by Steve Forbes
Eliminating inflation is not the same as price stability. Prices will continue to fluctuate with gold-based money, but they would do so in response to changes in supply, demand, and productivity.
We’re not saying that gold would mitigate the normal industry shakeouts that can sometimes occur or that it could prevent market distortions created by bad government regulation or excessive taxation. Gold-based money, however, would enable the market’s system of communication to convey the true worth of goods and services being exchanged. In other words, price signals would be free of distortion.
Under a gold-based system, prices would tend to drop more than they do today because there would be lower commodity prices. Food and energy prices would likely be lower, as would the prices of goods and services that make heavy use of those commodities. Lower fuel prices, for instance, would cause airfares to drop. Imagine how much less punishing winter would be with half the fuel cost.
Gold would have prevented the housing bubble and other imbalances that have occurred in response to price signals distorted by the ever-weakening dollar. Oil would not have skyrocketed from $3 to nearly $40 a barrel in the 1970s, nor would there have been the exploration mania and eventual crash in the 1980s. Gold-based money would have spared us the other inflationary disasters in farmland, copper, commercial real estate, and gold prices—and the busts that followed when the Fed tightened and markets came back down to earth.
George Soros May Have to Find a New Job
A single fixed exchange rate under a gold standard would drastically reduce speculative trading and the windfalls it produces. As we’ve mentioned, much of the speculation that takes place in today’s financial markets is a response to the volatility produced by the collapse of the Bretton Woods gold system.
Capital and brainpower instead would be directed into ventures that meet people’s real-world needs and desires. No more tax shelters and protective investments. After all, why would you need to invest in gold unless you make jewelry or want to wear it? Society would benefit.
We had a taste of this after the early 1980s through much of the 1990s, an era of semi-sound money when the price of gold, despite ups and downs, averaged around $350 an ounce. The United States became a world leader of innovation. Cocktail chatter turned from tax shelters to tech investments. The Dow Jones Industrial Average surged 15-fold from under 800 to over 11,000. Short-term interest rates came down from their height of around 21% to 5%. The interest rate of long-term government bonds dropped from a high of 15.75% in 1981 to a little over 6% in the 1990s.
The Reagan boom saw huge job creation after inflation was conquered in 1982: in the rest of the decade 20 million jobs were generated. U.S. growth during this period exceeded the size of the West German economy, the third largest in the world. George Gilder has observed that the United States created more private sector jobs during that era than in all of Europe and Japan put together.
This occurred despite the economic depressions that took place in energy, agriculture, and commercial real estate. The U.S. economy in the 1980s was liquidating the malinvestments of the 1970s and roaring ahead with investments in technology, media, autos, and other sectors. There was more capital for productive ventures because of the lower price of lending and borrowing that came about with more stable money. The 1980s saw the rise of the personal computer, telecommunications technologies like fiber and cellular, cable television, and other innovations. America’s share of the global GDP moved upward.
The boom continued under the Democrats in the 1990s. The Clinton administration was, for the most part, a sound dollar administration. Then the George W. Bush administration started the United States on the road to a weak dollar policy, and all of us continue to live with the consequences. Despite the abundance of anti-Bush rhetoric, the Obama administration has only doubled down on the loose money policies of his predecessor.
A return to the sound dollar policies of Reagan and Clinton would mean more wealth creation through innovation. Forbes.com political economy editor John Tamny points out that, if the United States returned to gold, people like George Soros—or, for that matter, Paul Tudor Jones or John Paulson—could not amass such immense fortunes from speculation; they would have to channel their energies elsewhere.
Had Nixon never freed the dollar from gold, Tamny believes: “It’s a fair bet . . . that the three (along with many of their numerous competitors) would have grown rich through the creation of efficiency-boosting software, a cure for cancer, and transportation advances that would make today’s cars look positively pedestrian.”
The Gold Standard: Four Possibilities
How do we get there from here? Implementing a gold standard would require choosing one of several systems of gold-based money. Most people are probably not aware that there are several different gold standard systems. Two have been put into practice: the classical gold standard, which was used by the world’s largest economies from 1870 to the outbreak of the First World War in 1914, and the gold exchange standard, which was used after both world wars. Another two have been proposed: a 100% gold-backed currency and what we call the gold price system.
Each has its critics and supporters. But in all, gold is the yardstick of value. We thought a quick guide would be useful, since you are likely to hear more about them in the near future.
The Classical Gold Standard
The classical gold standard was the system established by Great Britain and later used by others during the nineteenth century. Countries pegged their currencies to a particular weight of gold. Anyone could take gold to a bank and exchange it for currency at a fixed rate, or they could swap money for gold. Governments during the classical gold standard era possessed gold reserves: gold bars. Most also had bonds denominated in foreign gold-based currencies.
Gold coverage—the ratio of gold reserves to the monetary base—varied and fluctuated in each country. Convertibility, however, was sacrosanct. A drop in a nation’s gold reserves meant countermeasures had to be taken, such as raising interest rates to attract short-term money and perhaps cutting spending or raising some taxes to demonstrate fiscal prudence.
Contrary to myth, trade balances weren’t needed for the system to work. Great Britain routinely had enormous trade surpluses and was proportionately the greatest capital exporter ever. The United States, by contrast, routinely experienced trade deficits and was a major capital importer. Yet the dollar remained successfully fixed to gold.
As we’ve noted, the classical gold standard was destroyed by the First World War. The breakup of the German, Russian, Austro-Hungarian, and Ottoman empires produced numerous new countries with their own currencies and central banks, making the system harder to implement.
More critically, there was also the mistaken perception that wartime inflation had created a gold shortage—not enough gold to restore the kind of gold-backing prevalent before hostilities. Such a fear stemmed from the longtime misguided focus on the supply of gold rather than how it functions. Had nations simply pegged their currencies at the postwar value, gold could have resumed its role as a standard of measurement. The imagined shortage would have quickly disappeared. Instead the solution was to abandon the existing system in favor of a new one: the gold exchange standard.
The Gold Exchange Standard
The gold exchange standard was seen as the answer to the supposed gold shortage because it required fewer nations to hold gold than under the classical gold standard. The U.S. dollar and the British pound would be directly fixed to gold, but other countries could forgo using gold bars and instead link their currencies to dollars and pounds. Government reserves would include not only gold, but also U.S. and British government bonds.
Countries didn’t mind this. Unlike piles of gold, bonds paid interest. Reserves could grow effortlessly. If nations wanted more gold, they could redeem their dollars and pounds to get it.
Gold standard purists then and today, however, were appalled by the substitution of debt for gold in government rese
rves. Believing that countries needed to hold physical supplies of gold, they considered such a use of leverage inflationary, little better than a pyramid scheme. Critics claim to this day that such flaws helped encourage an excess of credit creation that produced the disaster of 1929. This was an incorrect reading of what was occurring in the market, which was rising because of an incredible surge in corporate profits. The cause of the Depression was the U.S. enactment of the Smoot-Hawley Tariff, which we discuss in greater depth later in this chapter.
Another gold exchange standard, the Bretton Woods system, emerged in the waning days of World War II, as we noted earlier. At that time, the United States owned more gold than the rest of the world’s governments combined. So only the U.S. dollar was fixed directly to the precious metal, redeemable in gold bars solely by governments or central banks. Other currencies were tightly pegged to the dollar.
That was the problem. When Nixon closed the gold window in 1971, there was no gold-based currency in the world for the first time ever. This made resurrecting a new arrangement extremely difficult. Remember that the classical gold standard was preceded by Great Britain, the United States, and other nations having gold-backed currencies. The Bretton Woods gold standard would have worked if the United States had played by the rules and understood how to manage the system.
A 100% Gold-Backed System
Some gold standard supporters advocate a system where the currency is 100% supported by gold. That wasn’t the case under a classical gold standard. Only a percentage of the money stock was covered; it was widely assumed that not everyone would simultaneously seek to redeem paper for gold. The system operated somewhat like our modern system of fractional reserve banking, under which banks loan out most depositor money, keeping only a fraction on hand as reserves.
For some of the same reasons that fractional reserve banking and its leverage have discomforted critics, some believe a gold standard demands 100% coverage. In a 100% system, gold would support the entire money stock, making it 100% redeemable. Supporters of a 100% system like it because they believe it eliminates the risks of bank runs and the system failure that might come with dependence on leverage. Banks would have to have gold reserves on hand to redeem 100% of depositors’ money.
Advocates also claim that, since the global gold supply grows at about 2% a year, in line with long-term economic growth rates, a 100% system would not be deflationary. Sadly, they’re mistaken. Here’s why: Say you pegged the dollar to gold at the market price, which has been fluctuating at around $1,200 to $1,400 an ounce. Given that the United States holds 261 million ounces of gold that would mean the total monetary base—the currency in circulation and bank reserves on deposit at the Fed—could not total more than $325 billion. That would require a huge contraction in the monetary base and a deflation to end all deflations. Even before the Fed’s QE binges, the monetary base was a tad under $900 billion. Today it is $4 trillion.
Some respond that we could take a page from Franklin Roosevelt, who devalued the dollar from $20.67 to $35 in 1934, and jack up the dollar price of gold to $10,000 or more an ounce. Then you’d end up with the opposite problem: Weimar-style inflation.
A more realistic variation of this idea would be a gold-based currency board. Currency boards have been around for over 150 years. A government simply uses a sound or widely used currency to back its own money. Its money is 100% backed by that other currency. Several countries use such a system today, including Denmark, Bulgaria, and Lithuania. Hong Kong has had a currency board tied to the dollar since 1983. In these cases, their monetary bases are made up of only euros and euro-denominated bonds plus some gold. Their central banks have no discretion. People can turn in the local currency for euros at a fixed rate, and vice versa. Their domestic money supplies are solely determined by the needs and wants of their own people.
So why not such an arrangement that is gold based? Johns Hopkins economics professor Steve Hanke, a world authority on currency boards who helped design them for Bulgaria and others, has outlined how such a system might work. Instead of a currency, such a board would “hold reserves in gold or in highly rated or liquid securities denominated in gold or fully hedged against changes in fiat-currency price of gold.”
One could see how a currency board would work for a smaller country, but it would be impractical for a large country like the United States because of the difficulty of having a 100% backed dollar. And, as we have noted, it’s not necessary.
The Gold Price System
This new version of the gold standard has been proposed in legislation introduced by U.S. Representative Ted Poe. It uses the precious metal as strictly a yardstick of value and does away with the need for nations to hold gold supplies. The system is the essence of simplicity. The dollar would be pegged to gold at, say, $1,200 an ounce. If the market price goes above that level, the Federal Reserve would engage in open market operations, selling bonds to extract reserves from the banking system until gold settled back to $1,200. Conversely, if the price went below $1,200, the opposite action would occur. The Fed would purchase bonds, which would put money back into the banking system. A strength of the gold price system, as Louis Woodhill has noted on Forbes.com, is that there is no way for speculators to attack the system by buying up supplies of gold. And as we’ve said, you don’t need to hold any gold for the system to work.
The key challenge of this method is setting the gold/dollar ratio. Setting the price of gold at too low a level, such as $400 an ounce, risks delivering a deflationary shock to the economy, as happened in Great Britain in 1925. Probably the best method would be to take a 10-year or even 5-year average of the dollar/gold price, mark it up 10% as insurance against deflation, and go with it.
A Gold Standard for the Twenty-First Century
If America is ever to attempt to restore the vitality of its economy, it must return to the tradition of sound money via a gold standard. Below we present a proposal for a new gold standard for the twenty-first century. It combines the fundamentals of the old systems, using gold as the yardstick of value, while avoiding the vulnerabilities: no more manipulating interest rates, no more misguided focus on the balance of payments, no worry about who buys U.S. debt, and no concerns if there’s another big gold discovery.
The United States doesn’t have to worry about stockpiles of gold. It simply must have the knowledge and the will to defend the ratio between the dollar and gold. The following list lays out the basic features.
A fixed dollar value that would be maintained by the Fed.
The twenty-first century gold standard would fix the dollar to gold at a particular price. As we mentioned, that price might be decided based on a 5- or 10-year average of recent gold prices, marked up as insurance against deflation. The Federal Reserve would use its tools, primarily open market operations, to keep the value of the dollar tied at that rate to gold.
The program would be phased in gradually.
The process need not run more than 12 months. The government should announce a certain date when the conversion to a gold standard will take place. A gradual phase-in will help markets prepare for the return to gold-based money. With no more fears of future inflation, a more natural gold price should reemerge, making it easier to arrive at the gold/dollar ratio. The transition period would also enable financial institutions and investors to adjust expectations about future interest rates and alter investment strategies to reflect a new environment of stable money. Global markets would make similar adjustments. The dollar would be permitted to fluctuate against gold with a range of 1%, the rate used under the Bretton Woods system for currencies against the dollar.
The system would be backed up by law.
To minimize the inclination of central bankers to exercise “discretion,” procedures governing the twenty-first century gold standard would be codified into law. This legislation should also bar the Fed from manipulating interest rates. The U.S. central bank could no longer use its tools to fix the federal funds rate, the inter
est rate banks pay to one another for borrowing reserves. The Fed could still set the discount rate that banks pay to borrow money from the Fed at its discount window. That charge would be set above free-market rates of similar maturities so that banks don’t use the window to get a cheap source of money to lend out.
Barriers to alternative currencies would be removed.
Removing barriers to alternative domestic currencies would also help to keep Washington playing by the rules. The rise of competing currencies would be another signal to the Fed to defend the dollar. After all, people use U.S. dollars as a matter of convenience. To consider an alternative would mean a very real distrust of the dollar’s integrity.
To permit currency diversity, no taxes or government fees could be levied on sales of gold and silver bullion, as is the case today. Capital gains taxes would also be a no-no. Onerous reporting rules that now afflict gold and silver bullion buyers would be prohibited. Individuals would be permitted to launch alternative currencies.
The convertibility of dollars into gold would be restored, if needed.
