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What would a gold-backed currency do to America?

Larry Kummer, Editor

Summary:  The history of gold-based currencies, from Newton to the Great Depression, warns us that they are no panacea. If not carefully structured they can destroy an economy in extremis by preventing radical monetary easing.  This is part two of two looking at gold-based monetary systems, the theory and the history. See part one here.

Commerce has set the mark of selfishness,
The signet of its all-enslaving power
Upon a shining ore, and called it gold;
Before whose image bow the vulgar great,
The vainly rich, the miserable proud,
The mob of peasants, nobles, priests, and kings,
And with blind feelings reverence the power
That grinds them to the dust of misery.
But in the temple of their hireling hearts
Gold is a living god, and rules in scorn
All earthly things but virtue.

— Percy Bysshe Shelley, Queen Mab, Part V, Stanza 4 (1813)

All that glitters is not gold.

Contents

  1. Phillip II, broke with all the gold in the world
  2. Gold’s great failure during the 1930’s
  3. Gold’s role inciting WWII
  4. Newton vs. the gold bugs
  5. About Central Banks buying gold
  6. For more information

(1)  Phillip II, broke with all the gold in the world

A monetary system — the rules by which a State runs its money — can rest on almost any foundation.  Metals (like iron ore, which has skyrocketed in price during the past decade), a basket of commodities or currencies, or the faith and credit of a nation.  Systems work well to the extent they accommodate shocks and changing circumstances.

Nevertheless the probably futile search continues for a rule that binds human frailty and works in all conditions. Which is one reason many people like rigid gold-based systems (as opposed to other gold-based systems). The classic story about the limitations of traditional gold money is Phillip II: with almost all the gold in the world he still went broke (defaulted on his debts).  Twice.

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While the details are of little applicability to us, centuries later, they illustrate the vital point that traditional gold systems have prevented neither accumulation of government debt nor financial bubbles.  The manias and depressions of 19th century USA and UK, discussed yesterday, prove this. For more about this see:

(2)  Gold’s great failure during the 1930’s

Any reasonable monetary system can work in normal times. Like any complex system, what happens under stress determines its utility.

The gold standard failed on such a scale during the Great Depression that nobody familiar with economic history suggests repeating the experiment — and no nations today uses a gold standard.  Although on a gold standard, the US debt level ballooned to over 3x GDP during the 1920s.  What followed was a near-death experience for not just us but all western nations, locked into depressionary spirals but unable to apply sufficient stimulus to break out.

No nation recovered from the Depression without going off the gold standard. Everyone that did so quickly began to recover, as they initiated fiscal and monetary stimulus programs. It’s astonishing that one of the clearest lessons of modern history has become obscured by little more than intellectual dust kicked into the air (especially since the massive fiscal stimulus called WWII restored all economies to full-employment, although it can hardly be called a cure).

This graph should be burned into the mind of every undergraduate taking Econ 101, every Congressmen, and every columnist writing about economics:

(3)  Gold’s role inciting WWII

This is too complex to more than mention, but it’s important. Germany went off gold quickly, followed by massive fiscal stimulus (eg, autobauns, tanks) — conservative economists didn’t argue with Hitler (his rebuttals were too tough).  France was one of the last nations to go off gold during the Great Depression.

As a result in 1938 Germany was stronger, France was weaker.  WWII followed.  For details see “The French Gold Sink and the Great Deflation“, Douglas A. Irwin, National Bureau of Economic Research, June 2012 — forthcoming Cato Papers on Public Policy — Summary:

The gold standard was a key factor behind the Great Depression, but why did it produce such an intense worldwide deflation and associated economic contraction? While the tightening of U.S. monetary policy in 1928 is often blamed for having initiated the downturn, France increased its share of world gold reserves from 7% to 27% between 1927 and 1932 and effectively sterilized most of this accumulation. This “gold hoarding” created an artificial shortage of reserves and put other countries under enormous deflationary pressure.

Counterfactual simulations indicate that world prices would have increased slightly between 1929 and 1933, instead of declining calamitously, if the historical relationship between world gold reserves and world prices had continued. The results indicate that France was somewhat more to blame than the United States for the worldwide deflation of 1929-33. The deflation could have been avoided if central banks had simply maintained their 1928 cover ratios.

Newton, by Godfrey Kneller (1689)

(4)  Newton vs. the gold bugs

As fascinating aspect of our day is how so much hard won knowledge has been lost. Here is an example in economics.

The Ayn Rand speech that so influenced Paul Ryan’s life calls for eliminating paper money and going back to gold coins (see “Francisco d’Anconia on Money“, Paul Krugman, New York Times, August 2012).  It is an  old idea, to which Issac Newton gave a powerful rebuttal — described in “Sir Isaac Newton and the currency“, G.F. Shirras and J. Craig, The Economic Journal, June – September 1945 (red emphasis added):

Newton showed by statistics that the fluctuations of Mint output, gold and silver being taken together, had been due to changes in England’s foreign trade, mainly owing to war, and not to the growth of paper credit. Such credit — for example, “Exchequer Bills, Bank of England Bills, Malt Tickets, Million Lottery Tickets, Annuity Tickets, etc” — was in his view a useful substitute for, or supplement to, coin scarcely distinguishable from coin in its effects up to the point where it caused loss of coin sufficient to support it, and led to national bankruptcy.

“If interest be not yet low enough for the advantage of trade and designs of setting the poor on work … the only proper way to lower it is more paper credit till by trading and business we can get more money.”

… “Tis mere opinion that sets a value upon [metal] money,” adding “we value it because we can purchase all sorts of commodities and the same opinion sets a like value upon paper security.”

Another excerpt describes how even in the 17th century wise people understood the disadvantage of a fixed money supply:  it forces painful swings in the real economy. And, despite current myth, gold was not always considered the best monetary medium.

In these papers {John} Locke laid down the following views: Money throughout the civilised and trading world is silver, the metal, measured by quantity. … The purchasing power of money depends on the ratio of its quantity to the quantity of purchasable things. If a country contains too low a quantity of silver, the defect can only be remedied by a control of trade.

… Bimetallism is impossible. The nominal or minimum legal value of gold coin should be deliberately placed below the market value of the metal. … Locke suffered from the drawback to a completely rational mind that it is apt to assume that what is flawless in logic is, therefore, practicable.

Another example of lost knowledge: Recovering lost knowledge about exhaustion of the Earth’s resources (such as Peak Oil).

(5) Central Banks buying gold today

A few central banks are building their gold reserves.  Only a few because it is impossible for central banks to buy gold on any significant scale (there’s not enough gold) .  In the first half of 2012 three central banks bought significant amounts of gold (3/4 of all central bank purchasers): Philippines, Russia, Turkey. The Philippines and Russia bought locally mined gold. Russia is doing so because they don’t trust the US-run global financial system. Turkey is buying gold for complex internal reasons.

This raises a seldom-mentioned point: US use of the global financial infrastructure as a weapon against its enemies will drive our rivals (a broader group than “enemies”) to develop alternatives. Today holding gold is the best option, but over time alternative mechanisms will evolve.  Eventually perhaps the global financial system will evolve to a multi-polar system not dominated by the United States.

Some Asian central banks are buying gold to maintain the mandated composition of their reserves; this might stop or even reverse as their massive current account surpluses return to balance (as China’s may have already done).

For details about this see the IMF’s Currency Composition of Official Foreign Exchange Reserves (COFER).

(6)  For more information about gold-based monetary systems

(a)  Major works about gold:

(b)  Articles about gold for a general audience:

(c)  Other posts about the gold standard

  1. Government policy errors as a cause of the Great Depression, 1 November 2008
  2. Everything written about the economic crisis overlooks its true nature, 24 February 2009
  3. Fetters of the mind blind us so that we cannot see a solution to this crisis, 1 April 2009
  4. A top businessman and banker explains our political and economic challenges, 30 April 2011
  5. Explaining the gold standard, the Euro, Default, Deflation, and Hyperinflation, 17 December 2011

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