China Doesn’t Need Much Gold To Create a Gold-Based Dollar Alternative
April 17, 2014
(This item originally appeared at Forbes.com on April 17, 2014.)
http://www.forbes.com/sites/nathanlewis/2014/04/17/china-doesnt-need-much-gold-to-create-a-gold-based-dollar-alternative/
Although the idea of Classical money — in practice, a gold-based currency — is not popular today in the U.S., it actually has quite a lot of support elsewhere. Both China and Russia are clearly making moves in that direction, even if perhaps in the form of contingency plans should the present dollar-based system become unusable.
However, this trend has been handicapped to some degree by the notion that enormous amounts of gold bullion need to be accumulated in vaults before any new currencies are introduced.
There are two basic reasons for this idea. The first is that this was the way it worked during the last incarnation of the world gold monetary system, the Bretton Woods system that began in 1944. During the late 1930s and up through the first part of World War II, enormous amounts of gold flowed from Europe to the U.S. Treasury for safekeeping.
U.S. government holdings of gold bullion increased from 194 million ounces in 1933 to 649 million ounces in 1941, which at that time constituted about 78% of all the gold bullion held by world governments and central banks, and 44% of all the aboveground gold bullion in the world. U.S. government official gold holdings later peaked in 1949 at 702 million ounces.
It was an incredible degree of concentration of ownership, perhaps unprecedented, and made possible by global war.
However, it doesn’t have to work that way. In 1910, Britain was unquestionably the leader of the world gold monetary system of that time, and people expected it to remain so for many decades hence. The British pound was the world’s premier international currency. In that year, the Bank of England held 7.2 million ounces of gold, which was only 1.2% of all the gold in the world at that time.
So, it turns out that you don’t really need much gold bullion at all to run a gold-based monetary system — even for the world’s leading international currency.
The second reason is actually related to the first. The United States, experimenting with Keynesian notions and also out of pure ignorance, did not operate its gold standard system correctly. It had what I sometimes call a “gold standard policy,” the general notion of keeping the dollar’s value at the promised $35/oz., but no coherent method to actually achieve that goal.
In fact, the various experiments with Mercantilist (“Keynesian”) money-manipulation notions actively undermined the concurrent goal of maintaining a stable dollar/gold parity. This was ossified into the notion of a “domestic monetary policy” (interest rate manipulation with the goal of “full employment”) and a “foreign monetary policy” (exchange rates), and made even more problematic by separating these two duties into two separate departments, the Federal Reserve (domestic) and the Treasury (foreign).
In other words, the official U.S. monetary approach of the Bretton Woods period essentially amounted to: “shoot yourself in the foot.” The Mercantilist “domestic monetary policy” was crippled by the “golden fetters” of the gold parity policy. The gold parity policy was undermined by Mercantilist funny-money jiggering. Everybody was unhappy.
It surprises people even today when I tell them that people of that time actually had no idea of what they were doing. Richard Nixon and his hand-picked Fed chief Arthur Burns — the men who actually blew up the Bretton Woods gold standard system — were actually quite adamant supporters of gold-based money. The degree of ignorance implied is difficult to even imagine.
The end result of all this was that gold consistently flowed out of the U.S. government’s vaults, a result of the fact that the dollar was being mismanaged. To somehow maintain this impossibly contradictory policy stance, layers and layers of government coercion were imposed, including capital controls and various forms formal and informal market-jiggering such as the London Gold Pool. Even this was only a temporary stopgap, and, after losing over 400 million ounces to gold outflows, leaving about 275 million ounces, Nixon shut the “gold window” in August 1971.
Thus, it seemed that immense gold bullion holdings were “necessary” to maintain the Bretton Woods system in the face of its inherent contradictions, and that the system ended when this gold bullion ran out, or seemed in danger of doing so.
In the end, the Bretton Woods system lasted only 27 years, and failed in the midst of peace and prosperity worldwide.
How is it that the Bank of England had the world’s premier gold-based currency for roughly two centuries in 1910, gradually accumulating gold during that time, a hot streak that ended only with the outbreak of what was then called the War to End All Wars in 1914, while the United States flopped in the middle of blue-sky prosperity? How did the Bank of England accomplish all this while holding only 7 million ounces of gold — and the United States did a huge faceplant in 1971 after only 27 years of peace, after starting with 700 million ounces?
How is it that a hundred times more gold — a hundred times more! — resulted in quick failure? Even with all the capital controls of the Bretton Woods period, while capital flowed freely in 1910?
The difference, of course, is that the Bank of England did not suffer from the Bretton Woods period’s self-destructive conflicts. The Bank of England not only had a “gold standard policy” of maintaining the pound’s value at 3 pounds 17 shillings 10 pence per ounce of gold, it also had a coherent daily operating strategy to do so, that was not compromised by Mercantilist money-jiggering ambitions.
So, it turns out that gold in a vault actually doesn’t mean much at all. You can have as much as anyone has ever had, and fail miserably in a short period. Or, you can have a pittance, and enjoy centuries of success.
The difference is in the daily operating mechanisms. That’s why I wrote a whole book about it, Gold: the Monetary Polaris, which is now available in free eBook format. It is the magic factor that separates Britain’s experience pre-1914 from the U.S. experience post-1944.
That’s one reason some people today — such as Steve Forbes — are insistent that you don’t actually need any gold bullion at all to run a gold standard system. If you have mastery of the correct operating mechanisms, gold in a vault becomes largely irrelevant.
If you don’t have mastery of these techniques, you can stack up a mountain of gold, and it will do you no good. Even many gold standard advocates have little understanding of these things, which is why they too tend to make proposals involving huge amounts of metal in vaults. They think this golden rabbit’s foot will help paper over their ignorance, but of course it won’t.
It’s just a piece of metal!
Unfortunately, there isn’t much evidence that this monetary understanding is common in China today, or Russia for that matter. The Chinese yuan is ostensibly pegged to the dollar, and has been since 1950 although the pegging rate changes from time to time. This should be accomplished via some sort of currency-board-like system, such as that used by Hong Kong, which is of course today a Chinese territory.
Instead, China maintains this dirty peg through a combination of capital controls and enormous “foreign exchange reserves,” the direct analog of the strategy used by the U.S. during the Bretton Woods period.
Listen China: If you want to be the big guy, you have to master these things. Learn from the success of pre-1914 Britain, which lives on today in the former British territory of Hong Kong. Don’t imitate the U.S. failure.
