Time for a Modern Gold Standard

In the “Fact and Comment” section of the June 16, 2008 issue of Forbes magazine, Steve Forbes writes:

“But Bernanke mistakenly believes that the old gold standard somehow caused and deepened the Great Depression. Therefore, he is unlikely to adopt a modern gold standard, such as gearing monetary policy so that the dollar gold price remains in the $550- to $600-an-ounce range.”

Because Mr. Forbes is correct in saying that the only way out of our current economic and financial chaos is for the Fed to stabilize the dollar, two points must be made:

1. The old gold standard did, in fact, cause the Great Depression.

2. This fact should not discourage the Fed from establishing a modern gold standard.

In his 1991 book, Golden Fetters—The Gold Standard and the Great Depression 1919–1939, author Barry Eichengreen gives an excellent “play by play” account of the rise and fall of the old gold standard. His thesis is that the “classic” gold standard of 1880 – 1913 worked well, but the “interwar” gold standard of 1925 – 1931 was doomed from the start.

Golden Fetters is a work of great scholarship, but I believe that it misses the most fundamental flaw of the old gold standard—that it was based upon a lie.

One of the laws of the universe is, “Without integrity, nothing works”. A corollary is, “At the core of every business (or economic) disaster is a lie.” The Great Depression was the greatest economic disaster of all time, so at the heart of it had to be an enormous lie.

The old gold standard was based upon the collective promise of the participating governments to redeem their currencies for gold at a fixed price upon demand. From the beginning, there wasn’t enough gold in the world to honor this promise. This was the fundamental lie.

The lie was implemented via “fractional gold coverage” laws that allowed central banks to issue (typically) up to 2.5 times as much base money as the value of their gold holdings. Then fractional reserve banking was used to leverage the monetary base to create even more money. When the game of “let’s pretend” being played by governments, central banks, financial institutions, and the public collapsed, so did banks, employment, trade, and the gold standard itself. Because gold was the only real money, when the crunch came, everyone wanted to redeem their money for gold—at the same time.

So, why base the world’s monetary system on a lie? Why not just use 100% gold coverage for the monetary base and 100% reserve banking? The answer is, “because the resulting deflation would have been politically intolerable”. As the world economy became more differentiated, productive, and complex, there was a need for more and more money. Despite the many “tricks” described in Golden Fetters that were employed to “stretch” the available gold, the old gold standard was marked by chronic deflation. The U.S. GDP Deflator was more than 17% lower in 1929 than it was in 1920. When the “stretched” world money supply finally “snapped” in late 1929, the deflation accelerated, with the price level plummeting another 26% by 1933.

What the world learned from the old gold standard is that you cannot use anything physical as money and maintain integrity. Any commodity that is valuable enough to start using as money will be too scarce to continue using as money.

Today we have the “Bernanke Standard”. Like many other “fiat money” regimes around the world, the Bernanke Standard is also based upon a lie. In this case, the lie is that “money” and “capital” are the same thing, and that it is possible to regulate the value of money by manipulating interest rates. They are not, and it is not.

Since March, 2001, the dollar has lost about 70% of its real value, whether measured against gold or retail gasoline. During that time, the Fed lowered its Fed Funds interest rate from 5.00% to 1.00%, raised it to 5.25% and then lowered it to 2.00%. Clearly, there is no direct relationship between the Fed Funds rate and the value of the dollar. But why would there be? The Fed Funds rate is the price of a certain type of short-term capital, and capital is not the same thing as money.

Because, “Without integrity, nothing works”, the only way out of our current mess is to restore integrity to the dollar. We must have a monetary system that is not based upon a lie. A “modern gold standard” would do the trick.

Under a modern gold standard, the Fed would use its Open Market operations to force the COMEX price of gold down to (say) $500/oz and keep it there. At that point we would have a fiat currency whose value was defined in terms of the market value of gold. Unlike the old gold standard, gold would not be money, and monetary operations would not create any additional demand for gold. The monetary base would automatically expand and contract in response to market demand. Because the Fed has the power to deliver on a commitment to stabilize the value of the dollar against gold, a modern gold standard would have integrity.

Under a modern gold standard, the world would be certain of future value of the dollar. All of the economic costs currently devoted to hedging fluctuations in the value of money would be avoided. Interest rates would fall. The economy would boom. Crude oil prices would fall from today’s $134/bbl to $77/bbl—or less.

If we restore integrity to the dollar, our economy will start working again and the current climate of fear and anxiety will abate.