## Sunday, January 06, 2013

### Economic growth and the gold standard

Assuming a gold standard were possible (i.e. that people wouldn't just create fiat money around it), it doesn't seem possible that we could get optimal economic growth under a gold standard.

In market/capitalist economics, Y * P = M * V: Real gross domestic product (Y, the total production of final goods and services) times the price level (P) equals the quantity of money (M) times the velocity of money (V, the number of times, on average, a unit of money is used in a transaction for final goods and services). We can also say Y = (M * V) / P. We can choose our units so that P = 1; therefore Y = M * V.

Remember that V in this case is not just the number of transactions using a particular unit of money, it is the number of times the unit of money crosses the production/consumption boundary. Alice's employer pays her; that's one transaction. Alice buys food at the store; that's two transactions. The store uses the money to buy food from a wholesaler. That's not a transaction that counts towards V, because the store and the wholesaler are both on the production side. Similarly, when the wholesaler pays the processor, or the processor pays the farmer, or when the farmer pays his mortgage, those are not transactions that count in the velocity of money. It's only when the store, wholesaler, processor, farmer, or banker, pays an employee, investor, or landlord does the money cross the producer/consumer boundary and V increases. It seems clear, therefore, that V is physically limited. No matter how an ounce of gold is represented, whether it's a physical coin, an ingot, or an entry in a database that corresponds to some physical gold, money can move only so quickly.

The point of a gold standard is to physically limit M, to create a quantity of money whose increase is physically limited. Since V is already physically limited, that means the quantity of money in motion, M * V, is physically limited. If we have price stability, then P is constant. Therefore, an increase in real gross domestic product is limited to the limit of the increase in the physical quantity of gold. But there is no particular reason to believe that the limit on the increase on the physical quantity of gold is the optimal increase in real gross domestic product. And that's absolute GDP; there's no reason to believe that the increased quantity of gold even match even population growth.

Furthermore, what is the value of a specific quantity of gold? Gold has very little intrinsic value, outside of electronics and jewelry: you can't eat or drink it, nor does it keep you warm or dry. Gold does, however, have a physical cost: the marginal socially necessary abstract labor time to produce the "last" unit quantity of gold. Expressed in money, the marginal cost of one unit quantity of gold is one unit quantity of gold. In other words, all the economic growth would go to the gold producers. There really isn't a world with an industrial economy in which a gold standard is a good idea.

There are, of course, any number of people that support a gold standard who have just not thought through the economics. But there must be gold standard advocates who have thought through the economics. Some of them, I suppose, really would limit real economic growth, but I've never seen a gold standard advocate say explicitly endorse limiting economic growth to the increase in the supply of gold. The others, however, realize that some sort of fiat currency is necessary for economic growth in an industrial economy. The question, then, is who gets to control economic growth, and, more importantly, who gets to distribute the benefits of economic growth. It is fairly obvious, then, that such control would go to the people that own most of the gold.

Economic power, control over the means of production, is political power. One does not imply the other; they are the same thing. In an advanced industrial economy, the means of production is not ownership of factories or land, but ownership of money itself. By definition, the government is the set of institutions and their members that own the money. Thus there can be no such thing as "private" ownership of money: the fundamental owners of money are, by definition, the government. So the question is not whether we should have government ownership of money, but rather what kinds of institutions, with what kinds of members, should constitute the governmental ownership of money.

I'm not a big fan of republican democracy, but a republic is, at least to some extent, accountable to all the people. Putting the government in the hands of people who say proudly and explicitly that they recognize no accountability except to their own well-being seems like a Very Bad Idea.

1. Thank you very much for your articles on the basics of Economics and your various takedowns of the gold-standard hoo-haa - they've been very informative and easy to read.

I have a couple of questions - you say "we can choose to set the price level to 1" but from my own (admittedly brief and uninformed) research the price level, being an average of goods and services over a set time, would seem to fluctuate. Does this have an impact, or am I confusing the hypothetical "price level" with the "price index?"

Also, we often hear in the US that small businesses (ie. businesses with few [or no] employees) are the engine of growth for the economy. I'd love to read an explanation from you of how the size of a company can affect the velocity of money in the economy (since that seems to be the easiest way to stimulate growth.) Also, has there ever been legislation to increase V (obviously the government setting prices would be one way, but are there others?) And would legislation like that provide some relief to a gold-backed currency? Or does that just get us back to a fiat currency with gold as the basis? Thanks again.

2. I have a couple of questions - you say "we can choose to set the price level to 1" but from my own (admittedly brief and uninformed) research the price level, being an average of goods and services over a set time, would seem to fluctuate.

Yes, the price level does fluctuate (it tends to increase over time). I'm just trying to simplify the problem by excluding these fluctuations. Also, a gold standard purports to give near-absolute price stability, so ex hypothesi we could hold P at 1 indefinitely.

I'd love to read an explanation from you of how the size of a company can affect the velocity of money in the economy (since that seems to be the easiest way to stimulate growth.)

I don't think company size affects velocity of money. AFAIK (but I'm no expert in this aspect) most of the monetary growth in modern society is in the quantity of money.

Also, has there ever been legislation to increase V (obviously the government setting prices would be one way, but are there others?)

I suspect it's very difficult for a government to affect V directly, especially when it nears its physical limit. You can get some money moving out of savings (where its velocity is 0) by having a higher inflation rate, but there are limits. I don't think the government can change V by setting prices, but if the government is setting prices, you have a fiat currency again.

I recommend Understanding Modern Money by L. Randall Wray.

3. Also, part of the problem when real interest rates are near the zero lower bound is that increasing the quantity of money just lowers its velocity, as people just save the extra money. But that's not about a gold standard.

4. Note that I'm kind of using V equivocally: in one sense, it's the velocity that some identifiable unit of money moves; in another sense, it's the average number of times all the units of money move. Which sense I mean should be clear from context, and the connection between the individual units and the average is the standard statistical meaning.

5. Thanks for the responses, and the recommendation - I'm adding it to my reading list now.

Apropos of nothing, but has the fact that we've adopted an "electronic" currency (lines on a spreadheet vs. notes in a vault) have any impact on V, or am I letting the physics definition of velocity cloud my understanding? I suppose once you have the "cash in hand" it doesn't matter what that cash looks like, but does the ability to instantaneously transfer money between accounts, regardless of geography, have any bearing on V?

6. Apropos of nothing, but has the fact that we've adopted an "electronic" currency (lines on a spreadheet vs. notes in a vault) have any impact on V, or am I letting the physics definition of velocity cloud my understanding?

I think electronic currency/transfers does increase the velocity of money to some extent, in the same way that paper money does increase the velocity over coins.

However, money still has to be accounted for, which requires some degree of time and labor. Even if everyone were to account for and pay all their bills and payroll every day, that means that any given unit of currency could move only 365 times per year. And even with computers, most people are still paid once or twice a month.

Furthermore, both households and businesses usually want to keep a stock of cash on hand. For example, no matter how I'm paid, I want to keep at least a month's (six months is better) worth of living expenses in liquid form. No matter how I'm paid, or how often I'm paid, that cushion is money not in motion.

7. Larry,

this

-- "But there must be gold standard advocates who have thought through the economics. Some of them, I suppose, really would limit real economic growth, but I've never seen a gold standard advocate say explicitly endorse limiting economic growth to the increase in the supply of gold." --

presents, at best, quite a sloppy supposition. Indeed there are a lot, although not so many in academe, of gold standard proponents, mostly in policy, who have thought through the economics. And the reason you haven't seen any who endorse limiting economic growth is the same reason you (presumably) haven't seen any unicorns: there aren't any.

Just, maybe, the discourse is not where you habitually look. And to make a long story short the argument you posit conflates quantity and quality theory of money, a little like saying keeping the definition of the inch or the ounce (other units of account)rigorously defined will lead to a shortage of yardsticks and scales, and, thus, to economic growth. Patently absurd ... as certainly you will realize after just a moment's thought.

Virtually all of its leading proponents favor the classical gold standard because it correlates so strongly with robust economic growth, growth rates that have not been sustained since Mr. Nixon, with whose policies you seem to be in sympathy, dissolved the last elements of the gold(-exchange) standard on August 15, 1971.

We suspect, with good reason, that there is more than a coincidental correlation here, which might have to do with Total Factor Productivity, although the actual mechanisms at work beg for further study by smart scholars like you.

Assuming that you are operating in intellectual good faith -- and that gold's most rigorous proponents simply live in a universe obscure to most academics -- you might begin with the Lehrman Institute's monetary policy website, http://thegoldstandardnow.org (of which I serve, professionally, as editor).

If that whets your appetite for more, you are invited to contact me through the Institute and I will be very happy to point you to the work, mostly in policy but some elegant and rigorous academic, of some key modern gold standard proponents.

Best regards,
Ralph Benko
Washington, DC

8. Thanks for the commentary, Ralph. I will discuss your substantive claim in a separate post.

It is perhaps the case that there are adequate defenses of the gold standard. You place me in the difficult position, however, of spending considerable time, effort, and energy hunting for something I don't presently believe is possible or desirable, and which even my conservative economics professors do not believe to be tenable.

This is the same position I'm in regarding "sophisticated" Christian theology, left-anarchism, and other... unconventional... ideologies. I'm told I do not understand what seems on its face unreasonable, and I'm told to go out and hunt for the good presentations. And every time I (or another researcher) find one supposedly good presentation, and it turns out to be deeply flawed, I'm told that, no, that one is really bad; go out and find the good ones. It's tedious and frustrating.

I've looked at your profile and the website you link to, and I've found no other way of contacting you except via postal mail, which requires more effort than I want to expend.

You have three options. First, provide a link to the best justification for: I'll read it, post the link, summarize the article and offer my analysis and response. Second, email me an article and I will post it here on the site, subject to ordinary editorial discretion (grammar, spelling, organization, citations and quotations, that sort of thing). Third, we can just let it go.

It's up to you. I'm willing and able to engage directly with the best you have to offer, but I'm not going to go hunting without a map.

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