FT says "Bring gold dollar link back"

This morning a thought provoking article in the FT. Author Richard Duncan argues that ever since 1971 when the gold exchange window was closed by the US, the world has been living the consequences of the monetary flows that have resulted from fiat money.

Basically once the US govt got free reign to print it's own money, it did and got the world economy clocking again. In a sense it was a crowning moment for Keynes. The cycle of boom bust ensued, starting with a big rash of inflation in the 70's and then world chaos in predictable order. The machine spun until it inflated the biggest asset bubble "housing" (or a bubble too far as the article calls it), until that one deflated.

The article concludes with a call to design a new monetary system. Gold seems to be an emotional favorite.

The events of September 2008 – the nationalisation of Fannie Mae, Freddie Mac and AIG; the disappearance of the investment banking industry in the US; and the Bush administration’s $700bn bailout to save what is left of Anglo-American capitalism – demonstrate that the 37-year experiment with fiat money and floating exchange rates has failed catastrophically.

When Richard Nixon destroyed the Bretton Woods International Monetary System in 1971 by closing the “gold window” at the Treasury, he severed the last link between dollars and gold. What followed was a spiralling proliferation of increasingly spurious credit instruments denominated in a debased currency. The most glaring and lethal example of this madness has been the growth of the unregulated derivatives market, which has ballooned in size to $600,000bn, the equivalent of almost $100,000 per person on Earth.

Under the post-Bretton Woods dollar standard, credit growth powered economic growth. In the US, the ratio of total credit to gross domestic product rose from 150 per cent in 1969 to 350 per cent in 2007. Credit financed consumption and sucked in imports with a devastating impact on America’s trade balance. By 2006, the US current account deficit had reached almost $800bn.

As the dollar standard flooded the world with funny money, economic instability spread around the globe. The reinvestment of “petrodollars” created the Latin American economic boom in the 1970s and then the third world debt crisis of the 1980s. Japan’s trade surplus with the US drove up Japanese property prices in the late 1980s until the imperial gardens in Tokyo were worth more than California; and then produced the lost decade in Japan when that bubble popped in 1990. Next came the rise and fall of the Asian miracle bubble. Each economic convulsion resulted from the excessive influx of dollars into those economies. No regulatory regime could cope when confronted with such an extraordinary incursion of exogenous money.

The Bretton Woods collapse severed the link between the world’s currencies and gold. Central banks were then free to create as much money as they wished. Between 2001 and today, central banks outside the US created the equivalent of about $6,000bn. This can be seen in the seven-fold increase in foreign exchange reserves in that period. The money created (which accounted for most, if not all, of Federal Reserve chairman Ben Bernanke’s so-called global savings glut) was used to buy dollars and suppress the value of the currencies of US trading partners to perpetuate their trade advantage.

When those dollars were reinvested in dollar-denominated assets, it was America’s turn to bubble. As central banks bought up US treasury bonds, they drove up their price and drove down their yields. However, there were not enough new Treasury bonds being issued to absorb the rest of the world’s trade surplus earnings, so central banks bought Fannie and Freddie debt as well. That allowed those government-sponsored enterprises to acquire or guarantee more than half of all the mortgages in the country before they failed. Between unnaturally depressed interest rates and the buying spree by Fannie and Freddie, US property prices surged. The US housing bubble followed the ill-fated Nasdaq bubble. However, the inflation of the US housing market was one bubble too far. When it imploded, the global financial system was hurled into crisis, leaving the 21st century version of Anglo-American financial capitalism discredited.

The lesson that must be learnt from this disaster is that “free market” capitalism under a fiat money regime does not produce the same blessings (sustainable prosperity) that are produced by true free market capitalism within a monetary system anchored by gold. When President Nixon severed the link between the dollar and gold, he changed the nature of the Anglo-American economic model and ultimately destroyed it.

The world cannot return to a gold standard overnight without provoking a brutal contraction of credit and a global depression. However, neither can we afford to pretend that nothing has changed and that the global economy can continue to function on the dollar standard. The time has come to convene a forum of the world’s leaders to hammer out and begin the transition to a new rule-based international monetary system predicated on sound money and balanced trade. Current Group of 20 efforts fall well short of what is required.

The writer is author of The Dollar Crisis: Causes, Consequences, Cures

I don't get all these calls for Gold to make a come-back as a monetary standard. I would have to read up on monetary policy under a gold standard. Governments, specifically in the US have expanded dramatically. Undoing this sounds difficult and a bit idealistic.

On the other hand, getting back to a gold like fixed exchange rate stability, would minimize the occasions for economic war. That would be a good thing. But could this could be achieved through negotiation rounds, but this is not something that will happen overnight. Getting all this crowd to agree is going to take some time.


Barry Kelly said…
The emotions behind gold are indeed irrational. All money is based on trust, whether it's belief that the gold behind the currency will be worth what one thinks it will, or whether one believes that the government won't debase the currency or renege on its debt. But gold is also subject to speculation and debasement in the form of e.g. gold discoveries, and manipulation by e.g. gold hoarding.

But the fact that people use banknotes and not actual gold pieces means that in practice, all money is fiat money. Even if it is notionally backed by a currency, you're still trusting the banking system / government not to renege and break the link.

The theory behind commodity-backed currency is that it automatically regulates exchange rates according to trade flows. If there are too many imports, there will be less gold to go around the nation, and thus things will get more expensive (i.e. deflation). That will reduce competitiveness in trade, and thus the balance of trade payments should swing the other way. It should work out the other way too.

A key advantage of fiat currency, AFAICT, though, is that the government can forcibly prevent deflation through the printing press. Deflation is the big monster, more feared than inflation.
Marcf said…
Hey barry,

Is stable money supply a product of the gold standard? Is it just a way to make sure governments do not spend but what they raise in taxes?

Yes, the way I understand the advantage of fiat is that with public spending you can stabilize prices. Debt is good as it stimulates an economy, too much of it can kill however.

With fiat a government doesn't need taxes, which is why Obama is saying he won't raise taxes after all?
Army No Va said…
Obama does not want to repeat Hoover's and Roosevelt's mistakes of raising taxes. Hoover raised them to something like 65% and helped turn a deep recession into a depression. Roosevelt later raised them to 85% and killed the 1934-35 recovery and rekindled the depression. He later raised them to 94% in WWII.

I give Obama credit for listening to history and today's advisers and for being smart.

Governments hate things like gold standards as they lose a lot of flexibility to run deficits and such. Also, it does make it hard to stop deflation. Of course, in a debt ridden society like we are now (far worse than in 1929), deflation means massive default. Becomes a vicious cycle.

The US Govt is desparate to stop housing deflation...however, they can't because there is too much supply, not enough income and too much debt. All their market manipulations will do is postpone the inevitable and essentially freeze the housing market. Right now, the 2nd round of knife catchers, investors are jumping in thinking houses are a good buy compared to 2005. When they tire of running negative cash flows waiting for 2005 to come back, they will walk in 2010-11. And so it goes, like a ball bouncing down the steps till it reaches a stable point.

Now, with the mantra that "real estate only goes up" destroyed, there isn't a good reason to buy a house until it is cheaper to buy than to rent. We will see breath-taking deflation in real estate, especially houses and the new suburban commercial developments that support them, in 2009. Right now, we are only halfway or less to the bottom.

The government CAN'T go to a gold or other standard in this type of environment, otherwise we get the 1870s, 1890s or 1930s. The 1870s are instructive as the government shrunk the money supply generated by the Civil War to get back to a "sound", gold backed currency.

Looking past the immediate delfation problem, as government inject trillions of dollars into the system...

I expect, when foreigners (especially most Asian countries and oil producers) abandon the $, is massive inflation in things we need (energy, food, water, imported goods) and deflation in luxuries (houses, new cars, etc...), is a move for the US $ to be replaced with a North American Union money, call it the Amero. At this point, some Asian currency will likely become the new international standard for oil and other transactions. The American standard of living will fall to something like a more modern version of the late 19th century and we will become an export driven economy again.
Marcf said…

Ojala, as the spaniards say, we may become an export driven economy on ideas, because manufacturing is gone. Maybe Agriculture?

Good point on the difficulty for modern governments to achieve this.

I hadn't thought about it, but in a world of gold standard, our taxes are at 80%? 95 in times of war?

Small wonder we would prefer a stable fiat system.
Army No Va said…
In the 1920s Fed income taxes were more like they are today (really less). In 1913 it all started at 1% for the "rich"! :-) ... Before that, we had a MUCH smaller Fed govt that was funded primarily with import/export duties.
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