Scott Sumner  

All That Glitters Is Not Gold: A Parable

Prices and Your Pocketbook... New Reflections on the Evoluti...

Atlantis is on the gold standard. The unit of account is called the "dollar" and it's defined as one gram of gold. Atlantis has a state-owned gold mine with a monopoly on gold production, near limitless reserves, and a very low cost of production.

The gold mine is charged with the responsibility of keeping the value of the Atlantis dollar stable, by adjusting the quantity of gold it sells (or buys) each month. There are also privately produced metals such as silver, palladium and especially platinum, which are close (but not perfect) substitutes for gold. When the gold mine injects gold into the economy, they typically buy platinum, which is considered a relatively safe asset (in case the gold mine later has to sell assets to keep gold from losing purchasing power.)

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All goes well until Atlantis is hit by a financial crisis, caused by reckless lending (ultimately caused by an ill-fated attempt by the Atlantis government to insure bank deposits--but that's another story.) The panicking residents scramble for any sort of safe asset they can find, and now gold and platinum become virtually perfect substitutes, and even palladium and silver are being considered pretty close substitutes. Open market purchases of platinum for gold don't have the usual impact on the price level. The state-owned gold mine struggles to stabilize the value of gold, which is gaining purchasing power (i.e. prices of goods and services are falling.) Unemployment is rising.

The gold mine doesn't want to buy all the platinum, as it worries that market efficiency might be reduced. (Although if gold and platinum really are perfect substitutes, it's not clear why this would be so.) There are calls for the mine to buy palladium and silver, even . . . gasp . . . copper and zinc, but those purchases are viewed as excessively risky. Some radicals even call on the gold mine to start giving gold away, but the conservatives who run the mine wonder what would happen if prices started rising and they had to buy back lots of gold. Wouldn't the gold mine go broke without (platinum) assets on its balance sheet, or at least fail to achieve its mandate of stable prices?

A Swedish mining engineer named Lars Svensson comes along with a "foolproof" plan to stop the deflation. He proposes reducing the gold content of the dollar. Instead of a dollar representing one gram of gold, henceforth it would be defined as 0.90 grams of gold. This would cause the dollar to lose purchasing power; even if gold itself remained as valuable as before. Then a very old historian recalls that something similar was proposed about 80 years ago by Irving Fisher, the last time Atlantis had a big financial crisis. And Fisher discovered that there were more than a dozen still earlier proposals of this type, going all the way back to the deflation of the 1820s.

Unlike Atlantis, America is not on a gold standard. So I ask you, dear readers, what would be the fiat money equivalent of this foolproof escape from deflation?

PS. Did you notice that I wrote a parable about liquidity traps without even once alluding to such a thing as "interest rates"?

PPS. Svensson's plan worked at ending the deflation, but it led to court cases as to whether debts should be repaid in dollars as currently defined, or with dollars as defined at the time the loans were incurred. In a shocking (and legally dubious) 5-4 decision, the Atlantis Supreme Court allowed debts to be discharged using current dollars, even when the original contract specified payments in grams of gold. But the public didn't care; prosperity was returning to Atlantis.

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COMMENTS (7 to date)
Jerry Brown writes:

The foolproof escape from deflation would be giving the gold to me in very large quantities. I would be happy to take on the responsibility of this task. Trust me.

Andrew_FL writes:
In a shocking (and legally dubious) 5-4 decision, the Atlantis Supreme Court allowed debts to be discharged using current dollars, even when the original contract specified payments in grams of gold. But the public didn't care; prosperity was returning to Atlantis.

Oh well if "The Public" doesn't care, why be at all upset that the government has just assisted every debtor in the country in commiting a massive fraud against their creditors.

BJH writes:

Great post.

Jeff writes:

You are describing Irving Fisher's Compensated Dollar Plan, but you only described it as an attempt to stop deflation. What Fisher actually proposed was to vary the amount of gold in the dollar (i.e., vary the dollar price of gold) in order to target the overall price level.

If you're the Fed and your goal is to target the price level and you're on a gold standard, Fisher's scheme is one way to do it. Another way would be to just buy lots of gold when prices were too low and sell gold when prices are too high. If you buy and/or sell just the right amounts, you could end up with a gold price that varies identically to what Fisher prescribed. But there's nothing really special about that particular path to the goal, and there may be good reasons to follow a different path to the same price level outcome.

In a fiat money world, the Fed can still target the price level by buying and selling stuff. As your parable points out, it's likely to work better if the things the Fed buys and sells for dollars are not close substitutes for dollars. So equities would work better than short-term bonds, and other assets with low transactions costs could also work well. In fact, the Fed could just buy and sell precious metals to change the quantity of dollars out there.

What you don't want to do is to have the Fed exchanging base money (mostly reserves held at a Federal Reserve Bank, but also currency) for something that is a very close substitute. This is another reason why paying interest on excess reserves is such a bad idea -- it makes reserves into a very close substitute for short-term Treasury Bills. After the 2008 financial crisis, the Fed created vast quantities of base money that had very little stimulative effect for this reason.

One other thing should be mentioned, and that is that any targeting scheme will work better if the ultimate goal is publicly known. That may be something our host could do a post on.

Scott Sumner writes:

Everyone, The modern equivalent would be CPI futures targeting.

Jerry Brown writes:

My offer still stands.

Thaomas writes:

Why doesn't the Atlantan mine just announce that they will buy or sell a price index fund in whatever amounts necessary to keep the index at 1.00?

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