My current understanding of why the gold standard is not suitable for a modern economy

[chess]

The gold standard keeps being advocated to me by all corners of the internet. I still think it is useless for a modern economy, and this is why:

Money Supply needs to be controlled to determine the level of risk that should be taken in investments - too much money in the system and bad investments are constantly made (leading to wasted actual resources, like abandoned factories); too little money in the system and good investments are not made (leading to unemployment).

In a gold standard or other commodity standard, money supply is entirely linked to how much of that commodity people are producing and how much gets lost/destroyed/decayed/used up.

The gold standard relies on constant supplies of gold being found and dug up out of the ground.

This works very well when there is a small constant supply of new gold strikes and mining productivity improvements such that more gold constantly enters the market - you get a small but positive inflation value, which encourages people to invest but not too much and makes them happy that their numbers are going up and 'progress' is being made.

(Even when it's working fairly well, you still get occasional abberations like a Gold Rush, where the money supply goes too high as a big supply is found, but not too many of them to cope with and they tend to be local.)

It does not work at all well when the supply of the commodity / gold begins to run out, and suddenly vastly un-environmental behaviour like tearing up rainforests to mine the gold under them is heavily incentivised to keep the good times rolling...

And eventually even that doesn't work, and you are left with a deflationary currency, as gold supplies go out of the system (through being milled into tiny pieces and lost, or hidden by savers who know it will just grow and grow in value).

A deflationary currency means that it's always worth keeping hold of the money you have - so nobody invests in anything, nobody buys anything, and the economy grinds to a halt.

Edit: I got the last paragraph entirely wrong, sorry! I have now fixed it so it says what I meant, which is the exact opposite of what I said before!

Comments

[(Anonymous)]

As I understand it was abandoned for being bad in a crisis but often led to prices falling as production increased and the economy grew. Of course this was dependent on ripping off other countries for commodities.
Abner

[ilanin.livejournal.com]

Wow, somebody learned some Austrian economics fast.

The gold standard is, as I understand it, the economics version of intelligent design - it has an awful lot of supporters and pretty much all of them are crackpots, including a small number who really ought to know better. Extremists of all sorts like the gold standard because commodity-backed currency is much harder for governments to manipulate, and people who whole extreme political views of any sort don't like governments.

[(Anonymous)]

You don't explain well how the money supply affects the interest rate (determining which investments will be funded). I have the Austrian view that the interest rate should be determined by supply and demand in a market, taking into account the preferences of lenders and borrowers.

Why would a deflationary currency mean that no-one can save? Do you think that the rate of inflation is equal to the (average) rate of return on an investment?

I understand investment as investors refraining from spending money, and thus freeing up real resources to be used in the investment. If the investment creates enough new goods or services that people are willing to buy, then the investment is profitable. (I find Say's law quite a good way of understanding economic growth - spending is diverted from the investment's competitors, but total spending can grow because the revenues are re-spent through wages or other inputs.)

I do not see a problem with savers hoarding money leading to a lack of spending. If producers can't sell everything they produce, then clearly they will have to drop their prices.

[chess]

I was entirely wrong about the last paragraph - teaches me to write this an a hurry! A deflationary currency would encourage saving to the point that the economy locks up for lack of investment, not discourage saving...

I understand 'investment' as people providing money/resources to other people who then spend it on hopefully improving future productivity - investment and spending are the same thing, money goes into businesses which can then improve productivity, often by employing people and hence improving those people's productivity too.

If money is being hoarded, then spending slows down, money remains static and productivity remains static as there is no money free to spend on infrastructure improvements / paying new employees, or even declines as businesses fail due to being unable to pay maintenance costs.

[(Anonymous)]

Saving usually involves that money being spent in the form of investment. Even if that isn't the case, and somebody hoards banknotes, or gold bullion, whatever money is left should have a similar purchasing power, as I will try to explain.

Suppose we have an economy with a fiat currency, and then a lot of new money is printed and stuck in a safe somewhere. This new money is causally unrelated to the economy, so it should carry on before - with similar price levels.

What we have to consider is if instead of being printed, this money is hoarded out of the currently existing supply. This is a dynamic situation. We should expect prices to drop. Eventually, whatever money is left in the economy should be able to pay for consumption or investment just as before, because everything is cheaper in terms of money.

[chess]

This post is talking about what happens under a gold standard system, rather than yet considering the alternatives.

So under a gold standard system you fairly regularly / easily hoard money in a way that takes it actually out of circulation - you hoard the gold itself.

In situations where there is a single hoarding incident, you should get stabilisation eventually, as you say. But if the pressure to hoard continues - so every time someone gets hold of some money, there is a great temptation to hide it away rather than spending it - this can paralyse the economy.

The gold standard with no new gold extraction provides a situation where whenever you get some gold, if you can possibly survive without spending it you should hoard it rather than spending it - so there is not just one hoarding incident but every time money becomes available people will attempt to save it rather than spend it, and that is what paralyses the economy.

[ilanin.livejournal.com]

Deflation would rapidly get out of control even in the case where currency wasn't backed by finite and diminishing resources. Deflation encourages hoarding of money, since it will have more purchasing power in the future. This hoarding is itself deflationary. The fact that prices are falling will not make investment profitable unless there are some sectors showing significant growth, because falling prices applies equally to whatever you're producing as it does to what you're buying.

(This is why Keynes advocated (inflationary) government spending in order to stimulate demand and allow certain sectors of the economy to rebuild; these sectors can then form the basis of a real recovery. The problem with this approach is that if the sectors of the economy the government is creating demand in are not sustainable, then the recovery that it's trying to promote won't be either, and you get the inflation without actually causing much in the way of growth. See: the 1970s).

[(Anonymous)]

PS If you think the Euro creates problems the gold standard would probably be worse.
Abner

[chess]

Some people attempt to give me the theory that in a gold standard you couldn't manipulate exchange rates in the way Germany has been doing to keep export prices low, because manipulating exchange rates is harder when there's gold behind each currency and so there's an obvious natural exchange rate. I'm not convinced I believe them though.