Gold, Price Stability & Credit Bubbles

John Cochrane thinks that central banks can attain the price-stability of the gold standard without actually having a gold standard:

While many people believe the United States should adopt a gold standard to guard against inflation or deflation, and stabilize the economy, there are several reasons why this reform would not work. However, there is a modern adaptation of the gold standard that could achieve a stable price level and avoid the many disruptions brought upon the economy by monetary instability.

The solution is pretty simple. A gold standard is ultimately a commitment to exchange each dollar for something real. An inflation-indexed bond also has a constant, real value. If the Consumer Price Index (CPI) rises to 120 from 100, the bond pays 20% more, so your real purchasing power is protected. CPI futures work in much the same way. In place of gold, the Fed or the Treasury could freely buy and sell such inflation-linked securities at fixed prices. This policy would protect against deflation as well as inflation, automatically providing more money when there is a true demand for it, as in the financial crisis.

The obvious point is that the CPI is a relatively poor indicator of inflation and bubbles. During Greenspan’s tenure in charge of the Federal Reserve, huge quantities of new liquidity were created, much of which poured into housing and stock bubbles. CPI doesn’t include stock prices, and it doesn’t include housing prices; a monetary policy that is fixed to CPI wouldn’t be able to respond to growing bubbles in either sector. Cochrane is not really advocating for anything like the gold standard, just another form of Greenspanesque (mis)management.

Historically, what the gold standard meant was longer-term price stability, punctuated by frequent and wild short-term swings in purchasing power:

In its simplest form (the gold coin standard), gold constrains the monetary base to the amount of gold above ground. The aim is to prevent bubble-formation (in other words, monetary growth beyond the economy’s inherent productivity) because monetary growth would be limited to the amount of gold dug out of the ground, and the amount of gold dug out of the ground is limited to the amount of productivity society can afford to spend on mining gold.

Unfortunately, although gold levels are fixed, levels of credit creation are potentially infinite (and even where levels of credit creation are fixed by reserve requirements, shadow credit creation can still allow for explosive credit growth as happened after the repeal of Glass-Steagall). For example, the 1920s — a period with a gold standard — experienced huge asset bubble formation via huge levels of credit creation.

In any case, I don’t think that the current monetary regimes (or governments — who love to have the power to monetise debt) will ever change their minds. The overwhelming consensus of academic economists is that the gold standard is bad and dangerous.

In a recent survey of academic economists, 93% disagreed or strongly disagreed with this statement:

If the US replaced its discretionary monetary policy regime with a gold standard, defining a “dollar” as a specific number of ounces of gold, the price-stability and employment outcomes would be better for the average American.

That question is skewed. A gold standard can also be a discretionary regime; gold can be devalued, it can be supplemented with silver, and it can be multiplied by credit. And the concept of “price-stability” is hugely subjective; the Fed today defines “price stability” as a consistent 2% inflation (which on an infinite timeline correlates to an infinite level of inflation — the only stable thing being the rate at which the purchasing power of a dollar decreases).

If anything, the events of 2008 — which I interpret as a predictable and preventable housing, securitisation, and debt bubble stemming very much from central bank mismanagement of the money supply under Greenspan — secured the reputation of central banking among academic economists, because the bailouts, low rates and quantitative easing have prevented the feared debt-deflation that Milton Friedman and Ben Bernanke postulated as the thing that prolonged and worsened the Great Depression.

The Japanese example shows that crashed modern economies with excessive debt loads can remain stagnant for long periods of time. My view is that such nations are in a deleveraging trap; Japan (and more recently the Western nations) hit an excessive level of debt relative to GDP and industry at the peak of the bubble. As debt rises, debt servicing costs rise, leaving less income for investment, consumption, etc.

Throughout Japan’s lost decade, and indeed the years that followed, total debt levels (measured in GDP) have remained consistently high. Simply, the central bank did not devalue by anywhere near enough to decrease the real debt load, but nor have they devalued too little to result in a large-scale liquidation episode. They have just kept the economy in stasis, with enough liquidity to keep the debt serviceable, and not enough to really allow for severe reduction. The main change has been a transfer of debt from the private sector, to the public sector (a phenomenon which is also occurring in the United States and United Kingdom).

Eventually — because the costs of the deleveraging trap makes organically growth very difficult — the debt will either be forgiven, inflated or defaulted away. Endless rounds of tepid QE (which is debt additive, and so adds to the debt problem) just postpone that difficult decision. The deleveraging trap preserves the value of past debts at the cost of future growth.

Under the harsh discipline of a gold standard, such prevarication is not possible. Without the ability to inflate, overleveraged banks, individuals and governments would default on their debt. Income would rapidly fall, and economies would likely deflate and become severely depressed.

Yet liquidation is not all bad.  The example of 1907 — prior to the era of central banking — illustrates this.

As the WSJ noted:

The largest economic crisis of the 20th century was the Great Depression, but the second most significant economic upheaval was the panic of 1907. It was from beginning to end a banking and financial crisis. With the failure of the Knickerbocker Trust Company, the stock market collapsed, loan supply vanished and a scramble for liquidity ensued. Banks defaulted on their obligations to redeem deposits in currency or gold.

Milton Friedman and Anna Schwartz, in their classic “A Monetary History of the United States,” found “much similarity in its early phases” between the Panic of 1907 and the Great Depression. So traumatic was the crisis that it gave rise to the National Monetary Commission and the recommendations that led to the creation of the Federal Reserve. The May panic triggered a massive recession that saw real gross national product shrink in the second half of 1907 and plummet by an extraordinary 8.2% in 1908. Yet the economy came roaring back and, in two short years, was 7% bigger than when the panic started.

Although liquidation episodes are painful, the clear benefit is that a big crash and depression clears out old debt. Under the present regimes, the weight of old debt remains a burden to the economy.

But Cochrane talking about imposing a CPI-standard (or Greenspan talking about returning to the gold standard) is irrelevant; the bubble has happened, it burst, and now central banks must try to deal with the fallout. Even after trillions of dollars of reflation, economies remain depressed, unemployment remains elevated and total debt (relative to GDP) remains huge. The Fed — almost 100 years old — is in a fight for its life. Trying to balance the competing interests of creditors — particularly those productive foreign nations like China that produce much of America’s consumption and finance her deficits — against future growth is a hugely challenging task. The dangers to Western economies from creditor nations engaging in punitive trade measures as  a retaliatory measure to central bank debasement remain large (and the rhetoric is growing fiercer). Bernanke is walking a tightrope over alligators.

In any case even if a gold standard were to be reimposed in the future, history shows that it is unlikely to be an effective stop against credit bubbles. Credit bubbles happen because value is subjective and humans are excitable, and no regime has proven itself capable of fully guarding against that. Once a credit bubble forms, the possibilities are the same — liquidation, inflation or debt forgiveness. Todaycentral banks must eventually make a choice, or the forces of history will decide instead.

20 thoughts on “Gold, Price Stability & Credit Bubbles

  1. Aziz: As best I understand macroeconomics, your sobering post is correct. Please forgive repetition, but the only real solution in a democracy/republic is electing better politicians and, long term, producing better citizens.

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  4. Sure, credit bubbles can happen, but it’s only in an environment where the monetary unit is monopolized, where a fractional-reserve pyramid banking system is propped up by force of law on a national scale, that such bubbles can grow to the level where they encapsulate and endanger entire the economy as a whole.

    • I agree. And with every kick of the can, it becomes more dangerous as more and more of the economy becomes dependent on continued credit pushing. Look at the way the markets trade Fed intervention possibilities more than fundamentals…

        • I read said article and switched off whe it assumed rational decision making.

          I too believed others are rational; my misguided youth. Then I realised that the standard distribution of said economic participants are not rational. Then I searched for a better model. Leave the market alone model. The economy i.e. People are too complex to model.

          There was regulation in the time of Adam Smith and it was causing very noticeable problems in the economy. Hence why Adam Smith felt compelled to write.

          Regulatory capture has been going on for a long time. Economists who follow Keynesian principles are the puppets of Politicians who use the public treasury to manipulate the market for their own political survival.

          Keynes was a Eugenicist, and therefore believed that man could control his environment. When you understand this you realise it was doomed to fail. Nature is too complex for man to control. thousands of individuals focussing on their immediate need to supply wants at a profit is far superior to a group of idealistic men controlling the economy by directing. State funds towards certain sectors of the economy.

        • Going to a full reserve system without a debt reset is impossible. I don’t think a full reserve system would necessarily improve things. Financiers got around present reserve requirements using securitisation. They would also get around stricter future reserve requirements, somehow. Credit bubbles happen, and I don’t think any law or rule can prevent it happening.

        • According to Dr. Michael Emmett Brady, Smith and Keynes realise that decision-making processes are non-linear and non-additive. (Even though Smith didn’t use those terms, he essentially realised that the mathematical calculus of probabilities is a special case.)

          Decision-makers are not “irrational” (“irrational” being defined as “irrational” relative to the model of Subjective Expected Utility), they have non-linear and non-additive preferences.

  5. That is the problem with the gold standard, no one understands it. We would have to go back to how the economy ran before the fed was formed. Forget fractional reserve banking because we would bankrupt the system in weeks, I know I would be requesting my gold in short order.

    I could see the US government having an imaginary gold standard where all the money is backed by the gold at the fed but you cannot touch it. Kind of what the europeans did with the euro, it is backed by 15% gold. Funny thing is much of that gold was sold.

    Have you looked into DeMarco over at the FHFA. He is an interesting person. He is a Bush holdover and he is trying to protect tax payers by refusing to write down Fannie and Freddie mortgages. Maybe he is trying to be a hard case as a republican in a democratic administration. Krugman hates him big time because he does not want to add to the national debt. Banks should pay for all mortgage write downs not the taxpayer.

  6. What I don’t understand is why you equate CPI inflation with value destruction. The U.S. has had net inflation for a very very long time – at least a century – and has created a lot of value in that time. What’s so bad about CPI inflation?

    • I updated the post to reflect your criticism that inflation does not destroy value throughout the entire economy, but decreases the purchasing power of an individual dollar.

      There are a few potential problems with continuous net inflation: residual debt buildup being the biggest one, as well as potential for systemic bubble formation.

      I would hypothesise that the occasional liquidationary crash (though certainly not the prolonged and enforced liquidationism we saw in the 1930s) is healthy because it clears out the debt overhang, just as the occasional flu or fever is healthy for human beings.

  7. Inflation Deflation Night Day Winter Summer Abundance Famine are all natural events. To manage prices is akin to trying to manage winter by using fossil fuels or using lights to manage night. It is not natural. We have manged to have a run of GDP growth by printing and withholding money at the discretion of the Central Bankers. The economy has been on steroids for too long, and like a steroid munching athlete is going to have health problems.

    If man has ruined nature by trying to control it so too will he ruin the economy. Recessions and Depressions are natural. They clear out the dead wood of frivolous goods and services. In the past agricultural patterns governed by natural rythms would cause rythmic gyrations in an economy. This pattern has been disrupted.

    How do we store our surplus efforts? In fiat currency? If this fiat currency is debased by printing it debases the physical efforts of man. This is immoral. This is pure theft.

    The only solution is to use your savings and accumulate tangible goods that are useful and allow you to live. A house and land that is well built and fertile, so that it lasts multiple generations, well made equipment and consumer goods. Well tailored clothing. A well made vehicle that can be restored and refurbished. Buy antique goods that store value and are valued by discerning collectors. Good art. fertile farmland that is rented at a positive cashflow.

    Gold just represents liquid value of the above, but if you are in no need to liquidate the above represent real money and wealth. Buy the above low and sell high. Never be desperate to buy high and sell low. Patience.

    Gold is traded on corrupted markets. It has subjective manipulatable value.

    The only time Gold has value more than the hard commodities I have mentioned, is in times of war. But by then, a couple of kilos of gold won’t help too much. Maybe save your life. Health is key. Enjoy life. Love. And smell the roses. You have only one life. make it memorable.

  8. You aren’t postulating a return to the gold standard as a fix all, but you certainly say it would be a help to stabilize. Why? It’s a commodity, and thus subject to supply and demand. You touch on supply somewhat. But imagine this, a giant heretofore undiscovered gold load is discovered that doubles the amount of gold in market. Or, on demand side, what if some new, revolutionary technology is developed that requires massive amounts of gold. Either of these or other shocks would dramatically change gold prices. Intrinsic value is a myth.

    FYI it was Irving Fisher who first postulated the debt-deflation theory of recessions.

    • I’ll be clearer: I’m not advocating a return to the gold standard, at the very least because I think it’s politically impossible.

      I think that we are stuck with pure fiat money in the near future, especially as a medium of exchange. Central banks will just have to do their best to make this arrangement work. It will be very, very difficult. The best hope for the fiat status quo is to completely change how they do monetary policy and switch to expanding the monetary base solely through uniform helicopter drops to the population at large to expunge debt. This will severely and immediately reduce the debt burden, which is the biggest macroeconomic problem right now.

      On the other hand, I strongly advocate personal gold ownership, especially in present economic environment (deleveraging trap). I don’t see gold as a commodity. I see it as a liquid asset, i.e. as a form of money (store of value) with no counterparty risk.

      • The main mandate of the Central Banks is inflation control THEN full employment. Maintaining Fiat currency is the only solution to ensure this. A Gold Standard won’t work because of physical logistics and mining realities. Gold wont grow with the world productive output.

        But instead of helicopter drop to expunge debt, fiscal policy would work in tandem with monetary policy responses to heat or cool the economy by ATM cash top ups or witholding as the economy requires. This would not be free money but via a taxation system that regulates excessive demand. A kind of working credit debit system. It is paternalistic but if the Statists really wanted to be Masters of the Economy, then this is a solution to stimulating or retarding aggregate demand to ensure full employment and price stability.

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