With the world economic crisis in full tilt, the US dollar is on the ropes and the clock is ticking. Chinese ministers have accused the United States of "squandering the world's wealth" and have expressed immense distaste towards the US Government's daily fiscal decisions. Special Drawing Rights (SDR), issued by the International Monetary Fund, has been proposed as a replacement as the world's reserve currency. The SDR will be a basket of currencies from around the world and should provide some measure of protection against any single country debasing their money — as the US has been doing ever since the Federal Reserve System was established. One curious, last minute demand was made by Russia, who wanted gold to be added to the basket as well. While this should come as no surprise to anyone who's studied the history of money (gold has served as money for over 5,000 years), it deserves some explaining since gold appears to be one of the most misunderstood topics in our present day.
What is Money?
To first understand gold, it's first important to understand money. More importantly, we want to understand what characteristics we desire in money. Many things have served as money such as tobacco leaves, seashells and even carved sticks but these currencies failed or couldn't function well as money. Money is the common denominator of all economic activity and is intimately connected to everyone's daily lives. It should be one of the most understood items of our modern existence but it is generally one of the worst understood, as so many people seem to take it for granted. Money is a commodity in its own right, the most widely accepted and sought after commodity in fact. This is what makes it a medium of exchange. Before money coalesced out of the marketplace, people bartered, i.e., exchanged goods and services directly for other goods and services. The problem with this is that people were constantly suffering from what's called the double coincidence of wants. In a barter economy, in order to trade, I first have to find someone willing to trade his or her goods for my goods. We each need to possess something the other desires. Money eliminated this restriction by becoming the universally accepted "good" in economic transactions.
Another feature of money is that it should function as a store of value. This means that we can rely on each unit of money to have the same value in the future as we assign to it today. Unfortunately, our current money fails miserably at this task. Since the establishment of the Federal Reserve System in 1913, the dollar now has approximately $0.02 worth of its original purchasing power. To put it in another perspective, a bottle of Coke that used to cost $0.02 now costs $1.00. Since so much more Coke can be produced today, we would expect the price to actually go down, but it didn't. Such a phenomenon would never happen if our money were a true store of value.
Finally, money is a unit of account. This is really just the end result of achieving the previous two requirements. The best analogy would be a yardstick. We all conceptually know what a yard is and what it measures. Money should be the same. However if people don't accept it in trade and its value isn't reliable then it's as if the definition of a yard is constantly changing to mean different lengths. Trade can never be expected to function optimally under such circumstances. Furthermore, a stable unit of account is divisible (ex. Dollars are divided into cents) and is also fungible, meaning any one unit of money resembles every other unit of money.
Now that you know what money is supposed to be, and why our current form of money fails the test, we can move on to the best candidate for money the world has ever produced.
Why is Gold, Money?
History is replete with examples of how gold has successfully served as money. It is also replete with examples of governments routinely attacking the soundness of the currency in order to spend without resorting to taxation. Money has sometimes been used to isolate societies from the rest of the world. Lycurgus tells us that the Spartans were banned from using gold and silver and instead used iron coins quenched in vinegar that were refused by all non-Spartans. We see the same tactic at play in the modern world when nations prevent their citizens from exchanging their paper currencies for the paper currencies of other nations, or imposing an unfavorable fixed exchange rate as seems to be the case with present-day China.
The history of money and the economy of the United States provide us with many examples of how gold produces stability and prosperity, while money created by government fiat (all current forms of money you're used to) produces short-term booms followed by busts. A brief summary of the monetary history of the United States goes as follows:
Figure 1: Continental Scrip1775 — In order to fund the Revolutionary War, the Continental Congress began issuing paper money called the Continental. Wars are always expensive endeavors and on top of the estimated $12 million total money supply at the time, Congress issued $8 million in the first year, another $19 million in 1776, $13 million in 1777, $64 million in 1778 and $125 million in 1779. A total of over $225 million had been created resulting in a devaluation of the dollar by a factor of 168:1. The government resorted to price controls to try to reel in the skyrocketing prices but that only created shortages. The term "not worth a Continental" became popular in its usage and George Washington remarked, "A wagon load of money will scarcely purchase a wagon load of provisions." Furthermore, the $600 million in public debt that the United States had issued and traded on the international markets was trading at roughly 4 cents on the dollar. The nation was born in a hyperinflation.
1789 — The government begins operating under the provisions laid out in the Constitution of the United States of America. Article 1, section 8 provides Congress with the power to "coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures." Furthermore, section 10 states that the States cannot "coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts." In other words, only Congress had the power to coin money, made of gold or silver, with fixed and regulated weights and measures and the States could not refuse it. Furthermore, "Bills of Credit," i.e., paper money, was banned.
Figure 2: $10 Gold Eagle Minted in 18661792 — Congress exercises its powers under Article 1, section 8 and passes the Coinage Act. It created a coin called a "Dollar," which was to be about 371 grains of pure silver. It also established a half dollar, quarter dollar, a dime (1/10 dollar) and a half dime. The act also produced a coin called an "Eagle," which was to be about 247 grains of pure gold. There was also a half eagle and a quarter eagle. The eagle was set at a fixed exchange rate of 10:1 with the dollar.
1812 — War breaks out again between Britain and the United States. Fearing a run on their currencies due to the war, banks in the Southern states suspended gold and silver redemptions on their banknotes (exactly what Nixon would do 160 years later), effectively rendering them a floating, paper currency like we have today. The federal government also issued Treasury notes to finance the war. These notes paid interest and were declared legal tender and therefore amounted to an expansion of the monetary base. Inflation ensued. The banks of the Northern states had maintained gold redeemability of their notes and the government was soon trying to pay for Northern goods with unredeemable notes issued by Southern banks. Northern banks began to call for the redemption of Southern banknotes into gold but in 1814, the State governments to the south officially allowed the suspension of redeemability into gold.
1816–1817 — The US Treasury begins wholesale retirements of the Treasury notes that they had been issuing since 1812, effectively shrinking the supply of money. Deflation begins to set in and credit expansion by banks slows down.
1819 — Depression sets in as the growth in money supply is reversed. The easy money of the previous 7 years had found its way into the housing sector and financial sectors, creating a bubble. Once the flow of money and credit was shut off, the buying spree ended. In a letter to Richard Rush Ford, Thomas Jefferson explained that "The banks themselves were doing business on capitals, three-fourths of which were fictitious; and to extend their profit they furnished fictitious capital to every man, who having nothing and disliking the labors of the plow, chose rather to call himself a merchant, to set up a house of $5,000 a year expense, to dash into every species of mercantile gambling, and if that ended as gambling generally does, a fraudulent bankruptcy was an ultimate resource of retirement and competence."
1837 — Panic once again hits the United States as foreign banks, particularly from London, begin redeeming banknotes from US banks en masse. This situation had arisen throughout 1835 and 36, when the government was selling off vast tracts of land in order to pay down the national debt. Western banks, whose reputations for gold redemptions were spotty, were loaning vast amounts of funds to private citizens in order to buy the land. Stock prices peaked in mid-1835 and headed downward as inflation began to set in. The government, suspicious that it was being paid in unbacked notes, demanded in 1836 that all land sales be paid for in gold bullion, a decree known as the Specie Circular. By 1837 the bank run was in full tilt as others rushed to convert their notes back into gold.
Figure 3: 1862 Greenback1873 — After the outbreak of hostilities between the Northern and Southern States began in 1861, the government began issuing large quantities of US Notes, informally known as "greenbacks" even though this was a clear violation of the Constitution's prohibition against the emission of "bills of credit." These notes were immediately redeemed for gold, which would have put an end to the inflation. Instead, the government suspended convertibility on December 30, 1861 and the dollar became another unbacked paper currency. Issuance of these notes continued and by 1865 they had reached a devaluation of nearly 3:1. The Confederate government had responded by issuing their own paper notes and devaluing them by a factor of around 28:1. In 1865, Congress passed a resolution to begin retracting these notes and restoring the value of the dollar but this proved politically and economically unpalatable and was halted in 1868. Instead, they fixed the base money supply of the US at $656 million. Greenbacks had found themselves creating a boom in the railroad industry and when the banking system was finally loaned up to its limit and the monetary base was no longer expanding, the bubble burst, causing deflation and the resultant Panic.
Figure 4: Unbacked US Notes Issued in 18801873–1900 — The fourth Coinage Act was passed in 1873, ending the coinage of silver. Other nations around the world also began abandoning silver in favor of gold. The fixed exchange rates between gold and silver on the bimetallic standard had been creating difficulties throughout the world. For instance, in America, where the gold/silver ratio was fixed at around 15:1, people would convert silver into gold and take that gold to the international markets to trade back into silver at a ratio of around 30:1, thus doubling their money instantly and causing a gold drain on the United States. In 1900, the United States formally adopted a monometallic gold standard with the Gold Standard Act of 1900.
1921 — The crash of '21 began with the United States' entrance into World War I in 1917. The United States had initially been selling war supplies to Europe since the outbreak of hostilities in 1914 and had been collecting vast sums of gold as payment. This trend reversed in 1917 and in September of that year, President Wilson prohibited all gold exports without the permission of the Federal Reserve Board and the Treasury. In 1918 this was broadened to prohibit all private hoarding of gold. The net effect of these policies was to effectively de-link the dollar from gold. In order to assist with the war effort, the Federal Reserve had pushed interest rates down, an invitation for inflation, which is what the CPI reveals. When the gold embargo ended in 1919, gold flew out of the country, a clear sign that the dollar's value had dropped significantly over the war due to the overissuance of paper notes. Eventually the Fed began contracting the supply of paper dollars, turning inflation into deflation and a drop in prices and wages of about 35% manifesting as the recession of 1920–1921.
1929 — After a period of growing prosperity throughout the '20s the United States underwent a mild contraction in 1927. This caused the Fed to create large amounts of paper reserves in the hopes of forestalling any potential shortages at banks. Moreover, the Bank of England had been holding down interest rates below the market equilibrium in an effort to expedite the recovery from WWI. Authorities reasoned that if the Fed pumped excess paper reserves in the system, interest rates in America would fall. This indeed did happen and England's gold loss was halted, but the excess reserves fueled a fantastic speculative bubble in the stock market. Fed officials tried to retract the excess reserves in an attempt to halt the boom but the end result was the crash of '29. Austrian economists Ludwig von Mises and Freidrich Hayek foresaw the crash and publicly predicted that it would be coming very shortly. In order to pay back the Fed, commercial banks and brokerages had to call in their margin loans, triggering a massive selloff in the stock market. Stock values plunged. Furthermore, rumors of the coming passage of the Smoot-Hawley Tariff Act eventually forced investors to flee the US market. The passage of the Act triggered a worldwide retaliation as other nations rushed to similarly increase their tariffs. Global trade was crippled and the Great Depression was now underway. Up until this point, the Government had taken a more or less hands-off approach to dealing with recessions and as a result they were generally short lived. However in the '30s, both Hoover and FDR instituted spending projects and interventions never before seen in all of US history. UCLA economists have now discovered that the price controls and cartelization of industry caused by these policies are the prime reason for the length and severity of the Great Depression. In order to help pay for the government's interventions, FDR issued Executive Order 6102, seizing all gold in circulation and subsequently devalued the dollar from $20.67/oz to $35/oz, where it was to remain until 1971.
1971 — Using the Great Depression as an excuse for huge Keynes-inspired spending projects such as the Marshall Plan and the Great Society; the US government was pressed into running huge budget deficits. Coupled with prolonged wars in Korea and Vietnam, the money supply increased drastically over the course of the decades after World War II. Once again, Austrian economists accurately predicted that the long-term effects of these policies would be an inflationary depression. Keynes joked that we're all dead in the long run however being flippant is no cure for excessive inflation. The world monetary system was operating under the Bretton Woods agreement, which pegged the US dollar at $35/oz and all other currencies were then pegged to that. The flaw in the system was that there was nothing preventing the Federal Reserve from increasing the supply of paper dollars in circulation. As government borrowing and overspending persisted, the gold backing behind each dollar steadily declined. Eventually the French, under Charles de Gaulle, demanded the redemption of their US dollar notes into gold. Gold began flying out of the US at an alarming rate. In order to end the loss of gold and sensing a worldwide run on the dollar, Nixon unilaterally ended the Bretton Woods agreement on August 15, 1971 by putting an end to all gold redemptions on US dollars. With no physical limit on the supply of dollars anymore the money supply and debt levels began expanding rapidly, as did America's trade deficit. Stagflation set in and once again the government resorted to price and wage controls, which only made the situation worse. Inflation was finally halted in the '80s when Fed Chairman Paul Volker set interest rates to 20%. Monetary expansion was slowed and inflation was brought back to the single digits.
Ever since 1971, the United States has had no constitutional money supply. Public and private debts have expanded to unprecedented heights and the money supply continues to grow by leaps and bounds. With so many crises caused by the manipulation of the money supply, there should be no doubt as to what caused the NASDAQ and housing bubbles of the previous 18 years.
Figure 5: Annual Federal Government Spending from 1913 to 2006 (adjusted to 2006 dollars)US Government spending has been rising precipitously. World War II was the country's biggest spending project in all of history. When it was finally over and the budget cut in half in 1946, it only took the government 22 more years to reach the exact same level of spending. It doubled again in another 24 years. That brings us to 1992, and in just 16 more years government spending had reached three times the amount of WWII at its very height. This can't be good for the economy or its people. It means that the country has been spending as if it were in total war for over 40 years. It's been spending over twice that much for over 16 years. As of now, three times and it may hit four times before the end of President Obama's first term. These levels of spending are unsustainable, and have only been made possible by borrowing tremendous amounts of money from abroad or debasing the money back at home. Both of these actions have severe long-term consequences, and we may be coming face to face with them very soon. Eventually the system will run into its hard, mathematical limits. When interest payments on the national debt meet up with national income, the entire system grinds to a halt.
What Would a Gold Economy Look Like?
America once enjoyed perfect price stability. A dollar saved in 1820 had exactly the same value as a dollar in 1920, because the Coinage Act defined the dollar as a specific weight of silver or gold. A CPI reconstruction of the past 350 years, done by John Williams of Shadow Government Statistics, showed that the price index maintained a value of 5 for the vast majority of American history and only started taking off after the advent of World War II.
Figure 6: The Greenback's Fall Changes in the price of West Texas Intermediate crude oil this decade in dollars, euros, and gold.A more recent example of price stability under gold is seen in the chart to the left. From this, we can deduce that the skyrocketing price of a barrel of oil that was observed throughout the Bush presidency was merely an illusion. While oil prices went up 350% in dollars and 200% in Euros, prices in terms of gold have remained constant. This is because, like oil, gold requires effort to extract from the earth. It is a tangible, real good containing intrinsic value that cannot be removed or inflated away. For this same reason, gold becomes a very useful measuring stick for gauging the changes in real value of other items. Einstein said all motion is relative and the same applies to value. Before you can know the real value of an item, you need to express it in terms of another item of known value, which is assumed to be constant. Gold is the perfect candidate for this status, while fiat money clearly is not.
To drive this point home, all we need to do is take a look at the Dow Jones Industrial Average over the span of its history. In the first chart, the DJIA is expressed in US dollars from 1896 (inception) to the present day. Looking at the index through this lens seems to provide very little in terms of useful information. For instance, in 2008, was the Dow really worth several thousand times more than it was in the '40s? The answer to this is obviously no and we will find out why shortly. Also notice how the roaring '20s and the Great Depression barely even register on this scale. Because the value of the dollar is changing all the time (primarily in the downwards direction) it distorts the true shape of the DJIA. By valuing the index in gold, however, we can change the chart from this:
Figure 7: Dow Jones Index in Dollarsinto this:
Figure 8: Dow Jones Index in GoldConsidering the historical context we can now get a much better look at the real increases in value during the 1920s as well as the destruction of wealth during the 1930s. We see the beginnings of the Dow finally recovering from the Depression and WWII in 1946, the same year government spending was cut in half. We also notice something that was conspicuously absent from the previous chart, the postwar economic boom and stagflation of the 1970s. The inflation present during that period totally wiped out the changes in real value that actually did take place, as revealed by gold. Bush and Obama are on the same inflationary agenda trying to maintain asset prices at their formerly elevated levels. However, as gold clearly shows, this is a futile endeavor. By maintaining nominal asset prices, they will only succeed in raising the real prices of everything else. Welcome to the actual war on the middle class, where the vast majority of Americans are being reduced to working poor, and the working poor are reduced to destitution. Furthermore, the recovery that followed the bursting of the tech bubble is exposed as a complete fabrication. The real value of the Dow has been in a prolonged decline ever since 2001. In case you were wondering if this was a fluke, the S&P 500 gives all the same indications when valued in gold.
Anyone who still doubts the usefulness of gold as money need only look at present-day Zimbabwe. The government completely destroyed their paper currency and left the economy in shambles. Hyperinflation made the Zimbabwe dollar totally unusable. In order to compensate, the people have adopted gold as their new money. In a Zimbabwean marketplace, you can now buy loaves of bread for 0.1 grams of gold. Incidentally, at the time of the writing of this article, 0.1 grams of gold is equivalent to USD $2.88, approximately what it would cost you to buy a loaf of bread in a grocery store. Hundreds of years ago, a loaf of bread would still cost you roughly 0.1 grams of gold. This attests to gold's usefulness as a safe store of value, across geography and time, as well as its universality as a currency. Gold would stabilize prices the world over, as the example in Zimbabwe clearly shows.
How Gold Stabilizes World Trade
Gold provides a very important and natural mechanism to stabilize world trade that would prevent a nation from running too big of a deficit and running into problems with debt. The United States had balanced trade for a very long time but only after President Nixon broke the dollar's link to gold in 1971 did the country start running deficits that grew larger and larger. At its height, not even a year ago, the United States was importing $800 billion more per year than it was exporting. The difference being paid for with borrowed or printed money.
A gold standard would prevent any trade imbalance from persisting too long and reaching such heights. If a country begins importing far more than it exports, gold is taken out of circulation in that country as the country pays for its imports. As the quantity of money in circulation declines, the price system responds by lowering the price of domestic goods and labor. This makes that same country look better to foreign companies that may want to take advantage of the cheaper labor and it also makes the goods produced in that country less expensive to foreigners. Capital will flow back into the economy, creating jobs and more goods will be produced domestically for export.
Conversely, countries exporting large quantities of goods would have the prices of their domestic labor and goods rise because of the influx of gold. This makes the same country look less attractive to import from, and less likely for international businesses to set up shop in. That country will begin to import more and export less because of the changes to domestic and foreign prices. Thus, the balance of trade between countries is maintained.
Final Thoughts
While the addition of gold to the SDR would be very welcome, it is uncertain whether or not it will actually happen. Even if it were, the SDR is still a centrally managed currency that will be prone to the manipulations of governments. This is the reason behind the failure of the Bretton Woods system and Nixon's tacit admission of national bankruptcy by declaring gold redemptions on US dollars officially over. Governments have proven beyond all reasonable doubt that they will abuse money at every opportunity. If the SDR does become the new world reserve currency, I expect that the boom-bust cycle will persist as the SDR is slowly inflated into oblivion. Over the next 25 years we will probably experience a long period of economic growth under the SDR only to wind up with another inflationary bust. Unlike our current situation, where the asset bubble was primarily located in the United States, this bubble will be worldwide and the suffering unleashed will be unimaginable even by today's standards.
As Hayek declared in a speech he delivered in November of 1977, a move towards a privately administered gold standard may be our only hope for maintaining price stability and minimizing the business cycle. The complete elimination of financial panics has turned out to be a pipe dream invented by bureaucrats and economists who clearly knew what persistent inflation would do to a people, but decided that perpetual robbery was justified in light of the fantasy of perpetual economic stability. The reality is that "monetary policy" has only served to worsen economic cycles, produce stagnation and inflation, and a slow transfer of wealth from the poor to the politically well connected. The competition produced by free banking will bring about a new class of businesses whose product is a stable currency and secure deposits. Reason and morality should compel us all towards that goal, and I look forward to the inevitable day when that becomes a reality.
