Gold, Fiat Money and the Monetary Management

Having read most of the articles which followed the debate in the US on going back to the Gold standard, I was put off by simplistic arguments being made by both the sides. The primary arguments revolve around the role of Gold in controlling inflation on one hand and how it limits governments’ ability in managing business cycles on the other.  In this article I attempt to discuss both the sides in as much brevity as possible without choosing one over the other.

Both the primary arguments are strong enough to support either side’s point of view. Let me start with the role of Gold in controlling inflation. Stability in the purchasing power of a unit of currency – which is a store of value – plays a critical role in the efficient working of a market economy. This stability is threatened by the change in the price level (i.e. Inflation) within the economy. Inflation has been established as a monetary phenomenon such that any change in the units of currency in circulation (money supply) results in the change in the purchasing power of a single unit in the opposite direction. It is the inability of the government to change money supply in an economy with Gold as a unit of currency which is argued as a factor contributing towards the desired stability. David Ricardo makes a similar point by saying, "Experience shows that neither a State nor a Bank ever have had the unrestricted power of issuing paper money, without abusing that power.”

The argument that changing price levels is not only a characteristic of Fiat era is incomplete. Inflation episodes during past centuries, when Gold standard was in place, can be traced back to three main reasons: increase in the production of Gold (eg. 1848-1873); periods of government printing notes to fund war expenses etc. (eg. 1782-1814); and, decrease in the reserve ratios or other factor leading to increase in banking credit (eg. 1914-1920). The last two factors have explicit involvement of the government. The first factor, although important, plays a role in a way which does not lead to abrupt changes in the prices due to physical limitations eg. production capacity. Instead the change in price level is rather gradual. Data for the 19^th century also shows that on average, annual increase in gold production have been roughly equal to the annual increase in demand (around 3%) necessary to keep the prices stable.

I now step on the other side of the fence. The most important reason to me for not supporting ‘return to gold’ is the ability of the government to manage business cycles. Although money is neutral in the long run, nominal rigidities in the form of price, wage and information stickiness do allow significant room to central banks such that they can alter the money supply to stabilize the economy in response to shocks. Now one may argue that the volatility of business cycles is actually a causal effect of such government interventions to start with eg. boom (created lets say through cheap credit) must be followed by a bust. This latter argument does hold some ground but still this does not strip the central bank of all its ability to effectively stabilize the economy. So in a perfect world where government is benevolent, ability to alter money supply can decrease the volatility and stabilize the economy.

One may ask, and rightly so, that is the government really benevolent? Not really. There is always a chance that short term objectives will result in policies which will lead to inflation. However, it can be argued that the misadventures during the past centuries were undertaken in the absence of a proper economic theory such that the consequences could not be fully perceived. Similarly, during the 1950s and 60s, policy decisions were led by incomplete economic theory of a permanent trade-off between inflation and output. There is significant support for the argument that the monetary policy of the 80s and onwards (in addition to other factors like improved inventory management) in the US, with greater focus on the stabilization, was indeed successful in reducing the volatility of business cycles while the institutional framework (independence on central banks) allowed limited room for any monetary misadventures.

There may actually be a solution to the respective problems in both the regimes. Under Gold standard, monetary authority can regulate the banking credit to effectively alter the money supply to achieve the desired objectives. While under the Fiat system, it can adopt the price level targeting rule that can help in stabilizing the value of currency.

Ultimately it boils down to an empirical question. Are the benefits from the ability to stabilize greater than the costs associated with possible monetary misadventures? I do not know, as yet!