The Gold Standard Gets No Respect

A very good (and somewhat controversial) article by Chris Mayer. Originally published last year. Most finance/econ folks have strong views about deficit spending and the gold standard. Guess it's time to create some controversy…

THE GOLD STANDARD GETS NO RESPECT
by Chris Mayer

There is a lot of dumb stuff written about the gold standard and the Great Depression these days. I open the paper yesterday and I read a column by Robert Samuelson in The Washington Post, "Gold's Enduring Mystery."

To the world-improver set, confident they can push the right buttons and pull the right levers, the gold standard is nothing more than a straitjacket. To those who see gold's charms, that is precisely its chief merit. You see, the gold standard checks the creation of new money.

If every dollar must be backed by a certain amount of gold, then you cannot create money out of thin air. The gold standard says you must have the gold first. Governments find it harder to wage war, dole out entitlements and build public works with a gold standard tying them down. Banks can't lend as much money; hence they can't make as much money. This is why the banking interests of this country backed the creation of the Federal Reserve. They appreciated the value of a good cartel.

It's a bit like a cash-only bar. People with little money who like to drink tend not like cash bars.

Capitalism – or free markets – depends on contracts. Contracts are nothing but promises. When contracts cannot be enforced, then you join the world of banana republics and post-Soviet style looting. The system breaks down. So it was whenever the country reneged on its promise to back its own currency with gold.

Those who gave their gold in exchange for dollars – backed by a promise to redeem in gold – were simply left with dollars. Their own government essentially stole their gold from them. Dollars, I should note, that have lost a lot of value in the ensuing seventy years.

My comments: Here is a chart that clearly shows the decline of the dollar’s purchasing power over the last 200 years. Chart is courtesy of Barron's.

So, it took about 100 years for the dollar to lose 92% of its purchasing power (1900-2000). Roughly speaking, that's a 1% decline in the value of the dollar per year. Ouch!

Continuing with Chris Mayer's article…

But there's more than this. Money unfettered by specie is the main fuel for the unsustainable booms that later turn into the panics, crashes and depressions that pock the landscape of financial history. Gold was what reigned in such excesses. It was the anchor that kept the ship in the harbor.

Just because the government frequently broke these rules does not mean the gold standard itself is at fault. (The rules were broken with finality in 1972, when President Nixon quashed the last vestige of the gold standard). A man who cannot keep his promises cannot reasonably lay the blame on the promises. Such a routine breaker of promises may be a rogue, a thief, and a scalawag. Usually, the preferred term is "liar." Today we call such people politicians and "saviors of capitalism."

The Boom & Bust Cycle

Why should paper money create unsustainable booms? I'll attempt an answer in brief, at the risk of oversimplifying something that's taken centuries to get right and that is still being explored and elaborated upon by economists today.

Basically, in a free market, individuals decide how much they want to save. These savings are invested in the market – either by the saver or through an intermediary (like a bank). The price of savings is the "natural rate" or "pure interest rate." Just think of it as a natural market price, the result of supply and demand. So, when you create money out of thin air you give the impression there is more savings in the economy than there really is. You distort interest rates and the natural rate does not function so well. The market's signals are emitted through a monetary fog.

All this excess money leads to new investments and spending creating the "boom." As [Murray] Rothbard says, "the boom, then, is actually a period of wasteful misinvestment. It is when errors are made, due to bank credit's tampering with the free market."

At some point, the misinvestments are exposed as unprofitable, the growth unsustainable. "The depression is actually the process by which the economy adjusts to the wastes and errors of the boom, and reestablishes efficient service of consumer desires." In other words, the jig is up, reality sets in and the pull of the market price—the "natural rate"—start to assert itself.

It's just like any other price controls. Set it too high or too low and there are consequences. It is unsustainable. This is why we have markets, to discover the "right" price.

There's a lot more to this idea than I can delve into here. But the main point I want to make is this: The gold standard is not to blame for the crises of the past. They were caused by our inability to keep the promise to redeem in gold. And, secondly, that far from causing crises, the gold standard kept in check the growth in money. As a result, the gold standard served to stem unsustainable booms and avoid the necessary busts that follow.

Sincerely,

Chris Mayer

About the Author: Chris Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer's essays have appeared in a wide variety of publications, from the Mises.org Daily Article series to The Daily Reckoning. He is the editor of CrisisPoint Trader and Capital and Crisis.