Macroeconomists typically have an aversion against deflation. The belief is that deflation is associated with economic downturn. It is to be avoided at all costs. As the gold standard tended to be associated with deflation, many have adopted the view that this monetary system is a relic that will remain as such. We can describe the problem with the equation of exchange — that is, MV = Py, where M is the money stock, V is the velocity of money, P is the price level, and y is real output.
Assuming that a fall in M is not offset by a rise in V, the result of a contraction of the money stock will, in the short run, be a fall in the product of P and y. In the long run, prices will adjust to fully reflect the change in the money stock, but short-run changes differ, and they matter too. A fall in M may lead to a fall in y, especially if deflationary expectations are self-reinforcing.
There are two problems with this interpretation of the gold standard: (1) Markets tend to automatically offset a fall (rise) in prices under a commodity regime by increasing (decreasing) the money stock. And, in fact, the price level under the gold standard tended to be mean-reverting. (2) The gold standard is poorly understood by most non-experts. Usually, discussions of the gold standard refer to the international gold standard, where silver was demonetized and used only as token coins. But there are other gold standards.
To understand the first problem, we can rearrange the equation of exchange to show the effect of a rise in velocity on money produced endogenously in the market when any of the other variables change:
M = Py/V.
Or we can express the idea with the Cambridge version — M = Pyk.
In equilibrium, the money stock is equal to the product of transaction demand (Py) and portfolio demand (k). We can rewrite this dynamically, such that %ΔM = %Δ(Py) + %Δk.
If variables on the right-hand side of the equation change, then the money stock will adjust to offset at least some of this change. Under the gold standard, increases in aggregate income were offset in large part, though not perfectly, by increases in the gold stock, though the flow of gold took about two years to adjust to changes in demand for gold (Barro 1979; Rockoff 1984). And if we assume portfolio demand for money remains constant, an increase in the value of aggregate income not offset by an increase in the money stock must be offset by a fall in the price level (a rise in the value of money).
Problems that arose with the gold standard were certainly associated with deflation. That does not mean the gold standard was inherently deflationary. Rather, problems associated with deflation under the gold standard were the result of legal restrictions. When Western states decided to move to the gold standard en masse, they demonetized silver. In doing so, they eliminated a substitute for gold. The elimination of substitutes resulted in an otherwise unnecessary rise in the value of gold. This is another way of saying the elimination of substitutes for gold was inherently deflationary. At the time of the gold standard’s adoption in the 1870s, flows of gold were diminishing and therefore unable to fully offset deflationary pressures that resulted from this increase in demand for gold. Thus, we observe a secular deflation in the early decades of the international gold standard. It was this secular deflation that stoked the fury of populist politicians such as William Jennings Bryan, who demanded that “you shall not crucify mankind upon a cross of gold.”
As for the second misconception, deflation and populist politics are small beans compared to the fall in output observed during the Great Depression. Wasn’t the Great Depression the result of an obsession with the purity of the gold standard? Barry Eichengreen and Peter Temin, leading proponents of this view, argue that the “mentality of the gold standard” was responsible for tremendous international deflation. And they are correct. Artificially elevated exchange rates agreed upon at the Genoa Conference were not politically sustainable. At the start of the Great Depression, politicians and central bankers believed it was their responsibility to limit gold outflows, which limited the growth of the money stock during the crisis. The Federal Reserve and the Bank of France were guilty in this respect. The Federal Reserve increased its share of the world’s monetary gold during the first two years of the Great Depression. The Bank of France was the most egregious in this respect, more than tripling its share of the world’s gold stock over the course of the Great Depression. Demand for gold by central banks exceeded the rate at which the market was able to produce gold. This intervention, in combination with a restriction on the use of substitutes thanks to the earlier demonetization of silver, necessitated a massive deflation in light of poorly coordinated policies.
The failure of the international gold standard was a failure of management. A modern international gold standard would not need to be managed by the state. Changes in demand for money of any kind can be handled by the production of more units of the money used predominantly as well as by the adoption and production of substitutes (namely silver, in a world where base metals are used as money). Central bank management opens the door to mismanagement that may prevent the market from responding to a dearness of money.