Sunday, December 12, 2010

Still Searching for the Gold Standard

Contrary to popular belief, the gold standard lives on. Not as a linkage of paper currency to a precious metal, but as the human search for certainty in the value of currency. And the results today are as convoluted as earlier experiences with the gold standard.

The gold standard--making a unit of a paper currency convertible into a fixed amount of gold--was used first and foremost to provide assurance against uncontrolled printing of money and the inflation that could follow. Such inflation could be created by whoever issued the paper money--be it a bank or a government--and gold convertibility was seen as stabilizing the value of the currency.

Gold, however, doesn't ensure absolute certainty of value. When large amounts of gold become available (from mining or other sources), price inflation can result. The Spanish conquest of much of Central and South America in the 1500s resulted in massive amounts of Aztec and Incan gold and silver flowing to Spain. Price inflation followed, even though Spain used gold and silver currency.

Gold as a reserve for paper currencies has not always provided a foundation for stability. In the 1930s, central banks protecting the gold standard acted too conservatively to combat the growing economic depression. In doing so, they may have aggravated the deflation that resulted from the stock market crash and accompanying economic downturn, which in turn hindered recovery from the depression. Eventually, the U.S. and other nations had to devalue their currencies to help foster recovery. What happened here was that the nation issuing the currency had gone into a depression and the real world value of its currency had correspondingly fallen. The conversion value of its currency into gold had not changed, so the currency was overvalued and deflation ensued. Ultimately, the gold standard did not prevent paper currencies from falling in value because paper currencies takes their true value from the economic strength of the issuing nation.

Gold can serve as a currency because people think it's valuable and accept it as a medium of exchange. The same is true for anything people accept as valuable--tobacco, cotton, deer skins, beaver pelts, sea shells, and American cigarettes all have served as currency at various times and in various places.

People want their currency to be stable. It doesn't really matter what is used as currency. Most currency today consists of electronic entries in computer systems. But people believe these little bits and bytes of data have value, so they accept them as a medium of exchange.

What hasn't changed from the days of the traditional gold standard is the desire for certainty. And that's the problem. The Euro bloc, in which 16 nations have adopted the Euro as a common currency, is simply a reincarnation of the gold standard. By adopting the same currency, issued by a central bank that supposedly must limit its responsibilities to maintaining the value of that currency, the Euro bloc nations hope for an island of stability in the raging seas of the currency markets. But these nations can't reach Avalon unless all members row their oars together and pull their own weight. That hasn't been happening and the ship is foundering.

China and other nations that link the values of their currencies to the U.S. dollar also seek to create a latter day gold standard. Although now a distant memory, there was a time (the 1970s and 1980s) when the dollar was seen in some parts of the world as rock solid. In the Soviet Union and Communist China, U.S. currency was coveted and hoarded, while local currencies were regarded with suspicion and disdain (China has a long history of currency inflation). As China integrated market forces into its economy, it linked its currency to the dollar, not as an export weapon so much as an anchor against inflation. Some Latin American nations that struggled with inflation did the same thing at various times. (Most notable among these were Argentina and Mexico.)

China's dollar link was crucial to its ability to grow. It removed the risks of currency fluctuations, encouraging American businesses to invest in China. The Chinese very much wanted American investment in order to obtain American know how and technology. The intellectual capital gained by China from American (and other foreign) investment leveraged its rate of growth. On its own, China could never have achieved prosperity as quickly as it did.

Of course, as China grew, its currency became more valuable in relation to the dollar and China's dollar link conferred an exporting advantage that is now essential to its economic model. Despite increasing inflation and foreign political pressure, the Chinese want to protect their exporters, because they don't have internal markets to substitute for the export markets they would lose from a stronger yuan. To combat inflation, the Chinese have employed alternatives, such as higher reserve requirements for their banks, price controls, consumer subsidies and sales from state food reserves (the latter a tradition from the days of dynastic China).

Americans shouldn't think that their own government isn't implicated in China's search for a contemporary gold standard. The U.S. government was for a time quiescent about China's exchange rate policies in order to encourage China to ally itself with America against the Soviets, and to open up China to U.S. investment. Moreover, the inflow of inexpensive Chinese goods has helped keep inflation low in America, which in turn permitted low interest rates and booming real estate values. Okay, so not everything turned out wonderfully, but the 2008 financial crisis wasn't the fault of the Chinese. Indeed, they lost money investing in American mortgage-backed securities.

In spite of the financial turmoil of the past three years, Europeans and Asians still cling to their gold standards, looking for certainty in the value of currencies. Gold standards can have short term benefits. Long term, economic conditions change and so do currency values. The squabbles of the Euro bloc over bailouts, quantitative easing, haircuts for creditors and the growing disquiet of German taxpayers, are a struggle over who will bear the costs of maintaining Europe's latter day gold standard. China's accumulation of a vast hoard of U.S. debt securities (and their attendant investment risks), along with the fiscal costs of consumer subsidies and state-owned food stocks, are China's costs of maintaining its 21st Century gold standard.

The gold standard protects savers, investors and creditors. Pure fiat currencies tend to favor borrowers and spenders. Thus creditor nations prefer a gold standard. Borrowing nations argue for free-floating currency rates. A gold standard doesn't necessarily favor exporters--they are better off or not depending on where the exchange or conversion rate is set. The Euro bloc includes both creditor nations and borrowing nations; hence the conflicts that may yet cause the Euro to collapse. The dollar bloc similarly includes creditor nations and borrowing nations; its tensions, too, are palpable.

Ultimately, there is no permanent gold standard or other absolute reservoir of value. The never-ending quest for certainty is trumped by the incessant process of change, mutation and evolution in the economy. (See But the process of human advancement can be said to be a long struggle for certainty. Deliverance from the vicissitudes of hunting and gathering, the extremes of the weather, the unpredictability of farming, the dangers of aggressive peoples, the horrors of plagues and other deadly illnesses, the volatility of the business cycle, and the capriciousness of financial markets all underlie the imperative for human advancement. All the bug-eyed, rifle-cleaning, ridge-dwelling, fringe group wackos panting for the gold standard can wipe the drool from the sides of their mouths and rest easy. It's alive and kicking, and will continue to bedevil central banks, high ranking government officials, policy makers, business executives, and the rest of us as far into the future as one can see.

No comments: