I would rather adopt a policy that helps keep people working to one that benefits those with safe jobs.

So, the problem with gold isn't really that its price is arbitrary.  It is that most of the time gold production is too stable.  It doesn't create baseline inflation, and it doesn't react to high unemployment caused by demand shocks.

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