Gold Standard Vs. a Commodity Basket Standard


January 26, 2012

(This item originally appeared in Forbes.com on January 26, 2012.)

http://www.forbes.com/sites/nathanlewis/2012/01/26/does-a-commodity-basket-standard-measure-up-to-gold/


I taunted you last week to try to come up with a better system than a gold standard system, for attaining our goal of stable value. Not so easy, is it?

One idea that has been bouncing around for many years is the “commodity basket” idea. I don’t think today’s commodity basket advocates consider it original, but I wonder if they know just how long it has been around.

The economist William Stanley Jevons wrote a book about it in 1875, called Money and the Mechanism of Exchange. In the book, Jevons himself writes about the history of the idea:

Among valuable books, which have been forgotten, is to be mentioned that by Joseph Lowe on “The Present State of England in regard to Agriculture, Trade, and Finance,” published in 1822. … In Chapter IX. Lowe treats, in a very enlightened manner, of the fluctuations in the value of money, and proceeds to propound a scheme, probably invented by him, for giving a steady value to money contracts. He proposes that persons should be appointed to collect authentic information concerning the prices at which the staple articles of household consumption were sold.

People have held the idea for centuries that gold is a standard of stable value. Probably every culture has used some other commodity at some point, whether it be wheat, copper, cocoa beans and so forth. Warehouse receipts for tobacco were used as money in colonial Virginia. However, all of these systems were later abandoned for ones based on gold. This happened in Europe, in Asia, in Africa, and, to some extent, even in the pre-Columbian Americas.

We should respect this outcome generated from centuries of experience, not some coffeehouse debate.

However, people naturally want to see what evidence there is of gold’s stability. As I have mentioned, this is quite difficult, since if there were some definitive benchmark of value that was superior to gold, against which gold could be measured, we would use that as a standard of value instead of gold.

Most of the commodity basket fans seem to mistake the value and the so-called purchasing power of gold, assuming they are one and the same. Last week we discussed how these ideas are very different.  This is obvious if you think about it. The purchasing power of $100 in Manhattan is much less than the same $100 in Ecuador. However, on the same day, the value of $100 is the same in both places. The $100 didn’t change.

If you compare gold to a basket of commodities, going back to about 1500 in Britain, we find that the “price of commodities” in gold is remarkably stable. However, commodities prices go up and down in the short term, related to the “supply and demand for commodities” as Ludwig Von Mises would say. In other words, if the weather is bad, we would expect prices to rise, when measured in a currency of stable value, and when there is a surplus of commodities perhaps due to a bountiful harvest, we would expect prices to fall.

If we just considered gold to be perfectly stable in value – a rather overambitious assumption – we would expect to see something much like the actual historical record, of commodities prices going up and down somewhat. Most of the variation is closely related to wars, for reasons you can imagine.

The commodities basket fans often assume that their commodity basket is a perfectly unchanging measure of value (or “purchasing power” since they commingle the two). Thus, any deviation of price is assumed to be a variation in gold’s value/purchasing power. Once you begin with this flawed assumption, you end up with two conclusions: first, that gold’s value/purchasing power seems quite unstable, and second, that a commodity basket is superior, because we have assumed beforehand that it is a representation of stable “purchasing power.”

This is barely more than a self-contained tautology.

One of the reasons that a commodities basket is used is, quite simply, because that is what we have data for. Today’s “consumer price index” is really a product of the 1940s. There were a few precursors back to 1920, but before then, the only long-term data we have is commodity price data. Thus we have another assumption, that this rather limited selection of agricultural commodity prices (energy and metals were less prominent then) somehow represents the “purchasing power” of a currency.

What commodity prices? Every commodity that is not an atomic element has different grades and types. Brent, Tapis Light, West Texas intermediate, or Saudi Heavy? And where do we measure these prices? Especially in the days when overland travel was done by horse-drawn cart, the price of wheat in New York could be radically different than the price of wheat in Ohio, due to differing weather conditions and so forth. Goods are often subject to tariffs and so forth. Even today, the price of wheat in Kansas can be quite different than the price in Kiev, the world’s other “breadbasket.”

In other words, you could have the same basket, with the same weightings, and the “value” would be different in New York, London, Beijing and so forth. This is true today, and especially in 1845.

Would this commodity basket change over time? Who would make the decisions? Would other countries use the same basket, or a different one? Would their baskets change too? What would this do to the exchange rates between their currencies? Would that be good for business?

I could go on with many other criticisms, but I will leave that for you for now. It is a good mental exercise. I will add one thing, though: this confusion between “value” and “purchasing power,” especially as related to agricultural commodities, has in the past often had a certain agenda. The agenda is not to create a currency of stable value, but rather to create a framework of currency manipulation.

In the not-so-distant past, the majority of Americans, like the majority in other countries, were farmers. Naturally, any time that commodities prices declined, farmers’ businesses became more difficult. Many farmers were in debt.

One solution was to devalue the currency. The nominal price of agricultural commodities would tend to rise, thus bringing them back to a profitable nominal level, and allowing farmers to discharge their debt obligations. However, using the word “devaluation” has never been popular. Even today’s Keynesians avoid it. You could instead argue that the devaluation was necessary to “correct the rise in the purchasing power of gold.” This might seem somewhat silly, but these sorts of arguments were popular in the 1890s, when the U.S. threatened to devalue the dollar in response to a huge glut of commodities related to the expansion of railroads.

The Keynesians today have a somewhat more abstract, but similar, way of doing things. During a recession, prices tend to fall. When the situation is really bad, as it was in 1930-33, prices can fall a lot. Debtors face bankruptcy. The Keynesians are ready to counteract this natural decline in prices with what amounts to currency devaluation, thus preserving “price stability.” Ben Bernanke makes these sorts of arguments today.

The commodity basket idea has some good elements, but in the end, it is inferior to a gold standard system. That’s why gold standard systems were found around the world, and worked beautifully, while commodity basket pegs remained an intellectual exercise in forgotten books. The gold standard system worked so well, that there wasn’t really any problem that needed to be fixed with the introduction of another system. Many such arguments are really rather subtle justifications for money manipulation in the face of recession.