The Gold Standard and the Great Depression

[JustARandomPanda]

Noticed a thread in the main forum that diverted to economics, Communism, capitalism, etc. Thought I'd share an article I found a while ago and post it here. The thread seemed interesting enough to warrant continuing discussion here. Unfortunately I can't remember the name of the guy who penned this article or I would've credited him. If anyone knows who the author is please post it.

 

 

 

 

********************

 

How the gold standard contributed to the Great Depression.

 

 

There always seem to be voices raising the possibility that a return to a monetary gold standard could solve all our problems. Among those championing this meme this week were Chris Mayer at Daily Reckoning, Robert Blumen at Mises Economics Blog, and some of my fellow blogjammers.

 

Under a pure gold standard, the government would stand ready to trade dollars for gold at a fixed rate. Under such a monetary rule, it seems the dollar is "as good as gold."

 

Except that it really isn't-- the dollar is only as good as the government's credibility to stick with the standard. If a government can go on a gold standard, it can go off, and historically countries have done exactly that all the time. The fact that speculators know this means that any currency adhering to a gold standard (or, in more modern times, a fixed exchange rate) may be subject to a speculative attack.

 

After suspending gold convertibility in World War I, many countries stayed off gold and experienced chaotic fiscal and monetary policies in the early 1920's. Many observers reasoned then, just as many observers reason today, that the only way to restore fiscal and monetary responsibility would be to go back on gold, and by the end of the 1920's, most countries had returned to the gold standard.

 

I argued in a paper titled, "The Role of the International Gold Standard in Propagating the Great Depression," published in Contemporary Policy Issues in 1988, that counting on a gold standard to enforce monetary and fiscal discipline in an environment in which speculators had great doubts about governments' ability to adhere to that discipline was a recipe for disaster. International capital flows became more erratic, not less, as doubts were raised about whether first the pound would be devalued and then the dollar. Britain gave in to the speculative attacks and abandoned gold in 1931, whereas the U.S. toughed it out by deliberately raising interest rates in 1931 at a time when the economy was already near free fall.

 

Because of this uncertainty, there was a big increase in demand for gold, the one safe asset in this setting, which meant the relative price of gold must rise. If everybody is trying to hoard more gold, you're going to have to pay more potatoes to get an ounce of gold. Since the U.S. insisted on holding the dollar price of gold fixed, this meant that the dollar price of potatoes had to fall. The longer a country stayed on the gold standard, the more overall deflation it experienced. Many of us are persuaded that this deflation greatly added to the economic difficulties of those countries that insisted on sticking with a fixed value of their currency in terms of gold.

 

 

Ben Bernanke and Harold James, in a paper called "The Gold Standard, Deflation, and Financial Crisis in the Great Depression: An International Comparison" published in 1991 (NBER working paper version here), noted that 13 other countries besides the U.K. had decided to abandon their currencies' gold parity in 1931. Bernanke and James' data for the average growth rate of industrial production for these countries (plotted in the top panel above) was positive in every year from 1932 on. Countries that stayed on gold, by contrast, experienced an average output decline of 15% in 1932. The U.S. abandoned gold in 1933, after which its dramatic recovery immediately began. The same happened after Italy dropped the gold standard in 1934, and for Belgium when it went off in 1935. On the other hand, the three countries that stuck with gold through 1936 (France, Netherlands, and Poland) saw a 6% drop in industrial production in 1935, while the rest of the world was experiencing solid growth.

 

A gold standard only works when everybody believes in the overall fiscal and monetary responsibility of the major world governments and the relative price of gold is fairly stable. And yet a lack of such faith was the precise reason the world returned to gold in the late 1920's and the reason many argue for a return to gold today. Saying you're on a gold standard does not suddenly make you credible. But it does set you up for some ferocious problems if people still doubt whether you've set your house in order.

 

Nevertheless, I'm willing to grant Tim Iacono that the stuff is pretty.

[Marblehead]

If a nation prints and makes available more money than the wealth of the nation can support the only result will be to make the money less valuable and this leads to inflation. Bottom line what is going to happen is the the separation between the have's and have not's will broaden.

 

This is what happens every time a government spends more money than it has or expects in revenue (taxes).

 

It really doesn't matter all that much if the gold standard is used or not, IMO.

 

However, what with the global economy of today it is necessary to all nations involved in the global economy to value its money in exactly the same way else there will be unfair trade between the nations.

 

Peace & Love!

[mjjbecker]

http://www.amazon.com/Lords-Finance-Bankers-Broke-World/dp/0143116800/ref=sr_1_1?ie=UTF8&s=books&qid=1272281986&sr=1-1

 

A good book, well worth reading.

[Enishi]

I started reading lots of financial blogs and websites ever since the financial crises started in 2007. Many commentators are very good at pointing out the immoral and unstable nature of fractional reserve banking, but I agree that many of them seem overly obsessed with the idea of solving everything with a 100% gold standard.

 

The important thing though, is to make so that our currency is actually BACKED by something more tangible than government promises. See the article below:

 

http://www.newworldeconomics.com/archives/2010/010310.html

 

The GLD Standard

 

 

 

January 3, 2010

 

 

 

Managing currencies is simple. People today don't know how to do it, so it seems hard. But, actually, it is simple.

 

You can set up all sorts of currency systems. Hong Kong has a dollar peg. Singapore has a peg to a currency basket. The U.S. and Europe have a cabal of bureaucrats who make shit up as they go along. However, the best system is to have a currency pegged to gold. Gold is the most stable thing out there, in terms of monetary value, so if you peg to gold you'll have the most stable currency possible. Not only is gold more stable than any alternative, but it is so stable that you can treat it as being completely stable, in an absolute sense.

 

Many, many governments have tried to peg their currencies to one thing or another -- usually a major international currency -- and most of the time, it has blown up in their face. This makes them rather hesitant to do so again. But, their failure is really a failure of technique. They didn't know what they were doing. So, of course it blew up. What did you expect?

 

Unfortunately, most gold standard advocates today also don't know how to peg a currency properly. They talk a lot about gold "backing," which is totally meaningless. You can tell they don't know what they are talking about, because if they knew what they were talking about, they wouldn't be talking about gold "backing." If these people wanted to set up a gold standard system -- with the best of intentions -- it would eventually blow up in their face. Probably pretty quickly.

 

I've said many times that the secret is supply and demand. Or, really it is just supply, because you can't control demand. You manage the supply to maintain the peg at your specified level. "Supply" is known as "base money." It is not MZM, M1, M2, M3 or any of these other measures which are measures of credit, not money.

 

Sometimes people halfway understand what I am talking about here, but they basically don't think it would work. The history of failed "pegs" weighs heavily in their mind. I mention in my book that the exchange rate between dollar bills and ten-dollar bills -- namely, 10:1 -- is maintained exactly by this method, and it always works. How is it that one worthless piece of paper -- a "$1 bill" -- is always worth 1/10th that of another worthless piece of paper, known as a "$10 bill"? It's not due to government coercion. There's no black market in $1 bills and $10 bills. Nobody goes to jail for exchanging seven $1 bills for a $10 bill. The Fed doesn't intervene in the domestic exchange market. The 10:1 ratio is not just a government edict, it is these paper chits' real market value. However, sometimes people need a little more help than that.

 

What is a currency? It is a worthless piece of paper. Why does it have value at all? It is a combination of two things. First, there is at least some demand. People want to use it as a facilitator of transactions. Probably the government demands that taxes be paid in that currency, and probably bans the use of other currencies domestically. What if I decided today to make my own currency, and printed up $200 worth? The supply is very small. Only $200. And limited, since I control it. However, nobody would take my funny paper in trade for goods and services. In other words, it would have no value, because there is no demand.

 

Second, supply is limited. For example, what if everyone was allowed to print $20 bills on their color laser printer, and this was totally legal? But, at the same time, the government would not take the homemade $20 bills in trade for anything. Of course the value of $20 bills would collapse to their production cost.

 

Oddly enough, the value of $1 bills and $10 bills may not collapse, if their supply was controlled. The exchange rate between $20 bills and $10 bills would float. For example, my 90% silver dimes from the 1950s are worth more than a $1 bill today. This is because their supply is limited by the fact that they are made of silver. However, it is not necessarily the fact that they are made from silver that makes them valuable, but rather the limited supply. My MS65 $20 Saint Gaudens are worth about three times the value of their contained gold bullion. In this case, the supply is limited by the fact that they are not being produced anymore, and are in good condition.

 

Probably anyone would agree with this in principle. But, observe what we didn't say: we didn't say that a currency's value results from an interest rate policy, or because some government buffoon talks about a "strong dollar policy" in public. We also didn't say that there needed to be a vault full of gold, or foreign currency "reserves" or "backing" or whatever. These things are secondary, and ultimately unnecessary. The important thing is supply and demand.

 

So, as an example, let's take the GLD gold ETF. What is it?

 

The ETF is a "piece of paper." Actually, it is not even a piece of paper, but electronic ephemera. Literally, it is a liability on the part of your stock brokerage, set against an asset (presumably a "deposit") at the Depository Trust and Clearing Corporation. The DTCC doesn't own the ETF either, but rather has an asset with Cede & Co., which owns (supposedly) most of the equity in the United States. I don't think you could get an actual piece of paper -- a real stock certificate, which is a legal document indicating direct ownership -- even if you asked nicely. You might be able to get direct registration, so you would directly own the ETF rather than going through a chain of counterparties, but you would have to make a special request.

 

Who owns your stocks?

 

So, you own a commitment based on a committment, based on a committment, based on ownership of the ETF. What is this ETF? It is a legal contract, signifying -- well, what exactly? I suppose it's in the prospectus. Presumably, it indicates a fractional ownership of the assets of the trust. However, the GLD prospectus is very, very complicated. There is all sorts of language indicating that, if push came to shove, nobody is obligated to do anything for anyone ever. A paper currency signifies nothing whatsoever. It is not a legal contract for anything. GLD is more-or-less the same thing, which is to say nothing at all, though this is clouded in billows of legalese.

 

Robert Landis: What the heck is GLD?

 

We do know one thing: the ETF is "pegged to gold." Its market value is linked to gold bullion, in an apparently reliable fashion. How does the ETF accomplish this? Via the adjustment of supply.

 

Sometimes there are lots of buyers of the ETF. The market value of the ETF may threaten to rise above the market value of gold bullion. In this case, the manager of the ETF sells additional shares of GLD, on a real-time basis to meet the increased demand, and maintain the value of the GLD in parity with gold. The total number of GLD shares in existence increases. In central bank terminology, this is an unsterilized intervention. This is how the vast majority of GLD shares have come into existence.

 

Does the trust then buy gold bullion with the money from these new shares? Maybe. Maybe not. Who knows. The point is, GLD remains pegged to gold whether or not there is actually any gold (or tungsten!) in some vaults somewhere.

 

Note something else here: the shares outstanding of GLD has increased by a huge amount. However, the value of GLD is unchanged. It is pegged to gold. (Since we assume that gold is stable in value, that means that GLD is stable in value too.) There are all sorts of people who say that "printing money" -- in any quantity at any time -- is "inflationary." However, we see that the enormous increase in the GLD shares outstanding over the past three years or so was not accompanied by a decline in the value of GLD. This is because the increase in GLD was in response to rising demand. If the trust didn't sell freshly-printed shares of GLD in the open market, the market value of GLD would have risen! So, it is perfectly possible to have increasing "base money" without a decline in currency value, if that increase in supply matches an increase in demand.

 

Sometimes there are lots of sellers of the ETF. The market value of the ETF may threaten to fall below the market value of gold bullion. In this case, the manager of the ETF buys shares of GLD, to support the market value of the ETF. The total number of GLD shares in existence decreases. This is also an unsterilized intervention, in central banker-speak.

 

Let's say that, for whatever reason, nobody wanted to own GLD anymore. Why? I don't know. It doesn't matter why. Maybe they all wanted to switch to PHY, Sprott's new gold ETF which promises (unlike GLD) to hold gold bullion in physical storage on a 1:1 basis with shares outstanding. Heck, I would.

 

Info on Sprott's new physical gold ETF

 

GLD now has a market cap of $43 billion. Let's say that, within a month, 90% of the holders want to sell, and there are no new buyers.

 

Assuming that GLD maintains its link with gold bullion, then the GLD managers would have to buy 90% of the shares outstanding of the ETF. These shares would disappear from circulation. At the end of the month, the number of GLD shares outstanding would have fallen by 90%. However, the value of GLD would remain the same -- pegged to gold.

 

Think about that. We have a 90% reduction in "demand" in the very short time period of a month. But, the "currency" -- GLD -- remains pegged to gold. Unless you were paying close attention to the shares outstanding, you might not even notice that anything happened at all.

 

Some other important points here. The shares outstanding of GLD fell by 90%. That is a big reduction. However, the value of GLD did not rise. Thus, a decline in "base money" by itself does not create monetary deflation. It was in response to a change in demand. In fact, if the shares outstanding was not reduced by 90%, the value of GLD would have fallen below its gold parity.

 

Now let's take a different example. Let's say that 90% of GLD holders want to sell, but the GLD manager does not buy shares on the open market. Supply does not decrease. The number of shares outstanding ("base money") remains unchanged.

 

Obviously, with demand down, and supply unchanged, the value of GLD would fall. It would fall below its parity with gold bullion.

 

The second thing that would happen is that GLD holders would observe that the value of GLD is falling below its gold parity, and that the GLD managers are not doing what they said they would do. As a result, there would be even more selling, and even less buying, as it has become apparent that the GLD managers are either incompetents or criminals. The demand for GLD would absolutely plummet. In other words, GLD would have a "currency crisis."

 

This is how most currency crises come about. For whatever reason -- any reason will do -- there is a decline in demand for a currency. The currency managers fail to address this decline in demand by reducing supply (base money) appropriately. The result is that the currency does something unpleasant, which leads to an even larger decline in demand, which is normally followed by a similarly incompetent response. Kaboom!

 

Observe that there is no "interest rate policy" for GLD. Nor is there a "strong GLD policy." Nor is there a "forex intervention" of the manipulative, invasive, coercive sort. Nobody cares about MZM, M1, M2, M3 yadda yadda for GLD. GLD has no government deficit, unemployment rate, stock market, or associated economy. The GLD manager does not have to make public pronouncements with carefully worded language. The IMF doesn't have to make promises, carefully balanced with demands. None of this is necessary. The only thing that is necessary is that supply is adjusted to meet demand, in accordance with the GLD:gold bullion parity.

 

"Aha!" the gold-"backing" people say here. "But GLD has 100% gold bullion reserve coverage of its outstanding shares!"

 

Oh really? Maybe it does. Maybe it doesn't. It doesn't matter.

 

After all, the reason that Sprott is introducing PHY -- a real, 100% physical gold-storage fund -- is that GLD is nothing of the sort, even if they like to make vague inferences that they are.

 

Now, here's the catch: it doesn't matter in principle.

 

Let's take our example above. The "demand" for GLD falls by 90% in the space of a month. There is huge selling of GLD (not gold bullion). The shares outstanding of GLD have to be contracted by 90%. In other words, the trust needs to buy 90% of the shares outstanding of GLD on the open market to maintain GLD's peg with gold.

 

Obviously, to do this they need money. Not gold -- money.

 

If the market cap of GLD is $43 billion, then the trust needs $43B * 90% or $38.7 billion of cash to buy up GLD in the open market. Theoretically, the fund gets this cash from selling gold bullion on the physical metal market, and then taking the cash and buying GLD in the stock market. I say "theoretically." Because, actually it doesn't matter where the cash comes from. It could be diverted out of the budget of the Defense Department, for example. The Fed could print it out of thin air.

 

Now, let's say that the GLD trust didn't actually go and buy any gold. The trust doesn't actually have any assets at all -- no futures, derivatives, forwards, no nothing. Rather, the managers of the trust took the money they got by selling shares of GLD and parked in a personal Cayman Islands bank account. In other words, GLD is a Ponzi scheme.

 

The problem, of course, is that there is now no money to buy GLD in the open market. Like a Ponzi scheme, it works as long as the shares outstanding is growing. When the shares outstanding is shrinking, there are no assets to trade for GLD in the open stock market. This is why people want 100% backing of their "currencies." So it doesn't become a Ponzi scheme.

 

GLD also supposedly offers direct exchange of shares for bullion, for large accounts. I would be surprised if anyone was actually capable of doing this. It's probably one of those promises which is broken as soon as someone asks for someone to perform on that promise. Today, even the Comex futures market is not delivering in bullion, but rather in shares of GLD! Do you really think you're going to get gold bullion out of GLD? Not in any meaningful size, I'd guess.

 

The point, however, is that as long as the trust is able to buy GLD in the stock market -- in other words, as long as the manager of the currency is able to adjust the supply -- then GLD will remain pegged to gold.

 

For a real currency, the process is a little different. Instead of trading GLD for cash in the stock market, the central bank trades cash (base money) for government bonds. This reduces the supply of currency (base money). As long as the central bank has something to trade for base money, and that base money disappears (unsterilized), the value of the currency will be supported. The central bank doesn't have to sell bonds. It could sell stocks, or real estate. The government could even take tax revenues, and simply make them disappear, thus reducing base money. The point is, the supply is reduced.

 

Once you understand this process, then the fear factor is greatly reduced. People have confidence that, when they establish a gold standard system, it won't blow up in their face. Also, we can see that it is not necessary to have lots of gold in a vault somewhere. It's all about managing the value of a paper chit via supply adjustment. Gold in a vault does not manage the supply of paper chits. Gold doesn't have a brain. It cannot act. Gold, by itself, does not increase or decrease the supply of base money. Hoping that "100% backing" -- a big pile of gold in a vault -- will somehow manage the supply of paper chits for you is extremely irrational

[Apech]

Churchill tried the gold standard in Britain in 1924/5 and it was a disaster. I would say that history indicates that it is not the way forward for any modern economy.

[joeblast]

Where did the author get this fallacy that somehow getting off the gold standard miraculously got us out of the great depression??? The gold standard was abandoned so that congress could spend with reckless abandon, and that was necessary for FDR's insane plethora of government programs that many erroneously attribute to somehow getting us out of the great depression - it wasnt great in extent but for america, precisely because of the thousand government boards, regulations, and huge expansion of the public sector. It simply does not make sense to expand like crazy jobs that produce no wealth and only consume it.

 

If anything, the gold standard was a measure against excessive governmental spending and debt and also served as a minor deflative measure.

 

You simply cant say a gold standard is bad overall when it is governmental instability and impulsiveness that wrecked the whole concept in the first place.

[jago25_98]

How's about, keep fiat money but turn all banks into democratic affairs by:

 

- public listing(capatalist approach), including the Bank of England. Especially the ones that are allowed to make more money.

 

- everyone owns it/has a say, run it like the Cooperative Bank (UK) (communist/socialist approach)

 

and so on...

 

or

 

Make every person a bank (decentralised p2p banking)

 

or

 

Local councils become local banks (semi decentralised banking)

 

 

The key thing is that banking and the money is power. People know something is up, so we don't vote mostly. But there's some sort of unclarity around the area, leaving a few both in the know and with the resources able to run things. Things have got pretty clear with quantitative easing, but it seems it needs to be even simpler, Sun reader level to hit perhaps before change happens. Perhaps a single article in the tabloids stating `The Bank of England is the power because they print money devaluing yours, democracy doesn't exist` might do it.

 

It's very simple really. `They print more of your money and yours is worth less` but it just doesn't seem to get through until we're Weinmar republic to understand it.

I'd imagine when that happens, big fight from the old boys.

 

p.s. there's signs of gold market manipulation too (source anyone?)

Edited April 29, 2010 by jago25_98

[joeblast]

I disagree with the gold market manipulation bit. Its a market price, after all, and with everything being done to destroy the dollar, people have been searching for more stable ways to invest their money - and with how volatile currency is lately, simply investing your money where dollars will still be dollars is a bit of a gamble in and of itself. Higher demand means higher price, pretty simple.

[Owledge]

I agree with the author urging us to remember that measures like a gold standard can always be abandoned again. This reminds us of the whole credibility factor.

Everything else in that article, though, is pure monetaristic speculativistic advocacy. Those poor speculators who can't trust the government. Hah! They are contributers to the problem!

 

When the prices of potatoes fall with a gold standard, when a deflation sets in, this points to a very important problem, and that is neglected in this article, too. Isn't is supposed to happen after so many years of inflation, which means the devaluation of money? People finally 'get back' what was stolen from them by the fraud of the monetary system.

In a fraudulent system like that, of course crazy things happen no matter in what way you tinker with it without understanding the fraud.

Dissolving all fraudulent activity in this system probably would leave no money at all.

Edited May 1, 2010 by Hardyg

[Cloudhand]

I disagree with the gold market manipulation bit. Its a market price, after all, and with everything being done to destroy the dollar, people have been searching for more stable ways to invest their money - and with how volatile currency is lately, simply investing your money where dollars will still be dollars is a bit of a gamble in and of itself. Higher demand means higher price, pretty simple.

 

Im with you brother its supply and demand that what made USA great. Not gold, its a come on use at hard ecomomic times trying to fool people in buying more gold. Cloud

[joeblast]

People finally 'get back' what was stolen from them by the fraud of the monetary system.

In a fraudulent system like that, of course crazy things happen no matter in what way you tinker with it without understanding the fraud.

Devaluation of currency does not equal anyone 'getting anything back,' it means that the unsustainable things that have happened get wiped off the table, i.e. government debt - so largess gets passed on to those who rely on the stability of the currency - so if saying people getting it in the back you would be more accurate. Naturally some private entities will also be on the positive side of the equation, so for instance something like all of those people that had far more generous pensions than were due ostensibly legally "took/were given money from the system" and got away with it, the situation simplified enough.

Edited May 3, 2010 by joeblast

[Owledge]

Joeblast, I was confused when I read you post and maybe it is because we think of different things. You write about devaluation of currency, but I was referring to the example of potato prices falling, and that's deflation, the opposite of devaluation of currency.