The Gold Standard is the worst standard, except for all the others.
In a recent post at Nada es Gratis (Nothing is Free), Jesús Fernández-Villaverde discusses a visit to the vault where gold is stored at the New York Fed. The post and subsequent comments evolve into some criticisms of the gold standard. I won’t deal with the one that has been frequently commented on here or at Free Banking, but on another that is quite common but, I think, misguided: “That the gold standard is wasteful because a lot of resources need to be allocated to dig up gold just to ship it to the other corner of the world to put them back underground”.
Fernández-Villaverde continues arguing that to believe in the gold standard today is more “nonsense than to not believe in evolution or global warming.” It is this evolution, however, which allows one to make sense of the structure of a gold standard.
It is a very different problem to understand how a system like the gold standard evolved in the market than to argue that gold would have been money forever and that no better system could be envisioned. Surely, if central banks know how to perform better than the market, a fiat based monetary system may be more efficient than gold, but that is not the case. It is unfair to the gold standard to use an unreal perfect situation as a benchmark; instead the reality of the gold standard versus the reality of central banking is what should be compared head to head. The question is not how a gold standard could be better, but why market evolution came up with such a system and didn’t get rid of it despite its costs. Nothing is for free, so there should be some benefit from the gold standard rules.
The evolutionary process in the market chose gold as a store of value and money, not bricks. The evolutionary process in the market found out a way to economize the use of gold with fractional reserve banking (without the need of a central bank). The same evolutionary process shows how the market found a way to economize the use of resources allocated to gold. It is, on the contrary, under an unreliable fiat monetary regime that extra resources are used to secure alternative stores of value rather than ornaments or industrial applications. Under free banking with fractional reserves, the actual demand for gold for transactions is reduced; only a part of it is stored in the banks to redeem banknote turnover and clearing requirements from other banks. When the gold standard was suspended, to hold banknotes was not secure anymore, and demand for money increased for both security and speculative reasons. If the concern is the use of resources, then fiat currencies are a great benefit to gold mining companies and countries with gold endowments.
But the question that went unanswered is why today gold, if ’’ts a barbarous relic as Fernández-Villaverde believes, is stored at the New York Fed? As Judy Shelton discusses, that gold is barbarous relic may be what policy makers may say, but not how they behave. Central banks do store gold, rather than bricks, as part of their reserves. Wouldn’t it be more efficient to free all this gold to the market and reallocate all the safety resources to something more useful? The situation of gold today in the vaults is different to the situation of gold when central banks issued convertible banknotes. With convertible banknotes, gold was a liability to be returned to banknote holders; with fiat currencies, gold is an investment with potential capital gains. For central banks this barbarous relic is still a good investment and worth holding in their portfolio of reserves.
The fact that at any given time gold is sitting still in a vault (and maybe stays that way for a long time) does not make the situation economically useless any more than the emergency parachute which is very rarely used. The paratrooper has very good reasons to invest in a second parachute even if it’s very rarely used. Similarly, the bank has a very good reason to keep gold in reserves in case it needs to redeem en extra amount of banknotes.
Before central banks, gold was the chosen currency in the market. It is hard to say what the currency would be today had central banks would never evolved. But the institutional contribution of the gold standard applied to central banks (gold standard in itself does neither require nor benefit from the presence of a central bank) is to limit the power of central banks to debase its currency to finance fiscal deficits (a breach of contract and a non-legislated taxation). Surely, bricks and printed fiat currencies won’t do a good job in constraining government voracity. The increase in the price level and government spending since the gold standard was abandoned shows that to store (gold) bricks in secured vaults is not nonsense.
Nicolas Cachanosky is a doctoral student in economics at Suffolk University, as well as a previous Sound Money Essay Contest winner.