Ron Paul apparently made a bigger splash in the Republican presidential debate than he was expected to. He promised that, in his second week in office, he would end the “inflation tax.” What he meant was, he would push to abolish the Federal Reserve, and to revert to the gold standard. (See the second video clip at this link; then read his gold standard speech here.)
Ron Paul’s stance on money scares me. [See the end note to this article for my apologies to my several libertarian friends.] He strongly favors “sound money,” and so do I. But to Ron Paul, “sound money” is a system that avoids inflation, and he thinks the gold standard is the system to deliver that end. To me, however, sound money does a lot more than avoid inflation.
Sound money, at a minimum, avoids at least two undesirable conditions:
• Inflation, which is a hidden tax on lenders and on fixed-income consumers; and...
• Deflation, which is a hidden tax on borrowers (i.e., entrepreneurs) and on producers of goods and services.
Inflation means that lenders will be paid back in less-valuable dollars, and that fixed-income consumers will not (by definition) experience offsetting inflation in both income and outgo. Deflation means that borrowers will be forced to pay back loans using higher-value dollars, which would discourage many entrepreneurs from risking innovating; it also means that many producers will be caught in the vice between the falling prices they collect versus the sticky wages and raw material contracts they pay. Whether it's inflation-avoidance or deflation-avoidance, it will be a giant sucking sound diverting economic resources away from the more-important tasks of real wealth creation.
Here’s how I picture the continuum of money-policy results; note that only one of the five conditions (#2) represents “sound money”:
I assembled five graphics to illustrate each concept. Let’s take them one at a time. Here’s the first concept chart, showing the well-known inflation condition of “too much money chasing too few goods”:
Second is the only “sound money” condition: just the right amount of money chasing the goods produced by an economy evolving at maximum potential:
Third is a subtle, difficult-to-detect situation in between inflation and deflation, also undesirable. It yields the false appearance of “sound money”—nevertheless, it's when a too-tight money policy artificially holds real growth below its potential (see red arrows).
Fourth is when deflation becomes noticeable in the numbers. Deflation is almost unheard of in the public debate; nonetheless, it is a tax on would-be borrowers and on producers.
Last is the worst scenario: deflationary depression. For an instructive example, refer to the decade-long period known as The Great Depression.
Advocacy of maximum real growth is the underlying reason this weblog exists. “Growth” means escaping from poverty; I therefore favor policies that remove obstacles to growth. “Sound money” does not mean simply preventing inflation; it also means preventing obstacles to growth. A gold standard would not only be an obstacle to growth whenever the gold supply contracted, remained static, or grew at a rate less than the economy’s potential for real growth, it might not even be capable of preventing inflation (see end note for the explanation).
In four out of the five conditions above, our grandchildren would suffer a poorer quality of life than otherwise. But Ron Paul’s gold standard obsession only promises to avoid one of those four undesirable conditions, and it might not even be able to deliver on that promise. That’s why his stance on money policy scares me.
Here's an animated version of the five graphics above, in case it helps illustrate the differences. [Again, these are "concept" charts; that's intentional. Not only am I trying to convey the ideas in simplified pictures, it relieves me of the bothersome task of scaling the axes accurately. Authors of economics textbooks taught me that little tactic.]
End note—especially for Ron Paul admirers:
Once upon a time, I almost had myself convinced I was a libertarian. Why? Because libertarians "often argue that in a truly capitalistic society, even the poorest would end up better off as a result of faster overall economic growth - which they believe likely to occur with lower taxes and less regulation."
I agree with much of what libertarianism stands for. As you probably know by now, economic growth advocacy is the underlying reason this website exists. Café Hayek is one of my favorite blogs. EconTalk is my favorite source for podcasts. I support the Cato Institute. I subscribe to Reason Magazine, and always look forward to receiving the next issue in the mail. In short, I’m almost a libertarian. But not quite.
There's this one not-so-minor thing standing in the way: Signing up to be an advocate of the gold standard. That's a show-stopper for me. If advocating the gold standard is an implicit requirement of libertarianism—and it seems to be—then I have to stop short, and content myself with being some kind of “hybrid.”
My problems with the gold standard
I’m convinced that a reversion to the gold standard would be an unfortunate step backwards to 19th century mercantilism, and—worse—a relinquishment of sovereignty over the US dollar to foreign interests. This is one spot where I draw the line on trusting laissez-faire to work its magic: I do not trust the worldwide producers in the gold market—Russians and South Africans, for example—to act only on the basis of their unfettered economic self-interest when it comes to supplying the USA with the gold it would need to support its growing economy. I strongly suspect that international politics, subterfuge, and blackmail would become key risk factors to a gold-backed US dollar. In short, when it comes to guardianship of the US dollar’s value, I trust foreign gold mine owners far, far less than I trust US citizens appointed by the US government—a.k.a. the Fed Board of Governors. We have infinitely more control over the Fed than we have over the foreign interests in control of most of the world's the gold supply.
Besides all that, I have one other nightmare about a gold-backed dollar: Someday, technology will enable an enterprising firm to extract gold from, say, seawater at a cost of a nickel an ounce (plus-or-minus a few cents). If we were saddled with Ron Paul’s dream of a gold-backed dollar, that could trigger Weimar-republic style hyperinflation. How ironic that would be: Ron Paul’s gold standard causing the dollar’s value to implode.
A friend of mine, Dr. Rick Boettger, put it succinctly: “Gold is just an old fashioned form of money. Using gold to back up money is like using old poker chips to back up new ones.”
Has the Fed made mistakes? Yes, many times; no question about it. Is that sufficient reason to abolish the Federal Reserve and put the dollar back on the gold standard? Well, Congress, the presidency, and the Supreme Court have all made mistakes—but is that sufficient reason to revert back to the Articles of Confederation, or perhaps to see if monarchy is less mistake-prone than our current form of government? No, of course not.
Let’s keep Congress, the presidency, the Supreme Court—and the Federal Reserve—and let’s improve them instead of abolishing them. [Examples: I would strongly support a government project to improve the Commerce Department’s ability to measure true inflation, and to predict inflation six to twelve months out—even if that project cost billions of dollars. Its value in improved control over inflation and deflation could turn out to be worth many times its original cost. I would also support changes that would make the Fed more accountable, including formal post-audits of prior policy actions—sunshine is the best disinfectant—and improvements to the hiring/firing process. The point: Let's fix it instead of vaporizing it.]
My apologies to gold-bug libertarians, with whom I share agreement on many philosophical principles—including the desire for a stable currency. What we do not share is a desire for a reversion to the gold standard. We live in the 21st century, not the 19th; we should be looking forward with confidence, not backpedaling in fear.