A New Gold Standard?

This occurred to me last year, but I didn’t write anything about it because it’s the sort of thing about which I don’t know enough to have an intelligent opinion.  The question is this:  If people around the world buy and sell gold and quote its price in paper currency, how different is this from a de facto gold standard?  Now along comes Dr. Marc Faber and says,

“I think we already have now a gold standard . . . created by the market place.”

CNBC’s report on this pronouncement is a little thin, and Faber doesn’t really elaborate in the video clip they provide.  But I think the general idea is that, despite the fact that governments have stopped making their currencies redeemable in gold by law, the currencies are in fact still redeemable in gold — not by governments, but in the commodities markets and through secondary channels for buying and selling gold.  If you are holding currency that you believe is overvalued, you can use it to buy gold.  You give up the paper and get the gold, just like you could do at your bank until 1933.  Is it fair to call this a de facto gold standard?

Admittedly, the notion that one is “redeeming currency” whenever one buys gold is a little strained, unless one is also willing to say that one “redeems currency” by buying oil, wheat, or diamonds.  No one thinks we have a de facto diamond standard.  But oil, wheat, and diamonds all fail to satisfy one or more of the essential properties of sound money in historical usage.  In particular, all three are too elastic in supply.  Oil, wheat, and most other commodities are famously difficult to store, let alone carry around.  Diamonds are great on portability, but they are not easily divisible into uniform units of weight or value.  Nor are diamonds (or other gems) fungible, and the differences that affect their value are generally apparent only to specialists, making them unsuitable as units of exchange.  By contrast, people have used gold (and silver) as money since time immemorial, and it seems to me accurate to say that many people are doing so once again.

Does it matter that this is occurring without government initiative?  I don’t think so.  After all, the original evolution of money was an organic development in which the people transacting business led and governments followed.  (David Boaz argues, quoting Hayek, that four of the greatest social institutions in the history of human civilization — language, law, money, and markets — all share this trait of organic and decentralized development.  Boaz’s book is great, by the way, but I digress.)

There are some important differences this time, to be sure.  For one thing, the price of gold now fluctuates freely, whereas in the old days the currency was pegged to gold at a specific price.  And more importantly, the fact that currency is now “redeemed” by a private gold dealer in a private market, rather than from a government treasury, short-circuits the most important feature of the old gold standard, namely the way it disciplined wayward governments.  When countries spent more than they took in, they lost gold.  When they started stupid wars, they lost gold.  Under a de facto gold standard, the value of the currency may fall without much effect on the government itself.  If the government (or its central bank) can print more money, it can go a long time without losing purchasing power, even as the value of its currency steadily drifts downward.  And if the government happens to be deeply in debt, the government actually benefits as the purchasing power of the currency falls, because it gets to pay back its debts in notes that are worth less than the notes it originally borrowed.  People will eventually refuse to buy any financial instruments denominated in such a nation’s currency, which will lead to economic collapse; but the strategy works until it doesn’t.

It may be illuminating to compare the present-day world monetary system to the “free banking” system that prevailed in a number of places before the rise of central banks.  Under free banking, as I understand it, there is no central bank monopoly on the printing of currency — any bank can do it.  But each bank can only print currency that is redeemable at that bank.  If a bank prints too much currency relative to its actual reserves, then the value of the notes becomes suspect, and no one wants to hold that bank’s notes.  People who receive them in trade try to redeem them as fast as possible so as not to get stuck with them if the bank should collapse.  If the shaky bank keeps printing, depositors may move their accounts to banks they believe are sounder.  Eventually, if the shaky bank keeps printing, merchants may even refuse to accept its notes, and at that point the collapse of the bank is foreseeable if not inevitable because it’s notes are no longer considered money.  So far, the analogy to today’s international monetary system seems pretty close.

But in free banking, net losses of gold from the bank’s reserves serve as the early warning sign that all is not well.  The bank knows, long before the collapse occurs, that its ways of doing business are not sustainable.   At that point, the bank must change its policies, or face collapse.  That’s why governments don’t like any true gold standard (i.e., one that involves a right of redemption); it limits their flexibility to be totally irresponsible.  Unsustainable policies — say, far-flung military outposts, aggressively interventionist foreign policy, massively inefficient bureaucracies, and the accumulation of unfunded future liabilities for ever-more-generous entitlement programs — all those unsustainable policies can go on longer without a right of redemption than would otherwise be possible.  It will work until it doesn’t.

How much longer can it work?  I wish I knew.


3 Responses to “A New Gold Standard?”

  1. George Peacock Says:

    Thanks for the post and for the link to Boaz’s book. I usually read with my mind with the repeating thoughts of “but, what about…” and “so what?” It helps me get a better handle on things. Throughout your post I thought “own some gold.”

    On another note, when I was at Friedman Billings & Ramsey (FBR). the firm took many prime and subprime issuers public. FBR itself was a big player in the Mortgage-Backed Securities (MBS) business, as well. They traded them and owned them and levered them. I remember asking one of the shrewd fixed income guys there about it.

    He said that it was a great business and a safe business. After all, he reminded me, real estate always goes up.

    After pausing and smiling, he said “Real estate always goes up. Until it doesn’t. And once it stops, this will be a disaster. And real estate doesn’t even have to go down. It just has to stop going up.”

    I think our real estate lesson and recent global economic “Minsky moment” [Hey, is there a way for a commenter to add a hyperlink? Until I know: http://en.wikipedia.org/wiki/Minsky_moment%5D is but a prelude to the currency Minsky moment(s) to come. Because there is no early warning system like the depletion of gold in the vault, we are able to stretch the rubber band further and further and further, making the snap back that much more powerful and destructive.

    I suspect this will continue to go on longer than we currently imagine. As Kaynes said, “The market can remain wrong, longer than you can remain solvent.” But, first, there is no guarantee it will do so and, second, when it happens, those who were prepared will benefit greatly and those who were either unaware or unprepared will be very sad.

  2. Ken Metcalfe Says:

    To me, what folks like Faber (and Jim Rogers, among others) are acknowledging here is simply that gold is, as it has been for 10,000 years, money (as we’ve discussed here before).

    While people have been long-used to fiat currency, human nature and common sense say that the faith placed in it is fleeting. And when that faith is undermined, as it’s been for many hundreds of fiat currencies in our history, something that fits the criteria of more “real” money will take its place. Man has long found that something to be gold and silver (though many other types tangible assets have been used for brief periods of time in various locales).

    And thanks to people like James Blanchard and Ron Paul, what for 40-odd years was illegal for Americans to possess, became legal again in the 70’s.

    One key aspect to a currency, though, is that LOTS of people have and use it/take it in exchange for goods and services. While there are lots of entities that will, even today, work with such exchanges (and de facto “clearinghouses” like Goldmoney.com that will effect them), what REALLY stops gold today from being a monetary standard is that so few people own it. But when (not if) the fiat currencies of today ultimately do devalue in earnest (and sink to their intrinsic value–that of paper), history has shown that those currencies will not be able to buy sufficient gold at any price. So anyone that one cares about should be convinced to keep at least some of their assets in what has been one of mankind’s ultimate assets for millenia.

    When the time comes, those that have taken such precautions now will help to set the new standard… (And, of course, if I’m wrong, you can always trade your gold back in for paper… :-)


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