In gold we trust?

While there is merit in some of these arguments, they all rest on one broad and very questionable premise – that gold, unlike paper money, has an objective value.

But no serious economist would advocate this idea, and indeed it goes quite contrary to the principles even of Austrian economics itself. One of the first principles of the Austrian school is that value is in fact subjective.

Price emerges through the operation of a market which aggregates all the individual choices made by myriads of individuals who buy and sell in that market. The whole point indeed is that each individual makes his or her own choices, which are driven not only by their interests, but also by their values. Those values are not measurable, but the objective market price established through exchange is (see Robert P. Murphy's post on the U.S. Mises Institute site).

The price of commodities has risen and fallen over the ages influenced by both supply and demand and by fashion. Many of the sailors on Henry VIII's famous Mary Rose warship died with collections of peppercorns sown into their pockets. Why? Because peppercorns were new and exotic and rare, and were regarded as an ideal way to store value. Over the centuries, their novelty value wore off, and supply increased, to such an extent that they became commonplace and small amounts of peppercorns are worth only a few dollars now.

But through all this time gold has kept its value, and has never suffered these types of precipitate declines – why?

While the prices of other commodities have been through extreme variations through time, eventually falling out of favour, humans have valued gold in all known societies where it has been present, ranging from West Africa through to Spain, which sent expeditions to South American in search of El Dorado. It has been valued both for its relative scarcity, and for its aesthetics. Other elements are scarcer, but not as attractive and so not seen as effective stores of value.

For hundreds of years the gold price in England and the U.S.A. was set by governments. There have been steady increases in the amount of gold on the market over the long term since the price was deregulated in 1968, matched overall by steady advances in price, from $38.31 to $1,889 per ounce. The supply of gold has not shot ahead like the supply of peppercorns, and humans continue to love gold even more than they love peppercorns. This is partly because of its innate attractiveness and partly because of its reputation as a hedge against inflation. Mike Hewitt, another advocate of gold and Austrian economics, argues that the market price of gold in the long term is related to the growth in the global money supply (see various papers on goldnews.bullionvault.com). When the money supply rises, people buy gold because they anticipate that inflation will also rise.

On the same U.S. Mises Institute site, Robert Blumen (29 May 2010) explained that the price of gold is not determined simply by the increase in the supply of gold from mining in a particular year. The price of gold derives from the total demand at any point in time for the total amount of gold that exists.

The key reason why the Austrians saw gold as a source of price stability was that the supply of gold onto the markets cannot be manipulated by governments. When currency consists of digital artefacts, governments and central banks can increase the quantity of it almost at will. This has been the principle policy response of recent years to the lingering effects of the GFC, and so the four leading central banks have increased the money supply by $8 trillion in the last five years. Money is created and then lent to banks and to governments at very low interest rates. This is otherwise known 'quantitative easing' (QE) or 'printing money'.

Ben Bernanke, the President of the Federal Reserve is a long-standing student of the Great Depression and an adherent of the view that the deflationary effects of a contraction in credit of this magnitude need to be fought by expansion in the money supply.

On the other hand, adherents of the financial instability theory of Hyman Minsky and others (such as Australia's Steve Keen, who calls himself a 'post-Keynesian'), argue that economies move through cycles of boom followed by bust that are fuelled by excessive growth in credit during the good times. When the bubbles burst, a period of deflation inevitably follows that cannot be counteracted, in their view by monetary expansion.

Both the post-Keynesians and the Austrians place great stress on the excessive expansion in credit in the boom phase, as a key causative factor leading to a compensatory deflation afterwards, caused by severe falls in aggregate demand, in turn caused by unwinding levels of private debt.