Tuesday, October 14, 2008

Malthus, price levels and the gold standard

(This will end up being posted on Wednesday, but I started writing it on Tuesday, honest!)

Lately, I've been reading Thomas Malthus's Principles of Political Economy (full text available at the link).

It's a fantastic book on basic economics, written before math was introduced to the subject. In fact, there's a brief section where the author wonders whether formal math should be introduced into 'political economy' at all, since the clarity it brings is at the expense of complexity.

What makes the antique text blogworthy at this particular point in time is what it has to say about price levels.

There are more than a few intelligent people of the opinion that much of the current (and past) financial turmoil was caused by leaving the gold standard.

Before the mid-twentieth century, most currency in the world was backed by silver, gold or a combination of the two. Effectively, this meant that there was a global currency. France may have its francs, and China its taels, but if both were convertible into silver at a fixed rate, then they were just placeholders for the true currency, precious metals.

This is what the 'gold standard' meant: that you could exchange paper money for a known amount of gold at any bank. There was never more money than there was gold. Because gold is a rare metal, many countries found it useful to use silver, as well. The rate of conversion between silver and gold was well-known.

This system collapsed during the Great Depression, in an interesting way that is too complex to summarize in this brief post.

These days, most currencies aren't backed by anything except the government that issues them. In daily practice, this works out pretty well, with some spectacular exceptions.

It used to be that money worked like the market for precious metals, because money WAS precious metals.

Now, money works more like the market for baseball cards, or artistic prints. If a government prints a lot of money, the currency becomes less valuable, just like if a baseball card company printed large numbers of a particular card. This is what's going on in Zimbabwe right now. If a government keeps its printing under control, then the value of the currency can be kept as high as it likes. Witness the British pound.

The argument for returning to a gold standard is that the current system is inherently unstable. Trusting governments to print the 'right' amount of currency has not worked, and instead has led to wild swings in prices, and in currency crises such as that in south-east Asia in 1997.

As far as the argument goes, there's certainly a lot of truth to it. If nothing else, a gold standard would make situations like Zimbabwe's current difficulties impossible... as long as countries stuck to the standard. The reason it collapsed in the first place was that, faced with financial crisis, several governments decided to abandon the standard.

(This is similar policy response to that seen in 1997. Several countries in the crisis zone had tied the value of their currency to the value of the US dollar, and abandoned that standard when under speculative attack.)

Suppose that the world did revert to a gold standard, and stuck to it.


Actually, that's a very complicated theoretical exercise. Instead, let's make things easier. Let's go back to a point in history where the world WAS on a gold (and silver) standard. The economic literature of the time should give a good idea of whether this brought price and financial stability.

This is where Malthus fits in. He was a keen observer of current events, a careful thinker and a compelling writer. The sections of his work that treat with price levels and financial crises of the time are eye-openers: in practice, the gold standard led to surprisingly volatile price levels, as well as the occasional currency crisis.

I've linked to the entire book in PDF form, so it's simple enough to search for 'gold', 'specie', 'silver' and 'currency' and read the relevant sections yourself, but I'll summarize one of his arguments, which struck me for its insight and simplicity.

Malthus noticed that prices in England, a wealthy country, were a lot higher than prices in poorer countries. He wanted to know why. After all, England was the workshop of the world - if it could produce things more efficiently than Sweden, say, then why was everything so much cheaper in Sweden?

The reason given by Malthus? Currency movements. Precisely because of the gold standard, these were very easy to think of and keep track of.

For the sake of argumetn, suppose neither England nor Sweden mined gold. England's goods were in very high demand by the rest of the world. As a result, other countries bought England's goods and paid for them with their gold. On the whole, gold flowed fromt the rest of the world, into England.

What about Sweden? Its economy was based on copper, wood, fish, small amounts of high-quality iron and other natural resources. It was nowhere as wealthy as England. In fact, it had to import many goods - gold tended to flow out of Sweden.

Note that I've only talked about gold movements. Since I assumed neither England nor Sweden produce gold, these movements do not affect production in either country.

Relative to the goods available at home, there is very little gold in Sweden, and a lot of gold in England.

By definition, the gold in each country MUST be enough to buy everything traded in that country. (Remember, the only currency IS gold.) The large amount of gold in England means that gold is relatively 'cheap' in terms of goods: price levels must be high. The small amount of gold in Sweden means that gold is scarce there: a small amount of gold must be able to buy more goods. Prices are cheap.

A really neat, simple argument, and evidence of puzzling price differences under a global gold standard.

I've simplified the argument considerably - Malthus is extremely careful in his thinking, as I mentioned, and he goes over all sorts of possibilities, variations and extenuating circumstances.

Definitely worth a read. Especially if you're currently of the mind that changing back to a gold standard will fix the world's currency-related problems.

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