Our politics have reached an ideological pitch more strident than any I can remember. Perhaps bad economic times encourage the gravitation toward extreme ideological positions. Sensing the shift in public mood, politicians respond by adopting and espousing those rigid ideological positions themselves. These musings are triggered, in part, by the ongoing debate over the budget and raising the debt ceiling, but that is not what I want to comment on. Rather, it is how ideology has started to drive the debate over monetary policy.
As in the budget debate, most of the ideological fervor about monetary policy seems to be on the right. The Fed stands accused by James Grant in the weekend Wall Street Journal of “flooding the system with dollar bills;” it is also held responsible for devaluing the dollar, fuelling inflation, and creating commodity and asset bubbles, all while failing abjectly to produce the recovery that all that money printing was supposed to have produced. General anti-Fed sentiment and resentment over its monetary policy have been catalysts for reviving interest in and support for the gold standard. The gold standard has become the ideological fad du jour.
But do supporters of the gold standard understand what it is that they are supporting? Do they have any idea what it would it mean for the dollar to go back on a gold standard and how would it be implemented?
Many, perhaps most, people who say that they support going back on a gold standard think that a gold standard means that every dollar has to be “backed” by a specified amount of gold reserves for each dollar. But gold “backing” (i.e., the holding of a fixed quantity of gold per dollar) does not establish a gold standard, and it would be entirely possible to go back on the gold standard with no, or almost no, gold backing in the sense of a fixed quantity of gold reserves held per dollar. Holding gold reserves for each dollar would mean only that to print more dollars the US would have to go out and buy gold to “back” the extra dollars. That would not pin down the value of the dollar, it would merely transfer some or all of the profit that the US Treasury earns from creating dollars (seignorage) to the owners of gold. So you can see why owners of gold would be charmed by the prospect of increasing the gold “backing” of dollars. Having to share its profit from creating dollars with owners of gold would certainly reduce the Treasury’s incentive to create more dollars, but the value of the dollar would not be linked directly to the value of gold. Only convertibility of the dollar into gold at a fixed exchange rate that can do that.
As I understand a gold standard, and I believe that my understanding accords with that of most monetary theorists who understand how the gold standard worked, a sufficient condition for a gold standard to be in operation is that the issuer promises to redeem the currency at a fixed, unchangeable, exchange rate between the currency and gold. The higher the fixed gold price is set, the less valuable is a unit currency in relation to gold. But that is just a nominal value, the real value of the currency is the real value of the corresponding amount of gold.
This past Friday, the value of gold rose to almost $1600 an ounce. If the US established a gold standard tomorrow at a fixed rate of $1600 an ounce, making $1 the equivalent of one-sixteen-hundredth of an ounce of gold. What would that do to the value of the dollar? Well, the value of a dollar would have to equal the value of one-sixteen hundredth of an ounce of gold. But what would that value be? It would depend on the demand for gold in relation to the supply. There is a huge stock of gold sitting in bank vaults and other treasure houses throughout the world, and hardly anyone has a good handle on what that supply is. But the available supply surely dwarfs both current production and the current demand for gold in industrial and ornamental uses. So the current value of gold is almost entirely dependent on the demand to hold gold by people who have no use for it except to keep it locked up in a vault. Does that fact make anyone feel confident that the value of gold in the future is likely to be stable?
Or look at it another way. Supporters of the gold standard like to point out that since creation of the Fed in 1913 the dollar has lost 95% of its value. Well in 1913, the dollar was convertible into an ounce of gold at $20.86 an ounce. So while the dollar has lost 95 percent of its value, gold has appreciated even more rapidly than the dollar has depreciated. If gold had kept its value in 1913, its value today would be somewhere between $400 and $500 an ounce. Accept for argument’s sake the claim of supporters of the gold standard that the recent run up in the value of gold was caused by a loss of confidence in the dollar. Would it not be reasonable to conclude from that assumption that if the dollar were made convertible into gold, people would then start selling off their gold, the threat of dollar depreciation having been eliminated?
But wait. If people started selling off their gold, the value of gold would decline. If the real value of the gold fell from its current value back to its value in 1913 when the dollar was convertible into gold at $20.86, the value of would lose two-thirds to three-quarters of its value. We are talking about two or three hundred percent inflation. Does that make you feel more confident about the value of your savings?
James Grant, in a recent interview by Larry Kudlow, another advocate of restoring the gold standard, made the following point.
Our monetary policy today is dependent upon the judgment of a clique of monetary policy Mandarins, whose judgment is sometimes right but more often wrong because they are, after all, mortal people. So the gold standard has been billed as something antediluvian, and the idea of returning to it, or moving forward to it, is typically characterized as something quixotic, but on the contrary, it seems to me, this is the most eminently practical step we could begin to discuss. We must begin to discuss it.
Mr. Grant, a very intelligent, practical, and insightful analyst of business and financial affairs, seems somehow oblivious to the fact that the gold standard never managed itself; in its classical period from 1870 till World War I it was under the constant management of the Bank of England with the occasional assistance of the Bank of France and other major banking institutions. As gold reserves accumulated rapidly in the late nineteenth century and early twentieth century, managing the level of gold reserves held by the central banks to preserve a reasonably stable equilibrium in the world gold market became an increasingly challenging task requiring the full attention of the Mandarins who managed the gold standard in the days of its greatest glory.
Samuel Johnson called a second marriage the triumph of hope over experience. For Mr. Grant now to imagine that we could simply go back on the gold standard for a third time and enjoy the blessings of a stable currency with no risk of inflation or deflation and with no necessity for intelligent technocratic management is truly a stunning triumph of ideology over experience.