Myth 11: Setting the New Gold Parity is Too Hard

The danger of setting the new gold parity too low (too few dollars per ounce of gold) is exemplified, as Selgin (2012) notes, by Great Britain’s choice in 1925 to restore the old parity. At discussed above, because the price level had risen sharply, a return to the old parity required a sharp deflation to return to the old price level.  The danger of setting the parity too high is, conversely, a transition inflation to reach the new equilibrium price level.  Eichengreen (2011) summarizes the problem this way:

Envisioning a statute requiring the Federal Reserve to redeem its notes for fixed amounts of specie is easy, but deciding what that fixed amount should be is hard. Set the price too high and there will be large amounts of gold-backed currency chasing limited supplies of goods and services. The new gold standard will then become an engine of precisely the inflation that its proponents abhor. But set the price too low, and the result will be deflation, which is not exactly a healthy state for an economy.

To avoid transitional inflation or deflation, the new parity must be the one at which monetary gold supply and demand are equated at the current price level.  If we could assume that the supply and demand for monetary gold were unaffected by the reinstatement of the gold standard, the solution would be easy:  choose the current price of gold.  But that is unlikely be exactly true. As I earlier argued, the demand for gold bullion and coins today is an inflation-hedging demand that would be absent under a gold standard.  On the other hand, because a gold standard lowers the mean and medium-term variance of the inflation rate, the demand to hold currency and demand deposits for transaction purposes, against which banks would hold gold reserves, would rise.  As Selgin (2012) notes:

The problem here is, not that there is no new gold parity such as would allow for a smooth transition, but that the correct parity cannot be determined with any precision, but must instead be discovered by trial and error. Consequently the transition could involve either costly inflation or its opposite … .

Tyler Cowen (2008) cites the same problem: “One five or ten percent deflation is enough to crush the economy and indeed the whole gold standard idea. Given the socialist calculation debate, can we really know the right transition price?”

Choosing a new parity is indeed a problem.  There are two approaches to estimating the new parity that would avoid transitional inflation or deflation.  Note that new parities need to be chosen simultaneously by all participating currency areas in order to agree to return to the gold standard simultaneously so as to create the broadest possible international gold standard.  The first, more conventional approach is to use econometric studies of recent inflation-hedging demand for gold, and of transactions demand for zero-yielding bank reserves at gold-standard-type expected inflation rates.  The second approach, which calls for further study, is to derive guidance from market signals, in particular from the gold futures market or some new kinds of prediction market, in which market players put money on their own estimates of what the real purchasing power of gold will be following a return to the international gold standard.

In a world where prices and wages exhibit greater downward that upward stickiness, playing it safe in the choice of a new parity means erring on the side of a small transitional inflation rather than a deflation.

So as not to overstate the relative size of the problem, however, we should note that the same problem attends any significant change in the inflation path, or  significant change in other policy (such as the rate of interest on reserves) under a fiat standard.  The switch to a lower inflation rate target, for example, will cause the path of transactions demand to hold money relative to the volume of spending to jump upward (will shift the velocity of money downward).  Underestimating the increased demand, and failing to offset it with a one-time increase in the stock of money, will cause the policy to create an excess demand for money and will thus create a recession with unsold inventories of goods and unemployed labor services.  The Bernanke Fed’s switch from zero to positive interest on bank reserves in October 2008 sharply increased the banking system’s demand to hold reserves, swamping the money-supply-expanding effect of the accompanying “Quantitative Easing 1” expansion of reserves.  The result was seven months in 2009 (March through September) in which the year-over-year inflation rate was negative.  The downturn in real output already underway was amplified.  Curiously this “bad” deflation – and the first deflation of either kind in more than five decades – occurred on the watch of an expressly deflation-averse Fed chairman.

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The Most Important Thing Holding Up the US Dollar

by Ron Paul

Today’s economic conditions reflect a fiat monetary system held together by many tricks and luck over the past 40 years. The world has been awash in paper money since removal of the last vestige of the gold standard by Richard Nixon when he buried the Bretton Woods agreement — the gold exchange standard — on August 15, 1971.

Since then we’ve been on a worldwide paper dollar standard. Quite possibly we are seeing the beginning of the end of that system. If so, tough times are ahead for the United States and the world economy.

Yellen’s Missing Jobs

March 31, 2014

The new Federal Reserve chairman, Janet Yellen, gave a policy speech today at Chicago, where, in a startling gesture, she mentioned three working individuals by name — Jermaine Brownlee, Vicki Lira, and Doreen Poole. They lost their jobs the Great Recession and have been struggling ever since. It was a refreshing, even affecting demarche by Mrs. Yellen, who has made a return to full employment a public priority. She underscored her sincerity by telephoning Mr. Brownlee and Ms. Lira and Ms. Poole before delivering her speech.

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The Rueffian SynthesisJohn D. Mueller

Publisher's Note: Originally released in June/July of 1991, this detailed report discusses Jacques Rueff's economic theories and applies them to modern economic events.

By John D. Mueller

Who Was Jacques Rueff?

... Trained in science and mathematics at the Ecole Polytechnique, Rueff devoted his first theoretical work to showing that the same scientific method applies to “moral” or “social” sciences like economics as to the physical sciences (Des Sciences Physiques aux Sciences Morales, 1922). In both cases, he pointed out, individual acts can be “indeterminate,” but the pattern of large numbers of individual acts can be predicted as a matter of probability. And so in economics no less than physics, as he later wrote, “A scientific theory is considered correct only if it makes forecasting possible.”

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Excerpts From:

by Lewis E. Lehrman

"Forerunners of man lived upon the planet several million years ago. But the unique, modern, social order of man – civilization – emerged only four to five thousand years ago. Historical and archaeological evidence suggests that the institution of money evolved coterminously with civilization. From the standpoint of the 100,000-year history of Homo sapiens, civilization and money are but young and fragile reeds. Today their very existence is threatened by financial disorder."

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Turkey’s Cut-rate Expectations

Kathleen Packard  |  Apr 18, 2014
There is a lot of bad behavior in the global political and monetary world. Much of it comes in countries that should know better. Recep Tayyip Erdogan’s Justice and Development Party (AKP) easily won municipal electons in Turkey but the party’s candidates won far short of the nation’s votes. The Wall...
Hostility toward gold has a long pedigree.  19th century depiction of Pliny the Elder courtesy of the Library of Congress Gaius Plinius Secundus, commonly known as Pliny the Elder, in his The Natural History, Book 33, section 3, writes: Would that gold could have been banished for ever from the earth, accursed by...
Jacques Rueff, a key figure in European economic circles from the 1930s until the 1970s, was, first and foremost, an...
Selgin (2012) makes an important point when he notes that: the historical gold standard that … performed so well was an...
Prosperity Through Gold
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