More Thoughts on a Gold Standard

The article The Long Wave Versus the Printing Press: Central Banks Go All-In posted on motivated us to test an idea. The author states (the emphasis is ours):

This time around the world’s central banks have a new set of tools. In past cycles money was mostly gold and silver, which is to say it was real and in limited supply. Credit might have been flexible because of fractional reserve banking, but the money at the base of the financial system couldn’t be created out of thin air. Today, in contrast, it can. Since the US broke the final link between national currencies and gold in 1971, everyone has been running fiat currencies that can be created in infinite quantities and depend for their value on the trust we place in the competence and honesty of our leaders.

Indeed, the primary reason proponents urge a return to a gold standard is to contain the money supply and indirectly, the credit market and the economy. The effect on the economy we will put aside, but we do want to consider the relationship between base money and the total money supply and the credit market.

To understand the idea of constrained or limited supply, we look at world gold production numbers. Figure 1 suggests that global production is increasing at a linear or slightly exponential rate. A recent paper, Numerical Analysis of Historic Gold Production Cycles and Implications for Future Sub-Cycles, suggests a more strongly exponential rise in production. The authors analyze production in terms of a series of four sub-cycles shown in Figure 2. They advance the argument for “peak-gold” and the unsustainability of an exponential increase in production.

Figure 1. World gold production,1900-2010. (Click on graph to open in a new window)

Figure 2. World gold production,1840-2000. (Click on graph to open in a new window)

The key point is that gold production has been increasing at a non-linear rate that represents a constraint. The possibility of peak-gold would impact its use in relationship to a currency in the future through its effect on economic growth but this does not concern us in this essay.

Growth in the Money Supply

We have argued elsewhere that debt is money with a maturity that ranges from zero (Federal Reserve notes) to whatever the current limits in practice are (30-year mortgages and longer term instruments). We take total credit market debt owed (TCMDO) as the best measure of this that we have. So it is of interest to see how the growth of TCMDO relates to the growth in the currency supply (CURRCIR), otherwise known as M0. Figure 3 shows us how the growths compare based on the available data for TCMDO going back to about 1950. This at least captures the last 20 years of the gold standard.

Figure 3. Growth of CURRCIR and TCMDO, 1950-2012, with a scaling factor added to CURRCIR to overlay the lines. (Click on graph to open in a new window)

The graph suggests that the money supply expanded at the rate of M0 both pre-1971 and post-1971. To get a finer grained look at the relationship, we produced Figure 4, the ratio of the year-over-year percentage change in each of the two quantities.

Figure 4. The ratio of the yoy percentage change in TCMDO to the yoy percentage change in CURRCIR. (Click on graph to open in a new window)

Apart from anomalous behavior around recessions, the relationship between the two quantities is markedly constant. We have argued elsewhere that the growth in broader measures of money is independent of the nature of the currency base, either some form of a gold standard or a fiat currency. To date this is the case.

The Future of Fiat Money

Gold standard advocates do so as a means to restrain growth of the money supply. We have shown that a disciplined use of fiat money, a growth that is governed by the growth in the economy, has achieved the same effect. The rightful concern is that central banks are out of control in their money creation. Certainly the Fed thinks it can reverse its monetization with a well-rehearsed exit strategy and we assume the ECB thinks similarly. We lack their confidence.

Fiat money per se is no more dangerous than gold or a gold-backed currency. The problems arise in financial market operations – lending practices – and the ability of governments to regulate such.

Finally, we strongly recommend the following Forbes article that we came across in researching this piece: The Gold Standard, and the Myth About Money Growth. A huge insight that we gained from reading it is that the supply of gold and the supply of gold currency are not at all the same thing.

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