Ron Paul, the Gold Standard, and ABC Theory

Ron Paul seems to have made headlines recently for not making headlines.  The attention (or lack thereof, depending on viewpoint) has brought Paul back into the media's eye for another moment, and along with stories about Ron Paul come stories about the gold standard.    For advocates of the gold standard, there is no greater ideal than a return to gold-backed currency.  They believe this will solve the problem of economic "bubbles" and the subsequent "busts" that create recessions and economic turmoil. 

If it sounds fishy, that's because it is.  The theory behind Ron Paul's view of money is a school of economic thought called "Austrian Business Cycle theory,"  or more simply, ABC theory.   In order to understand why Paul thinks we should return to the gold standard, we're going to have to visit the strange and unusual world of the ABC theorist.  Be warned:  this is a world of crazy.

The first thing you need to know about ABC theory is that it denies empirical evidence can be used in economics.  Von Mises, one of the founding fathers of ABC theory, establishes this principle in his work, Human Action.  Von Mises surmises that man has free will, and therefore we can never make predictive judgments on the actions of man based on observation.  Each individual man choses for himself what his goals and actions will be, and observing one man or action tells us nothing about future actions or the actions of other men.  Therefore, the study of economics must only be the study of human behavior using pure theory and logic.  This specific methodology used by the ABC theorist is called praxeology.

What does this mean in practice?  It means that ABC theory will reject any use of historical data, scientific studies, or statisical analysis. This aspect of Von Mises work caused the economic historian, Mark Blaug, to quip, "his writings on the foundations of economic science are so cranky and idiosyncratic that one can only wonder that they have been taken seriously by anyone."  It is a fair criticism.  Without any ability to "prove" conclusions empirically, ABC theory borders on a faith-based approach to economics.  Additionally, it's virtually impossible to "disprove" ABC theory to a supporter, as evidence does not matter in their framework. 

Beyond the basic framework of praxeology, though, ABC theory has come to many conclusions about how the economy works.  Remember, real world evidence is not needed for these conclusions.  The first conclusion is that increases in the money supply create economic "bubbles."  The logic is simple (though erroneous):  given more money, individuals will invest in new things.  Given enough money, individuals will run out of "good" investments and start investing in "bad" investments.  This is the description of an economic bubble, and ABC theorists believe that the root cause of such a bubble is an increase in the supply of money. After a time, all bubbles "pop" and a recession occurs as the "bad" investments go away, the capital is reallocated to good investments, and workers adjust to the new economy with new labor demands. 

The current appeal of ABC theory should be apparent.  The recent sub-prime mortgage debacle appears to closely resemble the the "bubble" and "bust" paradigm.  Our monetary policy, primarily controlled by the Federal Reserve System, did provide for an increasing money supply leading up to the financial crash.  The heavy investment in sub-prime loans did resemble "bad" investment.  These simple correlations have lead many to believe that ABC theory might be onto something.  Finally, the solution to the problem of recessions in this framework is to contain the money supply.  That's where the gold standard comes in.

Ron Paul and his disciples believe that by pegging the value of the dollar to the value of gold, the money supply will therefore be fixed.  With the return to a tightly controlled money supply, bubbles will no longer be able to form.  Without bubbles, there won't be any busts.  Our economic woes will be over.  Aren't most of the world's problem this easy to fix?

The oversights of this logic become apparent once any sort of scientific analysis is introduced.  Let's start with the historical record.  America experienced recessions beginning in: 1796, 1802, 1807, 1812, 1815, 1822, 1825, 1833, 1836, 1839, 1845, 1847, 1853, 1857, 1860, 1865, 1869, 1873, 1882, 1887, 1890, 1893, 1895, 1899, 1902, 1907, 1910, 1913, 1918, 1920, 1923, 1926, 1929 (the Great Depression), 1937, 1945, 1949, 1953, 1958, 1960, 1969, 1973, 1980, 1981, 1990, 2001, 2007.   It's a long list, and I include it in it's entirety to demonstrate how often recessions have historically  occurred.  It's particularly notable that the United States has only experienced six recessions of varying intensity in the forty years since abandoning the gold standard.  Forty recessions, including the Great Depression, all occurred before this abandonment (with notable exceptions during war time).

What about more scientific studies and historical analysis?  Ben Bernanke delivered an illuminating speech in 2004 that discusses the effects of the gold standard during the Great Depression.  Relying on the work of the economists Milton Friedman and Anna Schwartz, Bernanke discusses how a constrained money supply slowed America's ability to emerge from the Depression.  Bernanke's speech expands on this idea by addressing the international community's use of the gold standard during the Depression.  As Bernanke states:

Perhaps the most fascinating discovery arising from researchers' broader international focus is that the extent to which a country adhered to the gold standard and the severity of its depression were closely linked. In particular, the longer that a country remained committed to gold, the deeper its depression and the later its recovery (Choudhri and Kochin, 1980; Eichengreen and Sachs, 1985).

In light of such evidence that debunks ABC theory, many are not deterred. Of course, for the pure ABC theorist, evidence does not matter.  For them, evidence only tells you what happened one time and has no application to what will happen in the future.  This is why Ron Paul and his gold standard rhetoric is so frightening.  It has no basis in history.  It has no basis in scientific observation.  It is only how the world should work inside his own head.  Such reasoning should not be involved in our economic problem solving.