Coming to the Defense of the Gold Standard...Again

Heather Long, an excellent financial columnist at CNN Money, recently posted an article Why Ted Cruz's Gold Standard Push Is A Bad Idea that unfortunately continues a string of misinformed commentary about the purpose and efficacy of a gold standard system.

For example, see recent articles by Binyamin Applebaum in the New York Times, Greg Ip in The Wall Street Journal blog Real Time Economics, Megan McArdle at BloombergView, and Alan Pyke at the website ThinkProgress.org.

What is so frustrating about these articles is that the authors apparently did not seek input from the many prominent advocates actively promoting a return to gold-based money.

Let's take a closer look at Long's article:

"It's a plan that is getting the 'you've got to be kidding me' reaction from the business community. 'I don't think that's going to happen. I just don't believe that would be possible,' says Peter Cardillo, chief market economist at Standard Financial."

This reaction occurs simply because most people don't know, or have never learned, what the purpose of a gold standard system is, why the U.S. officially abandoned gold-based money in 1971, and cling to the easily disproved myth that the gold standard was responsible for the Great Depression. Ignorance is no excuse. There is simply to much good educational material out there. Start with a free resource from the excellent Nathan Lewis, Gold: The Monetary Polaris. Lewis also addressed the issue of the feasibility of a return to the gold standard in The U.S. Embraced A Gold Standard For 182 Years, So Why Is It 'Impossible' Today?

"Most economists now agree 90% of the reason why the U.S. got out of the Great Depression was the break with gold, says Liaquat Ahamed, author of the 'Lords of Finance'."

The fact that the academic economics community almost universally believes this point tells you a lot about the state of the profession these days. Academic economists, particularly those toiling away at elite colleges and universities, are overwhelming from the Keynesian School. Little wonder that a poll taken from such a community would be highly biased against the gold standard. Keynesians believe that government bureaucrats, namely economists with Ph.D's from elite universities, are required to "manage" the economy via the manipulation of currencies and interest rates. A gold standard system takes that power away from them. Under a gold standard system, no one would know who the Federal Reserve Chairman was, nor would anyone really care.

There are a number of excellent commentaries dispelling the notion that the gold standard contributed to the Great Depression, most recently by John Tamny, The Fed and the Great Depression: A Myth That Just Won't Die but also by Nathan Lewis, Did the Gold Standard Cause the Great Depression? and Richard Salsman, Did the Gold Standard Cause the Great Depression?, a review of Barry Eichengreen's book Golden Fetters: The Gold Standard and the Great Depression, 1919-1939 published by the American Institute for Economic Research.

"But there's a major downside to the gold standard that caused President Franklin Roosevelt to get rid of it in 1933: It's akin to wearing an economic straitjacket".

Proposterous. The sole purpose of a gold standard system is to provide a currency with a stable value. A stable currency facilitiates investment and exchange (i.e. trade). A fiat currency system, such as the one the world lives under today, hinders investment and exchange like grains of sand in a moving gear. With a constantly fluctuating currency, investment decisions are impacted by the need to consider future changes in currency values. Will the investor receive dollars in the future worth the same as those committed today? This is a big reason why the derivatives market has grown so huge. Businesses and individuals must protect themselves from constantly fluctuating currency rates (as well as widely gyrating interest rates and commodities as a consequence of floating currencies). Capital that could be better utilized on wealth-creating investments must instead be used to hedge the risks brought on by unstable money.

Ask yourself this question: How did the U.S. become the world's economic superpower in less than 200 years while on the gold standard if such a system acted as an "economic straitjacket"?

"'I don't think the average Joe understands the economic impact. During the gold standard, there was high unemployment,' says John LaForge, co-head of real assets at Wells Fargo."

The first sentence is rather condescending; I believe that "the average Joe" indeed knows something is terribly wrong with the current monetary regime and this helps explain the call by presidential candidates Ted Cruz, Rand Paul and others for a reconsideration of using gold to back the dollar.

As for the claim of high unemployment, when exactly? During the entire period when the U.S. was on the gold standard? And precisely why would a currency with a stable value promote unemployment? It actually does the exact opposite. Since a stable currency promotes investment, it also promotes job and wage growth. It appears that Mr. LaForge threw that line out there without thinking it through.

"...The main reason is there just isn't enough gold out there to power major economies."

This is probably the second-biggest myth used to dismiss the gold standard after the Great Depression claim. The effectiveness of a gold standard system does not rely on the physical quantity of gold sitting in vaults somewhere or yet to be mined from the ground. Period. The value of the currency, not its quantity, is linked to gold. As Nathan Lewis wrote recently in Greg Ip Gets It Wrong: What a Gold Standard Really Was, And Could Be,

"From 1775 to 1900, the U.S. money supply (technically known as 'base money') increased by 163 times, from $12 million to $1,954 million. During this time, the total aboveground gold supply increased by about 3.4x due to mining production.  163 is not the same as 3.4" 

In fact, a well-functioning gold standard system would actually require very little gold to be held in reserve. If the public expects the currency value to remain stable into the future, there would be little demand to actually hold physical gold. Paper bills are a lot more convenient to carry/transact with than gold coins or bullion. 

'Beyond hamstringing the U.S. from responding to crises, the gold standard also relies on a commodity that is known for wild price swings."

It is common for gold standard critics (or those who simply are ignorant of how a gold standard system works) to claim that the price of gold is simply too volatile to serve as an effective value peg. Gold hasn't been used in monetary systems throughout human history because it is a shiny metal and looks pretty. The reason for its use is due to its unique characteristics. Essentially all of the gold ever mined is still in existence today. Annual mining production represents only a tiny amount of the total stock globally. It also has few industrial uses. The only real demand is for jewelry (and perhaps dentistry). In other words, gold displays favorable stock/flow characteristics. Therefore, changes in supply and demand have minimal impact on its value.

There's nothing magical about gold. Gold standard advocates would embrace alternatives if the characteristics of any such alternative were superior to gold. Alas, none have ever been identified that work as well as gold.

As for the price volatility of gold, what critics fail to understand is that it is not the value of gold that is changing in price, it is actually the currency that is fluctuating in value. A rising price of gold from a previously stable value indicates inflationary pressures that will eventually be transmitted through the economy, beginning with those goods most sensitive to currency fluctuations such as raw commodities. The opposite effect reflects deflationary pressures.

"If you look at the price of gold, the gold market certainly isn't anticipating [a return to the gold standard]," says economist Cardillo.

It's unclear to me how Cardillo was able to reach that conclusion. If anything, the price of gold falling from ~ $1,300/oz. in early 2015 to ~ $1,075/oz. today is signaling that deflationary pressures are building in the economy due to neglect of the dollar by the U.S. Treasury.

The financial press, echoing their contacts among the academic community, apparently is biased against a return to the gold standard. Recent columns have been anything but fairly balanced with opinion from both sides. Fortunately, there are many great minds out there who understand gold and the importance of gold-backed money, many of which I have cited in this article or are linked elsewhere on this blog.

Still not convinced? Please read this short, but concise column from none other than Steve Forbes, The New York Times' Leaden Analysis of Gold.

Putting the Blame for Low Interest Rates Where It Belongs

William Poole, a former president of the Federal Reserve Bank of St. Louis and now a distinguished scholar at the Cato Institute, penned a short commentary on November 24 for the Wall Street Journal where he makes a number of points worth elaborating on.

Poole correctly points out that the Fed influences the federal-funds rate, but does not control rates across the yield curve. He instead fingers the low-rate environment on non-monetary conditions, specifically the policies of the Obama Administration. As Poole mentions, "long-term rates reflect weak job creation and credit demand." 

Disincentives to business investment, from poor tax policy and onerous regulations to a unstable dollar, have been the principal reasons why the economic environment has been so subpar relative to prior recoveries. The weak economy is the better explanation of why interest rates are so low.

Capital will always migrate to where it is treated best. Little wonder then that investors have not been so enamored with the U.S. in recent years.

Since 2008, there have been numerous significant tax increases, including hikes in the top marginal personal income, capital gains and dividend tax rates, limitations or phase-outs of personal exemptions and itemized deductions for high-income taxpayers, and a new Medicare tax on investment income.

The U.S. corporate tax rate is among the highest in the developed world. While many countries in the OECD have reduced corporate tax rates in recent years, the U.S. has stood pat. The U.S. is also one of only a few countries that utilizes a territorial tax system which taxes income earned outside of the home country. This has resulted in massive amounts of cash held offshore as U.S.-based multinationals are loathe to repatriate the funds and pay the higher rate.

The uncompetitive corporate tax structure is also cited as a major reason that U.S. multinationals are choosing to relocate to foreign domiciles via corporate inversions.

Politicians in Washington D.C. continue to talk a good game about tax reform, but progress on simplifying the tax code by lowering the rate and eliminating deductions has been glacial. The corporate tax would ideally be eliminated, but that is a topic for another day.

To say that the "fourth branch of government", the regulatory state, has expanded in recent years would be an understatement. It has been hyperactive. The EPA, FDA, FCC, and a plethora of other regulatory agencies have been spitting out burdensome regulations on business at a rapid pace. Combined with the impact of major pieces of legislation, signed into law without much of the details written, such as Dodd-Frank and Obamacare, it is fairly easy to see why businesses may take a more cautious view on investment spending. Economist Bob Higgs coined it "regime uncertainty".

I am quite critical of the Fed's hubris and hope to see it dissolved in my lifetime, but I believe that many commentators, pundits, and investors give this institution far too much credit when it comes to "setting" interest rates or "managing" the economy. [Please see John Tamny's recent commentary on the Fed, "The Fed Can't Spot Nor Can It Stop 'Bubbles,' Nor Should It Try."]

Interest rates are the pricing mechanism in the capital markets, equilibrating the supply and demand for credit. Indeed, rates are being "manipulated" but put the blame where it belongs.  The poor fiscal and monetary policies of the Obama Administration with ineffective pushback by the Republican-controlled Congress are the prime culprits. Big Government is a prosperity deterrent. Low interest rates simply reflect this reality.

Gold and Liberty

My friend Richard Salsman, Ph.D, CFA, President and Chief Market Strategist at economic consultancy Intermarket Forecasting Inc., has generously provided a copy (PDF, below) of his excellent monograph Gold and Liberty published in 1995 by the American Institute for Economic Research.

This document is one of the first I read that helped me to understand and appreciate the critical importance of gold in a well-functioning monetary system.

Salsman discusses such topics as the origins of gold as money, the evolution of free banking, the purpose and mechanics of a gold standard system, government subversions of the gold standard, central banking and gold, and what the future may hold.

The monograph also contains a rich bibliography of source material.

Gold and Liberty is a fascinating and highly-educational read. Unfortunately, far too many policymakers, politicians, journalists, and academics are ignorant about gold and its historical record as the backbone of sound money. In just a few hours, this monograph would provide them with the proper respect and appreciation for gold and the futility of the current system of fiat money.

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