The Gold Standard: Inflation, Wealth and Economic Growth

Oct 12th, 2010 | By | Category: Economics, Featured Articles, Lead Article

Conservative commentators have been riling up their audiences recently with lots of talk about America ‘devaluing our money’ and expressing the horrors that befell us after the United States left the Gold Standard in 1972. Beck, as always, provides the well-crafted prototype of this line of reasoning.

What’s going on here? Let’s talk macroeconomic theory!

Money, as an abstraction, represents a sliver of the total productive ability of the economy. So, the value of the $20 bill in your pocket is ultimately determined by the productive ability of the economy divided by the total amount of money available at the moment.

Let’s assume that the productive capacity of the United States is stable. If North Korea manufactured a million $20 bills and handed them out to people on the street, the value of your twenty dollar bill would decrease. The term for this–when the growth in the supply of money exceeds the growth in the productive capacity of the economy–is inflation. If you have a wallet thick with $20 bills (you have lots of savings), inflation is working against you. If you owe money, inflation is great. Paying off the same debt (in dollar terms) requires less productive effort.

Assuming again the intrinsic productive capability of the economy is stable, let’s think through what would happen if trillions of dollars were suddenly evaporated–say by a gigantic retail bank failure obliterating checking accounts. Now, the $20 in your pocket represents a larger share of the economic output. That’s deflation. The winners and losers are opposite from inflation. The more savings you have, the better deflation is for you. If you’re indebted, you’re doomed.

Borrowing and saving are both critical for the health of the economy. Inflation discourages saving, deflation strongly discourages borrowing. Therefore, keeping a stable relationship between the productive output of the economy and the total money supply in the economy is the goal.

Here’s the rub: The productive capability of the economy is constantly in flux, and affected by an astonishing multitude of factors: New technologies, the availability of resources, monopolization of supplier companies for other companies, the weather, the overall enthusiasm of entrepreneurs, the number of work-capable people, the amount of labor each person can produce, the number of new ideas worth investing in, the state of infrastructure and on and on and on. Observing this, objectively, is beyond a difficult task; predicting the future productive state of the economy is even more difficult.

The old way to deal with this problem was to ignore it. Under the gold standard, the amount of money is fixed to be equal to the amount of gold in reserve. You could, at any time, exchange your crumpled dollar bill for a fixed amount of shiny metal. Therefore, the growth in amount of money was determined by how fast this one metal could be mined and refined from the earth. You can’t eat gold. You can’t make a home out of gold. And gold clothing is just tacky. The gold production rate is a poor correlate for the growth of the overall economy. The result–particularly during periods of rapid technological advancement in areas beyond metallurgy–were repeated cycles of catastrophic crashes. When an advancement dramatically increased the productive capacity of the economy, the money supply stayed relatively fixed–resulting in sharp, rapid deflation. The deflation stopped borrowing, stopping investment in new endeavors, crashing the economy over and over again. It was a terrible system, whose success depended almost entirely upon luck and faith in divine providence. Of course, Beck loves it.

Instead, we now attempt to measure as well as we can the state of the economy, and forecast how fast it is growing, and then ‘print’ enough new money (or, in theory subtract enough money) so that the ratio of the two stays roughly the same. While not perfect, it’s the far more rational way of dealing with the problem–harnessing mathematics, economic theory and plain-old empiric data.

Assessing and predicting the current and future state of the dollar-based economy is the primary mission of the Federal Reserve. Based on these predictions, the Federal Reserve adds (and theoretically subtracts) from the total money supply–in an attempt to keep the ratio of productive capability to money stable. Hence, the Beckian feverish repetition of, “…. how much money we’re printing at the Federal Reserve.” They (the Fed) are ‘printing’ money to replace that lost by catastrophic (entirely abstract) investments and reflect growth in the productive capability of the nation.

In it’s arsenal–to accomplish this herculean task–the Fed collects data on almost every aspect of the economy. Among all this data is a calculation of the inflation rate of the economy. A basket of goods (representing a cross section of productive output of the economy) is priced out in dollar terms on a regular basis. The rate of change in the price for the collection of goods is used as a measure of the inflation rate. This measure is probably the best sign of how well the Fed has done their matching job. High inflation rates mean too much money supply, low rates of inflation (or negative rates, reflecting deflation) represent too little money is being ‘printed’. Since the economic crisis that started in 2008, the rate of increase in this measure has been historically low–despite the historically large increases in the money supply by the Fed. Based on this measure, the Federal Reserve hasn’t printed enough money, to replace that lost by bankers in their spreadsheets.

There are reasons to be concerned about run away printing of dollars by the Fed–but it’s worth noting that the Fed is a quite conservative organization. At a baseline, the Federal Reserve tends to err on the side of too little growth in the money supply–fitting with the catering to the needs of the wealthy before the needs of the working that dominates US leadership generally. For now, there is no reason underlying the hysteria of the right-wing commentators.