Can Gold Cause the Boom-Bust Cycle?
This was a very popular topic during my online business cycle class (which has just wrapped up), so I thought I’d devote a Mises.org to it:
At the Mises Academy we are just wrapping up the inaugural class, on the Austrian theory of the business cycle. During the class, one issue that came up repeatedly was whether the Mises/Hayek story of the trade cycle could occur on a completely free market, using gold as money and a banking system that operated on 100 percent reserves.
As any good (and annoying) teacher would, I avoided giving a definitive answer one way or the other. Instead, I tried to give the best possible case for each answer, to prod the students to think it through for themselves. In this article, I summarize how even a Rothbardian could plausibly answer this question either in the affirmative or the negative.
Robert,
I think there is one major difference between the 100% hard money system and the fractional reserve system that you kind of missed out on in this article.
That is that the wide spread banking crisis and the risk of monetary deflation that results in the unwinding of the previous credit expansion cannot occur in the 100% gold system under any circumstance. So even if the hypothetical influx of new gold temporarily “distorts” the interest rate, there can be no wide spread liquidity crisis.
The argument that a boom/bust could happen with 100% gold reserves is straightforwardly economic. If someone finds a huge amount of new gold, this would have the same effects as if the government were to increase the money supply. Therefore if government increases in the money supply cause a boom/bust cycle, so would the gold find.
The no, argument, by contrast, is a moral, not an economic one. Bob argues that there would be nothing immoral about a guy who discovers new gold doing whatever with it, and therefore concludes that the gold find can’t be detrimental to the community. But that doesn’t follow. Suppose, for example, that a fire is raging in a town, and the only water around is in a lake on private property. The standard libertarian view would be that the owner of the lake has the right not to give the townspeople the water. But from the fact that he has the right to deny them the water, it doesn’t follow that the town won’t burn down if he doesn’t give it to them.
Hi Bob.
Isn’t the key point that, in the second scenario you mention in the mises.org article, while the miner’s real savings increase, everybody else’s real savings decrease once the price effects of the monetary expansion work themselves out?
Presumably, the same situation would arise with gold as with paper money if a) making paper money was really really difficult due, for example, to a scarcity of the right type of tree for making pulp, b) as a result, paper money had evolved as the monetary standard rather than gold, and c) the paper money producer subsequently stumbled on a previously unknown stand of the right type of tree.
On the question of externalities, I am assuming that Rothbard didn’t deny the possibly of pecuniary externalities, i.e., those that have their affects through the price system. This strikes me as perhaps being one of those externalities.
The whole discussion suggests that, under free banking, even with a commodity standard and 100% reserve requirements, extreme physical scarcity of whatever backs the monetary standard is very very important. Which explains, I suppose, why gold evolved as the free market monetary standard – it was essentially the market’s answer to an empirical question (what’s really really scarce?). In a sense, I suppose that the gold standard (with 100% reserve requirements) is the best way to satisfy the Friedmanite low-and-stable monetary growth rule (given that the world’s gold supply does in fact grow very slowly). Perhaps Friedman was really a Rothbardian and didn’t know it (!).
It also suggests that, whatever the monetary standard, economists (even, or perhaps especially, paleo-Keynesians) should more vigorously oppose policies which increase the stickiness of prices.
BTW, I really enjoy your blog. I don’t agree with everything of course but your openness, enthusiasm and willingness to admit less than complete omniscience are very much points in your favour.
No, it couldn’t happen, and here’s why:
Gold production, like any other commodity, is produced based on market demand/supply setting a price point for gold.
The notion that a “motherlode” could be found that would undermine the basic assumed costs of production for gold is ridiculous on its face. It has never happened in the history of the world.
The market self-limits the production of gold to the exact correct amount of production necessary for the economy to run at maximum efficiency with gold acting as money and an industrial commodity.
Example:
Lets say a miner discovers a “motherlode” equal to half the existing gold in circulation. If the miner was to extract all that gold and put into a bank as new money for lending, and we say that the bank then lends all that out, there by debasing the currency by half – the miner would no longer find it profitable to continue extraction of gold.
The cost of production has not changed, yet the value of the gold has decreased by a third.
Miners who were not super-efficient with large economies of scale would be driven out of business and gold production would decrease until the economy grew to a point where gold production became profitable again.
“The notion that a “motherlode” could be found that would undermine the basic assumed costs of production for gold is ridiculous on its face. It has never happened in the history of the world.”
Actually it has happened. Importation of gold from the New World to Spain, for example, caused something like 300% inflation. And in that case extracting the gold involved shipping over an ocean.
“Lets say a miner discovers a “motherlode” equal to half the existing gold in circulation. If the miner was to extract all that gold and put into a bank as new money for lending, and we say that the bank then lends all that out, there by debasing the currency by half – the miner would no longer find it profitable to continue extraction of gold.”
First off, by that point it would be too late, as the gold would have already been extracted. Second, why assume that the cost of extracting the gold would be below the price of gold if the price were cut in half? Historically gold extraction has been limited chiefly not by the cost of extraction but by the fact that we don’t know where the gold is. Whenever a new gold area was found people would rush there and mine it all until is was gone, because the price of gold was many times greater than the cost of extracting it once it was found.
Importation of gold isn’t a problem these days.
And gold is very limited by the cost of its production. Today, we can see more mining companies already beginning to form because the price of gold is now making it more profitable.
Gold mining operations today are large scale operations like iron mines.
The notion that a “motherlode” of gold could be found is exactly the same as saying a “motherlode” of iron or coal or any other resource could be found which shocks the market.
This simply wouldn’t happen.
“The notion that a “motherlode” of gold could be found is exactly the same as saying a “motherlode” of iron or coal or any other resource could be found which shocks the market.”
The question isn’t whether this is likely. The question is whether it is possible, and if so what would happen. Again, contrary to your assertions there are such things as supply shocks, both historically for gold and for other resources.
Mining is far from the only cause of a change in the money supply in a gold based system. There are also international flows and technology shocks to alternate uses of gold. Suppose someone invents a new technology that requires gold to function properly. The increase in the demand for gold for non-monetary uses would be equivalent to a negative shock to the money supply. How likely these events are is debatable (although most people would probably conclude they are less likely than central bankers screwing things up).
Now this is a legitimate argument, however I point to other commodities as a baseline.
New technology has dramatically increased the need for Aluminum over the past century.
The markets have responded to this accordingly without massive shocks to the Aluminum market.
Technology progress over-time, and the market will adjust for those changes in demand over time as well.
“New technology has dramatically increased the need for Aluminum over the past century.
The markets have responded to this accordingly without massive shocks to the Aluminum market.”
If you go here, you can find spot prices for aluminum for the last five years. Note that the price of aluminum fell by roughly two-thirds during the last six to eight months of 2008. If the dollar fell by two-thirds over a six to eight month period, I suspect that you would view this as an irrefutable proof of the dangers of fiat currency.
Prices would not change over a 6 to 8 month period for goods and services.
We can look at CPI on the gold standard and the price of gold during that time and see that gold can fluctuate fairly dramatically without any wild swings in prices.
In order for changes in the price of a metal to have a real impact on prices, long term investment in production must occur (ie. ramp ups) or slow downs. – Because ultimately it is the actual supply of gold, not its price, that determines long term inflation rates.
I hope I’m getting across my point here. I’m talking about changes in the price of gold can swing in the short term, but that will not necessarily impact the CPI on an immediate basis.
I’m looking over a longer time line, say 5 years or whatever it takes to start up a new mining operation. Because it is the actual changes in production of the metal that matter.
Long term we can see there is basically zero inflation/deflation on a gold standard.
“Long term we can see there is basically zero inflation/deflation on a gold standard.”
Michael, you keep making assertions that not only aren’t true, but which you would know weren’t true if only you made the slightest effort to find out. During the latter half of the 19th century, when the gold standard was in place, there was a period of sustained deflation that lasted decades. It’s what William Jennings Bryan was so upset about.
baloney.
http://www.minneapolisfed.org/community_education/teacher/calc/hist1800.cfm
I’m looking at the CPI.
Also, during late 19th century is when America experienced explosive growth and prosperity.
The change in prices over that period remained relatively flat. There was a spike in prices in the 1860s followed by deflation back down to where prices should be.
Deflation is a good thing for savers.
From 1885 to 1905 the net inflation was basically zero.
nada.
which is exactly what it should be.
so all of your arguments are baloney.
“We can look at CPI on the gold standard and the price of gold during that time and see that gold can fluctuate fairly dramatically without any wild swings in prices.”
Um, under the gold standard the price of gold was fixed. So it couldn’t “fluctuate fairly dramatically” unless government decided to change the price. If you look at historical examples where governments have dramatically changed the gold exchange rate under the gold standard (e.g. Britain during and after WWI, the U.S. during the Great Depression) changing the price of gold did, in fact, lead to changes in prices, as of course it had to, since under the gold standard gold is money. Changes in the price of money and changes in the price of goods and services are the same thing looked at from two different angles.
that’s not a gold standard in a free market.
that’s a central bank manipulating gold reserves.
“that’s not a gold standard in a free market.
that’s a central bank manipulating gold reserves.”
First of all, the fact that the price of gold is fixed under a gold standard is not the result of central bank manipulation. That’s just what having a gold standard means.
Second, if you are going to cite the historical example of the gold standard, you can’t then turn around and say “well, that really wasn’t the gold standard because it wasn’t a totally free market.” I mean, you can do that, it’s a free country, but it doesn’t come across as being very persuasive.
Link here.
Michael,
What I said was: During the latter half of the 19th century, when the gold standard was in place, there was a period of sustained deflation that lasted decades.
The chart you cite from the Minneapolis Fed corroborates this point. For example, from 1865-85 (two decades) there was sustained deflation. Your counter that there were other periods under the gold standard without net deflation is like the story of the murder suspect who offered to produce witnesses who hadn’t seen him kill the victim. In other words, it is a non sequitur.
I congratulation you, however, on actually looking at some data before commenting this time.