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Commentary

The Gold Standard and Deflation

Gold is increasingly viewed in two kinds of angles, by seriously literate people all over the world.

1. That there will be inflation, and thus, gold will be our savior.

2. There is no real safe currency anymore, so we must run to gold instead.

Either ways, Gold is being bought, so much that it saw a 30% rise in August alone. An ET article says that Indians and Chinese are buying a lot – institutional holdings abroad haven’t gone up.

And then, people argue that moving to a Gold standard will cause deflation, because as gold prices go up, the price of everything else in gold terms goes down.

My view: Yes, a gold standard will cause deflation. Why? Because gold supplies are limited, today. At some point, there will be a need to go find gold, and then, supplies will increase. But to understand why a gold standard is deflationary, consider this:

a) There is just 100 grams of Gold in the world, which let’s say is Rs. 200,000. That is now all the currency that’s around, you can’t increase it without adding more gold on.

b) This 200,000 is lent to a guy manufacturing mobile phones, who’s currently making, say 100 phones a year. People only use phones, so they pay Rs. 2,000 per phone. (Hey, imaginary world)

c) With an increase in productivity, he’s able to make 100 more phones this year The total amount of money around is Rs. 200,000, now distributed over 200 phones – so the phone price falls to Rs. 1,000.

This is simplistic economics – things don’t usually work exactly this way but it’s the gist of the story.

The one way to counter a “productivity improvement” is to debase your currency a little. Imagine that the RBI then issued 200,000 more rupees, for a total currency issued of Rs. 400,000. So now the 200 phones will still cost Rs. 2,000 each. But issuing more currency against the same gold is what is not allowed in a gold standard. This is why the gold standard is deflationary.

But the argument is also that deflation isn’t necessarily bad. Krugman argues that deflation will make people hoard money instead of spending it. But that’s not quite true; prices of electronics have kept falling, and people still buy electronics. And it’s not all obsolescence; my desktop computer is a 2007 model that works just fine today. People use more when the price is lesser.

But it’s different for a debt economy – if I can’t increase the amount of money I receive for my goods, I can’t pay interest on my borrowings. Will a bank lend me money for no interest? Banks borrow from depositors at some interest rate, and lend at a higher one and make the spread; with deflation, there is no spread. Banks, therefore, will fail in their current “highly leveraged” form. Reduce the leverage, and things work out much better.

Deflation is a problem for a leveraged system (which is why banks are scared of it) and I think if we need to survive as a society, we need less leverage, not more; and that necessarily means that highly leveraged systems should cut themselves down to size, or die.

But the Gold standard is dangerous because it puts artificial constraints linked to the availability of a metal. You must be able to tweak things a little, this way or that. Instead, we could have limits on how much our country is allowed to debase its currency. If the RBI wants 4% inflation, like it has targeted recently, it should only debase the base currency by 4%. As recently as last week, it had increased the supply of base money by 15% year on year. When you have an irresponsible debasing of currency, you will have an irrational attraction towards other stores of value.

How can the RBI stop the debasement? Just sell the assets it has, for rupees, and take those rupees out of circulation. It could sell the dollars it owns, the gold it has, the government debt it owns – anything – and easily keep the monetary supply growth below 4%. But when they choose not to do that and choose to raise rates instead, is it a wonder that many of us find gold as the answer?

  • austrian_man says:

    Nice article Deepak. But can you explain this statement…”But the Gold standard is dangerous because it puts artificial constraints linked to the availability of a metal. You must be able to tweak things a little, this way or that.” Why is that?
    From a stocks to flow standpoint, gold production is actually very stable. I think the ratio is like 80:1, so you have a lot more gold above the ground and production adds very little to the supply. With energy constraints (peak oil), taking gold out of the ground becomes more costly to a point where it won’t be worth it. At that point – supply won’t change at all. But does the supply of money really matter?
    Here’s Murray Rothbard, from “What has the Government done to our money?”:
    Thus, we see that while an increase in the money supply, like an increase in the supply of any good, lowers its price, the change does not—unlike other goods—confer a
    social benefit. An increase in the money supply, then, only dilutes the effectiveness of each gold ounce; on the other hand, a fall in the supply of money raises the power of each gold ounce to do its work. We come to the startling truth that it doesn’t matter what the supply of money is. Any supply will do as well as any other supply.
    Full book is available at: http://mises.org/books/whathasgovernmentdone.pdf

    • Austrian: Artificial constraints = where your money supply is linked to production, controlled by a few entities. If there is more gold out there that is found, it can rapidly raise supply artificially (esp govts.) Would rather we use fiat currencies not linked to a standard but keep transparency on how the debasing (or rebasing) happens, at a real time level.
      Will read the book, thanks!

      • austrian_man says:

        Deepak,
        Your expectation then would be something like a Riksbank (very responsible IMHO) and a corrupt-free governance (again Sweden and New Zealand come to mind – Transparency International rates them > 9 on a scale of 10 on corruption perception index) world-wide. This is impractical (as is evident today with ECB, Fed, SNB et. al printing like crazy), which is why gold will impose the required honesty.
        Gold should be allowed to flow freely across borders then we have a single world-wide currency that hardly changes in purchasing power. Supply of gold should also be dictated by the market. If it is economical to take it out of the ground, it can be taken. Govt. Mint can charge a nominal fee to mint the gold into currency that can circulate. If it is not economical (as would be the case when oil becomes very costly), supply stops changing but the value of money starts increasing.

  • Dark Lord says:

    “Krugman argues that deflation will make people hoard money instead of spending it. But that’s not quite true; prices of electronics have kept falling, and people still buy electronics.”
    Electronics is an exception rather than the rule. Housing might be a better example. If you know that the prices are going to fall over the next year, you will hoard the money and make the purchase next year. Electronics is exceptional because a) Being the first owner/possessor in the social cohort (Apple, book release etc) wherein consumption/want is immediate and b) Krugman is talking macro i.e all prices are falling whereas you are going for electronics falling whereas other prices are stable

    • I don’t think so (about electronics being an exception). See cars – In India car prices have fallen over the last 9 years, and people still continue to buy them. Nearly every field that has seen a level of productivity improvement beyond the basic level has seen demand go up. Even at a macro level, the productivity improvements in the ssytem,
      Assets that are stores of value see some level of hoarding but people who want to buy, buy anyways. People who look for a house to live in, and who have the money (i.e. don’t have to take on debt) will buy at whatever level. The problem with deflation is that they don’t get credit for housing because the value of the collateral diminishes. But that’s okay, because people have to realize that buying a house is like buying a car; you don’t bet on the collateral, you bet on the creditworthiness of the borrower. If we make real estate a consumption good rather than an investment, we really get room for other things. (And you honestly won’t need a high valued gold either).
      You can only hoard for so long, once you realize that value stores are no longer important, and that deflation isn’t a big deal, you’ll buy when you need the goods.
      Prices at a macro level, if they fall, will find a floor, and in the process change a number of social concepts (like wage deflation will happen). People who can afford maids today won’t be able to because maids will demand the same high salary while deflation makes it difficult for us to pay; instead, we’ll find a way to work by ourselves (and indeed, they will find different professions) Deflation can result in quite a social change, if we do allow it to happen.

  • Mehul says:

    Do we know cases of deflationary periods anywhere in the world in near history? It sounds like fun, on a lighter note 😉

  • Shafeek M K says:

    If, due to increase in productivity, prices of all things go down; why would a maid not agree to work for a lower salary? I.e, in this hypothetical situation, price of food has gone down (relative to gold) due to an increase in production, price of housing has gone down due to increase in number of available units etc. Then a person should be able to save the same amount (relative to gold) with a lower pay.
    I guess we’re looking at it from the current mindset, where the value of money never goes up, only goes down. So we would never agree to work for a lower pay. If we adopt a gold standard, we should look at a mindset where we all expect our incomes to regularly go down, unless there is an increase in productivity. And one would not look at value of anything only relative to value of gold, which would constantly go down. Rather value of any product would be relative to what else you have in the market.
    Improvement in supply of any product (more cars, houses etc) should lead to a demand for all other non-competing products.
    Though Krugman argues for a higher rate of inflation these days (stimulus et al), I think he also had proposed a fixed 2-3% annual debasement earlier.

    • Very good point – and that is a part of the social change I speak about – the agreeing to a lower salary. Deflation is good for that as a concept – at least better than inflation. I know Krugman hates deflation, but it seems like that might not be such a bad choice. Don’t know about a gold standard though.

    • austrian_man says:

      Excellent point Shafeek. This is exactly how the mindset will change if gold was the standard world-wide currency.
      Krugman demonstrates all the classic Keynesian fallacies, that are well-illustrated in this book: http://www.hacer.org/pdf/Hazlitt00.pdf
      He said world war II was good for the US economy, which demonstrates the Broken Window fallacy. When you start seeing the world through an Austrian Economics perspective, things start to make a LOT more sense.

  • Indi says:

    I try and read a lot of finance and economics blogs (both for professional and personal reasons) and I use articles such as yours to separate amateurs who think who can write about serious stuff (precisely the article above) from those who know what they are talking about (Krugman). When you don’t have a clue, do not start making claims like “deflation is not necessarily bad” (I can clearly see that you have no economic framework to refer to while making such a statement and if you have one, please state it). Please try and avoid the temptation to write about it. I hope this is not the way you manage your trading or the way you manage you professed business of educating people about finance and stock markets. You know what they say about half knowledge…that it takes you half way to becoming the ignorant American that every Indian laughs at. The rest is left to learning the American accent and constant use of Fair and Lovely. Good luck with your finance writing and try your very best not to dabble in economics again. My readership of your blog comes to an end here.

    • Thanks. Your response adds nothing to the discourse other than “you’re wrong, Deepak”. Which, to me, is as useless as you think my blog post is. You won’t be missed.

      • Indi says:

        I can’t offer any! I am not an economist, I can’t do an economic model. But I can read when an argument is poorly researched, framed or derived!
        In case you missed the point!

        • austrian_man says:

          ” I am not an economist, I can’t do an economic model.”
          That much is obvious.
          “But I can read when an argument is poorly researched, framed or derived!”
          This is false, as you think Krugman is a great economist. He is not, He is prone to Keynesian fallacies. I’m not saying he’s wrong all the time bear in mind, I’m saying he’s wrong on several key points. He believes there are benefits in deficit spending when clearly there is not. He believes destruction of property or human lives actually helps the economy, which can be clearly shown to be broken window fallacy. Google and read about it and learn what we’re talking about here.

        • No arguments – While the post is about the fact that Gold is deflationary, I say that deflation isn’t necessarily bad, and I provided examples. A larger example is Japan, which hasn’t had a bad time during it’s deflation. I could go on, but I don’t think I’d make any progress since you don’t have a concrete counterpoint about what’s wrong, just that you don’t like it. Point taken, we’ll just move on.

    • Rohan Choukkar says:

      As someone who has come to the US and been quite impressed by what I see, I will adopt “your” tactic and tell you to abandon all that self-scratching nationalism. Our country was and is in the hole that it finds itself in for a reason. Continue to laugh at the US and we will remain in that hole.
      I second Deepak. You won’t be missed.