The Key to Managing Currencies

The Key to Managing Currencies

May 6, 2008

(This appeared in the Daily Reckoning on May 6, 2008.)

Managing currencies is simple if you understand the fundamental principle: supply and demand.

I told you it was simple.

The “supply” comes from the currency manager. Today, that’s the central bank and Treasury Department or Ministry of Finance. They produce base money, which is actually the only money in existence. Base money is mostly coins and bills, and a little electronic bank reserves. Every other sort of “money” is actually credit, not money.

The “demand” comes from everyone else, who is holding the currency, or, as is sometimes the case with the U.S. dollar today, choosing not to hold the currency.

I bring this up because, at some point in the not too distant future, people may begin to clamor for a solution to the world’s worsening monetary problems. Perhaps, as inflation worsens, there will even be interest in a gold standard system. At that point, there will have to be someone who can actually solve the monetary problems. That person will have to understand the fundamental principle of currency management – supply and demand – because, if they don’t, their system will eventually collapse as well. Probably sooner rather than later.

People have long believed that a currency “backed by gold” will remain stable, but there is no such guarantee. If you take a mammoth amount of gold, and lock it in a vault, it does not emit magical energy waves that automatically manages the value of otherwise worthless paper currencies. There are many methods of keeping a currency pegged to gold. Some of them involve large hoards of gold, or even making coins of gold, and some do not. However, all of them, if they are to be successful, have at their core the fundamental principle.

Which, as I mentioned, is supply and demand.

Indeed, if you understand this fundamental principle, you can peg a currency to gold even if there are no gold reserves at all.

Everyone knows that a central bank, or other currency manager, can “print money,” either electronically or physically. It is not as well recognized that a currency manager can “unprint money,” or remove base money from circulation. The currency manager does this by selling something, typically a government bond, and making the money received in payment disappear. This happens nearly every day in the course of the Fed’s regular operations.

For example, the Fed has been rather vigorously lending money to banks. The Fed “prints money” and lends it to the banks. However, the overall supply of base money, according to the Fed’s statistics, hasn’t changed much. This is because the Fed is “unprinting money” elsewhere to compensate for its direct lending.

Central banks don’t really control interest rates. What they do is to print money and unprint money in a fashion that influences interest rates. Or, a central bank could adopt a different operating mechanism. During the early 1980s, the Fed printed money and unprinted money – in other words, altered the supply of money – in an effort to influence various credit statistics such as M1 or M2.

A currency board system prints money and unprints money in an automatic fashion that keeps the currency pegged to another currency. Typically, a currency board has a “reserve” of foreign currency, but this reserve is not necessary if supply is being properly managed. If supply is not being properly managed, then the foreign exchange reserve is typically depleted in short order, and a crisis results.

A gold standard is essentially a currency board linked to gold. Doesn’t it make more sense to peg to gold, the ultimate currency of mankind, rather than some government’s paper plaything? This used to be very obvious.

It seems that every gold standard advocate has their own special system, involving some idiosyncratic policy of reserve holdings or coin issuance. They will work, if they are based on the fundamental principle. If not, they would soon collapse.

My own idiosyncratic system is the gold standard that involves no gold at all. There are no gold coins, and no government gold reserves. Gold bullion is freely traded on the open market, just as it is today.

In my system, the currency manager (governments today) would adjust the supply of currency on a daily basis to maintain its value at the gold peg. When the value is a little low, you unprint money. When the value is a little high, you print money. In effect, it is a currency board linked to gold.

The idea of a gold standard with no gold usually drives the traditional “gold bug” insane. They are very attached to their piles of ingots and eagles. I use it mainly as a teaching device. When a person fully understands the fundamental principle – supply and demand – they say: “Yes, of course that would work.” If they are still attached to the idea of locking gold in a vault, they think it’s ridiculous, because there’s no vault.

Because many gold standard advocates do not understand the fundamental principle, they fall back on another, more primitive principle, which is to use gold coins exclusively. This system is best suited for a more primitive world. Yes, gold or silver coins are better than a wheelbarrow of paper money when you’re trying to buy bread in a hyperinflation. But consider: Warren Buffett just took part in a buyout by Mars Inc. of Wm. Wrigley Jr. Co. for $23 billion. What if they had to make payment in gold? Would they put $23 billion of bullion in an armored car? In the ninth century, this is how businessmen in China made large commercial transactions. The process of loading ships and wagons with silver coins was so cumbersome that they invented paper money, pegged to silver.

In 1910, the gold standard centered on the British pound and the Bank of England encompassed the world. At the time, the Bank of England held only 7.2 million ounces of gold. This was only 4% of all the gold held by governments and central banks in 1910, and only about 1.2% of all the gold in the world. The Bank of England didn’t have much gold, because they didn’t need it. They understood the principle of supply and demand.

When the U.S. left the gold standard in 1971, the government held 291 million ounces of gold. This had been depleted from 630 million ounces in 1942. Unfortunately, the Fed did not understand the principle of supply and demand. They were printing money aggressively to pump up the economy, with the result that everyone (especially the Bank of England and the Bank of France) wanted to dump the excess paper back on the Fed and get the gold in return. The system failed, even though the U.S. held forty times more gold than the Bank of England did in 1910.

In a fairly short time, as central bankers’ embarrassment becomes total, people may again search for someone who can manage a currency like the Bank of England did in 1910. Prepare now, or we will have to bear further decades of monetary chaos and ignorance, instead of the Golden Age we deserve.

Nathan Lewis
for The Daily Reckoning