Gold and the Trade Deficit
September 8, 2011
(This item originally appeared in Forbes.com on September 8, 2011.)
Almost everything that people say about the gold standard today is baloney. One of the most popular items in the baloney store is the notion that a gold standard system causes “balanced trade.”
The United States used a gold standard system for 182 years. So, we should know what the answer is, right? Does a gold standard lead to ”balanced trade”? Did the U.S. have “balanced trade” for 182 years straight?
You already know the answer, don’t you? It’s a total fantasy.
During most of the 19th century – the gold standard years – the U.S. experienced capital inflows, or what is known as a “current account deficit.” In the 1830s, the U.S. imported an average of $125.4 million per annum. By the last decade of the 19th century, this rose to $3,071.4 million per annum.
Why was this? The U.S. was a good place to invest, so Europeans invested there.
In fact, all trade is “balanced.” That’s what trade is: the exchange of items of equal value.
However, we have some funny terminology in this regard. For some reason, when a person trades goods for goods, that’s “balanced,” but when they trade goods for financial assets of some sorts, primarily bonds, that’s “unbalanced.”
Why would anyone buy our bonds? For most countries, it is difficult to get foreigners to buy bonds denominated in local currencies. They only want bonds denominated in major international currencies, like the dollar or euro. Why is this? Because nobody trusts the Vietnamese dong or the Hungarian forint. Would you buy a promise to deliver ten million Paraguayan guarani ten years from now? Me neither, except at a very good price perhaps.
Now, let’s say you have a bond denominated in a reliably gold-linked currency like the U.S. dollar of the 19th century. After the dollar had been pegged to gold for over a hundred years in 1900, a German or Belgian investor could buy a ten or thirty-year bond and be reasonably sure that it would be worth something ten or thirty years from the date of purchase. The currency was stable, and didn’t fluctuate against the gold-linked European currencies.
Investors would pay a high price (low interest rate) for something like that. And, the bond sellers, or borrowers, would also be able to borrow more when interest rates were low.
In other words, having a gold-linked currency made the selling of bonds, or equities, also known as international capital flows, much more attractive. The great era of the worldwide gold standard, in 1870-1910, was a time of internationalization, free movement of capital, and high levels of investment in emerging markets.
Since international capital flows is another term for a “trade imbalance,” we see that the gold standard system actually “promoted trade imbalances,” to use that weird terminology. In other words, people were happy to invest in foreign countries because they had reliable gold-linked currencies.
We see that both borrowers and lenders benefit when they do business in a highly reliable currency. That is why the country with the best international currency typically becomes the world’s top financial center. When everyone wants to borrow and lend in gold-linked British pounds, then London is the world’s financial center. After a series of devaluations beginning in 1914, people’s opinion of the British pound waned, and the U.S. dollar became more attractive.
The U.S. dollar today is not a particularly reliable currency. What do you think the U.S. dollar is going to be worth in ten or thirty years? Hard to say, isn’t it? Thus, many people throughout the world are searching for a new currency to serve as the premier international currency. Unfortunately, they haven’t found an alternative.
Whatever country provides people what they want – a reliable currency – will become the world’s new financial center. Historically, the most reliable currency was always the gold-linked currency. The purpose of a gold standard system was to create the most stable and reliable currency possible.
Theoretically, there might be a way to make a currency even more stable and reliable than using a gold standard system. Alas, in five hundred years of trying, nobody has found such a system. Actually, there wasn’t really any need to look for an alternative, because the gold standard systems of Britain or the U.S. didn’t cause any problems
that needed fixing. They pretty much worked as advertised.
There are only two reasons why we don’t use gold standard systems today. One is that we have become enamored of the idea of trying to solve economic problems with currency manipulation. This is what Ben Bernanke talks about all the time. It’s what people in Britain talked about – just before the British pound became the world’s former leading international currency. It is totally antithetical to the goal of creating a stable, neutral, predictable currency.
The other reason is that people don’t know how to do it. They are still bogged down in laughable nonsense like “a gold standard causes balanced trade.” The fact that, as I mentioned, the historical record shows the complete opposite condition, does not seem to bother these people. They repeat the same platitudes decade after decade, oblivious to historical reality.
Before we are going to have a golden alternative to the endlessly-abused dollar, we will need to have some people who know how to play this game. It’s not actually that hard. I predict that the first major country to assimilate this knowledge will be China, and that – after a period of turmoil and transition perhaps – the Chinese yuan will
become the world’s premier gold-linked currency. The financial capital of the 21st century will be Shanghai.