I am not holding my breath over the Republicans’ plans for another gold commission to investigate the possibility of returning the USA to a gold standard in the case of the Romney-Ryan ticket winning.
Of course, I like the Classical Gold Standard, which existed from about 1880 to 1914, and I am convinced it was a humongous mistake to do away with it, a mistake that was further compounded by the abandonment of its weak successor, Bretton Woods, in 1971. And you know what I think of our present unconstrained fiat money system: It is suboptimal, unstable and unsustainable. It is fundamentally incompatible with capitalism, and it has now amassed so many colossal imbalances, from overstretched banks to a gigantic and never to be repaid public debt load, that it is firmly beyond repair. It is in its endgame.
But I don’t believe the best solution would be to go back to a government-run gold standard. We should not trust politicians and bureaucrats with money, certainly never again with entirely unconstrained fiat money, but probably not even with a monetary system that comes with the strait jacket of an official gold standard. I would argue instead for the complete separation of money and state, and for an entirely private monetary system. Let the market decide what should be money and how much there should be of it. I do strongly believe that gold would again play an important role in such a system. After all, gold and silver have been chosen forms of money for thousands of years, in all cultures and societies. That is what the trading public always went for when it was free to choose.
Nevertheless, I would agree that even an ‘official gold standard’, such as the US had before 1933, and in particular before the Federal Reserve was established in 1913, would still be much better than anything we have today. But the chances of such a system being reintroduced are slim.
Political obstacles are immense
Remember, there already was a gold commission under Ronald Reagan in the early 1980s, and it rejected the idea. And I think the chances for a return to gold through the established political process were considerably better 30 years ago than they are today.
For all his faults, Reagan was a much more libertarian politician than Romney, with incomparably better free market credentials, a stronger philosophical core, and a superior talent for communication. I don’t trust today’s Republican Party implementing a truly libertarian program.
Also, in the early 1980s, it would have been much easier to transition to a gold standard. Constant fiat money expansion had not yet created the massive imbalances and the illusions of prosperity that characterize our economies today. Back then the total debt of the US government was less than $1,000 billion. Today, the annual budget deficit is bigger than that. Today, the withdrawal symptoms would be considerably larger for the state, the financial industry and the distorted and hugely inflated asset markets, all of which are now thoroughly addicted to the crack cocaine of a never-ceasing flow of super-easy money. In the early 1980s, then-Fed chairman Paul Volcker had in fact stopped the printing press for a while and allowed higher interest rates to cleanse the system of some of the accumulated distortions. There was in fact a discernible political will to implement hard money. Compare that to the situation today!
So if Romney wins the election (a very big if), then it is still likely that the commission will reject the idea, in my opinion. Nobody wants to take the short-term pain of turning off the monetary tap, even if the long run benefits are considerable. Wall Street, the media, academia, and, of course the Fed, are strongly on the side of fiat money. I don’t see any commission overruling these powerful factions.
In many ways, the worst outcome would be some watered down, pseudo-gold standard under the management of the Fed. If the crisis then persisted, which it would, the easy-money advocates would blame everything on the ‘gold standard’ tying the hands of ‘our saviour, the central bank’. This is also a problem for a Romney-win in general, which is unlikely to bring the pro-market changes America needs although his policies will be branded ‘free market’ by the statist media. If Obama remains in office, at least nobody will call his program ‘capitalism’.
Media and academia are mainly pro-state, pro-politics, anti-gold
So I guess, we hard-money nutcases will have to wait for the crisis to get worse, while the advocates of fiat money and central banking can relax and happily cheer on the Printmaster-in-chief as he creates good and lasting jobs with QE5 and QE6. What has, however, been interesting in recent days has been the response in the mainstream media. Commentators have been in a state of apoplectic fit over the gold commission, writing dismissive pieces against gold that are as full of hysterical rage as they are void of economic reasoning.
I am fully aware, of course, that the present easy-money system controlled by educated bureaucrats has its adherents, in particular among people who perceive every problem in society to be best solved by politicians and the state. But the extent of economic nonsense and disinformation that was disseminated in these tirades, and the strenuous, laboured defence of the present system, I still found remarkable.
Bloomberg diagnosed that the critics of Fed activism, zero-interest rates and unlimited QE, suffer from an “anti-inflation obsession” that borders on “derangement”, while Robin Banerji in a piece for the BBC website remarks that advocating the gold standard had been the domain of “economic eccentrics” and followers of “folksy” libertarian Ron Paul, in short, ill-adjusted people who have not gone with the times, who are nostalgic, longing “for a simpler age”. You see, if you are an advocate of the gold standard you may suffer from psychological problems. Fittingly, Banerji’s article for the BBC is titled: ‘Gold standard: Could it return in the US?’, which make it sound like a disease. ‘Cholera: Could it return in the US?’.
Unfortunately, Mr. Banerji’s article does not give the economic layman a clear comparison of the key features of the two systems, fiat money and gold standard. Instead, the reader is left with the vague sense that a gold standard would either collapse instantly or lead to grave instability. The present system is, by comparison, described as successful and inherently stable.
To this effect, the article quotes three mainstream economists – Kenneth Rogoff, Anil Kashyap (return to gold “incredibly crazy”) and Charles Wyplosz – all opponents of a return to gold. Wyplosz provides this remarkable insight:
There has been no significant inflation in the advanced economies for the last 25 years, so the need for gold to defeat inflation seems unnecessary.
Hmmm. From 1997 to 2007, that is, the ten years that preceded the start of the present crisis, house prices in the US appreciated 3 times faster than in the preceding 100 years. We had drastic asset price inflations and various asset price bubbles around the world over the past 25 years, plus explosions in general indebtedness and massive bank balance sheet expansions, and these inflations set us up for the present crisis. Real estate booms that ended in banking crises occurred in Japan, Scandinavia, South East Asia, the US, the UK, Ireland and Spain, to name just the examples that come to mind immediately. But I guess, as long as a pint of milk in the supermarket only goes up by 3 percent a year, there is ‘no significant inflation’ for Mr. Wyplosz. Remarkable.
“Stable paper money versus unstable gold money.” – Really?
While the present system is supposedly doing swell, the gold standard is a source on instability. Harvard-man Rogoff has this to say:
The price of gold fluctuates a lot and therefore the price of your currency would fluctuate a lot.
This is a popular fear about the gold standard, and it is without any substance whatsoever, and any foundation in economic theory or history. Today’s gold price is volatile because gold has been (partially) demonetized and is now fluctuating against state-issued paper money, and the resulting price movements tell us more about the instability of fiat money than of gold.
Take a look at history: whenever gold was money, fluctuations in the purchasing power of money, or fluctuations in the ‘value of money’, if you like, were extremely small to almost non-existent. Inflations and deflations as problematic macro-economic phenomena were largely unknown when gold was money. Inflation and (corrective) deflation only became problems when the state introduced paper money. If you look at long-dated charts of the purchasing power of the world’s oldest currencies – the British pound and the US dollar – you can spot easily when these currencies were taken off gold or silver, and when they were later put back on gold or silver.
Gold has been stable money, while paper money has always been – without exception – unstable money. Paper money has always led to inflations, usually followed, at some point, by corrective deflations. Abandoning commodity money always increased uncertainty over money’s purchasing power for the money-user.
The pound and the dollar have, in their very long history, never lost as much purchasing power as quickly as they have since 1971, when Nixon closed the gold window.
To imply that gold could be unstable money is putting the historical record on its head. If we judge the two monetary alternatives, fiat money and gold standard, purely on purchasing power stability, there can be no question that the gold standard wins easily. The historical record is not even mixed on this. Also remember that at no point in history was gold or silver replaced with fiat money, because the public demanded an end to ‘volatile commodity money’ and craved ‘stable fiat money’. This never happened, to my knowledge. But on the other hand, monetary systems have repeatedly gone back from paper money to commodity money, such as gold, in an effort to restore economic stability. Britain did it in 1821 and the US in 1879. I find it hard to believe that Rogoff does not know this. Why he is happy to portray it otherwise, I can only guess. And the journalist Banerji is evidently uninterested in checking the facts.
In a similar direction go statements like these, again from Rogoff:
[The effect on the US economy of a return to a gold standard] could either be inflationary or deflationary depending on the initial rate.
Again this is highly misleading as it falsely associates the gold standard with uncertainty and instability. Based on history and economic theory, we can predict with reasonable certainty that a return to a gold standard would be deflationary in the near-term – almost regardless of the initial rate – as the preceding inflationary boom is unwound, but provide monetary stability in the long run. Under a gold standard the supply of (core) money would be essentially fixed or could only be expanded very slowly. There would no longer be any monetary policy, and banks would no longer enjoy the privilege of a “lender of last resort”. These are the key differences to the present system. Because of our fiat money system, the relative prices of many assets are distorted by constant monetary expansion, which does not – contrary to widespread misconception – lift all prices uniformly but some prices more than others. Additionally, banks are running low capital and reserve ratios because of the safety net provided by the printing press. The change of monetary regime would cause many prices to adjust, many probably to decline, and many banks to shrink their balance sheets to protect reserves. Once we are through this deflationary adjustment – which is, in my view, unavoidable at some stage anyway – we can expect the gold standard to give us money of superior purchasing power stability, as I explained above.
Over time, a proper gold standard can be expected, on conceptual grounds, to even deliver moderate deflation. Prices would have a slight tendency to decline over time. Statistically and historically, this phenomenon has been very minor, indeed, and such secular deflation, if it occurs at all, is never an obstacle to strong growth.
The problems of transition
Rogoff is, however, correct to highlight the general importance of the initial dollar-gold rate established by the new gold standard. The US has a sizable gold hoard but at the present gold price it is worth ‘only’ about $440 billion when years and decades of paper money creation have caused the monetary base to balloon to $2,600 billion, and M2 to more than $10,000 billion. For the official gold stock to back the entire monetary base the dollar would have to be devalued versus gold to a new price of $10,000 per once of gold, compared to $1,690 per ounce now; and if M2 was to be backed completely with gold, the new gold price would have to be $38,000 per ounce! Such a drastic revaluation of the dollar could have various knock-on effects, certainly in the international gold and commodity markets but probably elsewhere. Rogoff is right to point this out.
However, these are problems with the transition from one system to another. I am the first to admit that after 40 years of unrestricted fiat money creation a smooth and friction-free transition back to sound money is anything but straightforward. This is also my biggest criticism of present-day easy-money policies: they create illusions of stability by creating more imbalances and making a return to a stable system more difficult. But such a return will one day be necessary and unavoidable.
None of these objections mean that a transition to sound money is ultimately not possible and the long run benefits of it not highly desirable. Remember that transitions from paper systems back to gold were achieved repeatedly throughout history. More importantly, these points say little about the workings of a gold standard versus the operation of a fiat money system. The reader must wonder why anybody in his right mind would even contemplate going back to gold when all a gold standard could ever give us was volatility, uncertainty and chaos.
Well, in fairness to Banerji, he had this to say about the gold standard:
From 1945-1971, the period of the “gold exchange standard”, the US fixed the dollar to gold at $35 an ounce. Growth rates were higher and rises in wealth were more equitably shared across society than in the years that followed. Unemployment has been higher, growth lower, and wealth more unevenly distributed since the US dollar came off gold in 1971.
But then he hastens to add: “This could have been coincidence, however.”
What are the effects of money creation?
The Bloomberg opinion piece is equally hostile to the gold standard idea but it is less confusing and misleading, and instead provides the reader with a clear and rousing endorsement – incredibly naive and misguided, in my opinion – of fiat money and central bank activism, an apparently wonderful system that we would have to do without if the mad Republicans brought the gold standard back.
Contrary to what gold bugs and other Fed-bashers say, the Fed’s dual mandate and its policy of quantitative easing — buying bonds to nudge down interest rates– have been vital strengths, not weaknesses. They have helped to support demand and bring unemployment down, albeit slowly. Fiscal paralysis in Washington made the Fed’s unorthodox measures all the more necessary. Far from being reckless, the Fed has been too timid and needs to embark on the third round of QE that Chairman Ben S. Bernanke keeps hinting is on the way.
The key argument is a familiar one, and it goes something like this: economic crises occur, they just happen, gold standard or no gold standard, but under our present system we at least have a central bank that can lower interest rates and print lots of money to stimulate demand and get us out of the crisis.
Behind it lies a dangerous simplification, namely that fiat money creation has two effects and two effects only: all else being equal, injections of money lift the price level (i.e. they cause inflation) and lift GDP. Rising prices are sometimes good and sometimes bad. You can, of course, have too much inflation. But the growth-boosting effect of more money is always welcome. So, whenever inflation is not a problem (or when there is even a risk of deflation) the printing of money is an unequivocal positive. Who can be against it?
But injections of new money into the economy have many other effects than just lifting two entities of national account statistics. Have those who hold this simplistic macro-economic view ever thought about how the micro-economic act of injecting a certain amount of new money into the economy at a specific point, namely the banking sector, is supposed to translate directly, smoothly, and instantly into the macro-economic phenomena of higher prices all around and more economic activity all around? Alas, the whole thing is slightly more complicated.
Thankfully, but still unbeknown to the folks at Bloomberg, for centuries many high-caliber economists have worked hard to understand and explain the full range of effects of money injections. Indeed, one of the very first economists ever, Richard Cantillon, already made it an important aspect of his work, and his insights – almost 300 years ago – were already superior to what you can read in most financial market commentary today. For Cantillon already stressed that an inflow of new money will not lift all prices simultaneously and by the same extent but some prices more than others and some sooner than others. And that is as true today as it was in the early 18th century.
An inflow of new money into the economy must always change relative prices. Therefore, it must affect the use of scarce resources, the structure of production, and the distribution of income. Every inflow of new money must therefore create winners and losers. As a rule, the early recipients of the money (today, those are mainly to be found in the financial industry) benefit at the expense of the later recipients.
Inflows of new money tend to lower interest rates and also change the structure of interest rates, which in turn will affect the extent of investment and the structure of investment in the economy. In short, the delicate co-ordination between voluntary saving and capital investment that, in a free market, is conducted by market interest rates, is systematically distorted. The artificial cheapening of credit through money injections leads to capital misallocations and mal-investment.
For 200 years, many economists have blamed the business cycle on monetary expansion, usually as a result of artificial bank credit creation, often encouraged by the abandonment of a commodity anchor. The effects of money inflows listed above tend to create near-term booms that must be followed by corrective recessions later on. This phenomenon has to date been analyzed most comprehensively and convincingly by the Austrian School economists Ludwig von Mises and F.A. Hayek.
Mises called it the fundamental non-neutrality of money. Money can never be neutral. This means that any monetary economy, including a gold standard economy, will be subject to occasional disruptions emanating from the use of money, but the more elastic the supply of money is, and the more the supply of money is constantly expanded, the more severe these disruptions must be. Elastic money is also unstable and destabilizing money.
The crisis that the Fed is fighting today with easy money is the result of a housing bubble that the Fed itself inflated when it provided easy money to fight the previous recession, and that recession was the result of the collapse of the internet-bubble in 2001 which had previously been inflated by the Fed itself when it provided easy money to fight the consequences of the Asian debt crisis and the collapse of the hedge fund, LTCM, in 1999, which…. you get the idea.
Fact is, our unrestricted fiat money system is moving us progressively away from monetary stability and economic sanity. The Fed and other central banks have become serial bubble-blowers, and they have now created such vast imbalances that they are all on zero interest rates and repeated rounds of asset purchases to keep the system from collapsing. It requires such a naïve and simplistic macro-economic viewpoint as the one espoused by the Bloomberg editors to not see that this system is simply unsustainable.
I do not think that the US Republican Party will bring us back to a gold standard anytime soon. Sadly, I think the crisis will have to get much worse before this will be achieved. But there can be no question that we will have to transition to a hard money system eventually. The future of capitalism and a free society depends on it.
As Ludwig von Mises wrote in 1965:
If our civilization will not in the next years or decades completely collapse, the gold standard will be restored.
This article was previously published at Paper Money Collapse