The Gold Standard; Or is it?

29th August 2012

In the moments in which the world economy lurches downwards it is easy to feel that almost any monetary system would be better than what we have now! Today I intend to look at what we have right now and how this would change if we went to the gold standard that some are calling for.

The current monetary system

Different countries have different monetary system and right now we are seeing central banks meddle and interfere in all sorts of areas which are not their natural playground. However the monetary system is split into two main areas.

Narrow money supply

This is sometimes called the monetary base and at other times high powered money. It is controlled by central banks and involves the supply of notes and coins and banks deposits at the central bank. By manipulating these it can influence this measure of the money supply directly.

At this time with central banks working hard to influence the economy with all sorts of monetary expansion measures the concept of "high powered money" is something of a misnomer.

Broad Money Supply

This is where commercial banks enter the fray as the provision of loans by them is the main factor which moves us from narrow measures of the money supply to broad ones. Also we usually see a large expansion in the numbers due to this and if we look at the UK our measure of broad money or M4 is £2050 billion and our measure of narrow money is £291 billion giving us a seven to one ratio as of the latest Bank of England data.

So we see that narrow money (notes and coins and reserve balances at the central bank) is under central bank control but broad money has a more tenuous relationship with it. One of the reasons that central banks have control over short-term official interest-rates is that it is a weapon for influencing the path of broad money via the price of loans. Raising the price of bank loans via interest-rate rises should reduce the supply and reducing the price should increase it. They used also to directly intervene by legislating and ruling on the amount of credit and bank loans in the economy but this has mostly fallen into relative disuse although regular readers may recall that China still uses such a system.

You may have spotted that as we have travelled from narrow to broad money supply we have made the shift from money supply being the relevant player to money demand as in the demand for loans. This point is rarely made but when it is explained it becomes clear as to where central banks have struggled in the last few years to get broad money growing again at a rate they would like.

How does this act on the economy?

The amount of broad money influences the level of output in the economy as well as the amount of inflation. You could of course write that sentence in reverse but if we stay with the theme for today we see that in theoretical terms we have something which is flexible.

In normal times banks can expand their lending which supports the economy and both broad money and the economy can grow together.

It does not always work like that

Whilst the advantage of the above system is that it is flexible it is also quite reasonable  to argue that in the modern era it is too flexible. We have just gone through an era where bank lending surged on the lines of Buzz Lightyear's "Too infinity and beyond" and poured in many countries into housing markets leading to a boom and then bust. During that period I would argue that many central banks forgot the old dictum of central banking:

"to take away the punch bowl just as the party gets going"

Now in the credit crunch era we find ourselves in the reverse situation. Central banks failed to do much if anything about the boom but they have leapt and charged into trying to deal with the bust. Only, in spite of enormously expansionary measures by them the pilot light is not firing up the monetary burners let alone the real economy. For example M4 lending on the Bank of England's preferred measure had risen in the year to June by 0.4% which when you consider all the monetary stimulus gives you an example of how little effect it is having.

Why?

In the equation MV=PT which is supposed to represent the economy we have come to realise that M (Money) and V (Velocity) are much more interlinked than was previously thought. Here I am returning to M being the money supply although as discussed above the problem is that it is money demand which is already beginning to include velocity. Accordingly we see that we have problems before we reach the impact on P (prices) and T (the number of transactions).

We also see a potential problem for the future should we ever return to what we might regard as "normal". As we do so we see that the money and liquidity unleashed by central banks would be a very powerful force with "normal" velocity and unless you think that the real economy could immediately respond then we will see inflation in such an environment. The danger is in fact so high that it has been officially denied when US Federal Reserve Chairman Ben Bernanke told us that he was "100% confident" that he could deal with any ensuing inflation from his monetary expansion efforts.

Much more likely central bankers will delay and dither when there are signs of a genuine recovery which will let inflationary pressure build. After all having put so much into trying to achieve a recovery the last thing they will want to do is end it prematurely.

How did we get here?

We have changed. By this I mean that the expectations set of the people of the developed world has changed in the credit crunch era around issues such as inflation savings and economic growth. We may change back again to greed mode but in many aspects fear is currently winning. This is a major reason why I feel that monetary policy has proved much more impotent than might otherwise have been expected in recent times.

The Gold Standard

If we look at what this would entail I am immediately struck by the thought that this is a credit crunch of its own. As money would now be transferable into gold on demand then the amount of money is limited to the amount of gold an economy has. So in one way at least we would be in danger of entering
a permanent form of credit crunch.

The definition could and in the past has often been loosened to also include Silver but this still leaves us with the issue of a (mostly) fixed supply.

 

More on Mindful Money:

Why Nick Clegg is wrong on the wealth tax

Is the Quantitative Easing debate obscured by partisan papers?

Will 2012 turn out to be an economic re-run of 2009?

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