If The Gold Standard Is So Great, Why Aren’t We On One Now?

If The Gold Standard Is So Great, Why Aren’t We On One Now?
May 20, 2011

(This item originally appeared at Forbes.com on May 20, 2011.)

http://www.forbes.com/2011/05/20/gold-standard-currency.html

Sometimes people ask me: If the gold standard is so great, why aren’t we using it right now?

This is a good question. The basic answer is that it would prevent central bankers, and governments, from doing something they have become very fond of over the past several decades–attempting to solve their economic difficulties with some sort of “easy money” policy. You can see this remains very popular today.

The Classical viewpoint is that any form of currency instability causes economic problems. An economy functions best when the currency is as stable and reliable as possible. In practice, this always means a gold standard system because that is the most effective way to achieve these goals in an imperfect world.

The Mercantilist viewpoint is, you could say, the complete opposite. Mercantilists don’t see currency instability and monetary fiddling as problems; they see them as solutions. A gold standard system prevents them from implementing this apparent solution, which is why they sometimes refer to the “golden fetters” that used to hold them back.

Both of these ideas are literally thousands of years old. People were trying to solve their economic difficulties with currency fiddling in ancient Greece and China, in the 7th century B.C. or earlier.

Which is correct?

In some ways, they both are. If either had been proved to be totally fallacious, they wouldn’t have persisted as long as they have.

In the short term, a currency devaluation, or an easy-money policy, can create what appears to be an improvement in economic conditions. We saw this with QE1 in March 2009 and QE2 in late 2010. In the longer term, however, this sort of strategy tends to cause stagnation and economic decline. The notion that a country can become wealthy just by fiddling with its currency is patently ridiculous. The most successful countries worldwide have always been those with the most stable currencies.

You can see this in the values of asset markets. I would say that the effect of recent easy-money approaches by the Fed is to cause U.S. equities to be higher in nominal value than they would have otherwise been. And who doesn’t like that? Certainly politicians do.

However, if we adjust for the effects of currency devaluation, by measuring equity values in ounces of gold instead of devalued dollars, another picture emerges. The Dow Jones industrial average was worth about 43 ounces of gold at its peak in 2000. Today, it is worth about 8.5 ounces, a decline of about 80%! Yes, I think that best represents the economic reality of the situation. That is a huge decline, larger than would have likely occurred even given very high stock valuations in 2000.

In other words, these easy-money approaches cause asset markets to be lower than they would have otherwise been, in real terms.

The Mercantilists are focusing on the nominal world, and the Classicals are focusing on the real world.

A similar story could be told by per-capita GDP, in nominal and gold terms. Today, after 40 years of floating currencies–since 1971–U.S. per-capita GDP, as measured in ounces of gold, is back to levels first seen in the early 1950s. Forty years of easy-money currency fiddling has caused stagnation and decline, just as the Classical economists said it would.

However, only the most insightful economist is aware of this chronic economic deterioration, and able to identify a prominent cause, which is decades of Mercantilist floating currency fiddling. It would be very difficult to blame the Fed for this, or even identify the specific nature of this persistent malaise. Politically the Fed can deliver what seems to be effective short-term results, while it avoids blame for long-term negative consequences. Politicians, who are always looking to the next upcoming election, are eager to pressure the Fed for another pre-election boost.

The floating currency system appeared in 1971 for this exact reason. Richard Nixon wanted to boost the economy with easy-money before the 1972 election. Did it work? Officially, GDP rose 5.3% in 1972. Nixon was re-elected. This kicked off a decade of inflation and economic decline.

It is often not until the effects of these easy-money policies become utterly catastrophic–a hyperinflation perhaps–that the political consensus changes, and all easy-money approaches are shunned like deadly poison. Once again governments adopt a Classical, stable money approach.

The one government in the world that is most vocal about linking their currency to gold today is Zimbabwe. After the terrible hyperinflation there, they have lost all interest in easy-money currency fiddling.

The Classical economists have also been remiss. They should have their own answers about what to do about recession and unemployment, to offer as an alternative the easy-money proposals of the Mercantilists. All too often the Classicals have relied on “eventually it will get better” arguments, which too often sound like “do nothing.” Usually a great many proactive approaches would be appropriate, with some sort of tax cut or tax reform high on the list.

Ideally we will eventually conclude that it is best to keep currencies as stable as possible–in practice, this means linked to gold–and address economic difficulties with solutions that solve fundamental problems. These could be tax reforms, regulatory reform, targeted investment, reduction in government waste, and so forth. This would benefit the short term, and the long term as well.