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Saturday, August 25, 2012

My View of the Problems of the Gold Standard

The Gold standard, and its several equivalents, remains a testy and emotional topic and everyone seems to have some reason to strongly urge or patently discourage the reinstatement of such a standard. Most of the objections to such a standard relate back to the Depression Era when the gold standard reputedly prevented the Federal Reserve from ‘stimulating’ the economy and exiting the Great Depression, a classic piece of negative evidence.[1] Such a standard has desirable attributes so we need to examine some of the fiscal events that let up to numerous nations exiting and then reinterring the gold standard and how those antics led to fiscal problems such as inflation.

The need for money:

There must be some medium of exchange in commerce and gold or its equivalent has been the choice for some 60 centuries. Gold, thus, is money. Gold has been used as a currency and a currency reserve for centuries. In 550 BCE, gold coins were introduced by king Croesus of Lydia.[2] The attempt here was to standardize the coin weight although the metal was a complex mixture of gold and silver [63% gold and 27% silver]. This worked well as such a standard was necessary to avoid exchange rate squabbles and stalling markets. Earlier, the Egyptians and others used bulk gold as a transfer medium.  The Romans used silver coins initially but an influx of silver from their provinces forced them to switch to gold coins. The Roman system [about 1000 year depending on when you select start and end dates was excellent as there was no credit system and debts were collected by the military and  if the debtor failed to pay up, then the cosigners were assessed so that on Roman government contracts they never lost money. Inflation was low. The historical data seem to suggest that some standard such as gold is needed  and although this is not perfect and other options are worse in the long run.

 Gold as a reserve:

This history of gold as a currency or a currency reserve can be observed in two distinct fiscal outcomes in each century or even each decade in the last 500 years. Either the gold standard worked out rationally well or some event forced that standard to be changed in some manner and paper currency and its creation was always the reason the for instability. Government credit problems and urgent need to finance wars generally led to a provisional suspension of the standard and the rapid and simplistic printing of money. In most of the historical cases a precious metal standard was an asset to commerce until governments created episodes of credit expansion for wars and such.

Problems with keeping reserves constant:

As the Industrial Revolution progressed, trade with China became possible and profitable but the Chinese wanted only silver as payment for their goods. Thus reserves of European silver were almost depleted and this caused major problems with English currency based on silver. The British then smuggled opium into the Chinese ports of trade because that new medium of exchange was readily accepted but caused major social problems. This led to the Opium Wars in the periods 1839–42 and 1856–60 and the forced signing of the Treaty of Tianjin and later the Treaty of Nanking. An historical rendering of the specification in the first treaty translates as:

5. China was to pay an indemnity to Britain and France in 2 million taels of silver respectively, and compensation to British merchants in 2 million taels [1.33 ounces per tael] of silver[3]

That is about 5 million ounces and at today’s price amounts to $140 million dollars not adjusted to 1839 values.[4] Notice that this war effort resulted in the government silver reserves being essentially reinstated because the Western economies were suffering from the outflow of this metal. The Chinese economy was being crushed[5] as their trade balance in 1810 was 350 million Mexican silver dollars and by 1837 opium purchases equaled 57% of all Chinese imports. The British economy was in trouble from losing silver reserves and the Chinese economy was forced to return much of that silver. War accomplished this feat. We can presume [with caution] that if the silver reserves were stable then the effect on British trade would have been minimal in this case.

Effects of War:

An event that typically wrecks any reasonable silver or gold based currency is war and that was the case for the US Revolutionary War. Here government debt was high and silver coins were being exchanged for paper money as the standard specified so President Jefferson suspended the minting of silver coins in 1806. The Independent Treasury Act of 1848  forced the Treasury to deal with only silver or gold and some unsuccessfully and poorly chosen selected exchange rates between the two metals forced gold to exit the US from market forces. Due to the US Civil War the government suspended such metal payments.[6] In summary: Debt and war forced major changes in gold and silver standards. The reserve supply problem is always speculation where there is a market established using the currency and the reserve metals. An imbalance here forces an oversupply or shortage of either of these two items.

Paper currencies:

Greenbacks or demand notes were issued by the US government in 1861 at the start of the Civil War by buying goods and materials for the war and for payment to soldiers. There was no backing for these paper entities but there were options to get silver or gold ‘on demand’ on this paper. A stipulation was that such notes could not be used to pay import duties [tariffs], a process of merely returning the paper back to the government, forced a flurry of demand requests  and that led to a suspension of such redemptions in early 1862. The next month the government was forced to offer 5% interest on notes since gold was starting to vanish after rising about 2% over the paper price.[7] February of that year the United States Note was invented with the works “on demand” on the paper.[8]  Hoarding of commodities and gold prices rose. There were several more frantic manipulations of paper currency to the end of the war. The greenbacks eventually metamorphosed into the United States Note. The problems here were related directly to paper currency printing and an expansion of credit on the part of the US government. The Confederacy experienced the same problems and more as each succeeding state issued their own currency. All their currencies collapsed after they lost the war. Clearly, for reserve stability the market price of the metal and of the currency must be about equal or the reserve will either rise or fall on demand. This means that printing money that tends to debase the currency will always force redemptions of the reserve if one exists. Other options include buying other currencies.

Setting relative exchange rates:

From the time of the US Civil War and other wars, many countries attempted to independently set exchange rates based upon US or British gold standards. This was a period of chaos. There were various pegging schemes, all mostly temporary, and many of these failed. Today some countries like Belize use US dollars and, as such, have to follow the fortunes of that currency.


For the next war [World War I] the need was to fund armies and navies of all belligerents and, not unexpectedly, many nations abandoned their gold standards and started to print money and that forced differential inflation among the participants. This wrecked exchange rates and chaos ensued. The world’s international financial system collapsed in the summer of 1914[9] and the US stock market was forced to close in September of that year for about 6 months. Credit was essentially nonexistent for a while. Later, attempts by various nations to regenerate the gold standard resulted in mixed prices for various assets and commodities and chaos reigned again. Alternatives were needed: A bond sale was organized along the political scheme of the War Chest and Liberty Bonds were offered for sale with window notes that contributors could openly display to show they were loyal. The media published threats in the form of cartoons that queried:

Will you invest your money with Uncle Sam Now? Or, Let Germany take it away from you later?

Woodrow Wilson chimed in on the scheme by issuing a letter   Sept 30, 1918 that read, in part:

The money that is held back now will be of little use or value if this war is not won and the selfish masters of Germany are permitted to dictate what Americans may and may not do. [10]
This is a process called cleptocracy and is tightly entwined with emotion and demagoguery where governments steal the wealth of their citizens with propaganda or fright campaigns. It is a long stretch to suggest that the US had any business in either of Europe’s wars. The two World Wars saw 81 million dead bodies scattered across Europe and parts of Asia not counting Russia. Their losses were much higher.

These bond drives by all belligerents continued but the fear that gold reserves would be depleted by demand forced the British Government to pass the 1914 Currency and Bank Notes Act[11] with a convenient three day bank holiday so Britain left the gold standard and issued paper banknotes.[12] In that war period from 1914 to 1919, the Allies borrowed $10.35 billion dollars from the US Treasury. And, as noted above the US government borrowed from its own citizens. Foreign debtors were granted a three year relief period on interest payments.  The US government tried to obtain principal replacement in a period of 25 years. Much of this was paid off in inflated dollars. There is a theory advanced by Pierre Renouvin in his book, mentioned above, that the British pleaded with the Americans to loan them money at the expense of the Germans because the Brits owed them much more money and if the lost the war the US would experience defaults on those loans. As such loans and currency debasements can be used as weapons of war.

The [not so] Great Depression:

By 1931 the US’s former WW1 allies were off the gold standard. The latent debt loads for all participants in the Great War were too high to handle. Austria’s biggest bank failed. The uncertainties in post-war Europe forced runs on the Bank of England depleting much of their reserves. [13] The Depression in 1932 occurred because of a debt-driven deflationary spiral initiated by falling equity prices.

Gold became a major player in the depression game as the US Federal Reserve was mandated to back their paper with a 40% gold backing. This feature allows the left to criticize the government’s gold reserve program as they were not permitted to just print more money as most governments tend to do in a panic over debt or during some economic crisis such as a depression or in time of war. This forced the money supply M2 to a maximum level in March 1937 and a minimum in May 1938.[14] 

The inability to print money was thus offered as a defect in the gold reserve system by many economists. The trouble with this view is that printing money or works programs by Hoover for 3 years and FDR for another 3 or so failed. So far, there is little known value, other than political, when governments print money for infrastructure and other projects as we see in the US, UK and most of the EU. There are no direct and verifiable cases where Keynesianism has allowed bankrupt nations to print their way out of debt. There are numerous cases where printing money only made this worse as in Hungary in 1948 and Germany in the 1920s and Argentina more recently.
This notion that there must be freedom to print money has some merit if, and only if, such printing might solve some problems in the economy and not just raise the debt as is happening in the US and Europe today. The Austrian School maintains that depressions are the result of too much cheap credit and that seems to apply to most places where depressions occurred as one did in the US in 2006 with falling house prices due to a glut of housing and from the CRA[15] [Community Reinvestment Act] that forced lenders to offer mortgages to people who could not afford to service the loans. All this was pushed into debt with Fannie Mae now holding some 80% of all US mortgages and probably in debt in the $3-5 trillion dollar range. We are still suffering the effects of the housing bubble and deflation and depression from 2006.

John Maynard Keynes was against the gold reserve but also cautioned governments from printing too much money. He suggested that the power to print money should reside only at the Bank of England, a private company. [16] Cleptocracy is thus facilitated by this mechanism as explained by Keynes:

"By a continuous process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some".

Warren Buffet also echoes this same theme decades later:[17]

The United States economy is now out of the emergency room and appears to be on a slow path to recovery. But enormous dosages of monetary medicine continue to be administered and, before long, we will need to deal with their side effects. For now, most of those effects are invisible and could indeed remain latent for a long time. Still, their threat may be as ominous as that posed by the financial crisis itself.”[18]-- Greenback Effect By Warren E. Buffett

Every country that has denominated its debt in its own currency and has found itself with uncomfortable amounts of debt relative to the rest of the world, in the end they inflate,”-- Greenback Effect

Options to the Gold Standard:

The Bretton Woods agreement of 1944[19] was originally conjured up by frantic bankers. In this system, gold was fixed at $35 per Troy ounce and US dollars could be redeemed in gold. 44 Allied nations could participate if they tied their currencies to the US dollar. Countries like France thus exchanged dollars for gold [as expected] and gold reserves in the US shrank. President Nixon nixed this agreement unilaterally in 1971.  The price of gold quickly soared to $ 65 and then to $160 in the next year or so. The backing of the US dollar is now based on nothing.

The lack of any standard forced the creation of a currency market known as FOREX. This is a market where there is no intrinsic value to any currency only a relative value compared to other single currencies or based on a bag of such currencies as in the Dollar Index. So, the whole thing floats and currencies sink and fall. Some nations refuse to trade in FOREX such as China who has certain mechanisms that long allowed them to peg their currency artificially low against the dollar. The proof for such a mechanism becomes obvious when a plot of the exchange rates of the Dollar and Renminbi fall on a straight line for years.

Debt and government spending:

Since the gold standard is effectively gone with the exception that the gold market is driven by inflation of the dollar, the problem of deficits and debt are now the hot topics of the current presidential race in the US. The gold standard is effectively in place at this time because there is a huge market in currency and gold speculation and gold rises, as it should, when any currency starts to inflate.

The US GDP is sick and government spending is too high but many argue for more taxation.[20] Social unrest among the leftist radicals and other activists call for Wall Street to be ‘occupied’ and assets from that quarter stripped and distributed to the masses.[21]  The stale Rousseauian concept of the ‘social contract’ is constantly used as a pretext for more spending or taxation or both. [22]
Governments are too large in the US and EU.  The efficiency[23] of government runs by the inverse ratio of G/GDP where G is government spending and GDP = C +I+G where C is consumption and I is investment. Any time G/GDP exceeds 0.15 the government is too big and spending too much because G also includes deficits and is debt. Number essays lead to impossible scenarios like this prattle:

Meanwhile, the CBO estimates potential real GDP in 2021 at about $18 trillion in 2005 dollars, or around $19 trillion in 2011 dollars.[24]—Paul Krugman

Put these together, and they say that an extra trillion in borrowing adds something like a   mere pittance of 0.07% of GDP in future debt service costs. Yes, that zero belongs there. The $4 trillion S&P said it needed to see clocks in at less than 0.3% of GDP.”[25]-- The Arithmetic of Near-term Deficits[26]

My Conclusion:

Although the notion that currencies must be based on something like gold is problematical at best it must be noted that one desirable effect is limiting government’s ability to print money. Every country that went off the gold standard inflated their currencies and cheated their citizens out of their savings.
 Since going off the gold standard the currencies in the West have inflated greatly and since the 1990s governments have printed money with abandon and the debts are now unbearable. Following Buffett those governments will attempt to inflate thus robbing, again, their citizens of their wealth. This process is fashionably denoted as ‘ quantitative easing’ or QE. The purpose is to debase the currency to minimize the debt service problem.

This debasement effort at first appears to be sound for leftist governments to employ but the bond markets then force interest rates up to cover risk and profits and use derivatives to insure their investment. National debt service then rises and this is usually put into deficits or more borrowing to cover the expense. All this time the price of gold soars. What this means is that a de facto gold standard is in effect and is market based. Thus, the attempt to evade a rigid standard is futile and those who hold gold in ETFs or in coin will see their holdings rise faster than the inflation rate.
All the problems above seem to be based on governments that print too much money or encourage too much credit and that printing or borrowing causes all sorts of fiscal problems and wars. It is clear that the science of government and the conduct of its members is in its crudest state at this time and is not likely to improve unless another crisis appears like a depression, war or inflation. The quest for some gold standard  or some equivalent is thus misplaced and we should be looking at ways to curtain government growth and spending and maintaining a fixed money supply that grows no faster than the real growth and to use other measures to initiate growth in the private sector.


[1] That didn’t happen so we don’t know if it would have worked. Current stimulus is not working.

[4] Using an inflation calculator: What cost $28 in 1838 would cost $565.98 in 2010. The current 140 million would have been almost $7 million in 1838. This tempts us to make the crude assumption that the inflation multiplier back to 1838 is about 20 setting the silver value at about $2.8 billion dollars. There are several assumptions inherent in this calculation.

[5] “Equally disturbing for the imperial government was the imbalance of trade with the West: whereas prior to 1810 Western nations had been spending 350 million Mexican silver dollars on porcelain, cotton, silks, brocades, and various grades of tea, by 1837 opium represented 57 per cent of Chinese imports, and for fiscal 1835-36 alone China exported 4.5 million silver dollars.

[7] People are willing to speculate on a 2% margin.

[9] A careful reading of the 1957 book: War and Aftermath 1914-1929 by Pierre Renouvin enlightens us on the curious but celebrated practice of ‘diplomacy,’ it’s manifold failures, questionable utility, and the unavoidable events that led to World War 1, the forceful and fatal structuring  of World War 2 and the many more wars of the 1920s. War and Aftermath 1914-1929  by Pierre Renouvin Harper & Row, 1968. Hardcover. First edition.

[18] The Greenback Effect By Warren E. Buffett Op-Ed Contributor Published: August 18, 2009

[21] Krugman of the NYT is Immune to the Facts about Occupy Wall Street Protesters

[22] Tax Mongering at its Pinnacle: Krugman invokes the Social Contract

[23] Inefficiency in California, Greece and Other Places and the Socialist Disease of Parasitism: They will NOT stop spending and WILL default.

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