Why a gold standard is a bad idea

Inflation is coming...
For as long as I can remember, Jim Grant has never been a cheerful fellow. In fact, there was a standing joke in my office that after reading Grant you could cheer up by reading King Lear. The thinking in Grant’s latest missive in the WSJ runs parallel to my recent post Giving inflation chance that with the massive fiscal and monetary stimulus coming down the pipe, inflation is inevitable. Jim wryly notes that “Frostbite victims tend not to dwell on the summertime perils of heatstroke.” He continued:

Prescience is rare enough in the private sector. It is almost unheard of in Washington. The credit troubles took the Fed unawares. So, likely, will the outbreak of the next inflation. Already the stars are aligned for a doozy. Not only the Fed, but also the other leading central banks are frantically ramping up money production…It is far less certain that, once the cycle turns, the central banks will punctually tighten.

A return to the gold standard would be disastrous
Given the enormity of the recent crisis, there have been calls for radical solutions. The hard money crowd, for example, has called for the return of the gold standard. However, a return to the gold standard would be disastrous. It would be a prelude to an global downturn of unprecedented proportions and doom future generations to heightened economic volatility.

First, a history lesson: Many years ago, people decided on the use of gold as a monetary standard. It turned out that gold has many nice properties that could be used as a store of value. Throughout human history, money has been predominantly based on gold but not always. It has also been based on other commodities. Peter Bernstein’s book The Power of Gold details the history of gold and commodity based monetary standards throughout history, from salt to large stones, some of which lay at the bottom of the sea.

As time went on, people found that gold, along with other commodity based monetary standards, was hard to carry around. Used in coinage, they could be difficult to divide and this division problem was a hindrance to commerce.

Then came the financial innovation called banking. You could deposit your gold in a bank. The bank would issue you a receipt and you could use that paper receipt for trade and commerce. The bank would lend out your deposit of gold to others. This was credit creation, which expanded the money supply. For every ducat lent out, that ducat would usually wind back up in the banking system, creating another ducat available to be lent out. Even with the imposition of reserve requirements that constraine the amount of loans they could make based on their deposit base, this form of fractional bank lending expanded credit and created enormous number of jobs and raised prosperity.

When kings and political rulers got into financial trouble, there was always a temptation to debase the currency. The current episode of paper money debasement began in earnest when Richard Nixon took the U.S. off the gold standard and the world went to a Dollar standard for monetary reserves. The trouble was, the U.S. Dollar wasn’t based on anything, other than the good name of the U.S. government.

Today we stand on the edge of a precipice. America is in recession but deeply in debt. It is about to print money to try to climb out of its hole. This consensus has been supported by pretty much all of the central banks and governments around the world. Some analysts have argued that the imposition of a gold standard would create the discipline on the monetary authorities from debasing the currency in this manner.


What does a gold standard really mean?
Let’s think this through – what does a gold standard really mean? Does the hard money crowd want us to go back to carrying around pieces of gold coinage around? In that case, how do we facilitate global trade?

Do we just want to revive a gold backing for money? There isn’t enough gold around in the world to support a gold standard at current gold prices. Rough back of the envelope calculations show that the Fed’s holdings of gold, assuming that it is unencumbered and not lent out, is worth around $200 billion at current prices. Remember that the U.S. Federal Reserve is one of the larger central bank holders of gold in the world. While that change might satisfy the gold bugs, it wouldn’t help the vast majority of the population around the world.

One of the assumptions of a gold standard is that the currency is backed by gold at a fixed rate. Anyone could turn in their Dollars, euros, Yens, Pound Sterling and so on, to the appropriate central bank and get gold at a fixed gold price. Such a monetary regime also implies a fixed exchange rate arrangement like Bretton Woods. Instead of allowing the market to determine currency prices, the world would return to fixed exchange rates and periodic exchange rate revaluations. Is that really the regime that we want to return to?

A gold standard also creates economic volatility in the economy. Monetary theory is based on the elegant formula MV = PQ. Holding V (monetary velocity) constant, changes in money supply directly changes the GDP level. Under a gold standard, money supply is restricted by the supply of gold, based on world mine output. National gold supply could shrink because of shocks. As an example, the Roman empire was subjected to credit crunches during wartime when hostile forces captured Roman gold and territory.

The problem of fractional lending remains under a gold standard. The banking system could still create credit. Under such a regime, if everyone decided to redeem their paper currency for gold, the money supply would collapse and the result would be another Depression. Do we want to get rid of the banking system?

If we were to take the radical step of eliminating fractional lending, going to a gold standard would mean a drastic shrinking of world GDP given the amount of money sloshing around the world today.


Culling the herd?
This is financial Armageddon. The result would be the financial equivalent of mandatory infection of the population with the Ebola virus. Maybe we could get Disney to lend a PR hand as we play “The Circle of Life” while we infect everybody with Ebola so people would be persuaded to sacrifice themselves for the Common Good.




The end of the Dollar as THE Reserve Currency
Let's face it, the days of the USD as the principal reserve currency are numbered. Roger Ehrenberg over at Information Arbitrage believes that the US is at a strategic inflection point and the start of a downward spiral and I would tend to agree. The long term path of the Dollar and US influence is downward. Investors should prepare themselves for that eventuality.