Chapter 2: Findings and Analysis- Price Instability Problem - National Reserve Currency

2.9     Price Instability Problem

Where open markets operate, the prices of goods and services are determined by changes in their respective demand and supply. Money or currency is used to denominate the prices of goods and services where the value of a currency is determined by the quantity of goods and services that can be bought with a given sum of money.

Increases or decreases in the supply of money itself may cause a general increase or decrease in the prices of goods and services irrespective of supply and demand conditions within individual markets.

Michael David Bordo argued that the adoption of the Gold Standard leads to price instability in the short term and that this inhibits economic activity. At the same time and perhaps paradoxically the Gold Standard is said by others to cause deflation. However, when investigated empirically both assertions are contestable.

Despite the predominance of Fiat currencies in the world today, the first point to make is that over the last 250 years or so, implementation of the Gold Standard has been the norm rather then the exception. Since the beginning of the Industrial Revolution to the start of World War I - in excess of 150 years - the classic Gold Standard was implemented in the major economies of the world.

Looking at the Britain, where the Industrial Revolution began and being the dominant world power in the eighteen and nineteenth centuries, Table 1 above presents inflation in the UK since 1750 as recently published by the Office of National Statistics [3]. In these first 50 years, inflation averaged a steady 2% per annum.

Following a deflationary period between 1801 and 1851 when inflation averaged -1.2% per year, in the next 50 years prices rose by 0.3% per year followed by growth of 0.5% per annum to 1914 when the Gold Standard was abandoned in order to finance the war effort. Average annual price inflation of about 1% over the period 1750- 1914 suggests the classic Gold Standard produced unprecedented long run low price stability.

The evidence on inflation for the UK at least is clearly at odds with the argument that the Gold Standard causes deflation. Between 1800 -1914, UK prices were almost as likely to fall as to rise, when average annual inflation was close to zero. Since this was often caused by an increased supply of goods and services and not by a shortfall of demand, the resulting deflation was benign. Prices tended to rise when many countries abandoned the Gold Standard, during the First World War. As countries aimed to restore the Gold Standard at the pre-war parity in 1925, prices were required to fall back - resulting in policy induced deflation. This expectation of prices to fall helped contribute to an environment with relatively flexible prices and nominal wages.

From 1925-1929, the falling prices and increasing output make this deflation to be the likely consequence of beneficial developments reflecting the increased ability of the economies to provide goods and services. Since WWII, there have been few episodes of deflation worldwide, with UK experiencing an average inflation of 7% since then.

Between 1999 -2005 an unwinding of inflated asset prices associated with a crisis in the Japanese banking system prompted deflation in Japan, where consumer prices fell by an average of 0.5% per year. The argument of short-term price instability solely hinges on relatively high coefficient of variation ratios over the period of the Gold Standard (as cited by Bordo). However the coefficient of variation is a highly unstable statistic when the average (mean) of a dataset is close to zero as was the case with relatively low and stable long term inflation over the period of the Gold Standard. Thus the high coefficient of variation shows spurious short-term variability over the period of the Gold standard and is an unsuitable and improper measure of statistical variation.

Far from destabilizing markets, short-term price variability around a low average in actual fact suggests markets were providing effective signals for producers and consumers to actively engage in economic activity during the period of the Gold Standard. Indeed the unprecedented increase in industrial and agricultural output and international trade during the Industrial Revolution suggests the implementation of the Gold Standard had no apparent adverse or lasting impact on the economy. This is shown by the 0.5% per annum growth in the UK’s GDP per capital between 1750 and 1850 [4] - during implementation of the Gold Standard - allowing for the increase in population and inflation. Steady though unspectacular growth implies the Gold Standard had no underlying adverse impact on economic activity. Economic activity rose ahead with inflation and population increasing ‘average’ livelihoods, in spite of the inherent disparities in income and wealth created by capitalism.

Looking at the experience of Britain, this period between 1750 and 1914 of the implementation of the Gold Standard can be contrasted with the following decades when the Gold Standard was intermittently or partially implemented.

The Gold Standard was abandoned between 1915-1925 and 1932-1945 with inflation in Britain rising by 5.4% and 3.8% respectively. 1946 to 1971 saw the partial implementation of the Gold Standard through the Bretton Woods system and inflation rose slightly above 4% per year. Since the demise of Bretton Woods the UK’s inflation has been very variable exceeding 8% per annum between 1972 and 1993 with Fiat currencies in operation.

The Gold Standard anchors a currency to a relatively fixed monetary base guaranteeing low inflation, with possible periods of low deflation. In contrast Fiat currencies have a tendency to generate inflation – often at high growth rates - even allowing for the mitigating effects of restrictive monetary and fiscal policy.