Since I have been so hard on the Ron Paul supporters, I figure I will make it up to them today by paying attention to one of the issues (and there are several) where we agree. In this case, the need for a solid, reliable currency. And, since the greatest single figure in the destruction of our currency is John Maynard Keynes¹, he gets a second quote, in this case:

In truth, the gold standard is already a barbarous relic.

Of course, this quote is not precisely a technical one, nor is it particularly informative, but in its bold, simple statement, it is quite dreadfully wrong, as I hope to show, and show much more briefly than I have elsewhere².

I suppose the basic argument Keynes was making was that tying money to gold somehow kept the economy stagnant. At least I hope he was not openly saying "If we tie money to gold then the government can't spend with reckless abandon". That is the true motive behind many attacks on the gold standard, but they usually try to attach some pseudo-economic fig leaf, so I will assume Keynes was doing so as well. In general, such justifications tend to focus on the "inflexibility" and "unresponsiveness" of gold currency, arguing that gold doe snot allow us to "adapt" to circumstances, to "adjust" credit and keep us stuck in the "boom and bust" cycle, while a managed paper currency does not.

For the moment, I will ignore the fact that "boom and bust" cycles only occurred after the federal government intervened and created the "state banking system" that preceded the Federal reserve (with the exception of a few boom and bust mini-cycles during the short lived Second Bank of the US and immediately after its liquidation) . I will also ignore the fact that the greatest, most prolonged recessions and depressions have come under managed currency, and that their frequency has increased in the years since the closing of the gold window between 1971 and 1973. We can discuss all that later. First, let me just ask my reader to look at a classical, totally free gold standard, as ask what in particular is so "barbarous" about it. We can then look at managed currency in theory (both the monetarist/Keynesian theories and the opposing Austrian ones), and then look at the practice, which I have just mentioned briefly. Hopefully, in a few short paragraphs I can convince at least most readers the quote above deserves the "stupid" designation.

Let us start with what everyone learned at one time, though in very brief detail, the beginnings of trade and the origins of money. Basically, all trade is barter. Goods exchange against goods. Even with money, we only accept it because we know we can later exchange it for another good we want. So, in the end, barter is the basis of all trade, and so , let us begin there.

Barter is easy to comprehend. I have goods I don't need, you have goods I want, we trade one for the other. It works because you want what I have more than what you have, and the same in true --in reverse -- for me. However, there is a basic problem with barter, or a few problems. First, many times you have what I want, but you don't want what I have, or vice versa. And so, I end up trading my goods to a third party to get what you want, and then trade that to you³. Second, many times I have a lot of goods to trade, but don't want to exchange them for all the goods they would buy right now. Say, for example, it is harvest time, and I have all the goods I will make in the year, but I don't want to make all my purchases now. But, food being perishable, I don't want to store it forever, so I have to find a way to trade my food, and store the value for later, to make future purchases. Or, perhaps you want to buy all my goods, but I don't want to buy that much stuff right now, and so, again, I want to find a store of value.

In earlier times, many solutions were tried, mostly using items that were in high demand, such as cattle, precious metals, gemstones, luxuries of various sorts and so on. There were benefits and shortcomings to all of them. Cattle, for instance, are hard to subdivide to "make change", and since they can die, their value can diminish quickly. Other goods are perishable, such as many luxury goods. Or they cannot be subdivided evenly⁴. In the end, precious metals came to be the general solution adopted throughout much of the world. They were not perishable⁵, they were easily subdivided while retaining the same proportional value, they had a high value per unit of volume⁶, they were in high demand, they were scarce enough to be valuable, while not so scarce as to be hard to use⁷. And, of the precious metals, silver and gold eventually became the favored choices, which continued to compete with one another throughout recent history, right up to the defeat of specie by government fiat currency in the 1930's⁸.

Of course, coins were not the end of the story. Banks came into existence to help store and lend money, and they began to write bank notes, pieces of paper redeemable for a fixed value of coins. And from those notes, currency was born. And, for much of history, currency, at least paper currency, was a private product, with each bank writing its own, and individuals either having to go to that bank to redeem the notes, asking their own bank to do so, or working through a handful of regional clearinghouse banks which accepted all such notes and then cashed them themselves⁹. Banks also began to engage in fractional reserve banking, that is issuing more notes than they had reserves, on the assumption no one would cash in all the notes at once, and thus began to inflate the money supply. But banks had to worry about a run happening if they overinflated and other banks thought they were unstable, so they inflated pretty conservatively, and not in a consistent manner between banks. That is, there was not a uniform inflation of, say, 5%, the amount of inflation was decided by each bank, but restricted by the need to maintain confidence.

And that is the classic private gold standard. The unit of currency can be defined by the state (eg there are X dollars to an ounce of gold) or can be defined privately, often by tradition. It really doesn't matter, as an ounce of gold is an ounce of gold, so long as the unit of currency is defined in metal, working out an exchange rate is easy. Beyond that, the currency works pretty simply. You can sue gold, or you can use paper, but the paper is convertible into gold. Banks sometimes inflate, but if they go too far, then they are forced to close, or at least to convince investors not to run on the bank by offering some inducement. In any case, the essential desire of every bank is to make each note redeemable, so from the point of view of investors, paper will normally be "as good as gold". And, in return, whenever you buy something, you are exchanging goods for goods, that is gold for goods, or goods for gold.

On the down side, depositors and note holders may, from time to time, suffer hardship if a bank has bad management. When a bank overinflates, the depositors may not be able to withdraw their deposits, and might have to take only a percentage of the value in a bankruptcy settlement. On the other hand, this does not involve the whole economy, just isolated banks, and is generally avoidable by sticking to established banks.  And, historically, things often were even better than that, as some clearing house consortiums honored notes from failed banks at par to keep faith in the currency, meaning those holding notes didn't suffer, though depositors still did. In short, there were the risks inherent in the free market in general, but nothing that would make gold "barbarous" or "unworkable".

The only other objection is the nonsensical argument that gold cannot provide "enough" purchasing power. But that is an idiocy Lord Say dispelled over a century ago. If the amount of goods increases while the currency supply remains the same, what happens is not economic hardship, the price of goods simply declines. Which means your savings buys more. Of course, with prices falling, wages will falls slightly too, but given this description, not as fast as prices, meaning we can have simultaneous falling wages and increasing purchasing power. (This happened historically in the late 19th century in the US, a situation conventional economists strive mightily to explain away, as it doesn't fit their monetary theories.)

So, what about government currency?

Well, when the state controls currency, they can inflate to their heart's content, and, especially if it cannot be redeemed, there is no check on it beyond the inevitable recession or depression. Since money is nothing but paper the state prints, they can make as much as they want, and they do, which is why we lose purchasing power every year, though we have become so used to this we don't even notice any longer. In addition, it works as a hidden tax. When the government prints money and uses it to buy things, it drives up prices, making our savings worth less. In effect, they have secretly taxed every dollar of savings to finance those purchases. But inflation is worse than an honest tax, as it strikes unevenly, and tends to cause economic dislocations out of proportion to the numbers themselves. In addition, thanks to the ability to suddenly revalue currencies, nations tend to develop rather hostile economic policies as they attempt to be the first to revalue the currency to their advantage, before another nation does it to them. In general, fiat currency makes money management a tool for exporting economic loos to other countries.

And yet, this system, which hides taxes, wrecks economies and fosters hostile international relations, is modern and benevolent, while the stable system which exchanged value for value and could be run without the slightest government involvement was the "barbarous relic"? I can't understand how this thought process works. And, so, I have to argue it is a truly stupid quote.

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1. My earlier Keynes quote came yesterday in "Stupid Quote of the Day (January 6, 2012)".

2. Some of my earlier arguments can be found in "Monetary Issues Made Simple Part I ", "Monetary Issues Made Simple Part II ", "The Inflation Engine", "Why Gold?", "Proof Keynes (and Krugman) Are Insane", "CNN's Keynesian Nonsense ", "Inflation and Uncertainty", "Bad Economics Part 7", "Bad Economics Part 8", "What Is Money? ", "What Is A Dollar?" and  "The Gold Question, Not "Why?" But "When?""

3. This could obviously extend to several steps turning into one of those children's stories where John trades A for B, B for C, C for D, D for E and so on, until he finally trades Y to get the Z he wanted all along.  As should be obvious, this could make barter in a complex environment quite difficult.

4. Cattle are the best example, as a cow cut in half is not worth half of what the original cow was. Similarly, a silk robe is hard to evenly divide while keeping its value. Even gems have this problem, as a diamond cut in half does not produce two diamonds worth half as much each as the original gem.

5. Gold excels other metals in this regard thanks to it lack of corrosion and general resistance to most other chemical reactions. It is a bit worse in one regard, being so soft gold coins tend to wear more, but this can be solved by alloying it with silver or other harder metals. And the non-corrosive properties more than make up for the softness.

6. It is obviously desirable for a money to have a high value per unit. Imagine we were to use, say lead as currency. Imagine what $1000 in coins would look like. It would weigh hundreds of pounds and fill several sacks. Since gold can carry hundreds of dollars of value in a handful of coins, it is a very useful medium of exchange. (Though see note 7 below for the other side of this argument.)

7. A very scarce precious metal, such as platinum, would have such a high value per unit volume that minting coins in any useful denominations would be difficult. of course, we could  base a paper currency on such high value metals, but to redeem one would need to accumulate a large value of currency, making it less inflation resistant, as it would be easier to inflate with redemption being so difficult. Which is why a medium value per unit is much more desirable.

8. I say the 1930's as, while de facto fiat currency existed in many countries for some time, and officially in the us since 1917, the holding of specie was still legal and currencies were nominally still convertible to gold or silver. In the 30's, Britain agreed to back the pound in dollars, with most other currencies already being backed in pounds. So when in 1934 FDR made it illegal for citizens of the US to hold monetary gold, currency was effectively cut loose from gold and silver. In theory, foreign governments, banks and even private foreign holders of currency could still convert until 1971 (when foreign citizens lost the right) or 1973 (when foreign banks and governments did), but in practice, money was no longer backed by specie but by government promises. Of course the final blow did not come until the early 1970's, and that brought even more dire consequences, but for all intents and purposes, specie died in the 1930's.

9. The clearinghouse is an interesting example of how the private market reacts more efficiently than the government does. I won't go into the whole story here, but in colonial days in the US there was a problem with "wildcat" banks starting up in remote regions, printing thousands of unbacked notes and then counting on their remote location to keep those notes from being redeemed. Clearinghouse banks would accumulate large enough numbers of these notes to make it worthwhile to send someone to cash them and thus put a check on these wildcat banks through private action which the governments of the states had failed to do despite much rhetoric on the issue. (Actually, many states quietly supported such banks, as they gained the benefits of such currency, while normally shipping the costs out of the colony.)

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POSTSCRIPT

I realized as I finished that I had missed some of the points I said I would cover. However, I went on longer than expected, so I don't want to go back and add yet more. Instead, f anyone has any question about specific outcomes of the inflationary system, I would recommend looking through the lengthy list of articles linked in the postscript to "The Gold Question, Not "Why?" But "When?"". Every topic imaginable is covered by one or more articles in that list.