The Gold Standard: "A Barbarous Relic"

It is becoming increasingly common these days to hear people calling for a return to the gold standard. We are living in a period of economic and financial instability and are seeing increasingly extreme monetary policy from central banks around the world as they try to stave off a global depression. In response to the spectacle of unprecedented sums of money being created out of thin air, it is completely understandable that we would question our existing monetary system. And, for those looking for alternatives, gold is appealing due to its singular position as the dominant monetary standard throughout human history.

That being said, there are very good reasons why gold has been abandoned by every country that has ever used it as a basis for a monetary system. John Maynard Keynes — one of the greatest minds in the history of monetary thought — famously referred to the gold standard as a “barbarous relic”. To argue in favor of going back to the gold standard at this point is to ignore the lessons of history. Doing so would be analogous to returning to the use of leeches because of the drawbacks of modern medicine. Gold-based money is outdated and obsolete, and going back to it would almost certainly result in global catastrophe.

Throughout history, all countries which have used gold-based money have found that their economies were prone to recurring crises and ever-increasing inequality. This fact was apparent as far back as ancient Greece, when the legendary Spartan lawmaker Lycurgus outlawed the use of gold and silver money. Doing so swiftly resulted in a marked reduction in crime and corruption and led to a more equitable, prosperous society.

The main argument that people make in favor of the gold standard is that gold tends to hold its value over time. It has been observed that “an ounce of gold would purchase a fine suit of clothes in the time of Shakespeare, the time of Thomas Jefferson and during the Great Depression.” The stability of gold’s purchasing power is contrasted with the deterioration of value of fiat currencies, and this is seen as conclusive proof of its superiority by advocates of the gold standard.

The problem with this analysis is that it is based solely on money’s role as a store of value and completely ignores its function as a medium of exchange. The very qualities that make gold a good store of value are precisely the reasons why it is unsuitable for use as a medium of exchange. (Rather than repeat what was discussed in a previous article, please refer to Money: medium of exchange vs. store of value for a more thorough discussion of the contradiction inherent in asking money to serve as both a medium of exchange and a store of value.)

In The Natural Economic Order (1916), Silvio Gesell explained the reasons why any economy that uses gold as a medium of exchange will inevitably be plagued by commercial crises.

He started by observing that in a modern economy, the vast majority of people depend on the division of labor to procure the goods and services they need to live. As he explained, “We owe it to the division of labor that we produce more than we consume. Liberated thus from the compulsion of immediate needs, we can devote time, provisions and work to the perfection and multiplication of our means of production. Without the division of labor we could never have accumulated our present wealth of means of production, and without these means of production our labor could not have attained the hundredth part of its present fertility. The greater part of the population therefore owes its existence directly to the division of labor.”

He then went on to explain that the division of labor is dependent on the existence of a medium of exchange. Without a generally accepted medium of exchange, people cannot readily exchange the products of their labor for the goods and services they need to live and must therefore rely on what they can produce for themselves and what they can acquire through barter. Therefore it is no exaggeration to say that the vast majority of humanity is dependent on a medium of exchange for its very survival. If money disappeared today, almost everyone currently alive would be incapable of providing for their basic needs. Think about it. If you suddenly had to single-handedly produce all of the goods and services you need would you survive?

So the existence of a medium of exchange is literally a matter of life and death. And, while gold is an excellent store of value, it is a poor medium of exchange.

By what criteria do we evaluate the performance of a medium of exchange? Clearly the answer is that its performance should be judged based on the volume of goods and services that it facilitates the exchange of and the consistency with which it does so. The more goods and services that are exchanged — and the more consistent that exchange is — the better the medium of exchange. And, unfortunately, gold fails miserably in both regards.

In any monetary system there are two variables which determine the amount of goods and services exchanged — 1) the quantity of money in existence and 2) the rate of circulation of that money. (If the quantity of money remains constant while the rate of circulation increases, more goods and services will be exchanged. Likewise, if the rate of circulation is held constant while the quantity of money rises, more goods and services will be exchanged. And vice versa.)

So, what factors determine the quantity of gold in existence and its rate of circulation?

The quantity of gold in circulation is relatively inflexible. This is because, even during the most fruitful years for gold mining/extraction, the amount of new gold produced represents only a tiny fraction of the total amount of gold in existence (perhaps 1 or 2% annually at most). So, since the supply of gold is inflexible, the variable which primarily determines its effectiveness in facilitating the exchange of goods and services is its rate of circulation. And this is where gold utterly fails.

Because gold can be hoarded without loss, holders of gold (and gold-backed money) always have the option of sitting on the sidelines and delaying their purchases. And the incentive to do so is greatest at precisely the times when society most needs money to circulate — i.e. during times of crisis and uncertainty. If the economy is weak and prices are falling, holders of gold have an incentive to delay their purchases as much as possible — since they will be able to buy the same things for less money if they wait. This creates a built-in negative feedback loop anytime economic growth falters. Whenever prices begin to fall (due to lack of demand, for example), the incentive to hoard the medium of exchange increases, thereby reducing demand further, which results in a further decline in prices, more hoarding of currency, and so on. (This was a big part of why the Great Depression was so intractable and why the US and other countries were forced to abandon the gold standard.)

Let’s listen to Gesell describe this dynamic:

“An actual fall of prices is not necessary to cause the flight of money from the market. If there is a general opinion that prices will fall (no matter whether the opinion is true or false), demand hesitates, less money is offered, and for this reason what was expected or feared becomes an actual fact. Is not this sentence a revelation? Does it not give us a clearer explanation of the nature of commercial crises than is contained in any of the many-volumed explanations of the matter? From this sentence we learn why a Black Friday, a crisis scattering death and destruction, often comes like a bolt from the blue. Demand withdraws, conceals itself, because it is insufficient to effect the exchange of wares at the present price-level! Supply exceeds demand, therefore demand must disappear entirely. A merchant writes an order for cotton. He hears that the production of cotton has increased and consigns the order to his waste-paper basket! Is that not comic? But production continues to throw new masses of wares upon the market, so the stock of wares increases if sales are interrupted — just as the water-level of a river rises when the sluices are closed. Supply therefore becomes larger and more urgent because demand hesitates, and demand hesitates simply because supply is too large in proportion to demand. Here again there is no mistake, no misprint. The phenomenon of a commercial crisis, so ridiculous to the onlooker, must have a ridiculous cause. Demand becomes smaller because it is already too small, and supply becomes larger because it is already too large.”

This dynamic is the primary reason why gold-based monetary systems have always been plagued by crises throughout history. It is perfectly rational, logical and inevitable that falling prices will lead to diminished demand and further price declines in economies which use gold as a medium of exchange.

(This phenomenon is not limited to specie-backed currencies. Our existing forms of fiat currencies suffer from the same problem. Ever since the financial crisis of 2008, the world’s central banks have been desperately pumping new money into the system in an attempt to prevent a deflationary collapse, but as much money as they print, they are powerless to compel its circulation. Therefore we see a historically unprecedented amount of bank reserves which stubbornly refuse to circulate. Under a depreciating currency system of the kind Gesell proposed, the circulation of money would be much more consistent and reliable, since holders of money wouldn’t be able to hoard it without suffering losses.)

Gold-based money also behaves in exactly the opposite way from how we would want it to when the economy is threatened with too much activity rather than too little. Here is Gesell’s description of this part of the problem:

“But what happens when demand is too large in proportion to supply, when the prices of commodities rise? How does the possessor of money act when prices rise? He expects or knows that what he has bought today can be sold tomorrow at a higher price. He knows that rising prices make everything, from the merchants viewpoint, cheap and that by turning over his money he can gain increasing profits. He buys therefore as much as he can, that is, as much as his money and credit allow… Money circulates more rapidly when prices are rising; during a trade-boom the circulation of money attains the maximum velocity which the existing commercial organization allows. But demand is the product of the quantity and velocity of circulation of money; and demand and supply determine prices… Prices therefore rise because they have risen. Demand is stimulated and enlarged because it is too large. Merchants buy wares far beyond their immediate needs; they seek to secure stocks for future sale — because supply is too small in comparison with demand. When supply increased and became too large in proportion to demand, the merchant reduced his orders to the minimum, to what he could at once dispose of. He could not allow any time to elapse between buying and selling, for during this time the selling price would have fallen below the price he had paid for the ware. But if wares are scarce he is eager to buy; all the purchases he can make seem nothing to him, he is anxious by every means to increase his stocks. The debts, based on bills of exchange, that he contracts in doing so, sink daily in significance in comparison with his assets, which are daily increased by the rise of prices. These debts cause him no anxiety — as long as prices are rising. Is not this a fantastic phenomenon, worthy of the other fantastic phenomena of a trade boom? The demand for wares must always increase far above its usual volume as often and as long as supply is insufficient. Yes, our gold standard, offspring of the theory of value, stands the test. That our investigation has clearly proved. It causes an increasing demand when demand is already too large, and restricts demand to the personal bodily wants of the few holders of money the moment demand becomes too small! A starving man is deprived of nourishment because he is starving, and a glutton is filled to bursting because he is a glutton.”

So, whereas classical economics describes the free market system as “self-correcting”, under the gold standard it is in fact the opposite of self-correcting. Gold-based money causes small deficiencies of demand to become large deficiencies, while, on the other side of the spectrum, it causes small excesses of demand to become large excesses. In other words, regardless of whether we are threatened by inflation or deflation, gold-based money makes the situation worse.

And, lastly, hoardable currency also gives rise to interest (which would not exist with a depreciating currency), and interest is one of the primary causes of the permanent and growing inequality that plagues all of the major world economies. But that is a subject for another essay…