Tuesday, October 25, 2011

The Problem with Gold

Okay, so I fully expect to annoy fellow libertarians with this post, but, as a natural-born contrarian that does not bother me as much as it probably should.  Let me start by saying that this is in no way intended to be an endorsement of our current Federal Reserve system or of fiat currency in general.  I think that our current monetary policy is responsible for the exacerbated business cycles we have experienced since the days of Jimmy Carter, and that it is an upwardly redistributive system that allows for direct transfers of wealth from the middle and working classes to big businesses and banking institutions. 

Many libertarians suppose that a gold standard would be an excellent replacement for our current system.  I agree that the Federal Reserve system should be eliminated and that a gold standard would be a vast improvement.  However, a gold system presents problems of its own, and those problems should not be ignored. 

The main problem I see is that switching to a gold standard would greatly expand the gold-mining industry and transform it from a productive, value-adding industry into a value-destroying industry. 

Currently, gold has several industrial applications in addition to its ornamental value.  Hence, extracting gold is an endeavor that adds value to society and makes everyone richer as a result.  But would this continue to be the case if gold was used as currency?  Probably not. 

To see what I mean, perhaps it would be useful to revisit how wealth is created in a free market system.  If I manufacture motorcycles, I am creating wealth for society.  I am taking parts and raw materials and assembling them into something that has more value than all of the parts and materials have individually.  If I were not adding value by assembling them into a motorcycle, I would not be able to stay in business very long, because the parts and materials would cost me more than I would be able to sell the motorcycle for.  If my time and the materials I use cost me $5,000 and I sell the motorcycle for $10,000, I am $5000 wealthier.  If the buyer of one of my motorcycles gets $15,000 of value out of the motorcycle, he has also become $5,000 wealthier.  Society, then, has become $10,000 wealthier as the result of my actions.  Although I only have regard for my own self-interest, I have been guided by the invisible hand of the market to make society better off. 

Now let’s say that a gold-standard is re-instituted and I decide I can make more money by becoming a gold miner than by making motorcycles.  I buy a track of land, some equipment and begin mining gold.  Every ounce of gold I pull from the earth makes me one ounce of gold richer (assuming I have no employees to pay.)  But how does this affect society as a whole? 

Well, since the gold is used as currency, it does not make anyone else better off.  It simply makes everyone else’s gold worth less than it was before.  The value of their gold has been diluted by my extra ounce of gold.  A gold miner cannot make society richer by pulling gold out of the ground any more than the Federal Reserve can make society richer by printing more money.  I have simply inflated the money supply through my actions, and so I have made myself richer only by making everyone else in the country incrementally poorer. 

Of course, barring the discovery of a heretofore unknown massive mountain of gold on some corner of the Earth, the actions of individual gold miners will never be able to inflate the money supply as rapidly as the Federal Reserve can, as evidenced by the recent quantitative easing programs.  So the natural scarcity of gold acts as a sort of hedge or limit on inflation.  This is one of the key advantages that a gold standard has over the Federal Reserve system. 

However, there is also a significant disadvantage, and that is the attraction of otherwise productive labor to the gold-mining industry.  Remember in my example above that prior to the institution of the gold standard, I was productively working as a motorcycle manufacturer, adding value to society.  When the gold standard was instituted, I decided to divert my labor to the mining of gold.  As a result, society will not just be poorer because of the presence of more gold, but it will be poorer again because of the absence of my motorcycles.  As Frederic Bastiat might say, we have to look for both the seen and the unseen.  The seen is the inflated gold supply, the unseen is the motorcycles that go unmade. 

Now, in a more realistic setting, it will probably not be motorcycle manufacturers who become gold miners.  But the miners of other materials that have important industrial applications may well be attracted to the gold-mining industry.  We can expect the prices of other metals and minerals to increase incrementally, as miners are attracted away from those productive endeavors.  The public will pay more for all of the products that include those affected raw materials and will have less money to spend on other things.  Hence, in at least one way, we will be poorer. 

Is this any reason to think that a reinstitution of the gold standard will be disastrous?  No.  Again, it will be a huge improvement.  On net, the gold standard is much better than what we have.  However, we cannot be deluded into thinking a gold standard is perfect.  It is far from perfect, and we should acknowledge those imperfections. 

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