Ezra Klein Mistakes the Arsonist for a Firefighter

Steven Horwitz

In Friday’s Washington Post, Ezra Klein raises a number of criticisms of the gold standard using as his hook the call for a new Gold Commission that appears in a draft of the new Republican Party platform.  Putting aside the question of party politics and what a new Commission might do, Klein’s arguments against the gold standard are not as strong as he thinks.  I want to respond to three of them here, and in reverse order of importance.

He argues, as many do, that tying the dollar to gold means that the value of the dollar will vary with the “global price of gold as opposed to the needs of our economy.”  There are several problems here.  First, are the fluctuations in the price of gold any greater than the current factors that affect the value of the dollar, including changes in the judgment of Federal Reserve officials and the politics of money creation?  In fact, one could argue in response that the major cause of fluctuations in the price of gold is the very fact that the Federal Reserve has discretion over the money supply and thereby affects inflationary expectations, which in turn destabilize the price gold.  The variance in the price of gold is not exogenous to the monetary regime.  In other words, a gold standard might dramatically reduce the variance in the price of gold, avoiding the problem Klein raises. 

And does Klein really believe that the Fed currently adjusts the value of the dollar according to “the needs of our economy?”  Is the Fed totally immune from political concerns?  Does the geo-political situation matter not at all for its decisions?  We have some evidence of political business cycles, which suggests that the Fed is hardly pure in its intentions.  Klein commits a version of the Nirvana Fallacy by setting up his comparison as that of an imperfect gold standard versus an idealized Fed.

Like many pundits, Klein also never precisely defines what he means by a “gold standard,” which the GOP is guilty of as well.  Does he mean Federal Reserve Notes backed by gold, or does he mean a system of gold coins?  If the former, with what reserve ratio?  Better yet, he never asks the most important question:  some of us who would like to see gold have a role in the monetary system want it to be in the context of a purely competitive banking system that does not require a central bank.  Some of the other issues Klein raises in his column would be non-issues if by a “gold standard” one means closing down the monopoly of Fed and allowing banks to produce currency and deposits competitively. 

Finally, and most important, Klein argues that a gold standard would prevent the Fed from acting as a lender of last resort and preventing financial collapses as it supposedly did in 2008.  Putting aside whether the Fed’s actions were, in fact, necessary or how much they helped, Klein misses the bigger picture.  If we had a commodity-based free banking system, we would not have had the boom and bust of the 2000s in the first place.  The powers that enable the Fed to create liquidity ex nihilo in a crisis are the very same powers that enabled it to drive the real Federal Funds rate below zero for two years and fuel the housing bubble, which gave us the financial crisis and recession. 

Remember: the Fed is like the arsonist disguised as a firefighter who claims only he can put out the fires he started.  Yeah, maybe the firefighter can’t rescue people from the building if he doesn’t have an axe to break down the door, but giving him a way to break in makes it far more likely that he’ll set fires in the first place. 

Claiming that a gold standard ties the Fed’s hands is exactly the reason to favor it, not oppose it. The Fed was primarily, though not solely, responsible for getting us in this mess in the first place precisely because its hands were free to flood the market with artificially cheap credit. 

The discretion of Big Players like the Fed is the problem, and the solution is not somehow hoping that next time they will use that discretion only for good and not evil.  Tying Federal Reserve Notes to gold would take away some of that discretion, and eliminating the central bank completely in favor of a competitive monetary system with commodity backing of any sort would take it all away. 

When the arsonist can’t set fires, we don’t need to worry about whether or not he has the tools to put them out.  That is the fundamental argument for constraining both central banks and competitive ones by making the money they create redeemable in gold.

Comments

[perfectlyGoodInk]

Under a gold standard, the government still retains control over the money supply, just via a different mechanism. After all, a gold standard is when government controls the exchange rate between currency and gold rather than letting it float.

[Bob Murphy]

Good response Steve. It's just funny because I can understand why Ezra Klein thinks he is being quite scholarly and reasonable about all this, whereas the Austrians are the oddball cranks.

[Lord Keynes]

If we had a commodity-based free banking system, we would not have had the boom and bust of the 2000s in the first place."

This is plainly absurd.

By the 1860s, the Australian banking system had these characteristics:

(1) a gold standard
(2) no central bank;
(3) no capital controls;
(4) few legal barriers to entry;
(5) no branching restrictions;
(6) no credible restrictions on assets, liabilities or bank capital;
(7) no legally established price controls;
(8) no government-provided deposit guarantees.

What happened? A disaster: a huge asset bubble in property and certain financial assets, which then collapsed causing a debt deflationary depression so severe it was worse than Australia's Great Depression.

For the evidence, see here

http://socialdemocracy21stcentury.blogspot.com/2012/05/free-banking-in-australia.html

http://socialdemocracy21stcentury.blogspot.com/2012/05/tale-of-two-depressions-1930s-and-1890s.html

[Lord Keynes]

"The powers that enable the Fed to create liquidity ex nihilo in a crisis are the very same powers that enabled it to drive the real Federal Funds rate below zero for two years and fuel the housing bubble, which gave us the financial crisis and recession. "

The same expansion of the money supply, causing asset bubbles, could easily happen in a gold standard, free banking world:

(1) you might find huge deposits of gold in your country.
(2) speculative capital could flood in through the capital account (as in Australia in the 1880s)
(3) even a free banking system could generate significant new money by private banknotes and debt instruments; the largest private banks could expand to the point where their private banknotes are considered as "good as gold" and could be issued in excess.
(4) or combination (1), (2), or (3).

[FC]

Pseudonymous link trolling is common enough. Using the name of a greater man than you is very low indeed.

[Barkley Rosser]

In the US we had the Panic of 1837. And while I would agree that the politically driven monetary expansion of 2003-04 aggravated the housing bubble, that had been going on since 1998. The real expansion was in the shadow banking sytem, an essentially free banking system on its own.

[Allan Walstad]

"Lord Keynes" is surely right that under a gold standard a huge influx of newly-discovered gold could have the same destabilizing effect as credit expansion by a central bank. Two comments:

1. It still doesn't make sense to have a central bank generating additional (and no doubt far more frequent) boom-bust cycles. After all, just because it is possible for someone to trip on their own feet and fall down, it does not justify sticking your leg out and tripping passersby intentionally. Steve's assertion that "If we had a commodity-based free banking system, we would not have had the boom and bust of the 2000s in the first place" is almost certainly correct.

2. If boom-bust episodes CAN possibly occur in the absence of central banking and fiat money, it emphasizes the importance of convincingly demonstrating that monetary and fiscal intervention are not useful tools for restoring prosperity in such cases. The argument exists, of course, and it is quite straightforward. The influx of money distorts the capital structure by masking the trade-off between present and future consumption. Once the structure of production is sufficiently distorted, output must fall (unless people can be induced to work harder for less pay). Return to prosperity depends on directing labor and resources to repairing the structure of production, and this can only be done by entrepreneurs operating in a reasonably undistorted market. If the politicians and central bank bureaucrats could do it through their various impositions, then socialism could work. But it can't.

[Brad]

I have a hard time seeeing how someone can argue that a convertible currency prevents booms and busts. We had booms and busts throught the period that we were on either agold and silver or pure gold standard. One can debate whetehr they were more frequent or more severe than under the Fed, but not whether they happened. To say that it would eliminate booms oversells the gold standard. Gold could flow in because of political unrest in another country or because of a speculative boom here. Either way, money and credit would increase.

The other problem is that governments screw around with the flow of gold. It can be argued that the Bank of England's attempts to alter international gold flows played a role in at least two crises in the U.S. (1837 and 1907)and Doug Irwin has argued that France's gold hoarding was a significant factor in the Great Depression.

Finally, when push comes to shove, during wars or recessions, we always abandon the gold standard.

I don't think the gold standard is crazy. A real gold standard, consistently followed, reduces exchange rate risk and uncertainty about inflation.

I doubt that we would ever have a gold standard, consistently followed.

[Jonathan M.F. Catalán]

I think the real stabilizing factor in a free banking system is the competitive currency feature. Competitive currencies haven't always been the case in approximations to free banking systems. Such was the case in Australia, for example. Where there are competitive currencies, losses play a bigger role in constraining destabilizing actions by part of banks.

[Steve Horwitz]

But competition without redemption won't work, which is the problem with Hayek's system. Free banking needs both. Either option of one but not other is better than the status quo (at least a Fed tied to gold is) but not as good as both.

What makes competition effective in free banking is the fact that other banks will send back your liabilities in return for base money. You can't separate the benefits of competition from those of redemption.

[Roger Koppl]

Right on, Steve. The gold standard is beneath contempt in the minds of many intellectuals, which makes it hard for them to construct a strong argument against it. We've now had both the Great Depression and the Great Recession under the Fed. That's not a good track record.

[Jonathan M.F. Catalán]

Steve, agreed, but I think emphasizing competitive currencies is important, especially when a lot of people think that returning to gold means circulating gold coins.

[Steve Horwitz]

Absolutely Jonathan! I try not to even use the phrase "gold standard" and talk about competing currencies instead.

[Jerry O'Driscoll]

Barkley raises an important point about the housing boom and bust. The roots do go back to 1998. And it was largely financed by the shadow banking system.

The shadow banking system depends, however, on the financial backing of the commercial banking system. I have been told by an active participant in the shadow banking system that the Fed could have stopped the mania by telling the commercial banks to stop lending to the investment banks.

As Greenspan has told us, however, it would have been politically impossible for the Fed to do so. That doesn't change the fact that the Fed was the sustaining cause of the crisis.

[Jonathan M.F. Catalán]

It's also worth considering that, if Jeffrey Friedman's and Wladimir Kraus' interpretation is correct (Engineering the Financial Crisis), the assets created by the shadow banking system were shaped by the financial regulations which controlled capital reserves. In turn, these relied on the ratings provided by rating agencies using market prices, which had been distorted by fiduciary expansion. Given this, one has to wonder to what extent the shadow banking system as it exists today would exist under a free banking regime.

[Bill Stepp]

The growth of the shadow banking system was a response to sub-market interest rates. And it is not a sort of free banking system. Free banks have the ability to issue bank notes, which hedge funds, pension funds, etc. cannot do.

[Ravi]

I wrote the below post on my blog to explain the gold standard to my friends.

http://economese.wordpress.com/2012/07/07/a-guide-to-the-gold-standard/

Most of the commentary against the gold standard are so grossly wrong that you dont even know where to start explaining the facts.

[Craig]

Steve,

Isn't the biggest problem with central banks epistemic rather than political. That is, even if they could be insulated from special interests, they would still not have the knowledge necessary to set the correct interest rate.

[Bill Stepp]

I think the problem of "setting" the correct interest rate(s!) is more than epistemic; this implies that just having the knowledge of the ever changing supply and demand schedules of present and future goods is enough. These market relationships are constantly changing, and are affected by such things as changing expectations of the purchasing power of money. Only the market can determine what the "correct interest rate" is; epistemic knowledge is just the vortex of this complex relationship.
Would someone tell it to Comrade Bernanke?

[Paul Marks]

Australian did not exist as a country till 1901. So if one wishes to talk about the 1860s it must be in the context of the colones if New South Wales, Victoria and so on. And their economic policies were NOT all the same - for example Victoria had higher import taxes than New South Wales did.

However, the basic point remains - why are Keynesians complaining about an increase in the money supply? I am sure Keynesians could have found "unemployed resources" (including unemployed people) who a increase in the money supply would supposedly (magically) help.

It is rather unlikely that a massive increase in the amount of gold is going to exceed the amount of "money" that a Central Bank can create (in a few seconds) by pressing buttons on a computer keyboard.

So if Keynesians are now converted to a fear of gold being TOO LOOSE (too expansionist) for money - they should be utterly horrified by government fiat money.

However, it is unlikely that a increase in the gold supply ON ITS OWN is going to lead to a boom-bust.

It will certainly lead to INFLATION (indeed by a tradtional defintion of the term - an increase in the money supply IS inflation, whether prices in the shops go up or not).

But inflation on its own is not a boom-bust.

A boom-bust occurs when "broad money" (bank credit) gets wildy out of line with the "monetary base" - i.e. when bankers lend out "money" that NEVER REALLY EXISTED (try to lend out "money" at an a LOWER INTEREST RATE than real SAVERS would demand for their SAVINGS).

Contrary to Lord Keynes book keeping tricks (by a Central Bank or by private bankers) are not "the same" as real SAVINGS - credit-money expansion is utterly different from real savings (see Hunter Lewis "Where Keynes Went Wrong" for this point).

If there is more gold (because people are digging lots out of the ground) prices may go up (if the gold is increasing faster than the increase in the production of goods and services) but that (ON ITS OWN) is NOT a boom-bust.

Only if with gold as money (or silver, or government fiat notes - or anything) bankers build a inverted pyramid of debt can a classic boom-bust occur. The "boom" being the expansion of credit money, and the BUST being the inveitable correction (which will come - sooner or later).

Getting rid of gold does not prevent this - on the contrary it makes credit-money bubbles (i.e. boom BUSTS) BIGGER - vastly bigger.

As does CENTRAL BANKING.

Creating a Central Bank does not limit the size of banking credit bubbles - it is absurd for Keynesians (of all people) to imply that it does.

The whole point of Central Banking is to EXPAND credit - to make the credit-money bubbles BIGGER.

That is what Benjamim Strong (of the New York Fed) did in the late 1920s (thus showing that a gold STANDARD does not prevent government utterly perverting the capital structure with malinvestments) thus leading to the BUST of 1929 (the bust that came as such a surprise to Irving Fisher - just as the bust of 1921 had utterly surprised him, although "Austrian School" economists predicted both crashes, so much for "empirical" economics, so "empirical" it ignores evidence and learns nothing by experience).

However, Alan Greenspan (without any gold STANDARD) did much the same thing as Benjamin Strong did - Greenspan did it for years in the run up to the 2008 bust (his support for credit money expansion made a the great BUST inevitable - time and time again Alan Greenspan "saved the world", i.e. saved the credit bubble, but he "saved it" by making it BIGGER AND BIGGER - thus making the eventual bust WORSE AND WORSE).

And, of couse, B.B. (of only that stood for "Bilbo Baggins" - he would have more sense), is carrying on the monetary antics.

He has not yet got to the stage of "throwing money from helecopters" (after all that would not profit bankers or other special interests), but B.B. has done everything short of that.

All in a desperate effort to create a boom-let in order to reelect Barack Obama.

Is that the sort of monetary system that Keynesians (and Chicago people) want?

A monetary system based on POLITICAL WHIMS - where the "long term" in November 6th?

Is that what you want?

If the answer is "yes" then wait for 2013.

If you think what happened in New South Wales (and so on) in the 1860s was bad (although did not the American Civil War rather disrupt the world economy in this period?) then wait for 2013.

2013 and 2014 (and onwards) in the United States (and the rest of the Western World)will make what happened in New South Wales (and so on) in the 1860s look like a picnic.

Your credit bubble government fiat monetary system will be discredited - utterly discredited.

Still at least the "mainstream" media (including dear Time magazine) will be destroyed by the economic collapse.