The Resource Costs of Fiat Money Exceed Those of a Gold Standard
By David Henderson
One of the articles I read in graduate school that persuaded me that a gold standard would be inefficient was Milton Friedman’s “Commodity-Reserve Currency,” published in the Journal of Political Economy in 1951 and later reprinted in his Essays in Positive Economics.
Back in 1999, Lawrence H. White had an excellent critique of Friedman’s point. The bottom line is that Friedman is way, way off.
In summarizing both Friedman’s point and his own critique of Friedman, Larry writes today:
Milton Friedman (1951, 1960) provided influential back-of-the-envelope estimates of the costs devoted to extracting gold under what he called a “strict” gold standard. I have criticized those estimates elsewhere (White 1999, pp. 42-48) for exaggerating the volume of gold reserves used by actual gold-standard economies, and thus exaggerating the resource cost. Friedman’s estimates assumed a 100 percent gold reserve ratio against demand deposits (1951) or against all bank deposits (1960), whereas sophisticated banking systems in gold-standard economies historically operated on small prudential reserve ratios (as he elsewhere recognized). Plugging a historically observed 2 percent reserve ratio against all the bank liabilities in the broad monetary aggregate M2, rather than Friedman’s 100 percent, yields a resource cost estimate one-fiftieth of his 1960 figure, namely 0.05 percent rather than 2.5 percent of national income.
This is from his “The Resource Costs of Fiat Money Are Now Higher Than Those of a Gold Standard,” Alt-M, December 17, 2019.
It gets worse. Larry goes on to point out that the fear of inflation generated by a fiat money system leads people to hold a lot of gold. How much gold? He continues:
Recent data on gold production from the World Gold Council (2019) allow us to revisit the question with something better than casual empiricism, and to reach a conclusion. Plugging recent numbers from the World Gold Council into Friedman’s own model, it is fairly clear that gold coins and bullion in recent years have been produced in greater volumes than would have been the case under a gold standard with reasonable prudential reserve ratios, and thus gold-extraction resource costs have been higher under fiat money in practice. Note that this accounting effort provides an underestimate of the total resource costs induced by fiat money, because it neglects the costs incurred in acquiring silver, collectibles, cryptocurrencies, and other inflation hedges.
In the rest of the article, Larry gives the numbers that back his claims. He sums up:
These estimates indicate that the historical switch from gold to fiat standards, contrary to the sincere hopes of Milton Friedman and other advocates of the switch, has increased the resource costs associated with the production of gold coins and bullion. Perhaps this was avoidable. The establishment of trustworthy non-inflationary fiat money systems (as Friedman of course prominently advocated) might have given private citizens no reason to invest in gold coins and bars, and might have brought a resource cost saving over the gold standard. But that experiment has not been run.
One small numerate criticism. Larry writes:
When President Richard Nixon “closed the gold window” to end what remained of gold redemption of the US dollar on August 15, 1971, the official par value was $35 per ounce, while the market price had floated to $44.60. In the last half of 2019, with fiat standards prevailing around the world, the price of gold has hovered above $1450 per ounce. The ratio of $1450 to $44.60 means that the dollar price of gold has risen more than 32-fold since August 1971.
But the increase is not a “more than 32-fold increase.” It’s more than a 31-fold increase.