Tuesday, May 5, 2009

The Real Case for a Gold Standard

There are many perceptions concerning the usage of gold as money, many of which are either misplaced or misunderstood. A recent article in the Financial Times is a clear example of the couple of widely accepted, yet simply wrong, comments that circulate popular press. In this post I will highlight these and provide reasons that should give more clarity on the issue.

The article claims that “it is effectively impossible for gold to replace the dollar” as an international reserve currency. While this a true statement, it does not provide an explanation supporting this argument. Since time immemorial gold has served as money. This fact alone precluded governments from absolutely controlling the means of production in an economy without using outright force. This means individuals have the liberty to pursue their own affairs as they deem fit, without much interference from a central authority. Therefore, gold as an international reserve currency in effect creates a ceiling in terms of the activities governments want to perform. From about 1870 until 1913, the world operated on money fully-backed by gold. It is of no coincidence that during this time world production boon on the back of foreign investment. Monetary stability reduces risk premia, thus stimulating capital mobility. Under the gold standard all governments must surrender central bank policy tools, since overt interference in the market by printing more currency than allowed by gold deposits would lead to its sharp sell-off. Ambitious governments, i.e. those that have pursuits that extend beyond domestic borders, detest the idea of a gold standard. The gold standard was discontinued due to the advent of WWI because governments did not have the sufficient money backed by gold to pay for the human slaughterhouse (aka war); therefore they abandoned it and turned to simply printing money.

The article further claims “the logistical issues with replacing the dollar with gold as means of payment are hard to overcome.” This is an outright exaggeration and unfounded. If this were true, how could the gold standard have lasted uninterrupted between 1870-1913? The logistics of gold settlement for international transactions are not at all different than the process to clear checks between international banks. Central Banks could simply perform an accounting entry in their books to the foreign bank’s book transferring ownership of the commodity. Dollars, Yuans, Yens, Pesos, etc. would not disappear. On the contrary they would represent different names (currencies) for the same money everywhere (gold). As a result, there is no need of “actually shipping it from one continent to another, the shipping security, etc.” If a country were to print currency without the appropriate gold backing, other countries would present the first with the excess printed money for redemption. Since 1971 the world desisted from operating under a gold standard. This continues to be true today.

Mainstream economists, including the so-call “free-market” economists from the Chicago School, disdain gold as money. They claim that it is inherently unstable in terms of prices. Yet, empirically this perception is false. Take a look at the following chart. The data are obtained from the Minneapolis Federal Reserve. You will notice that the CPI is anything but stable particularly post-1971.

(Note: Chart was obtained from: http://www.chartingstocks.net/wp-content/uploads/2009/02/cpi.png)

The solution to the current financial and economic crisis reveals that the foundation of the present monetary infrastructure has lacked sound footing. In effect, this represents an extraordinarily large Ponzi (or Madoff?) scheme, which eventually will come to an end. This already has begun.

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