Why gold?

Read our article in the Cayman Financial Review Magazine, eversion 

In 1971 President Nixon delinked the dollar from gold, putting an end to the Bretton Woods System that had ruled the world’s monetary systems since the end of World War II.

This was a watered down version of the Classical Gold Standard, under which central banks could create money only when backed with gold (and, in the Bretton Woods system, with dollars, which were backed by gold).

By discarding it, he left in place a system based on fiat money – that is, money freely created by central banks, in amounts supposedly calculated to maximise growth and employment while keeping inflation down.  

Reality was unkind to the new monetary arrangement. Rather than bringing about a sustained expansion of production with low inflation rates, it presided over two long episodes of instability: the stagflation of the 1970s and 1980s, and the severe bubbles of the 1990s and 2000s, which led to the current crisis.

In between, there was a period of stabilisation, which came to being only because one Governor of the Fed, Paul Volcker, decided not to create money from 1976 to 1986.

The economy stabilised. However, enthusiasm for monetary creation returned. When Volcker left, the Fed created money to elicit growth, then to deal with the busted bubbles that arose from the excessive monetary creation, then to deal with failing banks, and so on in a vicious circle of excessive monetary creation carried out to protect the economy against the consequences of previously excessive monetary creation.

It is no wonder that many voices have called for replacing the current international monetary arrangement with one that would secure global financial stability and facilitate economic growth.

To design a new monetary system, we should first identify why did the current one fail? This is easy. It was excess monetary creation that led to the 1970s stagflation, the 1990s and 2000’s bubbles, and the current financial crises and stagnation.

That freedom to create money could lead to excesses was known from uncountable experiences throughout history. The idea was that this would not happen this time for two reasons. First, the money issuers would be more prudent because they would be better economists than those that debased currencies in the past.

Second, if self-control failed, the International Monetary Fund would impose order.

These defences, however, failed to work. Even the bad experience of the 1970s was rapidly forgotten. As Friedrich Hayek noted, politicians (and politically elected technocrats) find it impossible to resist the temptation to create money.

It is this weakness, the tendency to run amok creating currency that the new design must remove.

There are two ways in which we can approach the design of the new system. One is to build on the current arrangement, leaving the central banks free to create as much money as they wish, but following improved rules under a stronger IMF.

The problem with this approach is that we cannot pretend to ignore two things. First, that the power of the IMF is nil when dealing with great, powerful countries that, based on that power, control the board of directors of the IMF itself.

Second, that these powerful countries have proven unable to control their own instincts to create money excessively. Giving the power of the IMF to weak countries would not be sustainable, and fortunately so, because then the disarray would be worse.

The other possibility is to take the power of creating money discretionally away from the central banks, giving it back to the markets. This solution has been tried before, and was extremely successful until it was abandoned in 1914, at the beginning of World War I.

The crucial feature of the Gold Standard was that it empowered the common people to control the amount of money that central banks could create. They exerted this control in the following way. The national currencies were backed up by a promise to deliver gold to the bearer at the fixed official price.

But gold was also traded in the free market, with prices set by demand and supply. So, there were two prices of gold – that promised by the central bank, and that set by the free markets. The arbitrage between the two was what kept central banks honest in their monetary printing.

If they printed more money than warranted by their gold reserves, overall prices went up, including the free-market price of gold. People could exchange their currency for gold at the fixed central bank price and then sell it in the open market at the higher price.

The result was that the gold reserves of the central bank and the supply of currency went down (local currency was being returned to the central bank in exchange for gold), thus forcing a reduction of the prices that had gone up before.

The Classical Gold Standard had other crucial advantages. It was a modular system, which reproduced at the international level the same features that gave shape to it domestically. Foreigners could exchange their currency for gold as much as the local citizens. This kept the equilibrium between countries, automatically.

For this reason, there was no need to design a complex institutional setting and go through difficult political negotiations to put the system in place. No IMF was needed. Each country could decide independently to adopt the system.

In fact, that was the way the international monetary system of the nineteenth century was created. Britain adopted it unilaterally and was so successful that most other countries copied it.

The Classical Gold Standard imposed a tight discipline, worldwide.

Prices in 1914, the last year the system worked all over the world, prices were about the same as they had been forty years before, even if in that period the world went through a radical transformation that paralleled the one taking place today – the second stage of the Industrial Revolution and a trade and financial globalisation that was as deep as today’s.

There are two main objections to the Gold Standard. First, the Great Depression is blamed on the rigid limits that it imposed on monetary creation. In fact, the monetary collapses have all been created by excessive monetary expansions that violated the strict rules of the Classical Gold Standard.

The 1920 bubbles that led to the Great Depression were caused by excessive monetary creation permitted by the Gold Exchange Standard, a watered down version of the Classical Gold Standard that allowed central banks to create money independently of their gold reserves. The Bretton Woods system broke down because the Fed created too much money in violation of the system’s rules and ran out of gold.

A second argument in favour of discretional monetary creation is the need to create liquidity to overcome financial crises. Yet, central banks operating under the Classical Gold Standard also issued currency to overcome panics, following the rules of Walter Bagehot, which still guide central banks’ liquidity interventions: in times of liquidity panics, create as much currency as needed to extend credit to the endangered banks, but do it at a high interest rate and only based on solid collateral (Walter Bagehot, Lombard Street: A Description of the Money Market. Philadelphia: Orion Editions, 1991 [1873], pp 96-97).

Quite recently, Sir Mervin King, the current governor of the Bank of England, declared as much:

“It is very clear, from the origin, that lending of last resort by a central bank is intended to be lending to individual banking institutions, and to institutions which are clearly regarded as solvent. And it’s done against good collateral and at a penalty rate.” Gavyn Davies, 20 November, 2011, Financial Times, http://blogs.ft.com/gavyndavies/2011/11/20/when-should-the-ecb-buy-sovereign-debt/#ixzz1eI89B1Bi. This is the doctrine applied by the Bundesbank as well. It comes from the Gold Standard. Dealing with liquidity crises is not an invention of fiat money.

The most daunting obstacle for the reinstatement of the Classical Gold Standard could be the fact that, being automatic, would turn redundant enormous numbers of people. If only this obstacle could be overcome, we could have a truly modern and stable monetary system, conducive to growth.

There is no need to create a worldwide system from the very beginning. It would be enough if the United States adopted it. Then the others would follow.