Returning to a Gold Standard II

Returning to a Gold Standard and Gold Equilibrium looked at the relationship between the optimum price of gold (the price level) and the spot price of gold (POG).  A return to a gold standard, without the induced economic stress of inflation or deflation, requires that the dollar link occurs at the optimum POG—where debtors and creditors are in balance, and neither is advantaged at the expense of the other.  If the spot POG differs from optimum, a significant error in selecting a parity link may cause economic stress such that the gold standard is abandoned before equilibrium can return.  The U.S. experienced deflationary stress returning to its gold standard parity after the Civil War—the dollar devalued from $20.67/oz to $50/oz during the Civil War.  Great Britain abandoned its attempt in 1925 to return to its pre-WW I gold parity level for the same reason.  

Despite the spot and optimum POG’s convergence in equilibrium, creditors and debtors in balance, and inflation and deflation eliminated, risk remains in returning to a gold standard.  The risk comes not from the monetary discipline that a gold standard will provide.  The hallmark of fiat money is the lack of monetary discipline under the guise of economic theory and PhD expertise.  This failure of “expertise” to maintain the value of the dollar as practiced by the Federal Reserve is responsible for the precarious state of the global financial system.  Rather, the risk today with a gold standard arises from capital allocation and interest rate adjustment that will occur with a return to stable money.  A gold standard will cause a great unwind as capital flows from unproductive churning to productive growth.  We have had a decade of asset capital allocation based on interest rates manipulated by central banks to the zero bound and below.  With a return to a gold standard, the price of credit will rise to its natural market set level.   

The end of the Bretton Woods in 1971 in favor of a fiat dollar resulted in rising interest rates to compensate for the declining value of the dollar.  A return to a gold standard at any time prior to QE implementation would have resulted in economically stimulative declining and stable interest rates.  This economic positive would have overwhelmed any negative effect as capital reoriented from financialization to productive use.  In other words, prior to unconventional QE monetary policy implementation, the return to stable money would act as an immediate, positive economic stimulus.  

Today, a return to a gold standard will have the opposite effect.  Manipulated interest rates to the zero bound will rise to their natural market level.  Sustained negative interest rates are unprecedented in the 5000-year history of organized finance and could never occur without central bank manipulation.  A return to market set interest rates will result in a massive capital adjustment.  Markets are non-judgmental.  Capital flows to wherever it receives the best return based on the conditions in place.  The adjustment to a rise in interest rates will reorient capital.  Debt issuers will require higher interest rates.  The binge of global debt issued under QE will become unsustainable without a return to historical economic growth rates.  This adjustment requires supply-side fiscal policy enactment along with the return to stable money.  Stable money and low taxes were the Reaganomics formula that ended the 70s stagflation malaise and set off a two-decade global economic boom.  Nathan Lewis defines the policy in his new book, The Magic Formula.  If a return to stable money gets the formula wrong and a recession occurs, the gold standard will get the blame.  Calls for its abandonment will occur before an established gold standard can provide the foundation for stable money.    

A foundation for economic growth based on stable money and low taxes is essential to fund the trillions in debt that governments have piled up under QE manipulation.  Rising interest rates will subject zombie corporations, Silicon Valley unicorns, and perpetual money-losing companies—propped up by low-interest rate/free money—to market discipline.  The market will select winners and losers based upon merit rather than first-in-line crony access to Fed manipulated money.  The benefit of stable money and a return to historical levels of economic growth must outweigh the negative adjustment from a decade of monetary distortion and capital misallocation.    

Consider the effect of a decade of unprecedented central bank monetary experimentation on the global financial system.  The current global financial system requires perpetual central bank asset buys, currency churning, derivative trading, and interest rate manipulation to maintain a semblance of stability.  It is the hypertrophy of finance as described by George Gilder in The Scandal of Money.  At the extreme of central bank commanded interest rates, the BOJ has nationalized its government bond market and is in the process of nationalizing its equity market.  The Fed is slowly headed in the same direction unless it reverses course and returns to stable money.  It threw in the towel after one year at its attempt at balance sheet normalization because market volatility exposed the financial system’s instability.  The operating mechanics of a gold standard are incompatible with post-2008 central bank policy.  A gold standard would force central bank balance sheet reduction through selling assets, returning to nominal excess reserves, and eliminating interest paid on reserves, IOR.  Interest rates would float.  The Fed can only hit one target with its monetary arrow.  On a gold standard, the Fed’s sole target is maintaining dollar parity with gold.

It is far better to return to a gold standard as a correction to a fiat episode than after a complete currency collapse.  Great Britain went off its gold standard during the Napoleon Wars and returned 13 years later in 1815.  It maintained its gold standard until 1914.  The U.S. did the same during the Civil War.  Between World War I and World War II, a series of countries abandoned their gold links, attempted to return, only to abandon again.  In 1944, Bretton Woods established a new international monetary system linked to gold and ended the interwar monetary chaos.  Nixon terminated Bretton Woods and the U.S.’s 171-year history of a gold-linked dollar.  History is replete with deviations and returns to gold standards followed by sustained, high levels of economic growth.

History also records the result of a fiat currency collapse.  Weimar Germany is the most infamous example.  Adam Fergusson records the destructive societal effect in his book When Money Dies.  Even with complete currency collapse, a return to stable money based on gold is a simple process.  Hjalmar Schacht in 1923 returned Germany to a gold-based rentenmark after hyperinflation made worthless the Weimar mark.  He did this with the Rentenbank holding no gold bullion, in a week, operating from a janitors supply closet with a staff of one secretary.  Schacht accomplished this by managing the rentenmarks supply to maintain the gold parity.  Even amid complete economic ruin with no gold reserves, it is possible to link a currency with gold, achieve stable money, and return to economic growth.    

After 48 years of fiat monetary chaos, we are at an inflection point in our currency crisis.  A fiat dollar of no defined value results in an endless series of economic crises and is unable to produce sustained economic growth.  Despite our constant fiat turmoil, the ominous monetary trend is toward even more unstable fiat monetary policy.  NGDP targeting—based on fungible government statistics of no defined reference—and MMT, Modern Monetary Theory, are gaining traction in policy discourse.  They are further theoretical attempts to justify and extend fiat system failure.  There is no history of a sustained, successful monetary system that ignores gold as the unit of account.  The average lifespan of a fiat currency is 27 years.  If the Fed goes there, MMT is the endgame for the fiat dollar.  MMT posits that the Fed can create unlimited dollars to fund whatever programs and expenditures the federal government can dream up.  It is intuitively idiotic, yet the natural path of least resistance when intellectual bankruptcy ascends to its highest level of incompetence.     

A great unwind will result from Bernanke’s unprecedented QE monetary experiment that central banks enacted after the 2008 financial crisis.  A decade into it, QE asset purchases, ER, IOR, negative interest rates, and bloated balance sheets have left the Fed trapped and confused.  The Fed’s equation centric econometric models did not predict the “secular stagnation” that QE policy created.  The Fed finds itself constantly reversing policy and has resorted to making it up as it goes along.  It is clear that in another crisis the Fed will double down with another round of fiat monetary policy that has been an abject failure over the last decade.  This is all it knows  The Fed and its army of PhD economists have reached an intellectual dead-end.  A return to stable money is the only solution.  The question is:  Will we make the required adjustment to stable money and economic growth or will we continue further down the path of fiat decline? 

Returning to a Gold Standard III will discuss the mechanics required to return to a gold standard.

Returning to a Gold Standard

Gold Equilibrium

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