Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Gold standard and Austrian economics

After I mentioned the gold standard in my last post
on three centuries of UK interest rates, I received a number of
comments relating to the gold standard and Austrian economics.

Mahesh asks about the advantages and disadvantages of going from a
paper currency to the gold standard. I do not think of the gold
standard as something to do with the physical commodity called gold; I
think of it in terms of targeting the price level rather than the
inflation rate.

Nowadays central banks target the inflation rate, not the price
level. Suppose the initial price level was 100, the inflation target
was 2% and actual inflation is 5%, then the central bank writes a
suitably remorseful letter to the government explaining its failure to
meet the target. In most cases, the government might accept and even
endorse the explanation, though in the worst case, it may replace the
head of the central bank. In either case, the inflation target for
the next year would remain at 2%; the implied target for the price
level at the end of the second year would be roughly 107 (105 plus 2%

Under the gold standard, essentially you are (implicitly) targeting
the price level. In the above example, with desired annual inflation
of 2%, the target price level at the end of two years is roughly
104. Since the price level at the end of the first year is already
105, implicitly the inflation target for the second year is -1%. High
inflation in one year has to be compensated by deflation the next
year. This is what we see during the gold standard era in the
inflation graphs in my earlier post. During periods of war, there may
be inflation for a few years, but this is acceptable if people believe
that it will all be reversed in due course. You can even go off the
gold standard temporarily if people believe you will come back to

Ideally in such a world, the detrended price level is a stationary
process in econometric terms. In modern inflation targeting, the price
level is a non stationary random walk (unit root process). For long
term decisions, the reduction in volatility achieved by eradicating
the unit root is huge.

The gold standard in practice also involved much lower inflation
rates – most multi-decadal inflation rates are in the range of
-½% to +½%. On a hedonic adjusted basis, this almost
certainly implies persistent deflation, probably related to the
inability of gold supply to keep pace with the growth of the global
economy. I am not convinced that the trend rate of growth of the price
level is hugely important so long as the detrended price level is a
stationary process. If you worry about menu costs and money illusion,
you may be less sanguine than I am.

In my view, the benefits of the gold standard had nothing to do
with gold itself. I tend to regard gold as a (rational?) speculative
bubble that has lasted five thousand years. The demonetization of
silver in the late nineteenth century led to a collapse of the equally
long lived (and equally rational?) silver price bubble. There is an
ever present risk that the same could happen to gold one day. If the
bimetallic ratio of 5-8 between gold and silver prices that prevailed
for several millenia before the nineteenth century reflects the
relative intrinsic worth of the two metals, gold could fall
catastrophically. Of course, this might not happen in my lifetime nor
in yours; that is why the bubble could be a rational speculative

Pravin asks whether inflation during the gold standard was due
mainly to wars or government actions. Inflation could result not only
from fiscal expansions but also from private sector credit
expansions. Generically, I like to think of inflation in any one
country under the gold standard as a deviation from purchasing power
parity (PPP). Inflation would cause a departure from PPP, but since
PPP asserts itself only over a period of a few years, this departure
could persist for a short period, but in the medium to long term, the
price level mean reverts to its old level.

Another complication is that even in a land with metallic money,
one needs detailed historical evidence to determine whether the coins
were accepted “by tale” or “by weight”. Until
the nineteenth century, it was probably true that debased currency
was accepted “by tale”, and therefore what appears to be
silver (or gold) currency is actually fiat money.

As far as Austrian economics is concerned, I find Hayek, Schumpeter
and Minsky to be most in accordance with my tastes. The gold standard
is not to my mind among the more important ideas in Austrian
economics. But then I am not an economist. I find that I am able to
hold Keynesian, monetarist and Austrian ideas in my head almost
simultaneously without getting a severe headache.


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