Wednesday, August 1, 2012

Ron Paul's End the Fed 3: The Gold Standard

In my latest reading of End the Fed, Ron Paul argued in favor of the gold standard.  He talked about how Alan Greenspan used to be a solid supporter of the gold standard, but Greenspan held a different viewpoint during his time at the Federal Reserve.  Ron Paul narrates that he (Ron Paul) actually asked Greenspan to autograph a 1966 article that Greenspan wrote in favor of the gold standard!  Ron Paul also tells the story of how President Ronald Reagan admitted to him that "no nation that abandoned the gold standard has remained a great nation" (Reagan's words), and yet Paul said that Reagan was "swayed by staff pressure to be pragmatic on most issues" (page 74).

When Ron Paul defends the gold standard and says that the Federal Reserve printing more money results in inflation, it's easy for me to wonder: Why would anyone be against the gold standard, which prevents inflation?  Jack Kemp was often lauded, and yet his support for the gold standard was considered by many in the establishment to be a little eccentric.  Why? The gold standard means less inflation, or lower prices.  Why would anyone be against that?

I did some reading online about the gold standard.  I can't say that I understood everything that I read, but I'll share with you what I did understand.  One reason that some oppose the gold standard is that it hinders the Federal Reserve from pumping more money into the economy, which supposedly stimulates economic growth.  Paul Krugman says in his article here:

"The current world monetary system assigns no special role to gold; indeed, the Federal Reserve is not obliged to tie the dollar to anything.  It can print as much or as little money as it deems appropriate.  There are powerful advantages to such an unconstrained system.  Above all, the Fed is free to respond to actual or threatened recessions by pumping in money.  To take only one example, that flexibility is the reason the stock market crash of 1987----which started out every bit as frightening as that of 1929----did not cause a slump in the real economy."

Wikipedia's documented article on the gold standard made the same sort of point, when discussing the Great Depression.  You can read the article itself for the references, but I'll quote some select passages:

"Some economic historians, such as American professor Barry Eichengreen, blame the gold standard of the 1920s for prolonging the Great Depression.  Adherence to the gold standard prevented the Federal Reserve from expanding the money supply in order to stimulate the economy, fund insolvent banks and fund government deficits which could 'prime the pump' for an expansion...The gold standard limited the flexibility of the central banks' monetary policy by limiting their ability to expand the money supply, and thus their ability to lower interest rates...Others including Federal Reserve Chairman Ben Bernanke and Nobel Prize winning economist Milton Friedman place most or all of the blame for the severity of the Great Depression at the feet of the Federal Reserve, mostly due to the deliberate tightening of monetary policy.  The US economic contraction in 1937, the last gasp of the Great Depression, is blamed on tightening of monetary policy by the Federal Reserve resulting in a higher cost of capital and weaker securities markets, a reduced net government contribution to income, the undistributed profits tax, and higher labor costs...Higher interest rates intensified the deflationary pressure on the dollar and reduced investment in U.S. banks...[T]he New York Fed had loaned over $150 million (over 240 tons) to European Central Banks to help them out with their difficulties. This transfer of gold out of the US acted to contract the US money supply...The forced contraction of the money supply caused by people removing funds from the banking system during the bank panics resulted in deflation; and even as nominal interest rates dropped, inflation-adjusted real interest rates remained high, rewarding those that held onto money instead of spending it, causing a further slowdown in the economy."

According to this article, the gold standard hindered investment during the Great Depression.  This article may also explain one of the things that Ron Paul criticizes in his book----President Franklin Roosevelt's ban on people owning gold.  If less gold was in the hands of the Federal Reserve, then that meant less of a money supply, resulting in deflation.  Ron Paul does not consider deflation to be all that bad of a thing, and, after all, wouldn't many of us love lower prices?  But there are possible problems with deflation.  For example, it can discourage investment, for why would people invest in a business if low prices would prevent them from getting a profit?  (UPDATE: On page 121, Paul acknowledges that both inflation and deflation can cause loss of wealth.)  I read in an economics book a while back that some farmers supported free silver because they wanted inflation, for they needed to pay for their expensive farm equipment, and deflation was inhibiting them from earning enough money from their crops to do so.  Regarding deflation and the Great Depression, even F.A. Hayek, an economist whom Ron Paul admires, said the following:

"I agree with Milton Friedman that once the Crash had occurred, the Federal Reserve System pursued a silly deflationary policy. I am not only against inflation but I am also against deflation. So, once again, a badly programmed monetary policy prolonged the depression. "  See here.

Another reason that some dislike the gold standard is because the price of gold is not easy to control.  Paul Krugman states: "gold is not a stable standard when measured in terms of other goods and services.  On the contrary, it is a commodity whose price is constantly buffeted by shifts in supply and demand that have nothing to do with the needs of the world economy----by changes, for example, in dentistry."

Ron Paul has a variety of responses to these sorts of arguments: that gold has had a consistently high value, that Herbert Hoover pursued inflationary policies, and that taxes (by both Hoover and FDR) and tariffs contributed to the prolongation of the Great Depression.  On page 75, Ron Paul refers to economist Murray Rothbard's argument that "it was not the gold standard that caused the Depression of the 1930s; rather, it was the misuse of the gold standard that led up to it" (Paul's words), and Paul says that Rothbard preferred a gold standard in which people could redeem their currency with gold coins. (UPDATE: On page 111, Paul says that "It was the credit expansion of the 1920s causing the stock market bubble that was the real cause of the crash.")

So there are two (or more) sides to every story!  I have some questions, though.  First, why does a declining money supply have to correspond with higher interest rates?  Second, why wouldn't deflation encourage spending and investment, since prices (and thus costs) are low?

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