Tuesday, December 30, 2008

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.


Mark Herpel said...

We already have digital gold currency as an alternative to banks and paper dollars.

Mark Herpel

Sentiment_Al said...

Just wanted to thank you for this blog. I've been a loyal reader for months now, and have learned a lot from you. Best wishes for 2009!

Gamma said...

Wow, how simple-minded and incorrect. Are you just simply repeating what others have said or did you actually apply some logic to it???

Not enough gold? That is hardly the case unless of course you want to keep the price of gold fixed. Gold is just another currency, like the Euro, Sterling or Yen. Because it cannot be debased in the same way as other currencies ( a HUGE plus), the central banks of the world have sought to keep a lid on it's price as a means of "debasing" it.

If gold were valued at a its true free-market price, you would find that there is plenty of gold to support world currencies.

Pete said...

"Is that really the regime that we want to return to?"

I like your blog, but...that's your argument?

And of course there's not enough gold at current gold prices, due to the reckless inflationary policies followed by the world's governments. Numerous examples are around of how we could really return to a gold standard, most of which have the price of gold increasing 400% to 1000% IIRC.

Shaheen Jeeawoody said...

Thank you. At last, one smart person who sees the evils of returning to the gold standard.
@Gamma There isn't enough gold in the world to cover the US currency right now. The current total of gold mined is $4.5 trillion. We have $7.6 trillion in circulation today. We'd have to devalue gold by half to cover this huge difference, or allow huge deflation (which is horrible for the economy). And when other countries follow our lead and revert to the gold standard, then we're all doomed.
Let's just try to fix the system now instead of reverting to an archaic mess.

Arvind Damarla said...

"First, a history lesson: Many years ago, people decided on the use of gold as a monetary standard."


Firstly, no one "decided" to use gold. The free market naturally selected it as a currency, just as it will again if we repeal our legal tender laws.

I would highly recommend that you read Murray Rothbard's excellent pamphlet "What has the government done to our money" to understand the history of money before .

Seccondly, banking provided a financing mechanism for the industrial revolution through the economic innovation of self-liquidating credit. People didn't start using bank-notes because gold became hard to carry around! They used bank notes because they were "as good as gold" in terms of their risk of default.

I am a fan of your blog but it seems you have much to learn about the gold standard!

Chris said...

very good post. I have to admit that I'm not wise in the ways of a gold standard, but I do want to understand it. I grew up listening to my mother ranting about the US not being on the Gold standard. I always wondered if this was a big deal. I decided long ago that it was not purely based on the fact that the country as a whole was doing well - surely no worse off than before we went off the gold standard. I found this post a wealth of information.

oh, and I love the website name too! (I have a site studentofmarkets.com - feel free to remove the link - not trying to spam)

Ginger Snaps said...

People don't carry around gold coins because President Roosevelt confiscated all of the citizens of the United States gold coins during the gold confiscation of 1933. Why do you think that paper could possibly be worth more than gold? That is an outrageous statement.

And yes, of course there is inflation. We're simply waiting for the hyper-inflation to hit before we experience the next depression. The Federal Reserve of course is responsible for the economic state our country is in. They just print as much money as they want too, and even with the printing presses constantly running, we are still trillions of dollars in debt. You have been eating up the lies that our government is feeding to you. I strongly encourage you to look into the issues of the Federal Reserve bank, not a branch of the Federal Government, but a privately held franchise. We cannot allow a monopoly on our monetary system. Read "End the Fed" by Dr. Ron Paul, and I would also recommend "The Case Against the Fed" by Murray N. Rothbard.

Try to understand the issues before posting lies on the internet.

Unknown said...

A goldstandard was fine when the world was smaller with a lot fewer people. There is not enough gold available to replace everyone's wealth with metal. GDP would have to shrink to the amount of gold in circulation.

This idea is ridiculous. It only appeals to those who now own gold, which is understandable.

Dizzy said...

Ummmm, having trouble following your theory professor... Didn't Woodrow Wilson sign in the Federal Reserve?