Last week, Chatham House, formerly known as the Royal Institute of International Affairs and a non-profit, non-governmental institution in London whose “mission is to be a world-leading source of independent analysis, informed debate and influential ideas on how to build a prosperous and secure world for all”, published a report with the title, “Gold and the International Monetary System.”
This report summarizes the findings of the Chatham House Gold Taskforce. This taskforce, comprising 10 permanent members but involving additional participants in meetings in Washington, London and Beijing, was set up to investigate “whether there is a role for gold in the international monetary system.” The conclusions are predominantly negative. Chatham House sees no important role for gold beyond being one of a variety of central bank reserve assets and occasionally an interesting portfolio component (a hedge against inflation).
I regard these conclusions ill-considered and rash, and in my view Chatham House fails to make an intellectually convincing case for them. But the conclusions are certainly not surprising. Looking at the descriptions of the taskforce’s mission and the procedure of its investigation, any other outcome would have been surprising. Support for the status quo was, by and large, to be expected.
Committed to the status quo
Chatham House stresses the independence of its research, and I have no reason to doubt it. I do believe that the conclusions were arrived at without any interference from or any implicit consideration of vested interests, and that they reflect the honest views and best judgement of the taskforce members. Independence is not the issue here. Something entirely different is the issue. And this other aspect is what makes the report ultimately interesting and worth reading beyond its rather predictable and conventional conclusions.
The report emphasizes that the taskforce took a “fresh and open-minded approach” to the gold question. But that is precisely what it did not do and from the start set itself up not to do. The taskforce was evidently content from the beginning to remain within the established consensus of opinion on money, on crises, and on the role of governments and central banks. The taskforce’s entire analytical toolkit, i.e. the theoretical framework that forms the foundation of its investigation and discussion, although often not explicitly stated, reflects the mainstream assumptions of the standard Keynesian and Monetarist textbooks. The taskforce does not articulate them, defend them or justify them. It just tacitly adopts them as if they were beyond critique or proper investigation.
One of the key questions in the gold debate – maybe THE most important question – has to be this one: Was it a mistake to abandon the gold standard and adopt a system of unlimited and elastic fiat money? Is this fiat money system superior, is it stable and is it sustainable? From here, certain follow-up questions impose themselves: What are the fundamental differences between a gold-based system and a fiat money system? Which is more compatible with the free market system?
It is not that these questions are being answered by the taskforce in favour of fiat money. These questions are not even being asked. It is already assumed from the beginning that a monetary system based on state-issued and state-managed fiat money is necessary in today’s world, it is already assumed (although never convincingly argued) that the gold standard failed (more about this later), and that the only question that remains, and the one that asking the Chatham House attests itself a lot of ‘open-mindedness’ for, is whether there is scope for any reform of this fiat money system that also involves gold.
But in order to go beyond the established mainstream, to question accepted common wisdom and to answer any of the fundamental questions above, one has to go back to first principles and conduct a theoretical economic analysis. That is precisely what I did, or at least tried to do to the best of my ability, in Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown. But the Chatham House report eschews any theoretical investigation. Thus, it remains hostage to the established mainstream and cannot drill any deeper into these fundamental problems than an article in The Economist or the Financial Times might do. The Chatham House report happily bobs about on the surface of the established belief-system.
There is also a strange and suspicious unwillingness to even acknowledge that an academic debate about the merits of fiat money exists, or could exist. The report mentions US congressman Ron Paul, who has “always distrusted central government” (page 3), as a critic of fiat money and an advocate of a gold standard, but fails to explain that Paul’s economic views are not the idiosyncratic ramblings of an eccentric politician but firmly based on the Austrian School of Economics, a strand of economic thinking that may not be mainstream in the sense that it dominates today’s standard academic education but that, with such prominent exponents as Mises and Hayek in the twentieth century, and Menger and Boehm-Bawerk in the nineteenth century, produced outstanding work in economic science. Furthermore, the ‘Austrian’ view that elastic forms of money, such as complete paper money systems, lead to economic instability (business cycles) had partially been anticipated by the British Classical economists (such as, among others, David Ricardo) in the early nineteenth century, and thus stands in a long and established tradition. We are not talking about the fringe of economic debate here. We are not talking about economic cranks or tiny scientific sects. Here are some powerful and influential theories. Two generations ago almost all established economists would have stressed the importance of basing a monetary system on gold and they would have shaken their heads in disbelief had they had a chance to inspect the present and rather novel system of unrestricted fiat money. None of these views even get mentioned. Can we be certain that they were wrong? How can we show this? After all, the present monetary system is only 40 years old, and it is not doing that well. Chatham House does not touch on any of this.
The Chatham House report mentions Keynes as an opponent of the gold standard, and while it also refuses to discuss his theories and while it certainly does not present him as the winner of the monetary debates of the 1930s, the taskforce tacitly adopts key elements of the Keynesian framework for its further discussion of monetary systems. In particular, the taskforce accepts that active stimulus policy is desirable and that the government needs control over monetary affairs in order to stabilize economic performance. Any serious discussion of the role of gold in a monetary system must rigorously test and investigate these assumptions rather than silently adopt them as benchmarks for the analysis of monetary systems.
It is not only the refusal to engage in theoretical and conceptual economic analysis – maybe this refusal is understandable given Chatham House’s overall focus on policy – but also its voluntary self-confinement to what it considers politically acceptable solutions that makes its approach anything but open-minded. On page 3 of the report we find statements such as: “A ‘Bretton Woods III’, however, still remains a distant goal … A ‘big bang’ approach to reform is clearly not on the cards ….In pursuing a more evolutionary approach….” All of this may reflect a solid understanding of realpolitik by the Chatham House researchers but it is clear that their wish to remain relevant to today’s policy establishment must confine their analysis to the boundaries of consensus views and prejudices. What we as readers are certainly not getting here is a ‘fresh and open-minded’ approach.
At this stage we may want to put the Chatham House report aside as just another articulation of the consensus view on gold. But I think the report is still quite interesting as the authors, while making an effort to stick to the established consensus, repeatedly trip over the alleged short-comings of gold and the proclaimed benefits of fiat money when laying out their case. The report is, for the careful reader, instructive as it shows the deep-rooted misconceptions about gold, deflation and economic crises that characterize today’s mainstream. On close inspection Chatham House’s analysis does not even support its own stated conclusions but in fact reveals – unwittingly – some of the essential fault-lines of the fiat money system. Let me explain.
That old deflation chestnut again!
Early on, in the executive summary, we find this paragraph:
“The lessons of both the Gold Standard era and the post-war Bretton Woods period suggest that reintroducing gold as an anchor would undoubtedly be impractical or even damaging, given bullion’s deflationary bias.” (page viii)
Here we have one of the standard arguments against a gold-based monetary system. As it is not to be expected that the supply of gold will keep pace with the growth in productive capacity of the global economy, a gold-based monetary system would have a tendency towards secular deflation, that is, a tendency for prices to fall and for the purchasing power of money to rise over time.
This is correct. But why is that a problem? Why is it better to have prices rise by 2 percent every year, which is the present goal of most paper money central banks, than to have prices decline by 2 percent every year? As we get more productive, things become more affordable. That is the normal capitalist process. Would it not be more ‘natural’ to have this constant rise in affordability, the constant drop in real prices, also reflected in nominal prices?
Of course, that deflation is bad in itself is a persistent theme in the mainstream media today but any thorough – and ‘open-minded’ – analysis of monetary systems needs to be more sceptical and inquisitive and should be willing to question these views.
As I show in detail in my book, the constant secular deflation of a hard money system is not only not damaging, it has in fact many economic advantages. But most importantly, as I also explain in some detail, any attempt to compensate capitalism’s inherent tendency towards falling prices through extra money-injections – as is now the official policy goal of all fiat money central banks – must always destabilize the economy as these money injections constantly suppress interest rates on capital markets, and must thereby lead to persistent mismatches between saving and investment, and thus to considerable capital misallocations.
These are all theoretical considerations, and as we have seen, the Chatham House taskforce eschews theory. Instead the taskforce bases its view that gold’s mildly deflationary bias must be harmful on its interpretation of the historical record, namely “the lessons of both the Gold Standard era and the post-war Bretton Woods period.” The report does give a brief historical sketch in chapter 2 (pages 6 to 9) with the subtitle “Why did the gold standard fail?” Bizarrely, this chapter does not support the conclusion in the executive summary that it was gold’s deflationary properties that derailed the gold standard or Bretton Woods.
It is a fact of history that, throughout the Classical Gold Standard, deflation was not a problem. Here the Chatham House report:
“In the run-up to the First World War, the Gold Standard provided the foundation for the expansion of the global economy in the first age of globalization. … In a period of globalization driven by technological advances and international migration, the deflation prevalent up to the mid-1890s was not accompanied by dramatic falls in output.” (page 6).
The last sentence is evidently a Freudian lapse. This deflation was not only not accompanied by falls in output, it was in fact accompanied by strong economic growth, rises in income, prosperity and overall living standards. Yes, deflation was accompanied by strong growth, as anybody who understands how capitalism works, should easily grasp.
Allow me to quote from my own book on this point:
“After the United States joined Britain on what became the Classical Gold Standard in 1879, prices declined on trend for the next 19 years at an annual average rate of just over 1 percent. This compares with a still positive inflation rate of 0.3 percent in Japan over the 20 years after that country’s money-induced real-estate bubble burst in 1990. Japan is today regularly cited by mainstream economists as an example of the evils of persistent deflation. Yet, the United States, during its two decades of gold-standard deflation, experienced solid growth and rises in income and wealth. In fact, even prior to joining the gold standard, the United States had gone through 12 years of almost no money supply growth and had experienced an almost halving of the price level from the elevated levels that prices had reached during the Civil War inflation. But still, U.S. economic performance was vibrant during this time, causing even such prominent advocates of state-paper money and central banking as Milton Friedman and Anna Schwarz to conclude that this constellation ‘casts serious doubts on the validity of the now widely held view that secular price deflation and rapid economic growth are incompatible’.” (Paper Money Collapse, page 136, 137)
But the authors of the Chatham House report do not want to give up their preconceived opinion that deflation must somehow be a problem. Almost comical is this footnote on page 6 that refers to the quote above about there being ‘no dramatic falls in output’:
“….the problem probably could have been resolved had the price of gold been increased (i.e. paper money devalued, the economic cure-all of today’s mainstream, DS) by a factor of three or four.”
But what problem? There was no problem with gold or deflation as the report itself just admitted in the body of the text.
The state versus gold
So why was the gold standard abandoned then? We find the answer in the next paragraph:
“To finance the war effort, however, the Gold Standard was suspended by combatant countries…” (page 6)
This is the crucial point. The gold standard was never an impediment to the growth of the capitalist economy, to the rise in living standards and to the growth in mutually beneficial trade. Quite the opposite, it was and still is the best possible – the only possible, in fact – monetary system for capitalism. Neither private citizens nor capitalist enterprises asked for an abandonment of the gold standard and the introduction of paper money. It is entirely wrong to assert, as the Chatham House report implicitly does, that gold’s inherent tendency towards falling prices posed a problem for the free market economy. But the gold standard put constraints on the financial dealings of the state. It was the state that did no longer desire to operate under the strictures of a gold standard. The gold standard did not fail, as the Chatham House report claims, it was dissolved for political reasons.
On further inspection it becomes clear that, once you abandon gold and start printing money, you may enjoy a temporary economic boom but at the end of this expansion you will be left with substantial dislocations, among them an overextended credit edifice. This is the essence of the monetary theory of the business cycles as developed by the British Classical economists, perfected by Mises & Co in the twentieth century, and entirely ignored by the Chatham House taskforce. Going back to hard money then is likely to incur a correction in these imbalances, and this correction is also likely to be accompanied by deflationary forces. But this is a very different type of deflation than the secular deflation of a hard money system that we discussed earlier. This is the corrective deflation after an extended inflationary boom. To put the blame for this deflation on the gold standard is complete nonsense. The blame can only be put on the inflationary boom, which was the result of a politically motivated abandonment of the gold standard.
These aspects clearly shine through the short historical account of the Chatham House report but the authors fail to connect the obvious dots. Here some examples:
“…but monetary expansion during the conflict had pushed prices up so much that when calculated at pre-war parities the available supply of gold had declined relative to the money value of the income it was intended to support.” (page 6).
At this point, it may be worthwhile to mention that there is nothing in economic theory – and certainly nothing in Austrian School economics – that would require a return to the old parities of the previous gold standard, such as was attempted by Britain in 1925. For a return to a system of stable and hard money, all that is required is to stop printing money and adhere to the new parity. Obviously, stopping further money injections will likely necessitate an economic correction, including a drop in certain prices, as the economy gets cleansed of the accumulated imbalances from the artificial boom, and this deflationary correction may not be easy to accept for political reasons. That is why, once the gold standard was abandoned, it was politically so difficult to go back to it. The inevitable dislocations from constant money injections – explained in detail in my book – were then papered over by more and accelerated money injections. The system moved progressively away from hard and apolitical money towards fully elastic money with no constraints whatsoever.
This is precisely why, after the gold standard, we had the gold exchange standard of the interwar years, then the post-WWII Bretton Woods system, and now, since August 1971, the non-system of unrestricted fiat money expansion and floating paper currencies globally. It is not surprising that the global monetary system has moved progressively away from inelastic money on which capitalism works best, and towards ever more elastic money that suits the money-issuers, first and foremost the state. The decline of the gold standard coincides with the rise, in the twentieth century, of the all-powerful warfare/welfare state. It is also no surprise that the system is now culminating, globally, in the cul-de-sac of zero-interest rates everywhere and ever more bizarre and desperate policies of ‘quantitative easing’.
Here is another revealing quote from the Chatham House report:
“The final straw for the United Kingdom was its realization in mid-1931 that the low ratio between its gold holdings and the amount of short-term obligations that could potentially draw on these reserves (and that had been issued in the preceding politically motivated off-gold credit boom, DS) made it impossible to defend the fixed value of gold.” (page 7)
And when the report speaks about the collapse of Bretton Wood, it again has to admit that the reasons were political, in particular the growing appetite of the state for control over the domestic economy:
“As the United States began running up persistently large external deficits while supplying the global liquidity required for international transactions, the volume of dollars held as foreign-exchange reserves by both official and private holders came to exceed the amount of gold in the Federal Reserve by a significant amount.” (page 8).
It is clear that under a proper gold standard this would not have occurred and that the trade imbalances would be self-correcting as gold would flow out of the United States and thus tighten financial conditions there, which would lower domestic demand and correct the deficit. But at this stage we had no proper gold standard any longer. Also, any automatic correction to excessive domestic demand was certainly unwelcome in the United States. What the United States cared about was not the effective discipline of a capitalist monetary system but to maintain what the Chatham report repeatedly calls ‘monetary policy sovereignty’ – the ability to manipulate domestic economic conditions by running deficits, lowering interest rates and printing money. This is really what is at the heart of the gold debate. Nixon closed the gold window in 1971 and thus ended Bretton Woods not because of any deflationary tendencies of gold and not because the, at the time, already tenuous link to gold hindered trade or overall economic growth but simply because he wanted to conduct fiscal and monetary policy without having to fear the negative consequences of gold outflows. In perfect analogy to the abandonment of the Classical Gold Standard, gold had become a straight jacket for policy-activists, not for economic growth.
The Chatham House authors are not only unwilling to question and investigate key theoretical assumptions of the mainstream macro-paradigm, they also readily accept that active macro-policy through control of the domestic paper money supply and the manipulation of market prices (predominantly interest rates) is desirable and beneficial to the overall economy. Again, they do not provide proof for this. They treat it rather as self-evident truth or as a given feature of the present political belief system.
Following is a rather apt description of the late 19th century gold standard economy that also casts some light onto why the Chatham House taskforce ultimately had to arrive at the conclusions it did:
“This was a time (the time of the Classical Gold Standard 1880-1914, DS) when governments had a limited responsibility for the economic welfare of their populations and intervened less in their national economies. Monetary policy sovereignty was not deemed to be as important as today, so the loss of sovereignty required for the Gold Standard was more easily foregone.” (page 6)
As I argue in Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown, our modern fiat money system, a system of fully elastic and essentially unlimited paper money, is entirely incompatible with capitalism. It is a system of constantly intensifying monetary interventionism that requires progressively more money injections to cover up its inherent instabilities and to postpone the dissolution of its imbalances. There is nothing in the Chatham House report that makes me question any of these conclusions. To the contrary, if you read the report carefully, it unintentionally provides at various points poignant support for my case.
The authors of the Chatham House report and the policy establishment which they so eagerly want to please, may continue to ignore the obvious fault-lines of this system but reality is quickly catching up. They may believe that a ‘big bang approach’ to reform is not on the cards. But the monetary system that they have helped create and that they now defend is getting ready for a big bang, and then some radical new thinking will be required, thinking that is more ‘fresh and open-minded’ and not so much hostage to the status-quo as what the Chatham House has presented here.
In the meantime, the debasement of paper money continues.