Guest Post: Paul Krugman’s Mis-Characterization Of The Gold Standard

Submitted by James E. Miller of the Ludwig von Mises Institute of Canada,

With a price hovering around $1,600 an ounce and the prospect of “additional monetary accommodation” hinted to in the latest meeting of the Federal Reserve’s Federal Open Market Committee, gold is once again becoming a hot topic of discussion.

George Soros made news recently when a filing with the Securities and Exchange Commission revealed that he had liquidated his position with major financial firms and had loaded up on gold; approximately 884,000 shares worth.  Jim Cramer, the CNBC personality in constant search of growing business trends, recommends putting at least 20% of one’s assets in gold.  Following the Republican National Convention, the party platform now proposes the establishment of a commission to study “the feasibility of a metallic basis for U.S. currency.”

Like the gold commission before it, this new interest in gold has brought out the critics who regard the precious metal as nothing short of, to borrow the infamous term coined by John M. Keynes, a “barbarous relic.”  Wesleyan University economist Richard Grossman writes in the Los Angeles Times that the idea of a gold commission is a “waste of time and money” because the standard hasn’t “worked for 100 years.”  In The Atlantic, fiat currency enthusiast Matthew O’Brien calls the gold standard a “terrible idea” and presents a few charts demonstrating that linking the dollar to gold failed to keep prices stable.  Economist and New York Times columnist Paul Krugman has praised O’Brien’s article on his blog and makes sure to point out that the price of gold has been highly volatile since 1968 by showing the following chart:


There is a remarkably widespread view that at least gold has had stable purchasing power. But nothing could be further from the truth.

Krugman points out that when interest rates are low the price of gold typically rises.  He claims that as interest rates tend to fall during recessions, gold’s rise in price would lead to “a fall in the general price level.”  Lastly, Krugman ridicules the notion that a true gold standard would prevent asset bubbles and subsequent busts from occurring by calling attention to the fact that America suffered from financial panics “in 1873, 1884, 1890, 1893, 1907, 1930, 1931, 1932, and 1933.”

These criticisms, while containing empirical data, are grossly deceptive.  The information provided doesn’t support Krugman’s assertions whatsoever.  Instead of utilizing sound economic theory as an interpreter of the data, Krugman and his Keynesian colleagues use it to prove their claims.  Their methodological positivism has lead them to fallacious conclusions which just so happen to support their favored policies of state domination over money.  The reality is that not only has gold held its value over time, those panics which Krugman refers to occurred because of government intervention; not the gold standard.

Right off the bat, the Nobel Laureate makes the amateur mistake of conflating two different gold standards.  There was not one set standard throughout the 19th century up to the Great Depression.  Until the first World War, the United States and much of the West was under the classical gold standard.  This meant that the dollar was just a name for a set amount of gold; generally 1/20 of an ounce.  Following the massive inflation used to pay for World War I and the Genoa Conference of 1922, the gold exchange standard was adopted by many Western countries including Britain.  Though the United States remained under an imperfect classical gold standard, other Western countries stopped redeeming gold coins for national currencies.  Instead, they redeemed their currencies for dollars or pounds which allowed for expanded fiscal policies because the constraint of gold was not so prominent.  At the same time, President of the New York Federal Reserve, Benjamin Strong, conspired with the head of the Bank of England, Montague Norman, to keep gold from flowing out of Britain by having the Fed adopt “easy money conditions in the United States” and “increase bank liquidity a great deal” according to economic historian Robert Higgs.  This backroom deal was carried out as England readopted the gold standard in 1926 at the pre-World War 1 parity despite the pound being devalued during the war.  Because trade unions and unemployment insurance made wage rates less flexible downwards, the ensuing deflation was detrimental and combated through further inflation aided and abetted by the Fed.

This new international agreement between central bankers may have appeared to be a maintaining of the classical gold standard but it was nothing of the sort.  The inflationary boom in the later half of the 1920s was a product of the monetary scheming of the Fed and Bank of England.  The final result was the stock market crash of 1929 which ushered in the Great Depression.  Contrary to popular belief, the Depression was not caused by the classical gold standard but because of its rejection.

As for the other panics Krugman mentions, neither were caused by the gold standard but by government intervention in the money market.  As economist Joseph Salerno explains, the pervasiveness of fractional reserve banking, or the expansion of credit unbacked by gold reserves, played a key role in creating financial instability.  The panics were caused primarily by

..the establishment of a quasi-central banking cartel among seven privileged New York banks resulting in the almost complete centralization of U.S. gold reserves in their vaults by the National Bank acts of 1863-1864.  This New York City banking cartel was able to expand willy nilly the monetary base and the overall money supply by expanding their own notes and deposits on top of gold reserves.   Their notes and deposits were then used as reserves by lower tier banks (Reserve City Banks and Country Banks) on which to  pyramid their own notes and deposits.

Moreover, banks, especially the larger ones, were encouraged in their inflationary credit creation by the firmly entrenched expectation that they would be freed from fulfilling their contractual obligations in times of difficulty by the legal suspensions of cash payments to their depositors and note-holders that recurred during panics throughout the 19th century.

In sum, an adherence to a real gold standard was not the main cause of all the financial panics Paul Krugman lists.  It was his favorite institution, the state, and the incessant fiddling around with the economy by the political class that created an unstable monetary system.  It is also worth pointing out that the late 19th century was a period of incredible economic growth for both the United States and the rest of the world in spite of the flawed gold standard.  Though it is often alluded to as a time of robber barons, worker starvation, and terrible deflation, the U.S. economy experienced its highest rate of growth ever recorded as the 1800s drew to a close.  As Murray Rothbard documents in The History of Money and Banking in the United States: The Colonial Era to World War II:

The record of 1879–1896 was very similar to the first stage of the alleged great depression from 1873 to 1879. Once again, we had a phenomenal expansion of American industry, production, and real output per head. Real reproducible, tangible wealth per capita rose at the decadal peak in American history in the 1880s, at 3.8 percent per annum. Real net national product rose at the rate of 3.7 percent per year from 1879 to 1897, while per-capita net national product increased by 1.5 percent per year…

Both consumer prices and nominal wages fell by about 30 percent during the last decade of greenbacks. But from 1879–1889, while prices kept falling, wages rose 23 percent.  So real wages, after taking inflation—or the lack of it—into effect, soared.

No decade before or since produced such a sustainable rise in real wages.

From 1869 to 1879 the total number of business establishments barely rose, but the next decade saw a 39.4-percent increase. Nor surprisingly, a decade of falling prices, rising real income, and lucrative interest returns made for tremendous capital investment, ensuring future gains in productivity.

When the United States maintained a gold standard to a fairly significant degree, the economy blossomed.  The relative absence of inflation ensured that the dollar acted as a store of value in addition to facilitating transactions.  Without the threat of looming price increases, the public was more willing to put off consumption and add to the supply of capital availability by saving.  The prudent technique of producing more than you consume allowed for a greater number of entrepreneurs to put capital to work.  This set the foundation for mass production and giving consumers access to an abundance of goods never thought possible just a century before.

To the Keynesians’ befuddlement, the economic renaissance of the late 19th century occurred at a time where prices weren’t rising or stable but actually falling.  The fall in the general price level occurred as the production capacity expanded at a faster rate than the money supply.  Today, economists of the Keynesian and monetarist school remain convinced that a stable price level is good thing when common sense dictates otherwise.  Falling prices are a godsend for consumers; not a catastrophe.  As long as entrepreneurs are able to utilize the inherent feedback mechanism of an undistorted pricing system to forecast input costs, falling prices are only a minor problem.  The focus on price stability is why many economists missed the Depression and the Fed-engineered boom of the 1920s.  In a free market, the tendency is for prices to fall as production increases.

Krugman denies not only that sound money leads to economic stability and growth, he does so while attempting to show that gold has been incredibly volatile since Richard Nixon cuts the dollar’s tie to the precious metal in 1971.  But Krugman puts the proverbial cart before the horse with his example as it hasn’t been the price of gold that has fluctuated to a high degree but rather the dollar’s value.  As Forbes editor John Tamny pointed out in August of 2011

as Brookes calculated in his essential book The Economy In Mind, “In 1970 an ounce of gold ($35) would buy 15 barrels of OPEC oil ($2.30/bbl). In May 1981 an ounce of gold ($480) still bought 15 barrels of Saudi oil ($32/bbl).” Fast forward to the present, and an ounce of gold ($1750) buys roughly 20 barrels of oil ($85)

Krugman also asserts that when interest rates fall, the price of gold increases [ZH - we discussed the various regime changes between interest rates and gold here in great detail].  But again he makes the same mistake of not recognizing the role dollar manipulation plays in both measures.  Interest rates haven’t been formed by market forces since the Federal Reserve was established.  In a free market, interest rates are determined by the public’s collective time preference or the discounting of future goods against present goods.  When more people are saving, and therefore putting off consumption, there is a higher supply of loanable funds.  This higher supply translates to lower interest rates as the price of present capital lowers.  Under a fiat regime like the Fed which oversees a system of fractional reserve banking, interests rates are manipulated by a few central bankers instead of the market.  These central planners increase the supply of money in an effort to push down interest rates and induce consumers into borrowing. This also has the effect of pushing up the price of gold as investors lose confidence in the dollar’s value.

In his crusade to keep Keynesianism as a legitimate school of thought, Krugman has yet again attempted to mischaracterize gold and blame it for crises caused solely by government intervention.  What Keynesianism amounts to is a theory of state worship and the virtue of hedonism.  Its leading proponents declare there is such thing as a free lunch and that it is served directly by the printing of money.  In other words, it is based on backwards logic and remains distant from reality.

The Keynesians admit there was a housing bubble then fret over an “output gap.”  They blame market exuberance for recessions but then prescribe the exact same policies that lead to exuberance to begin with.  This irrationality was best displayed with a remarkable quote by former Treasury Secretary and former director of President Obama’s National Economic Council Lawrence Summers who wrote in an editorial for the Washington Post:

The central irony of a financial crisis is that while it is caused by too much confidence, borrowing and lending, and spending, it can be resolved only with more confidence, borrowing and lending, and spending.

Keynesians have no pure economic theory; they are totally ad hoc in their approach.  Any data point which fits their view is trumpeted.  Any theory that presents a challenge to the idea that the economy can be finely tuned like a child’s trinket is dismissed as right-wing propaganda.  Keynesians ultimately reject the golden rule of economics: savings represents deferred consumption and producing more than is consumed.  Real savings in the form of capital goods (factories, equipment, machinery, etc.) are the backbone of any economy.  Government only squanders these scarce resources through its constant pillaging of wealth.

Keynes himself was contemptuous of the middle class throughout his professional career.  This is perhaps why he held such disdain for gold.  Gold is the market’s choice for money; not the statist ruling class dependent on spending virtually unlimited sums of tax dollars.  Because a true gold standard prevents runaway inflation and budget deficits from occurring in perpetuity, Keynesians will do all they can to discredit gold as a workable form of currency.  Their allegiance lies with the state and paper money; not the natural choices of the common man.