Friday, February 3, 2012

Gold Standard?

I already wrote about what I think about gold here and here and that's actually more than I want to say about it, but since there is more talk again about going back to the gold standard, I thought I'd make a couple of quick comments.

I actually don't care too much about this topic as I think a gold standard will never happen.  I think once people really think this through, they will realize that it is impossible to implement, and even if they did they will quickly realize that it won't work.

This "let's go back to the gold standard" argument is basically just a big protest against congress and the 'unelected' power of the Fed (and other central banks around the world). (As an aside, I find it interesting when congressmen criticize the unelectedness and unaccountability of the Fed as if we would be better off if congress controlled the printing presses and as if congress holds themselves accountable in any way for anything).

The argument, quite simply, is that congress and the Fed are out of control.  We need to control the process of money creation.  By linking money to gold, this will take away the Fed's power to create phony money (which leads to bubbles) and things will be O.K. 

So, the problem is basically the Fed.  And the answer is, abolish the Fed, tie the dollar to gold.  Simple.

As with so many things, these 'simple' solutions are rarely simple.  Early in the 20th century, I think, people found a way to get rid of white blood cells as they learned that this is the cause of pain.  Well, they got rid of the pain but then the patients died too.  Why?  Because the white blood cells were responsible for fighting infections; this is what caused the pain.  By eliminating the pain, they eliminated the patient (unintended consequence).  This story is just off the top of my head so I'm sure I got things wrong, but you get the point.

So let's look at some key points about the gold standard argument:

Inflation and out of control debt growth happened because we went off the gold standard
I find this argument to be backwards.  People point to 1972 and then the explosion in inflation after that and point to the delinking of gold from the dollar as the cause of this inflation.   My view (but I'm no economist) is that the U.S. had underlying inflation and debt growth that made the gold standard unsustainable.  This is why the U.S. had to get off the gold standard (or run out of gold, or plunge into a depression etc...).

The situation got to a point where it became unsustainable.  So for the first argument against going back to the gold standard, one answer is that we can try for a while but it won't last as it didn't last before.

You can control price or quantity but not both
A gold standard is quite simply a price control and as a free marketer, I tend to think price controls don't work.  Whether it's Nixon's WIN (whip inflation now) or currency fixing or Russian-style price control, it won't work.

If you control price, then you can't control quantity and vice versa. 

If we go back to a gold standard, then we will have no mechanism to smooth out economic fluctuations.  Many will argue that with a gold standard, we won't have the booms and busts that we've had in the past 30 years.

Wrong.

One of the biggest bubbles and bursts, even to date, is the 1929-1932 bubble and depression and as far as I recall, we were on a gold standard.  There were no derivatives.  There were no hedge funds.  There were no CDO's and CDO-squareds.  The booms and busts pre-Fed in the 1800s are far harsher than what we've seen in the 20th century since the Fed was created.  Depressions were deeper and lasted longer.

I don't know how the mechanics of a gold standard would work, but it may lead to a ban on owning gold.  This, again, I am hugely against.  I don't even like gold, but I dislike even more government control over asset ownership.  Restrict guns?  Yes, I can dig that.  But gold?  Nope.  That makes no sense.

If the economy takes a dip and the Fed can't create money, then we may very well enter a deep recession or depression.  That would create calls for devaluation of the dollar or the abandonment of the gold standard.  At that point, like in 1972, you will create huge disruption as the system that was built on it is shaken to the ground.

This is similar to what is going on in Europe right now; many economists say that Greece would not be in such a bind if they weren't tied to the Euro.  As a Euro member, they have no control over the value of their currency.  Now a debt restructuring is the only way for Greece to get out of it's bind.  So instead of a 50% depreciation in the currency over time (which is totally manageable as we have seen in the U.S. many times), they will have to cut government bond principle by 50%, basically overnight.  Many holders of these bonds were European banks that had zero capital set aside against them as they were presumably risk-free sovereigns.  And this is creating a bank crisis in Europe. So much for price fixing.

What if Greece was not linked to the Euro?  Banks would probably have had foreign exchange hedges against their Greek bond holdings so whatever problems they have wouldn't have been a 'shock' to the system.

This is the reason why Greece is in so much more of a bind than Japan, even though Japan has more debt; Japan can print their own currency, Greece can't.

Now if we go to the gold standard, things will look fine for a while, just like Greece looked fine for a while.  And just like Argentina looked fine for a while when they tied their currency to the U.S. dollar, and just like Asian countries looked fine for a while when they too had their currencies tied to the U.S. dollar (until the 1997 Asian crisis).

These 'fixed' prices are very misleading.  It makes things look good in the short run, but imbalances increase over time until it becomes unsustainable and blows up.  Just like gold prices/U.S. dollar in 1972, Asian currencies in 1997, Europe now etc...

All of these crisis events were preceded by a long period of 'calm' and stable prices/currencies.

If the price control is not working in Europe now (Greece etc...), I don't understand why people will think it will work here in the U.S.

Do we even have enough gold?
Again, I don't know what the mechanics would be of a new gold standard, but the dollar will have to be backed and convertible into gold to some extent for the link to be 'true'. 

So the question is, how much gold does the U.S. even own?   A quick look on the internet shows that we own around 8,134 tons of gold or 262 million ounces.  That sounds about right.  At $1,700/ounce, the U.S. owns $445 billion of gold.

How much debt does the U.S. government have outstanding?  $15 trillion.  Of that, foreign governments own $4.5 trillion.  China owns $1.2 trillion.

So what if China balks at the U.S. dollar, sells the treasuries for dollars and demands gold in exchange?  We don't have enough gold in this country to ship to China.

(By the way, people seem to think that a gold standard will also stabilize the balance of payments around the world.  But again, I think history disproves this.  I think what happens is that when someone starts to run out of gold, they start a war and steal gold from another country, or they just go off the gold standard (as has happened repeatedly in the past))

What would happen to the U.S. dollar if we went on the gold standard?
The other thing that I don't think gold standard fans really think about is what would happen to the U.S. dollar if we went on the gold standard.  Imagine if the dollar was backed by gold back in 2000.  When the dollar rises even 10% against other currencies, people complain about the U.S. becoming uncompetitive globally.

What will happen if the U.S. went on a gold standard?  Would the dollar not appreciate at an incredible rate? 

There is a case study, and that is Switzerland.  I think they were the last to go off the gold standard and that was because their currency became too strong, threatening their domestic industry (which depended on exports).

What would happen to what little U.S. manufacturing we have left?  Would exporters be happy with such a situation?

So then we have to all go on the the gold standard together around the world.  We have a case study in that too: Bretton Woods.  How did that work out?  The Japanese yen was fixed at 360 yen/dollar for decades until the Bretton Woods fixed exchange rate system collapsed.

Again, some claim the world went nuts because we abandoned Bretton Woods.  But my view is that we didn't abandon it because we wanted the world to go nuts, but we abandoned it because it became unsustainable.  Massive changes in economies around the world made these 'fixed' rates totally unrealistic and unreflective of reality.  (This kind of reminds me of China now; they are still fixed to the U.S. dollar, but many suspect that changes in the Chinese economy over the years make this current fixed rate completely unreflective of reality. Which leads to the question, who should then set and reset exchange rates over the years to adjust for these changes in economies?  A currency board?  The IMF?  Not.  I would advocate letting the markets decide, in real time, 24-hours a day.  And same with gold prices).

This is what would happen too, again, if the world went on a global gold standard.

You can point back to the Euro as exhibit A in this example too.  Fixing exchange rates, taking away the ability for some to control the quantity of money etc... won't work.  It just creates other imbalances that sooner or later makes the 'fix' unsustainable and it blows up with a louder sound than if you allow market forces to send signals so that people can react to problems over time, instead of overnight.

So,
  • Gold standard won't work because it's a price control.  Price controls don't work.
  • Gold standard may require limitations on individual ownership of gold; I am against this sort of government control over harmless assets
  • We didn't go off the gold standard to mess up the world, we went off the gold standard because it was unsustainable (due to our irresponsible behavior, which proves that a gold standard will not prevent that)
  • If we went back to the gold standard, it will be unsustainable just like all other price fixes proved to be unsustainable in history (Bretton Woods, gold standard, Euro, Asian currency link to U.S. dollar, Argentina currency link to U.S. dollar and currency board)
  • If we behaved, the gold standard might work.  But if we behaved, we don't need a gold standard.  If we have a gold standard and misbehave, we will just have another 1972 at some point in the future.

Anyway, I am not an economist or commodity/gold specialist. These are just my thoughts on the subject. And yes, I know there are many, many people way smarter than me calling for a gold standard so many will disagree with the above.  But again, these are just my thoughts and observations on the subject.




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