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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?

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