A)Beware Of The Fake Gold Floating Around
SOURCE http://seekingalpha.com/
B)THE GOLD STANDARD: CAUSES AND CONSEQUENCES
INTRODUCTION
The term "gold standard" signifies a paper money economy in which the
government is contractually bound to convert a unit of its circulating paper
money into an inter temporally constant amount of a real commodity, usually
a precious metal because of the relative transactional convenience of such
conversion payments. Whether or not a country is on a gold standard has
substantial effects on the welfare of its people.
The gold standard first appeared in China during an early-ninth-century
renaissance in ancient Chinese religion and effective democracy and was
consistently maintained there in some form throughout China's lengthy golden
age of technological and economic expansion until the standard, and the
extended renaissance, was finally brought to an end in 1620 with the maturation
of China's unfortunately durable reversion to philosopher authoritarianism.
Although the idea of the gold Standard was introduced to the West at the end
of the thirteenth century by Marco Polo who was greatly impressed by the
convertible certificates of the initially silver-rich Mongol Emperors, not until
four centuries later did the gold standard begin an independent life-cycle of its
own in the West.
1. The Rise and Fall of the Gold Standard in the West
Economic folklore attributes the evolution of the gold standard in the West to the development of a fractional goldreserve system by seventeenth century English goldsmiths who lent out a fraction of their idle gold reserves in exchange for promissory notes that they used to back private
issues of negotiable paper debt, i.e., paper money. But similar private banking
institutions had already developed much earlier without special comment in
medieval Florence and Venice.
The true innovators were the governmental leaders of England's new democracy following her "Glorious Revolution" of 1688. This path breaking democratic revolution, while providing a legal and philosophical ("rights-of man") commitment to compensate the citizen-Soldiers of the huge new armies of rifle-equipped Englishmen for their large wartime personal sacrifices, did nothing to prevent the new democracy from subsequently repealing its debts to those who had made large wartime financial sacrifices. Yet such Financial sacrifices had been necessary for the survival of the fledgling democracy because, as we shall see, military leaders cannot defend a democracy unless
they can override the self-defeating , but narrowly rational -- appeasement response to potential aggressors that characterizes any democratic legislature.
The governmental invention of the gold standard, by solving this critical problem in defense finance for the newly forming democratic nations of the West, cleared the path to modernity.
The evolution of the gold standard in the West was thus begun by the newly established Bank of England during the formative years of what was to become our first successful national democracy. Then, almost a century later. after a failed Swedish experiment to establish a national democracy
supported by a cumbersome copper standard (1719-1772), a second viable precíous metal standard was adopted in by the newly formed Bank of the United States in what was to become our second successful national democracy.
Then, due largely to the remarkable success of these two nations relative to their neighbors, the standard -- usually accompanied by substantial democratization -- spread to Continental Europe, Latin America and Japan during the nineteenth century. The restructured countries similarly enjoyed eras of remarkably successful national defense and exceptionally high, albeit fitful,overall economic growth. Eventually, in the early-mid 1930s, based largely upon the cumulative impact of the "Cambridge School" of economics led by the increasingly influential John Maynard Keynes, each European nation separately abandoned its gold standard in order to give its central bank greater flexibility in fighting the unemployment characterizing the Great Depression.
Only the U.S. remained on a gold standard, albeit one with harsh curbs imposed on the export and possession of gold. And only the U.S. could finance the military defense of the democracies during WWII.
After the end of WWII, an international "gold exchange standard" was set up. This was achieved by executing a 1944 agreement developed in an international monetary conference at Breton Woods, New Hampshire, in which financial representatives of the democratic nations of Europe all agreed to
work to make their countries' paper currencies convertible into the U.S. dollar as long as the U.S. maintained a conversion rate of the dollar into gold in exchanges with foreign central banks. This internationally cooperative kind of gold standard effectively served the emergency military requirements of the recovering European democracies, and in the same recession- producing way that the internationally individualistic gold standard had served prior to the early 1930s. Then, upon the completion of a U .S. centered nuclear defense system for the democratic nations of the West
during the late 1960-5, this last remnant of the gold standard was quickly phased out and finally eliminated when the U.S. closed the gold window on 15 August,197l .
Since that date, no government has made a viable claim of convertibility of its paper money into a real asset of any kind.
2. Business Cycles and the Gold Standard
Because, during periods of free commercialise of paper money into a real asset, the public is free to exchange idle real commodity stocks for paper money, or vice verse, the total demand for this convertible paper completely determines its supply. Governmental monetary authorities then
have no direct control over the money supply. The correspondingly passive money supply has been generally understood by political economists to be a property of a classical gold standard since the writings of Adam Smith, as reflected in the policy oriented writings of Thomas Tooke and the
English "Banking School" in the 1840s, of J. Laurence Laughlin and the U.S. "sound money school“ of the 1890s, and of the early supporters of the Federal Reserve Act of 1913. All of these authors saw great benefits in the system's ability to automatically expand and contract its peace time paper
money supply in response to "the needs of trade" without affecting prices to any significant degree.
Such benefits are absent during periods of suspended or non-existent convertibility. During such periods, independent governments, such as the contemporary U.S. government, are free to tix their paper money supplies "exogenously", i.e., without regard to legal commitments. Thus` with
observed governmental monetary authorities unwilling to Surrender their discretionary control to an automatic mechanism, sudden expansions or contractions in the demand for ìnconvertible paper money have regularly raised or depressed commodity prices and correspondingly generated
avoidable business cycles. This has been well-recognized since the early days of classical economics, as reflected in Henry Thortons famous analysis of the effects of a monetary shock on prices and interest rates during periods of suspended gold payments. The analysis was placed in
a somewhat more explicit, mini general equilibrium-type, setting for permanently in convertible, money economics in the late 1930s by Keynes and John R. Hicks and survives today as what is commonly called "neo-Keynesian macroeconomics".
Examples of such business cycles, and correspondingly of the social value of a passive money supply, are easily supplied. At the time of this writing, the last two U.S. recessions provide almost
identical examples of how sudden fluctuations in the demand for a fiat money create
modem business cycles that would have been automatically avoided if we had adopted a suitable gold standard. The suddenly higher demands for U.S. paper money, the medium for the payment of U.S. taxes, 'Following both the mid-1982 and mid-1990 Presidential announcements of near-
future tax-rate increases immediately precipitated almost identical economic declines rather than immediate increases in the stock of paper money. In contrast, these recessions would have been automatically avoided if our paper money supply ,had been freely convertible (into a real asset whose relative price were unaffected by the tax-rate) and therefore automatically expanded part
pasu with the tax needs of trade.
However, a gold-standard produces its own unique brand of business cycle. In particular, gold-standard depressions occur when, and only when, there are shocks that increase the equilibrium value of the conversion commodity relative to other commodities, thereby decreasing
the general price level by the Same percentage. A correspondingly severe gold-standard depression induces a percentage reduction in the endogenous money supply approximately equal to the percentage reduction in the price of ordinary goods relative to the fixed-price conversion commodity. In sharp contrast, the same relative demand shock would occasion no systematic change in the overall price level or aggregate output if there were an exogenous currency stock. The
gold standard government's inability to so fix the paper money supply, and thereby avoid the severe depressions caused by shocks that significantly increase the relative demand for the conversion commodity,is by far the main disadvantage of a gold standard.
Moreover such business cycles, including the Great Depression occurred regularly under the gold standard And despite the relative ease with which they could be -- and actually were -- predicted by financial experts, the cycles in real output under the gold standard were of much greater amplitude and duration than those observed under our recent, in convertible, governmental managed, monetary systems. Viewed solely from the standpoint of the economic costs of the business cycle, the gold
standard was, therefore, probably, on net, socially disadvantageous.
3. Emergency Finance and the Gold Standard
However, as already noted, by far the main advantage of a gold standard to an adopting country was its historically unique ability to facilitate the financing of large-scale military emergencies. The underlying reason for this ability is that a wartime suspension of a governmental conversion promise is widely regarded as a temporary force majeure, an excusable but temporary supply interruption in an otherwise inviolable contract between a powerful government and an innocent individual citizen,
the latter being conceived of as requiring the substantial protection of the law. Post-emergency law courts and legislatures therefore typically enforced depression-producing resumptions of pre-war gold conversion payments on their paper monies, although usually only after several years
of extended legislative debate during which time suitable revenue-increasing measures could be devised in order to finance the retirement of the large issues of wartime paper.
Before the nuclear age, when emergency national defense was a prolonged and expensive affair, this financial advantage had been necessary for the military survival of national democracies. Theoretically, this financial sine qua non of pre-nuclear modern democracy arises because
there is a time-inconsistent, overly appeasing, response of any narrowly rational collection of voters to each in a series of broadly rational threats of all out-war by external aggressors demanding individually small favors. A democratic nation whose leaders are unable to overcome this legislative
appeasement problem by independently Financing its military defense would, sooner or
later, be subjugated by external aggressors.
More specifically, the late seventeenth century founders of the Bank of England were acutely aware both of the historical reluctance of independent parliaments to supply funds necessary for emergency military defense and of the recent military failure of neighboring Holland's pioneering, but short-lived, national democracy. These perceptive British bankers, along with their new Dutch King, William iii, saw that Holland's failure was due to the disastrous legal inability of the Bank of Amsterdam to expand her innovative paper money supply in a defensive emergency (the War of 1672). This unfortunate infeasibility was due to a rule in the banks constitution limiting its issue of paper money to its effective gold reserve.
In any case, the war-troubled William III, his pragmatic English bankers and a Scottish banking promoter, William Paterson, worked to create a national paper currency that would flexibly expand during military emergencies, and do so without creating proportionate increases in the price
level. Under a gold standard, extra paper money could be created and spent during the defensive emergencies, although convertibility would have to be temporarily suspended to prevent a of the paper money back to the Bank. (The first formal suspension of gold payments thus occurred in
1695, barely one year after the money was first issued; and the suspension lasted only the two additional years that William required to impressively defeat the formidable France of Louis IVX.) The suspension-induced expansion of the paper money supply would in turn cause some wartime
inflation. But since the new paper money represented a durable contract between the individual money-holder and the government meant that English judges would likely attempt to enforce an eventual resumption of gold payments at the original conversion rate as a matter of common law.
Parliament , unwilling to risk yet another constitutional crisis and civil war predictably ordered the resumption of gold payments at the old conversion rate -- and continued to do so until 1931 despite the need for both a real post-war tax increase the finance the payments and a depressionary return to
the pre-War price trend was the very expectation of this post-war depression by the financial comm unity that allowed the wartime expansion in governmental purchasing, power that was in tum required for the survival of the democracy.
Then, early in the eighteenth century, after a couple of such wars widespread parliamentary support arose for large wartime issues of long-term national debt. For such borrowing served as a convenient substitute for wartime monetary expansion. Although moderate interest would be due
on such borrowing, repayment could be delayed to dates that would officially distribute the inter generational burden of the war in a more politically acceptable fashion or moderate the social costs of the anticipated post-war deflation. War finance in countries with mature gold standards
was therefore typically marked by substantial issues of legislatively approved, long-term, governmental debt as well as by Suspension-induced monetary expansions. The resulting appearance of a simple willingness on the part of the democratic legislatures of gold standard nations to support
defensive warfare with substantial domestic issues of long-term debt has obscured, for
even the most astute of contemporary economic observers, the basic problem that the gold standard was solving.
In any case without the gold standard, emergency finance would have doubtless remained in the hands of clubs of wealthy noblemen,bankers, and guild aristocrats, groups,,whose peacetime compensation for their extensive wartime sacrifices depended on maintaining highly elitist
religions and philosophies, antimodern (although currently re emergent) value systems deserving their countries by exaggerating the personal wisdom and benevolence of appropriately educated aristocrats.
Indeed, before the nuclear age, no independent nation evolved aristocracy to a surviving national democracy without the aid of a gold Standard.
4. Mainstream Macroeconomics and the Gold Standard
This major advantage of a gold standard, although never a recognized part of mainstream economics, has been particularly obscured to modern economists by an error in basic Keynesian economics leading to the theoretical conclusion that a permanent increase in a fiat money supply
lowers interest rates. This theoretical error, the source of a major unresolved empirical paradox in Keynesian theory called the Gibson paradox led Keynes and subsequent generations of economists, to a dangerously false belief. This was the misbelief that emergency expansions
in a money supply which were correctly understood to be permanent increases in the money supply would be partially hoarded. Such induced hoarding would occur because of the theoretically induced decreases in the foregone-interest cost of holding money. The increases in commodity
prices during emergencies would then be proportionately less than the corresponding money-supply increases. If this is true, then the permanent money-supply increases occurring during a wartime emergency in a flat money economy would produce unambiguous increases in emergency governmental purchasing power, just as had occurred for the temporary monetary expansions that had been induced by national emergencies under the classical gold standard. A correction of this
theoretical error leads to the opposite theoretical prediction. A permanent increase in a flat money supply in a capital-theoretically correct macro-model, by unambiguously increasing the marginal productivity of capital and leaving the rationally expected inflation rate constant, leads to an increase in interest rates and therefore an increase in the opportunity cost of holding money- Dis hoarding, not hoarding, is induced. Such a monetary expansion thus results in percentage increases in prices that the percentage increases in money supplies.
Besides freeing us from the Gibson paradox, this theoretical correction leads us to understand why democratic Europe was so uncharacteristically weak in its response to Fascist aggression in the late
1930s. It also enables us to understand why the U.S., the only country that did not abandon the gold standard, at least in international transactions, was able to generate uniquely large increases in emergency governmental purchasing power and, as part of the same process, maintain exceptionally
low interest rates throughout WWII.
Democratic Europe's intellectually fashionable abandonment of the gold standard in the early 1930s in order to forestall further depression therefore appears to have been a serious policy error. The fashionable abandonment left democratic Europe wide-open to the threat of all-out attack by rationally selected military fanatics, who then naturally emerged in the midlate 1930s. The only democratic nation that was sufficiently resistant to intellectual fashion to remain on the
gold standard, the U.S., was therefore the only nation able to finance a wartime defense effort adequate to the task of "defending the world for democracy".
Although it may appear peculiar, the mainstream literature on the gold standard has traditionally avoided the important political-economic issues discussed above in favor of narrower and more speculative discussions dealing with the dynamics of international price adjustment.
The latter include: (I) David seminal discussion of the laissez faire gold-flows, and corresponding price-level changes, occurring between nations in a suddenly disequillibrated hypothetical world whose only money consists of full-bodied gold coins; (2) the famous "currency school" versus
"banking school" debate leading to Peel's Bank Charter Act of l 844, which enshrined Hume's view of the natural adjustment process, except that the Central Bank could respond to a shock inducing continual gold drains by Bank borrowing (ie. by raising the Banks discount rate) serving to raise
the domestic relative price of gold and thereby hasten the final laissez faire price adjustment while at the same time preventing a costly overshooting of gold flows during the adjustment period; and (3) the increasingly acrimonious post-WWI discussions of the negative short-term employment
effects on other nations of the above, borrowing policies (or restrictive shortterm trade policies) and the corresponding international disapproval of gold-hoarding (perennially by France and, in
the critical I929-32 period1 by the United States) to the point that such borrowing policies were condemned as "not playing according to the rules" of an imaginary international game. The international sensitivity of these dynamical effects is probably what best accounts for the fact that the most influential authors in the field have traditionally been specialists in intellectual diplomacy and strategically sophisticated communication.
5. The Broad Price Trends Observed Under the Gold Standard
To describe the basic workings of the gold standard with added precision, it is help full to assume a zero "transaction costs"perfectly competitive, equilibrium in all markets. Then, multiplying the
governments fixed, inter temporally constant, money price of gold by the perfectly competitive equilibrium price of any other commodity relative to gold, we can immediately determine the my price of that commodity.
Since this can be done for all commodities, and without reference to the passively determined money supply, equilibrium relative prices in a perfectly competitive money economy can be determined independently of the monetary sector. The resulting "classical dichotomy" between the real
and monetary sectors of an economy., which was implicit in most of classical and early neoclassical economics, greatly facilitates the quantitative analysis of the economy.
In a perfectly competitive economy with a gold standard, idle Stocks of gold (called "monetary gold" when they are held by financial institutions), like any other currently non-productive asset„ must be
expected to appreciate at a rate equal to the real rate of return to holding currently productive assets. Thus, issuers of gold-convertible paper money need not pay direct interest on their monies. Indeed, Convertible banknotes bore no direct interest while money prices in gold-standard economies
generally fell slightly during` peacetime, reflecting the slightly positive real interest rate on alternative investment goods.
During wartime, when gold standard economies generated large increases in the money supply and suspensions of gold payments, there were typically substantial releases of monetary gold to the public, roughly constant money prices of gold, and therefore increases in the nominal prices
of most other goods. Nevertheless, the rational expectation of postwar resumptions of gold conversion payments, and corresponding postwar reductions in commodity prices implied higher-than-normal rates of return to holding paper money relative to goods during the wartime emergencies.
Increases in the governments wartime purchasing power therefore accompanied wartime increases in the governments nominal issue of paper money. This powerful financial weapon provided a goldstandard government with a potential wartime increase in zero-interest purchasing power limited only by the government's ability to repay the zero-interest loan after the war by suitably raising postwar taxes to finance future conversion payments. The increase in the rationally expected deflation rate also generated, after the Brie` learning period of 1695-1725, nominal
interest rates that typically remained low (below 5%) during major Wars throughout the gold-standard era despite the obvious wartime increases in both real interest rates and default risks.
But this main advantage of the gold standard also implied postwar depressions as monetary gold was gradually re accumulated by the central banks which correspondingly increased the value of gold relative to other commodities. Repetitive innovations economizing on gold conversion
during these resumption periods first by including silver as a conversion metal, then by limiting conversion to bullion, then by allowing conversion into another country‘s convertible currency, then by outlawing the private hoarding of gold, and finally by restricting gold payments to conversion payments made by a single country to foreign central banks , beneficially served to mitigate these consistently depressionary resumption costs and create a long-term trend of money prices in the West that was roughly constant throughout the entire quarter-millennial era of its classical gold standard, 1694-1944.
The demise of the international gold exchange standard in the quarter-century following WWII followed closely behind the development of an international system of nuclear defense, because, as already noted, a well—equipped nuclear power does not require large increases in cumulative expenditures during a defense emergency. As the underlying advantage of the gold-standard was thus becoming increasingly obsolete, the number of real experiences of the emergency financial benefits provided by the gold standard correspondingly diminished. And as the main disadvantage in the form of potential cyclical instability obviously remained most imminently in the form of a potential worldwide recession if the US,were to attempt a resumption of gold payments that had been suspended since 1968 -- the international political support for a gold standard by practical people rapidly eroded.
6. Emergency Finance After the Gold Standard
Nevertheless, smaller, non-nuclear armed, nations, while likely to be living under a larger nation's "nuclear umbrella", still have been facing substantial emergency financial demands to cover domestic political uprisings. Such countries, even after the abandonment of the BrettonWoods agreement, have typically attempted, quite rationally, to unilaterally keep their currencies convertible into the fiat currency of a large foreign country in order to maintain the financial advantages of a gold standard.However, the repetitive hyperinflation of the 1970s proved that the legal systems of these nations did not treat a domestic government promise to convert a unit of its currency into a fixed amount of an in convertible paper currency of a foreign nation anything like a promise to convert into gold.
The 1980-5 and early 1990s have thus been a period in which these countries have enlisted the aid of foreign governments, usually through international economic organizations set up at Bretton Woods and somehow surviving the collapse of the original agreement. to commit themselves to a more durably fixed exchange rate. These recent attempts,although much more successful in controlling the secular inflation rates of small countries, and correspondingly in achieving domestic political stability, have also produced a series of small-country, post-emergency depressions quite analogous to the large-country depressions occurring under the gold standard. Finally, looking to the future, the problem of emergency finance in large Democratic nations has not permanently disappeared. For one thing,the continuing growth of governmental indebtedness beginning about 35 years ago is steadily diminishing the abilities of governmental authorities to finance future emergencies, including domestic emergencies, with ordinary borrowing. There is therefore an increasing need for large democracies to provide mechanisms that will finance future emergencies.But prospective democratic legislatures cannot be expected to adopt mechanisms that will burden their future economies with post-emergency depressions anything like those observed under the classical gold standard. It follows that if new, depression-resistant, mechanisms of emergency finance are not adopted, and pre- l8th century history and recent trends are any guide, the increasing emergency usefulness of wealthy individuals relative to ordinary civilians will inevitably lead to a tortuous degeneration of our effective democracies back into elitist aristocracies such as those that had dominated our governments prior to the rise of the gold standard.
By Earl A- Thonipsori
SOURCE http://www.econ.ucla.edu
If you are a precious metals investor, the recent news of fake gold bars showing up in Manhattan should be of interest. News of the existence of tungsten-filled "gold" bars is certainly not new. They have been found in other parts of the world as well. But when people are successfully selling fake gold bars to reputable and knowledgeable gold dealers in the United States, it is time for U.S. based investors to be especially careful with their purchases.
Here are a few things to keep in mind when purchasing physical precious metals:
First, stay small. There is less economic incentive to fake a gold coin as opposed to a gold bar. It doesn't mean there aren't fake gold coins floating around (there are). But if you stick with a reputable dealer, and you know what a real coin looks like, you are less likely to get scammed than you might be when purchasing a gold bar. Moreover, if you are nervous about buying a fake gold coin, you can always choose to purchase coins that dealers have purchased directly from the U.S. or Canadian Mints.
The American Precious Metals Exchange (APMEX) has a program called MintDirect, which allows investors to purchase unopened tubes of gold and silver coins that came in "Monster Boxes" direct from the U.S. and Canadian Mints. In terms of gold, the 1 ounce American Eagles come in tubes of 20 coins, and the 1 ounce Canadian Maple Leafs come in tubes of 10 coins. Regarding silver, the 1 ounce American Eagles come in tubes of 20 coins, and the 1 ounce Canadian Maple Leafs come in tubes of 25 coins.
Additionally, if you are worried about fake silver coins, you could consider purchasing some of the older 90%, 40%, or 35% silver coins that used to be in circulation. These include silver dollars, half-dollars, quarters, dimes, and nickels. There would far less economic incentive to fake these coins. Although, again, it does not mean that fakes don't exist.
Furthermore, regarding silver bars: if you want to purchase physical bars and think you can avoid fakes by turning to silver, be aware that silver bars stuffed with lead are known to exist.
In terms of finding a dealer with whom to do business, the U.S. Mint has a "Coin Dealer Database" on its website that allows you to search for dealers by state. But be aware that the Mint includes the following disclaimer regarding the database: "The companies that appear on this list are neither affiliated with, nor are they official dealers of the United States Mint."
Also, if your exposure to physical precious metals comes through exchange-traded funds such as GLD, SLV, IAU, or PPLT, you should at least think through the potential for those funds to be backed by fake gold, silver, or platinum. One question to consider is what would happen if an audit of these funds' holdings actually did turn up fake precious metals. What do you think the chances are that investors would actually find out?
Finally, if the possibility of purchasing fake precious metals is a worry with which you do not want to concern yourself, you could always purchase the miners as a means of gaining exposure to precious metals. One of the more popular ways of diversifying exposure to the miners is through the Market Vectors Gold Miners ETF (GDX).
SOURCE http://seekingalpha.com/
B)THE GOLD STANDARD: CAUSES AND CONSEQUENCES
INTRODUCTION
The term "gold standard" signifies a paper money economy in which the
government is contractually bound to convert a unit of its circulating paper
money into an inter temporally constant amount of a real commodity, usually
a precious metal because of the relative transactional convenience of such
conversion payments. Whether or not a country is on a gold standard has
substantial effects on the welfare of its people.
The gold standard first appeared in China during an early-ninth-century
renaissance in ancient Chinese religion and effective democracy and was
consistently maintained there in some form throughout China's lengthy golden
age of technological and economic expansion until the standard, and the
extended renaissance, was finally brought to an end in 1620 with the maturation
of China's unfortunately durable reversion to philosopher authoritarianism.
Although the idea of the gold Standard was introduced to the West at the end
of the thirteenth century by Marco Polo who was greatly impressed by the
convertible certificates of the initially silver-rich Mongol Emperors, not until
four centuries later did the gold standard begin an independent life-cycle of its
own in the West.
1. The Rise and Fall of the Gold Standard in the West
Economic folklore attributes the evolution of the gold standard in the West to the development of a fractional goldreserve system by seventeenth century English goldsmiths who lent out a fraction of their idle gold reserves in exchange for promissory notes that they used to back private
issues of negotiable paper debt, i.e., paper money. But similar private banking
institutions had already developed much earlier without special comment in
medieval Florence and Venice.
The true innovators were the governmental leaders of England's new democracy following her "Glorious Revolution" of 1688. This path breaking democratic revolution, while providing a legal and philosophical ("rights-of man") commitment to compensate the citizen-Soldiers of the huge new armies of rifle-equipped Englishmen for their large wartime personal sacrifices, did nothing to prevent the new democracy from subsequently repealing its debts to those who had made large wartime financial sacrifices. Yet such Financial sacrifices had been necessary for the survival of the fledgling democracy because, as we shall see, military leaders cannot defend a democracy unless
they can override the self-defeating , but narrowly rational -- appeasement response to potential aggressors that characterizes any democratic legislature.
The governmental invention of the gold standard, by solving this critical problem in defense finance for the newly forming democratic nations of the West, cleared the path to modernity.
The evolution of the gold standard in the West was thus begun by the newly established Bank of England during the formative years of what was to become our first successful national democracy. Then, almost a century later. after a failed Swedish experiment to establish a national democracy
supported by a cumbersome copper standard (1719-1772), a second viable precíous metal standard was adopted in by the newly formed Bank of the United States in what was to become our second successful national democracy.
Then, due largely to the remarkable success of these two nations relative to their neighbors, the standard -- usually accompanied by substantial democratization -- spread to Continental Europe, Latin America and Japan during the nineteenth century. The restructured countries similarly enjoyed eras of remarkably successful national defense and exceptionally high, albeit fitful,overall economic growth. Eventually, in the early-mid 1930s, based largely upon the cumulative impact of the "Cambridge School" of economics led by the increasingly influential John Maynard Keynes, each European nation separately abandoned its gold standard in order to give its central bank greater flexibility in fighting the unemployment characterizing the Great Depression.
Only the U.S. remained on a gold standard, albeit one with harsh curbs imposed on the export and possession of gold. And only the U.S. could finance the military defense of the democracies during WWII.
After the end of WWII, an international "gold exchange standard" was set up. This was achieved by executing a 1944 agreement developed in an international monetary conference at Breton Woods, New Hampshire, in which financial representatives of the democratic nations of Europe all agreed to
work to make their countries' paper currencies convertible into the U.S. dollar as long as the U.S. maintained a conversion rate of the dollar into gold in exchanges with foreign central banks. This internationally cooperative kind of gold standard effectively served the emergency military requirements of the recovering European democracies, and in the same recession- producing way that the internationally individualistic gold standard had served prior to the early 1930s. Then, upon the completion of a U .S. centered nuclear defense system for the democratic nations of the West
during the late 1960-5, this last remnant of the gold standard was quickly phased out and finally eliminated when the U.S. closed the gold window on 15 August,197l .
Since that date, no government has made a viable claim of convertibility of its paper money into a real asset of any kind.
2. Business Cycles and the Gold Standard
Because, during periods of free commercialise of paper money into a real asset, the public is free to exchange idle real commodity stocks for paper money, or vice verse, the total demand for this convertible paper completely determines its supply. Governmental monetary authorities then
have no direct control over the money supply. The correspondingly passive money supply has been generally understood by political economists to be a property of a classical gold standard since the writings of Adam Smith, as reflected in the policy oriented writings of Thomas Tooke and the
English "Banking School" in the 1840s, of J. Laurence Laughlin and the U.S. "sound money school“ of the 1890s, and of the early supporters of the Federal Reserve Act of 1913. All of these authors saw great benefits in the system's ability to automatically expand and contract its peace time paper
money supply in response to "the needs of trade" without affecting prices to any significant degree.
Such benefits are absent during periods of suspended or non-existent convertibility. During such periods, independent governments, such as the contemporary U.S. government, are free to tix their paper money supplies "exogenously", i.e., without regard to legal commitments. Thus` with
observed governmental monetary authorities unwilling to Surrender their discretionary control to an automatic mechanism, sudden expansions or contractions in the demand for ìnconvertible paper money have regularly raised or depressed commodity prices and correspondingly generated
avoidable business cycles. This has been well-recognized since the early days of classical economics, as reflected in Henry Thortons famous analysis of the effects of a monetary shock on prices and interest rates during periods of suspended gold payments. The analysis was placed in
a somewhat more explicit, mini general equilibrium-type, setting for permanently in convertible, money economics in the late 1930s by Keynes and John R. Hicks and survives today as what is commonly called "neo-Keynesian macroeconomics".
Examples of such business cycles, and correspondingly of the social value of a passive money supply, are easily supplied. At the time of this writing, the last two U.S. recessions provide almost
identical examples of how sudden fluctuations in the demand for a fiat money create
modem business cycles that would have been automatically avoided if we had adopted a suitable gold standard. The suddenly higher demands for U.S. paper money, the medium for the payment of U.S. taxes, 'Following both the mid-1982 and mid-1990 Presidential announcements of near-
future tax-rate increases immediately precipitated almost identical economic declines rather than immediate increases in the stock of paper money. In contrast, these recessions would have been automatically avoided if our paper money supply ,had been freely convertible (into a real asset whose relative price were unaffected by the tax-rate) and therefore automatically expanded part
pasu with the tax needs of trade.
However, a gold-standard produces its own unique brand of business cycle. In particular, gold-standard depressions occur when, and only when, there are shocks that increase the equilibrium value of the conversion commodity relative to other commodities, thereby decreasing
the general price level by the Same percentage. A correspondingly severe gold-standard depression induces a percentage reduction in the endogenous money supply approximately equal to the percentage reduction in the price of ordinary goods relative to the fixed-price conversion commodity. In sharp contrast, the same relative demand shock would occasion no systematic change in the overall price level or aggregate output if there were an exogenous currency stock. The
gold standard government's inability to so fix the paper money supply, and thereby avoid the severe depressions caused by shocks that significantly increase the relative demand for the conversion commodity,is by far the main disadvantage of a gold standard.
Moreover such business cycles, including the Great Depression occurred regularly under the gold standard And despite the relative ease with which they could be -- and actually were -- predicted by financial experts, the cycles in real output under the gold standard were of much greater amplitude and duration than those observed under our recent, in convertible, governmental managed, monetary systems. Viewed solely from the standpoint of the economic costs of the business cycle, the gold
standard was, therefore, probably, on net, socially disadvantageous.
3. Emergency Finance and the Gold Standard
However, as already noted, by far the main advantage of a gold standard to an adopting country was its historically unique ability to facilitate the financing of large-scale military emergencies. The underlying reason for this ability is that a wartime suspension of a governmental conversion promise is widely regarded as a temporary force majeure, an excusable but temporary supply interruption in an otherwise inviolable contract between a powerful government and an innocent individual citizen,
the latter being conceived of as requiring the substantial protection of the law. Post-emergency law courts and legislatures therefore typically enforced depression-producing resumptions of pre-war gold conversion payments on their paper monies, although usually only after several years
of extended legislative debate during which time suitable revenue-increasing measures could be devised in order to finance the retirement of the large issues of wartime paper.
Before the nuclear age, when emergency national defense was a prolonged and expensive affair, this financial advantage had been necessary for the military survival of national democracies. Theoretically, this financial sine qua non of pre-nuclear modern democracy arises because
there is a time-inconsistent, overly appeasing, response of any narrowly rational collection of voters to each in a series of broadly rational threats of all out-war by external aggressors demanding individually small favors. A democratic nation whose leaders are unable to overcome this legislative
appeasement problem by independently Financing its military defense would, sooner or
later, be subjugated by external aggressors.
More specifically, the late seventeenth century founders of the Bank of England were acutely aware both of the historical reluctance of independent parliaments to supply funds necessary for emergency military defense and of the recent military failure of neighboring Holland's pioneering, but short-lived, national democracy. These perceptive British bankers, along with their new Dutch King, William iii, saw that Holland's failure was due to the disastrous legal inability of the Bank of Amsterdam to expand her innovative paper money supply in a defensive emergency (the War of 1672). This unfortunate infeasibility was due to a rule in the banks constitution limiting its issue of paper money to its effective gold reserve.
In any case, the war-troubled William III, his pragmatic English bankers and a Scottish banking promoter, William Paterson, worked to create a national paper currency that would flexibly expand during military emergencies, and do so without creating proportionate increases in the price
level. Under a gold standard, extra paper money could be created and spent during the defensive emergencies, although convertibility would have to be temporarily suspended to prevent a of the paper money back to the Bank. (The first formal suspension of gold payments thus occurred in
1695, barely one year after the money was first issued; and the suspension lasted only the two additional years that William required to impressively defeat the formidable France of Louis IVX.) The suspension-induced expansion of the paper money supply would in turn cause some wartime
inflation. But since the new paper money represented a durable contract between the individual money-holder and the government meant that English judges would likely attempt to enforce an eventual resumption of gold payments at the original conversion rate as a matter of common law.
Parliament , unwilling to risk yet another constitutional crisis and civil war predictably ordered the resumption of gold payments at the old conversion rate -- and continued to do so until 1931 despite the need for both a real post-war tax increase the finance the payments and a depressionary return to
the pre-War price trend was the very expectation of this post-war depression by the financial comm unity that allowed the wartime expansion in governmental purchasing, power that was in tum required for the survival of the democracy.
Then, early in the eighteenth century, after a couple of such wars widespread parliamentary support arose for large wartime issues of long-term national debt. For such borrowing served as a convenient substitute for wartime monetary expansion. Although moderate interest would be due
on such borrowing, repayment could be delayed to dates that would officially distribute the inter generational burden of the war in a more politically acceptable fashion or moderate the social costs of the anticipated post-war deflation. War finance in countries with mature gold standards
was therefore typically marked by substantial issues of legislatively approved, long-term, governmental debt as well as by Suspension-induced monetary expansions. The resulting appearance of a simple willingness on the part of the democratic legislatures of gold standard nations to support
defensive warfare with substantial domestic issues of long-term debt has obscured, for
even the most astute of contemporary economic observers, the basic problem that the gold standard was solving.
In any case without the gold standard, emergency finance would have doubtless remained in the hands of clubs of wealthy noblemen,bankers, and guild aristocrats, groups,,whose peacetime compensation for their extensive wartime sacrifices depended on maintaining highly elitist
religions and philosophies, antimodern (although currently re emergent) value systems deserving their countries by exaggerating the personal wisdom and benevolence of appropriately educated aristocrats.
Indeed, before the nuclear age, no independent nation evolved aristocracy to a surviving national democracy without the aid of a gold Standard.
4. Mainstream Macroeconomics and the Gold Standard
This major advantage of a gold standard, although never a recognized part of mainstream economics, has been particularly obscured to modern economists by an error in basic Keynesian economics leading to the theoretical conclusion that a permanent increase in a fiat money supply
lowers interest rates. This theoretical error, the source of a major unresolved empirical paradox in Keynesian theory called the Gibson paradox led Keynes and subsequent generations of economists, to a dangerously false belief. This was the misbelief that emergency expansions
in a money supply which were correctly understood to be permanent increases in the money supply would be partially hoarded. Such induced hoarding would occur because of the theoretically induced decreases in the foregone-interest cost of holding money. The increases in commodity
prices during emergencies would then be proportionately less than the corresponding money-supply increases. If this is true, then the permanent money-supply increases occurring during a wartime emergency in a flat money economy would produce unambiguous increases in emergency governmental purchasing power, just as had occurred for the temporary monetary expansions that had been induced by national emergencies under the classical gold standard. A correction of this
theoretical error leads to the opposite theoretical prediction. A permanent increase in a flat money supply in a capital-theoretically correct macro-model, by unambiguously increasing the marginal productivity of capital and leaving the rationally expected inflation rate constant, leads to an increase in interest rates and therefore an increase in the opportunity cost of holding money- Dis hoarding, not hoarding, is induced. Such a monetary expansion thus results in percentage increases in prices that the percentage increases in money supplies.
Besides freeing us from the Gibson paradox, this theoretical correction leads us to understand why democratic Europe was so uncharacteristically weak in its response to Fascist aggression in the late
1930s. It also enables us to understand why the U.S., the only country that did not abandon the gold standard, at least in international transactions, was able to generate uniquely large increases in emergency governmental purchasing power and, as part of the same process, maintain exceptionally
low interest rates throughout WWII.
Democratic Europe's intellectually fashionable abandonment of the gold standard in the early 1930s in order to forestall further depression therefore appears to have been a serious policy error. The fashionable abandonment left democratic Europe wide-open to the threat of all-out attack by rationally selected military fanatics, who then naturally emerged in the midlate 1930s. The only democratic nation that was sufficiently resistant to intellectual fashion to remain on the
gold standard, the U.S., was therefore the only nation able to finance a wartime defense effort adequate to the task of "defending the world for democracy".
Although it may appear peculiar, the mainstream literature on the gold standard has traditionally avoided the important political-economic issues discussed above in favor of narrower and more speculative discussions dealing with the dynamics of international price adjustment.
The latter include: (I) David seminal discussion of the laissez faire gold-flows, and corresponding price-level changes, occurring between nations in a suddenly disequillibrated hypothetical world whose only money consists of full-bodied gold coins; (2) the famous "currency school" versus
"banking school" debate leading to Peel's Bank Charter Act of l 844, which enshrined Hume's view of the natural adjustment process, except that the Central Bank could respond to a shock inducing continual gold drains by Bank borrowing (ie. by raising the Banks discount rate) serving to raise
the domestic relative price of gold and thereby hasten the final laissez faire price adjustment while at the same time preventing a costly overshooting of gold flows during the adjustment period; and (3) the increasingly acrimonious post-WWI discussions of the negative short-term employment
effects on other nations of the above, borrowing policies (or restrictive shortterm trade policies) and the corresponding international disapproval of gold-hoarding (perennially by France and, in
the critical I929-32 period1 by the United States) to the point that such borrowing policies were condemned as "not playing according to the rules" of an imaginary international game. The international sensitivity of these dynamical effects is probably what best accounts for the fact that the most influential authors in the field have traditionally been specialists in intellectual diplomacy and strategically sophisticated communication.
5. The Broad Price Trends Observed Under the Gold Standard
To describe the basic workings of the gold standard with added precision, it is help full to assume a zero "transaction costs"perfectly competitive, equilibrium in all markets. Then, multiplying the
governments fixed, inter temporally constant, money price of gold by the perfectly competitive equilibrium price of any other commodity relative to gold, we can immediately determine the my price of that commodity.
Since this can be done for all commodities, and without reference to the passively determined money supply, equilibrium relative prices in a perfectly competitive money economy can be determined independently of the monetary sector. The resulting "classical dichotomy" between the real
and monetary sectors of an economy., which was implicit in most of classical and early neoclassical economics, greatly facilitates the quantitative analysis of the economy.
In a perfectly competitive economy with a gold standard, idle Stocks of gold (called "monetary gold" when they are held by financial institutions), like any other currently non-productive asset„ must be
expected to appreciate at a rate equal to the real rate of return to holding currently productive assets. Thus, issuers of gold-convertible paper money need not pay direct interest on their monies. Indeed, Convertible banknotes bore no direct interest while money prices in gold-standard economies
generally fell slightly during` peacetime, reflecting the slightly positive real interest rate on alternative investment goods.
During wartime, when gold standard economies generated large increases in the money supply and suspensions of gold payments, there were typically substantial releases of monetary gold to the public, roughly constant money prices of gold, and therefore increases in the nominal prices
of most other goods. Nevertheless, the rational expectation of postwar resumptions of gold conversion payments, and corresponding postwar reductions in commodity prices implied higher-than-normal rates of return to holding paper money relative to goods during the wartime emergencies.
Increases in the governments wartime purchasing power therefore accompanied wartime increases in the governments nominal issue of paper money. This powerful financial weapon provided a goldstandard government with a potential wartime increase in zero-interest purchasing power limited only by the government's ability to repay the zero-interest loan after the war by suitably raising postwar taxes to finance future conversion payments. The increase in the rationally expected deflation rate also generated, after the Brie` learning period of 1695-1725, nominal
interest rates that typically remained low (below 5%) during major Wars throughout the gold-standard era despite the obvious wartime increases in both real interest rates and default risks.
But this main advantage of the gold standard also implied postwar depressions as monetary gold was gradually re accumulated by the central banks which correspondingly increased the value of gold relative to other commodities. Repetitive innovations economizing on gold conversion
during these resumption periods first by including silver as a conversion metal, then by limiting conversion to bullion, then by allowing conversion into another country‘s convertible currency, then by outlawing the private hoarding of gold, and finally by restricting gold payments to conversion payments made by a single country to foreign central banks , beneficially served to mitigate these consistently depressionary resumption costs and create a long-term trend of money prices in the West that was roughly constant throughout the entire quarter-millennial era of its classical gold standard, 1694-1944.
The demise of the international gold exchange standard in the quarter-century following WWII followed closely behind the development of an international system of nuclear defense, because, as already noted, a well—equipped nuclear power does not require large increases in cumulative expenditures during a defense emergency. As the underlying advantage of the gold-standard was thus becoming increasingly obsolete, the number of real experiences of the emergency financial benefits provided by the gold standard correspondingly diminished. And as the main disadvantage in the form of potential cyclical instability obviously remained most imminently in the form of a potential worldwide recession if the US,were to attempt a resumption of gold payments that had been suspended since 1968 -- the international political support for a gold standard by practical people rapidly eroded.
6. Emergency Finance After the Gold Standard
Nevertheless, smaller, non-nuclear armed, nations, while likely to be living under a larger nation's "nuclear umbrella", still have been facing substantial emergency financial demands to cover domestic political uprisings. Such countries, even after the abandonment of the BrettonWoods agreement, have typically attempted, quite rationally, to unilaterally keep their currencies convertible into the fiat currency of a large foreign country in order to maintain the financial advantages of a gold standard.However, the repetitive hyperinflation of the 1970s proved that the legal systems of these nations did not treat a domestic government promise to convert a unit of its currency into a fixed amount of an in convertible paper currency of a foreign nation anything like a promise to convert into gold.
The 1980-5 and early 1990s have thus been a period in which these countries have enlisted the aid of foreign governments, usually through international economic organizations set up at Bretton Woods and somehow surviving the collapse of the original agreement. to commit themselves to a more durably fixed exchange rate. These recent attempts,although much more successful in controlling the secular inflation rates of small countries, and correspondingly in achieving domestic political stability, have also produced a series of small-country, post-emergency depressions quite analogous to the large-country depressions occurring under the gold standard. Finally, looking to the future, the problem of emergency finance in large Democratic nations has not permanently disappeared. For one thing,the continuing growth of governmental indebtedness beginning about 35 years ago is steadily diminishing the abilities of governmental authorities to finance future emergencies, including domestic emergencies, with ordinary borrowing. There is therefore an increasing need for large democracies to provide mechanisms that will finance future emergencies.But prospective democratic legislatures cannot be expected to adopt mechanisms that will burden their future economies with post-emergency depressions anything like those observed under the classical gold standard. It follows that if new, depression-resistant, mechanisms of emergency finance are not adopted, and pre- l8th century history and recent trends are any guide, the increasing emergency usefulness of wealthy individuals relative to ordinary civilians will inevitably lead to a tortuous degeneration of our effective democracies back into elitist aristocracies such as those that had dominated our governments prior to the rise of the gold standard.
By Earl A- Thonipsori
SOURCE http://www.econ.ucla.edu
Labels: economic philosophy
posted by The visioner @ 9:08 PM
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