Why Metal Standards Don't Work

This post is inspired by the following article on TCS Daily titled "What Roosevelt Didn't Know". The crux of the article is about how policy makers and economists reacted to the Great Depression in the early 1930s and how, if they had the same access to economic indicators that we have today, they would have behaved very differently. One section, however, that really caught my attention was the following:

The Meaning and Effects of Deflation


Inflation is a general decline in the purchasing power of money. Deflation is a general increase in the purchasing power of money.

It is easy to confuse general inflation or deflation with a change in the relative prices of goods. Thus, a spike in gasoline prices might be mis-labeled as inflation, while a drop in the price of wheat might be mis-labeled as deflation. A genuine inflation involves rising prices in most goods and services.

Inflations tend to be good for borrowers and bad for lenders -- at least at first. In the early 1970's, mortgage rates of 8 percent looked pretty steep to homebuyers. However, inflation accelerated later in the decade, and mortgage borrowers did really well, paying back their loans in much-cheaper dollars. Lenders, on the other hand, were crushed, with many going out of business between 1978 and 1982.

Conversely, deflations tend to be bad for borrowers. The farmer who borrows today to plant a crop for harvesting in six months cannot repay the loan if prices fall during the meantime.

Lenders can protect themselves from inflation, but borrowers cannot protect themselves from deflation. When lenders see inflation taking place, they can charge higher interest rates, and they can make loans for shorter periods of time. When borrowers see deflation taking place, they do not have the ability to demand appropriately low interest rates, because the appropriate interest rate might be less than zero. Lenders will hold onto money rather than lend it at negative interest rates.

Irving Fisher understood this. Even today, among economists, the relationship between inflation and interest rates is known as the Fisher effect.

So, what does this have to do with metal standards and why do I feel compelled to touch on this issue? Before I answer that question, let's clear up something:

What is a metal standard?

Some of you may already know this - a metal standard is when you base your currency on metals, usually gold or silver. Back in the day, this meant that you could take a dollar (or pound, franc, mark, whatever) and get a predefined measure of gold or silver from a bank; the British Pound got its name because 1 British Pound used to be worth precisely 1 pound of silver. There are some benefits to a metallic standard:

- Conversions between metallic standard currencies is relatively easy; simply convert between currency A to the mineral it's backed on, then convert from that metal to the equivalent worth of currency B, which is also based on the same metal.
- A government cannot simply print more money, thus preventing extreme inflation. Since the currency is based on a particular tangible product, the government can only print enough currency to buy the amount of that tangible product that the government has.
- It's easy for people to understand and relate to. People trust gold a lot more than they trust the government, and they understand that gold has value because it's gold. Why is a dollar worth something? It's just a colorful piece of paper, right?

However, there are some big problems with metallic standards. The big two are:

1. A currency based on a metallic standard is basing its worth not on the value of the economy in which it's used, but instead on the value of a metal which may or may not be produced in that economy.
2. A government cannot simply print more money.

To fully understand these two issues, let's pretend the United States decided, for whatever reason, to base the dollar on oil. Oil has a tangible value - there's a finite amount of it, it has economic worth (we use it for fuel), it's portable (I wouldn't want any in my pocket, mind you), and everyone understands oil. However, as everyone knows, the value of oil can go up or down, often at the whim of countries quite hostile to the United States. Consequently, if the United States decided to enact an oil standard, the dollar would be at the whim of regimes with hostile intent that could inflate or devalue the dollar (by increasing or decreasing the supply of oil, respectively), which could severely disrupt the economy, and there would be nothing the United States government could do about it. If a hostile country started buying all of our currency to increase the value of the dollar, thus making our exports cost more overseas, could we print more money to counteract that, thus stabilizing prices? No - the amount of dollars we produce would be fixed to the amount of oil those dollars are worth. The only way we could print more dollars would be if we produced more oil, which would not be economically feasible if the cost of producing that unit of oil on which the dollar was based was greater than $1.

More on this tomorrow.