GOLD STANDARDS: TRUE AND FALSE

Mises University 2014Joseph T. Salerno

Spectrum of International Monetary Systems

BEST WORST

Market-Supplied Commodity Money Government-Monopolized Fiat Money

100 PercentGold

Standard

ClassicalGold

Standard1821–1914

FluctuatingExchange

Rates

Fixed Exchange Rates

Freely floating1981–84

Dirtyfloating1930s

1973–801988–present

Central bank

cooperation1971–731985–87

False gold standards1925–311946–71(Bretton Woods System)

Fiat reserves created by World Central

Bank

The Classical Gold Standard

• Main Characteristics:1. Monetary unit is legally defined as a weight of

gold. Gold and nothing else is money.2. Bank notes and deposits are instantaneously

redeemable for gold at par value.3. Gold coin is in circulation along with bank notes

and deposits (i.e., “money substitutes”).4. Central bank may or may not exist.

Monetary Unit• Under GS, the currency name is simply a weight unit

of gold. Examples:– U.S. $: 1834-1933 legally defined as $1:00 ≈ 1/20 oz. gold

(23.22 grains of gold)– British £: 1821-1931 legally defined as £1.00 ≈ ¼ oz. gold

(113 grains of gold); French franc ₣1.00 ≈ 1/100 oz. gold, etc.

Exchange Rates and the Gold Standard

• GS is not a fixed exchange-rate system, because all nations use the same currency, gold.

• So $/£ “exchange rate” (e/r) for 100 years = $4:86/£ ( = 113 grains gold ÷ 23.22 grains gold)

• This is simply a law of arithmetical equality, e.g., U.S. nickel = $.05; U.S. quarter = $.25; so e/r = 5 nickels/quarter because $.25 ÷ $.05 = 5

$20 and $5 (1921, 1906)

British Sovereigns, 1894 and 1931

Paper Currency under the Gold Standard

• Bank notes and government-issued notes under the gold standard were not money proper, but money substitutes, which substituted in exchange for and were claims to money (gold).

Money Substitute:Claim for $20 (1903)

Money Substitute:Claim for $5 (1908)

Classical Gold Standard: Principles of Operation

1. Did not involve fixed e/r or price fixing of gold. In redeeming $20 for 1 gold oz. the central bank or gov’t is not selling gold. It is fulfilling its contract to redeem a property title to money.

2. In the long run, MS is strictly limited by gold mining. Bank notes and deposits can only increase as new gold flows into banks. (“Golden Handcuffs”)

3. Result: prices tend to fall over time as saving and investment and improvement in technology increased the supplies of goods and services more rapidly than the ↑MS.

Growth Deflation under the Gold Standard• Gentle price deflation is natural outcome of the gold

standard. In U.S., 1880-1896: %↓P = 30% or 1.75%/yr while %↑real GDP = 85% or 5%/yr.

Price-Specie-Flow Mechanism

• The balance of payments (BOP) adjustment process or “price-specie-flow mechanism”:1. Maintained equilibrium in BOP.2. Distributed gold throughout the GS area according to

the relative demands for money.3. It also operates interregionally, e.g. between States

in the U.S.4. Limited ↑MS and inflation by CB and banking

system.

Price-Specie-Flow Mechanism

↑ MSUS → ↑ PUS > PW → ↓ XUS, ↑MUS → BOP < 0

(deficit) → ↓GOLDUS → ↓ MSUS → ↓ PUS < PW →

↑ XUS, ↓MUS → BOP > 0 (surplus) ↑ GOLDUS . . . .

• Under classical GS, banks could temporarily ↑ MS and cause an inflationary boom and subsequent recession but these were minor fluctuations compared to post-1914 business cycles.

Money Pyramid under Classical GS

Destruction of the Classical GS: 1914-33

• In the U.S. the classical GS existed from 1834 to 1933—sort of.

• During WWI gold reserves were centralized in the Fed, a heavy tax was placed on private issue of bank notes and the export of gold was prohibited in 1917.

• The Fed cut reserve requirements in half, from 21.1% to 9.8%, doubling the MS 1913-1919.

Destruction of the Classical GS: 1914-33

• Fed expanded bank reserves during 1920s to help Great Britain go back to gold at old parity of $4.86/£

• Great Depression and run on banks in U.S. spelled the end of gold standard on May 1, 1933 by Executive Order of FDR.

• Ownership of gold prohibited and gold devalued from $20/oz to $35/oz

FDR’s Executive Order

Bretton Woods System: 1946-71

• BW system was a false gold standard.• It as an attempt to bring order to the chaotic national

fiat-money systems an currency wars of the 1930s by camouflaging it as a GS.

• The main architects of the BW system were the U.S. and British gov’ts and their leading financial experts, Harry Dexter White (U.S.) and John Maynard Keynes (G.B.).

Bretton Woods

John Maynard Keynes Harry Dexter White

Harry Dexter White: Soviet Spy

• In August 1948, White testified and defended his record to the House Un-American Activities Committee. Historians agree he passed secret state information to the Soviet Union during World War II.

• Ben Steil says White acted out of idealism not as a member of the Communist Party "not simply because he believed that the Soviet Union was a vital U.S. ally but because he also believed passionately in the success of the bold Soviet experiment with socialism."

• White was not a Communist party member, because "White would not take orders from Moscow. He worked on his own terms.”

BW System: Key Characteristics

• The U.S. $ as the “key currency” was convertible into gold at a fixed rate of $35/oz.

• All other currencies were convertible into $ at fixed but adjustable e/r’s.

• $ was only convertible into gold for foreign official institutions (CBs, gov’ts). U.S. citizens could not convert $ into gold and were not even permitted to own gold.

• Non-key currencies were backed by $, not by gold.

BW System: Principles of Operation

• Foreign currencies are expanded and pyramided on top of $ and ultimately U.S. gold stock

• The BOP adjustment mechanism that limits inflation under classical GS is neutralized.

• ↑ MSUS → ↑ PUS > PW → ↓ XUS, ↑MUS → BOP < 0 (deficit) → $ outflow → ↑MSW → ↑ PW

• . . . WORLD INFLATION

Money Pyramid under BW System

“Deficits without Tears”

• BW system therefore caused a chronic U.S. BOP deficit and a global surplus of $.

• As long as foreign gov’ts and CBs were willing to accept and hold excess dollars the U.S did not have to worry about BOP deficits.

• “Deficit without Tears” (Jacques Rueff).• U.S. exported paper $ and inflation to the rest of the

world in exchange for real goods and services.

The Loss of U.S. Gold Reserves

• The continuing ↑U.S. prices meant that 1 gold oz could buy foreign currencies that purchased more goods than $35 did, so people began to sell $ for gold in free gold markets (London and Zurich).

• It paid to use the gold to buy foreign currencies and use them to buy goods to export to U.S. for even more than $35. This is called arbitrage:

• $35 → 1 oz gold → DM 70.00 → export goods → $40• U.S. had to sell gold and buy $ to maintain price at

$35/oz.

U.S. Inflation and the the Vietnam War• But U.S. cont’d to expand MS in 1960s to pay for Vietnam

War and social welfare programs. (“Guns and Butter”)• Foreign goods flowed into U.S. and $ flowed out. In

effect foreigners paid the “real” cost of the Vietnam war in exchange for paper money as U.S. residents consumed cheap imports.

• Foreign gov’ts, esp. France and Germany, began to demand gold in exchange for their dollars as U.S. gold stock began to decline and its foreign $ liabilities began to increase.

• Charles DeGaulle, Rueff, France and NATO

U.S. Gold Stock

YEAR U.S. GOLD STOCK FOREIGN $ LIABILITIES(billions) (billions)

1950 $25 $121961 $171967 $12 $501968 $10 $601971 $9 $80

• 1968: “two-tier” system implemented• August, 1971: Nixon closes the gold window

Nixon Closes the Gold Window

• I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold or other reserve assets, except in amounts and conditions determined to be in the interest of monetary stability and in the best interests of the United States. . . . .

The Dollar Bill Standard

• New agitation for gold standard since financial crisis of 2008 and the Great Recession

• A recent proposal calls for the Fed to “target” the price of gold and serves as the basis for a Congressional bill.

• H.R. 1576 (2013) entitled “The Dollar Bill Act of 2013” introduced into the U.S House of Representatives on April 16, 2013 by U.S. Representative Ted Poe (R-Texas).

Details of the Bill

• Would mandate the Fed to fix the price of gold within a narrow band.

• The first step: the Board of Governors of the Fed designates a “Target Week” starting no earlier than 90 days and ending no later than 120 days from the enactment of the bill.

• Using a “random process” the Board would then designate during the Target Week a precise day, hour, minute and second as the “Target Moment,” which would not be publicly disclosed

Details of the Bill

• The price of gold would be fixed at the price prevailing on the COMEX exchange of the NYMEX precisely at the Target Moment and maintained within a “target range” of + or - 2 percent of this price from that time onward.

• Fed would maintain the gold price within the Target Range “directly” by open market operations.

• It would be barred from using indirect methods like targeting the Fed Funds rate to carry out the bill’s mandate.

Principles of Operation

• Gold would not play a direct monetary role under the Dollar Bill system. – The U.S. dollar would continue as a pure fiat money,

inconvertible into gold. – The monetary base would be composed of fiat dollars, i.e.,

Federal Reserve notes held by the public and by the banks in their vaults and ATM machines plus reserves held by the banks on deposit at the Fed.

– Thus the Fed would continue to control the monetary base, by buying or selling bonds depending on whether the price of gold was falling or rising relative to its target price.

Principles of Operation: Example

• Suppose that the target gold price was established at $1,300 per ounce.

• The Fed would be legally compelled to conduct open market sales reducing the monetary base whenever the price of gold rose to $1,326, which is 2 percent above the target price of $1,300 and therefore the upper limit of the Target Range.

• If the price of gold fall to $1,274 at the lower end of the Target Range, the Fed would be obliged to expand the monetary base via open market purchases.

The “Goldless” Gold Standard

• The main problem: the Dollar Bill standard is a gold standard in name only. Its supporters describe it as a “goldless gold standard.” 1. There would be no gold dollars coined and in

circulation among the public. 2. The Fed would not be required to maintain

convertibility between dollars and gold or to hold any gold reserves at all.

3. Poe’s Dollar Bill Act would leave the fiat dollar fully intact and the supply of dollars subject to continued absolute control by the Fed.

New Gold Standard or Same Old Fed Monopoly?

• The Dollar Bill system is really a central bank regime with the gold price as the monetary policy target instead of growth rate of the MS or the inflation rate.

• The main supporters of the Poe bill are Steve Forbes, economic journalist Louis Woodhill and Nathan Lewis, author of two books on the gold standard.

• They all clearly recognize that the dollar would remain a fiat currency subject to monopoly control by the Fed and that gold would have no monetary role whatever.

The GS as Invention of Government

• Supporters of the Dollar Bill standard view the GS as an invention of government policy.

• Steve Forbes refers to “countless varieties” of gold standards and describes the “common characteristic” of real gold standards in the following terms: “Theoretically . . . you don’t need an ounce of the yellow metal to operate a gold standard; all you need is to refer to the price in the open market.”

Nathan Lewis

• According to Lewis, all historical gold have been an invention of government policy, “a fixed-value system with gold as the policy target.”

• Lewis claims that the 100 percent-reserve gold standard is no different than his preferred “no gold” gold standard in which the money manager does not buy or sell gold at the parity price but instead targets the gold price by buying or selling bonds--or even fine art.

Is Gold a Measure of Value?

• Supporters of Dollar Bill Act claim that gold is not money but a stable measure of value.

• Lewis: “[Gold standards] use gold as a measuring rod to keep the value of money stable. Why? Because the yellow metal keeps its intrinsic value better than anything on the planet.”

• Woodhill: “The fundamental validity of the gold standard rests upon the premise that the real value of gold remains constant over time. . . . The most fundamental thing about a unit of measure is that it be constant. . . . . Gold is not money, and it should not be money. However we can and should use gold to define the value of the dollar.”

The “Intrinsic Value” of Gold

• No definition is ever given by advocates of the goldless gold standard of what exactly the concept of “intrinsic value” means or in what units it is expressed. They substitute analogies for rigorous definitions:

• Forbes—“The fact that a foot has 12 inches doesn’t restrict the number of square feet you have in a house. The fact that a pound has 16 ounces doesn’t restrict your weight . . . . The virtue of a properly constructed gold standard is that it’s both stable and flexible—stable in value and flexible in meeting the market place’s natural need for money. If an economy is growing rapidly such a gold-based system would allow for rapid expansion of the money supply.”

Measuring Income in Gold

• Lewis takes the idea that gold is an absolutely fixed measure of value to its logical—and absurd—conclusion. If gold is intrinsically constant in value, he reasons, then the “equivalent gold value” of labor income computed at the current dollar price of gold will give us a truer picture of the trend of real wages than calculations using the fiat dollar adjusted for inflation.

Measuring Income in Gold

Measuring Income in Gold

Year Real Income (Gold Oz.)1955 1251970 2501980 252001 1502010 35

• According to Lewis, real income in 2010 was only 14% of what it was in 1970 and 28% of what it was in 2001!!

A Summing Up

• The Dollar Bill standard:– Is not a gold standard– Does not restrain the Fed from expanding the MS

and is therefore inflationary– Would collapse as certainly as the BW system did