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IS THIS THE GOLDEN MOMENT? With the price of gold hitting a record over $1,200 an ounce earlier this month, the precious metal has been attracting the public's attention in a way not seen since its previous peak in January 1980.
In the process, gold is being hawked by cable television talk-shot hosts at one end of the spectrum while gold-selling services are being fronted by rap stars. New ways to own the metal, such as the phenomenally successful SPDR Gold Trust exchange-traded fund (GLD), which has attracted over $40 billion, has gained additional buyers for gold.
The fundamental force behind the surge in gold is, of course, the economic crisis from which we may (or may not) be emerging. The inevitable outcome of the credit bubble and bust is a vicious debt and asset deflation that threatens to drag down the economy into a depression. That is, if the massive responses of governments of unprecedented deficits and money-printing don't produce hyperinflation.
No wonder prophecies of a Spenglerian demise of the dollar are proliferating. That's only fanned by the scolding from foreign creditors such as China, on which the nation is dependent as at no time since the U.S. became a superpower.
What started the U.S. down the road to monetary perdition, say many such critics, was the abandonment of the gold standard, the last remnants of which were shredded when President Nixon ended the dollar's convertibility into gold at $35 an ounce in August 1971. That act unleashed the price inflation of the 1970s and the debt excesses of this decade, they contend. To paraphrase Dostoyevsky, if gold is dead, then all is permitted.
In the perfect world of the gold standard, during expansions of output and surpluses of trade, gold flows into the country. That produces a monetary expansion, resulting in a boom, which pushes up prices. That, in turn, attracts cheaper imports and produces an outflow of gold to pay for them. The resulting monetary contraction cools off the economy; prices decline, exports rise and gold flows back in, starting a new expansion.
This system functions totally without governments' or central banks' fiddling in the monetary process. Money -- which is gold -- flows back and forth as automatically as the tides, which in theory is the main attraction of a gold standard. Credit inflations that are fueled by central banks' keeping interest rates below their natural level would be eliminated, along with the converse of rates being held too high, resulting in deflation.
In practice, however, the experience has been quite different. Contrary to the nostalgia shown by fans new and old who would favor a return to a gold standard, history shows that adherence to the gold standard severely deepened and spread the Great Depression of the 1930s around the globe. Moreover, a gold standard today would have prevented the heroic measures taken to counter the current Great Recession.
Economist Barry Eichengreen of the University of California, Berkeley, has researched and written extensively about the Great Depression and its monetary roots. While most analyses center on the U.S. -- concentrating on the 1929 Crash, Herbert Hoover's tax increases, the Smoot-Hawley tariff and misguided Fed policy -- Eichengreen poses the question of why so many countries were hit with the same shock at the same time.
His answer: under the rules of the gold standard, all nations that adhered to it had to follow deflationary policies simultaneously. Adjustments to falls in exports in response to contractions in global trade required deflation to bring down export prices. Conversely, monetary ease and devaluation were prohibited by definition under gold.
"The choice of deflation over devaluation was the most important factor determining the course of the Depression," Eichengreen wrote in a 2001 paper (co-authored with Peter Temin of MIT.) "Policy makers in all industrial countries insisted that the way out of depression was not to 'debase' the currency but instead to cut wages, lower production costs, and reduce the prices of goods and services. Devaluation did not become a respectable option until much later -- until after an unprecedented crisis had rendered the respectable unrespectable, and vice versa."
Moreover, Eichengreen also has written extensively that those countries that finally chose the latter and either abandoned gold or devalued their currencies in terms of gold began to recover from the Depression sooner than those who hewed to gold.
In 1931, Britain abandoned gold and began to recover after the Bank of England was freed to lower its lending rate. The markets then expected the U.S. to follow suit, resulting on a run on the dollar. Instead, the Fed more than doubled the discount rate at the very depths of the Depression, further exacerbating the downturn.
By 1933, with the dollar's devaluation through the increase of the price of gold to $35 an ounce from $20.67, the U.S. economy did embark on a recovery with gross domestic product expanding nearly 9% per annum through 1937. Then the Fed sharply tightened policy to absorb the excess reserves in the banking system that it feared posed a threat of inflation. Fiscal policy also was tightened as well; the second leg down of the Depression ensued and did not fully end until America's entrance into World War II.
Impassioned adherents of the gold standard gloss over the inability to counter deflation. Modern democracies simply will not tolerate the Dickensian unemployment and suffering brought on by debt deflations, however, which is why the Federal Reserve was created during the Progressive Era that also had previously brought anti-trust laws and the beginnings of other government regulation of business.
For all its faults, the floating dollar monetary system permitted policy makers to react aggressively to the worst economic crisis since the 1930s and prevent the Great Depression 2.0 this time.
Now, the challenge is to heed the message of the soaring gold price, but not mechanistically, as the gold standard would demand by raising interest rates. The problem is on the fiscal side from trillion-dollar deficits as far as the eye can see. A change in the monetary system will do nothing to address that disaster.
Comments: randall.forsyth@barrons.com
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