Gold Standards Elucidated:

TSIBR enjoys hanging out, every now and then, at Sage Francis’ highly politicized Strange Famous Records Forum:

http://www.strangefamousrecords.com/forum/viewforum.php?f=1

Things really stay poppin’ over there – for example, the forum exchange I am about to post, which explicates gold standards, answers readers comments, and addresses Ron Paul's views on gold, generated over 500 hits in less than two days.  Below other poster’s comments and questions will be in italics, my prose will be in regular font; and away we go…

Questions regarding 'gold standards' - what they mean, how they have worked in the past, why gold, why not now, why before, etc. - come up quite often around this forum.  As a political economist with a Ph.D. in Sociology and an interest in world financial systems I have studied the issue in some depth.  The following is an essay that I cobbled together from questions I have previously answered regarding gold standards.  I hope this helps to shed some light on the subject for the curious:

Let’s start at the beginning.  Theoretically there is really nothing too 'special' about gold as compared with other metals or commodities.  Its attractiveness, malleability, and lightweight portability made it a good proxy for value in Europe and beyond for millennia.  Additionally, because it is incredibly difficult to make convincing fake gold (especially earlier in history) people knew they were getting the right weight in gold when they transacted in gold. 

Over a period of centuries bankers in Europe came to use gold as their main store of value, and since that time gold has often served as the backbone of paper money simply by dint of historical inertia. ‘Goldsmiths’ as they were called would hold gold in vaults and issue paper that directly represented a certain amount of gold in their vaults.  These were the first ‘bankers’.

Interestingly, Immanuel Wallerstein and Fernand Braudel (two famous historical sociologists) have argued that prior to the discovery of the new world, gold (or paper representing stored gold) had become the standard store of value used in most transactions throughout Europe.  When the New World was discovered, all of the sudden there was alot more gold.  That gold rained down on Europe like manna from the sky (although we shouldn't forget that this gold was soaked in indigenous blood) and in the words of Wallerstein 'spawned capitalism'; suddenly there was surplus capital (i.e. gold) accumulating at theretofore unforeseen rates and levels.

So you see, gold became 'money' mostly by historical happenstance, and then discoveries of new gold suddenly meant more money.  So everyone searched for gold in order to have more money, and this perhaps spawned the original modern capitalistic dynamic. 

Now fast forward some three centuries and we arrive in 18th century Britain.  During the 18th century the Bank of England (BoE) brought order to national currency fluctuations by maintaining a gold standard - i.e. the pound was convertible to gold at a direct rate.  This prevented the British government from printing up paper money simply because it needed to or could (as France often did, leading the French economy to be weak and problematic). 

But what the BoE also discovered was that if citizens over time developed confidence in the BoE's management of currencies, then the BoE could periodically leave the gold standard in order to prevent credit collapses.  Thus during times of economic stress the BoE would suspend convertibility of pounds into gold thus enabling the BoE to print money with abandon for a time.

However, the BoE also realized that the long run effect of such crisis moments was to stimulate inflation thus eroding people's confidence in the BoE and the pound.  Thus to restore confidence and limit inflation, the BoE would reintroduce gold convertibility once the crisis had passed.

So really, by the 18th century, gold had become a check on a nation's propensity to over issue currency during times of crisis.  Nevertheless, economies of course grow over time, and thus they naturally need more currency.  On a strict gold standard, the only way to have the amount of currency grow is to mine more gold.  The idea is that the growth rate in gold discovery should mirror the growth rate in the economy, and thus the money supply will naturally grow in lockstep with economic growth.

Although there are still a few diehard strict gold standard advocates, I am not one of them.  I am in favor of gold acting as a check on government's ability to print currency (it need not be gold playing this role, it could be any portable / storable commodity, but it always will be gold because of historical inertia – people believe in gold as a store of value and thus central banks sit on a mountain of gold).  But I also believe that governments must have some flexibility to adjust the money supply in relation to gold given economic growth, development, and contingencies. 

The interesting and complex Bretton Woods system, which regulated currencies in the global economy from 1945-1973, allowed for some monetary flexibility, but with the constraint of dollar-gold fractional convertibility and periodically fixed and reviewed exchange rates.  In other words, other nations’ currencies floated around the dollar at rates that were fixed, but periodically reviewed, and the dollar was convertible into gold at a rate that was fixed but also periodically reviewed.  The rate at which the dollar was convertible, and also the rates at which all foreign currencies could be turned into dollars, was regularly determined by a meeting of the major powers of the globe.  In between meetings trade would put pressure on the pre-determined exchange bands, and at the next meeting, exchange rates would be adjusted accordingly.  The fact that the dollar was convertible to gold and all other currencies floated in a tight range around the dollar provided a check on any one country's propensity to issue currency in order to ease economic downturns.

After Vietnam the US was experiencing a heavy debt burden amid stagnant economic growth.  American indebtedness continued to grow even once the US had competed the pull-out.  In order to finance the debt burden without causing interest rates in the US and elsewhere to rise, the US government began issuing more and more currency.  Eventually, traders around the globe caught onto this occurrence and speculative attacks began on the dollar and other western currencies.  Rather than face the pain that would be required in order to maintain gold convertibility in the face of mounting speculative attacks, Nixon opted to leave the gold standard.  Although most nations continued to peg their currencies to the dollar, the dollar was now floating and subject to the whims of the US government with no automatic check.

After 1973 and the end of dollar/gold convertibility it became much more difficult to obtain a read on whether the growth in the money supply was reaching levels that would down the road cause inflation (or worse).  Previously gold would have told you, because if too many dollars were out there given the gold convertibility rate, people would simply exchange their dollars for gold, pressure would then be put on the convertibility rate, and the convertibility rate would have to be reviewed and changed.  This would not only reduce the value of each dollar in circulation, but would also serve as a caution to the Federal government that their monetary and debt policies were too loose - continue down that road on a fractional reserve gold standard (I use the fractional reserve language here simply to highlight the difference between a strictly fixed gold standard and the more malleable one that I am discussing) and you quickly get to a place where the dollar is worthless and everything including gold is incredibly expensive vis a vis dollars.

That is precisely the road that America was on when Nixon opted out of gold convertibility for the dollar; gold had acted as an automatic check on US propensity to issue dollars and debt, but now that check was gone.  At first, the dollar rapidly declined in value, thus breeding the stagflation of the ‘70s.  The dollar continued to decline in value until Fed Chief Paul Volcker rose interest rates in the US to well above the real rate of inflation (between 15-20% I believe), thus stabilizing the dollar.  At that point, the globe once again became very comfortable using dollars for savings and transactions, as if the dollar was backed by gold (although it was not).  Thus, once the dollar had stabilized, Alan Greenspan (and the US for that matter) was able to enjoy a long period of years where interest rates could be lowered without destroying the value of the dollar.

As a partial consequence, global development picked up pace, quite rapidly after 1982 or so.  Such rapid development mopped up excess dollars in the system as many of the globe's developing nations came to keep most of their savings and reserves in dollars.  Suddenly the Fed could print up many many more dollars because developing nations were accumulating them and then just hanging onto them.  In fact, in order to gain interest on their dollar holdings, developing nations used their dollars to buy US Treasuries, which meant that the US government could now go into multiple trillion-dollar debt without experiencing rising interest rates and inflation.  As a consequence, what can be considered a massive dollar/treasury bubble formed with dollars and treasuries being priced in markets far higher than US economic strength could support over the long-term.  In fact, it is safe to say that the tech bubble and housing bubble were both really an effect of the dollar/treasury bubble which has been growing for decades and will soon be in the process of bursting (if not as I write this).

What will become clear as that bursting occurs is that by 'exporting' its inflation (i.e. excess dollars) to developing nations (who were happy to just sit on their dollar reserves), the US has merely postponed the inflationary consequences of printing up too much currency.  There is a limit it would seem to how many dollars developing nations are willing to accumulate.  Such accumulation poses great risk for developing economies if the dollar declines.  The credit crisis has highlighted this danger and made it all the more real.  In fact, currently since the only option to avoid a sudden cessation in all economic activity is for the US to print up more and more dollars, it seems the globe has reached some new terminal stage of the dollar based fiat floating exchange rate system that has governed all economic exchange since 1973.

Thus presently nations en masse are looking for ways to diversify out of the dollar without causing the dollar to crater thereby destroying the value of whatever dollar holdings they have left.  It’s sort of like a game of chicken - who can diversify the furthest and fastest without entirely derailing the global economy.  Meanwhile, the only 'tool' available to the US to combat the credit crisis is the printing of more dollars, thus deepening the game of chicken and its ultimate consequences. 

Had the US never left the gold standard, developing nations likely would have put their reserves in gold rather than dollars and the US would have been prevented from printing up excess currency and exporting it to the developing world.  Additionally credit would never have been as easily obtainable as it was in the 1990s (and really up until just recently), and thus we never would have gotten the tech bubble, the housing bubble, or the credit crisis, which are all really symptoms (in my opinion) of the dollar bubble that was enabled by the US leaving the gold standard.

READER QUESTION:

Grantherbirdly wrote: "so why doesn't gold get swept into the market as just another instrument subject to supply and demand and thus become prone to wild variations of value?"

When the world economy is not at on a gold standard, this is precisely what happens to gold.  When the world is on a gold standard, gold can still fluctuate within a tight band (depending on the type of gold standard).  This band is predetermined by the nations maintaining gold convertibility of their currencies.  If the price of gold gets close to the upper limits of the pre-determined band this means that nations are issuing too much currency. 

At that point nations can either raise interest rates to choke off the creation of more currency, or raise the band itself to allow gold to fluctuate at higher levels.  So in a gold standard type system the price of gold is still subject to supply and demand, but governments make sure to adjust the money supply, thus affecting the demand for gold, in order to keep gold within the predetermined band.

When there is no gold standard gold is free to fluctuate any which way it might, as it has recently.  Over time though, gold prices should correlate with the amount of money in circulation vs. the amount of economic activity.  That's why if a nation prints currency into a downturn gold should be expected to rise.  Gold, given the history discussed previously, always stands as a key measure of currency depreciation vis-à-vis the existing stock of commodities.

READER QUESTION:

What do you make of this Ron Paul essay on gold?

http://www.house.gov/paul/congrec/congrec2006/cr021506.htm

Oh boy, trying to bait me into a Ron Paul debate are ya?  Well, ok, despite my better judgment, I’ll bite.  Before I get into this a bit, allow me to say that I have libertarian leanings, but I do not think that Ron Paul is the right face for the libertarian movement.

To his essay: Normally I don’t criticize writers for condensing thousands of years of history into a paragraph (sometimes this is necessary).  But when writers do so in order to make a clearly polemical point seem simply true, I bristle.  Towards the beginning of Paul’s speech, he talks of ‘moral decline’ as always causal for the fall of empires – I completely disagree.  What Paul would view from today’s world as ‘moral decline’ was simply culture back then.  To poorly summarize thousands of years of history in order to take a moralistic stance is, in my book, sadly silly.

For example, let’s take this sentence:  “When gold was used, and the rules protected honest commerce, productive nations thrived.  Whenever wealthy nations-- those with powerful armies and gold-- strived only for empire and easy fortunes to support welfare at home, those nations failed.” Oh really?  What nations are we talking about here?  Clearly the sentence is making a point about the US, but the point is made as if history is littered with nations that have had welfare programs of any sort.  This is simply disingenuous; in fact it’s absolutely ahistorical and ridiculous.

I would tend to agree with Paul that the Hegemon, i.e. the nation with the most military and economic might, is inevitably going to determine the rules of the global financial system.  But then he slips right back into that moralistic pejorative tone with: “The one problem, however, is that such a system destroys the character of the counterfeiting nation’s people.”  Gimme a break Grandpa.

Of course, Paul and I are in agreement that political pressure to inflate currency is too strong to bear for a nation not on a gold standard.  I also agree with Paul’s general descriptions of the Post WWII financial system, the role played by oil and currency in recent wars, and that the ultimate consequences of ever greater American indebtedness will ultimately be hyperinflation, more war, and an eventual return to some sort of gold standard.

However, Paul and I are in complete disagreement regarding what sort of gold standard system would best anchor today’s incredibly complex and dynamic informational global economy.  Paul believes a strict gold standard would work; I believe such inflexibility would greatly limit innovation and dynamism in today’s world. I would argue that only a flexible gold standard, managed by central banks, and composed of regularly agreed upon exchange trading bands (as described above) would allow dynamic economic growth to continue while at the same time providing a regulatory stick.  We need Bretton Woods II, not some idealized system of total private exchange governed by no state-related entities; a system, I might add, which has never truly existed, will never exist, and indeed cannot exist.

Last night I saw Paul on Bill Mahr and he was spouting about central banks being responsible for the business cycle.  I think Paul often misreads history to make his anti-governmental moralistic points.  When one closely studies capitalism’s development, one finds that in the nations that first spontaneously generated the system, central banks, capitalism, and business cycles developed synchronously.  One cannot separate central banks, modern markets, and business cycles; together, they are and always have been what the foundation of capitalism is.

Any nation that has practiced capitalism without a central bank (the US for example at times during the 19^th century) has always had the central bank of the Hegemon (the Dutch in the 16-17^th centuries, Britain in the 17^th-19^th centuries) to rely upon to regulate currency and money supply in global trade.  There has never been a capitalistic world financial system not anchored by the central bank of a Hegemon.  If one looks domestically at the periods when the US did not have a central bank, those periods were ones of extreme and extremely rapid boom bust cycles.  Indeed, as is usually the case, once the US adopted a sound central banking system, business cycles became more regular. 

The problem with central banks is that they become victims of their own success.  They begin to believe, like the citizens of the economically successful nation, that business cycles are coming to an end, that unending prosperity has arisen, that old economic laws can now be thrown out the window.  Thus after a long period of moderate business cycle fluctuations, there develops a huge boom where sound banking principles are thrown out the window.  Then comes the bust.  Hence the Great Depression and our current Inflationary Depression.  But the answer is not to do away with central banks, that’s moving backwards instead of forwards.  We might as well just return to barter. 

The answer is to create a better global central banking system, flexibly anchored to gold, and based upon time-tested sound banking principles; similar to the financial system that allowed the British economy, overseen by the Bank of England, to industrialize, export industrialization to the world, and grow without severe disruption from c.1780-c.1880.  Similar to the Bretton Woods system that enabled a period of global growth and exponential technological development theretofore unforeseen.  But slightly novel, thus incorporating IT based financial instruments and technologies along with multi-polar globalization.  Can I outline for you now what that system might ultimately look like.  Probably not.  Am I going to try?  Not today, of that, I am certain.

READER QUESTION ADDRESSED:

You write: "When the New World was discovered, all of the sudden there was alot more gold.  That gold rained down on Europe like manna from the sky (although we shouldn't forget that this gold was soaked in indigenous blood) and in the words of Wallerstein 'spawned capitalism'; suddenly there was surplus capital (i.e. gold) accumulating at theretofore unforeseen rates and levels."  You seem to be suggesting that this unprecedented influx of gold to Europe helped pull it out of the middle ages and into something more closely resembling modern capitalism, with the corresponding increase in economic productivity and commercial complexity. 

Now hold on just a second.  I said that Braudel and Wallerstein came up with this idea; I never said I completely agreed with it.  I think there is merit to the theory, but by itself it is insufficient to explain the rise of capitalism, insufficient by a long shot.

From this angle, the arrival of surplus capital led to a flourishing of industry and innovation.  What I don't understand is why the abundance of circulating gold didn't instead lead to inflation.  After all, wouldn't there simply be too much gold around for it to retain its former value?

This is an intriguing and erudite point.  The reason why gold did not spur inflation in Europe upon its arrival from the New World is that the European economy had already established a growth dynamic that was being held back by a gold shortage.  The European interstate trading system had become quite trade and market oriented by the 15^th century.  That is why the Discoverers were being sent on missions to find new spices, trading routes, and gold.  Little did they know they would find the motherload.  Once found and brought back to Europe, ships quickly got bigger and better while shipbuilders and merchants became locked in competitive struggle to gain more gold.  Fortunes were amassed and stored in goldsmith vaults; goldsmiths then began to issue paper convertible into gold.  Soon enough goldsmiths realized that they could have more paper out in the world than gold in their vaults as long as everybody maintained confidence in their paper, fractional reserve banking developed, yadda yadda yadda, capitalism.

What that neat little story misses is the strange and unique internal institutional development (and by institutions I mean codified laws, practices, and enforcement mechanisms) that occurred in certain European countries, which allowed the gold to have an expansionary rather than an inflationary effect.  Now, this is very complex and if you want to learn more you should read North and Thomas’s Rise of the Western World: A New Economic History.  But the basic point is that certain nations in Europe, owing to their historical trajectories going back to early Feudalism, developed institutional systems that allowed for the development of market dynamics, rulers under the law, and proto-democracy. 

Interestingly, most of the gold ended up in these countries.  Of course, Spain brought the most gold back to Europe, but Spain rather quickly became less powerful than the Netherlands (and later Britain).  This is because Spain eventually came to rely on the Netherlands for their ship production and such.  The reason Spain did so was because the Dutch ships were better.  They were better because the Dutch had developed market-supporting institutions that promoted competition and contract enforcement, while Spain had not.  As gold traveled from Spain to the Netherlands, so too did banking, global trade, and military power.  Soon the Dutch were the first Hegemon presiding over the very first capitalist modern world-system.

So was it the gold that spawned capitalism, or was it the institutions?  Why, of course, it was both; but the institutions came first, having developed over hundreds of years.

This leads to my larger question of what exactly "value" is, and what creates it.  The only theory of value I'm familiar with is Marx's, which from what I understand has been discredited (no pun intended). 

Marx’s theory of value was rejected for the law of supply and demand.  According to neo-classical economics all economic things have value because they are desired.  In order for something to be produced, people must be willing to pay marginally more than the cost to produce said thing.  As an economy develops, there are more and more economic things.  These things have value in relation to the supply and demand matrix that rises up around these things.  In Europe (and elsewhere), gold was one of these things.  It was pretty shiny, sparkly, light, malleable, seemingly magical.  But most importantly, it was portable and difficult to mimic. 

So imagine a situation where one trader has a ship and another trader has some hogs, and the hogs need to get on that ship.  But the shipowner says, listen man, I cannot get my ship to you until I sell my share of them pigs that you will owe me for transporting said pigs.  I need capital to buy sailors and supplies and such.  What to do?  Let’s sign a contract to have my goldsmith transport gold to your goldsmith, you bring your ship over here, my pigs get on that ship and we get down to selling some pigs.  Ya see, any pretty, portable, malleable, desirable commodity could have played the role of money, thus gold did.  Something needed to.  Precisely because market institutions and trading dynamics were developing throughout Europe.  Which came first, the trading system or the gold?  Neither, both, whichever, it doesn’t matter.  Fact is that trading and the use of gold as money developed synchronously in Europe.  Maybe god, if there is one, understands why more specifically.

The reason I ask about value is because it seems to exist in a paradoxical relation to capital, a relationship that in my eyes feels borderline magical.  Let me attempt to explain.  On the one hand, as you stated, the substance in which abstract value gets instantiated is arbitrary.  Be it gold, a dollar bill, or a diamond, these vessels of value are useless in and of themselves, or, put another way, they're valueless (in Marx's words, devoid of use value).

Not at all true.  Gold and diamonds are commodities.  They have been used for millennia to produce desirable decorative ornaments.  The dollar bill on the other hand is a piece of paper representing an IOU.  The IOU used to mean that the government would redeem the paper for gold at anytime.  Now it simply means that the US says this means value, which in the end means nothing at all.

But then on the other hand, and this is what mystifies me to no end, these useless vessels seem to not only hold, but create value.  From what I understand of your original post, the huge growth experienced in the United States from 1982 up until the recent collapse was largely attributable to the lowering of interest rates and the concomitant flood of dollars into the market.

Not at all.  In the 1970s, as the US economy sputtered, certain developing nations for the first time adopted capitalist market institutions.  In these nations developed a powerful growth dynamic.  After Volcker raised interest rates in the US to high enough levels to make the dollar seem as good as gold again for a while, dollars began to play the role in the newly industrializing countries (NICs) that gold had played in 16^th century Europe – dollars fed a growth dynamic that was already present and growing.  Mutual trade between the US and the NICs, and the NICs sitting on huge dollar reserves, then allowed America to issue more currency and debt than the long term growth dynamics of the American economy could handle, while also suppressing interest rates and inflation, as previously discussed.

Suddenly wealth was being generated where it previously didn't exist.  Across the globe, cell phones appeared in people's hands, flat screens on their walls, big houses rose around them, new roads were paved beneath them, and so on.  The previously poverty stricken found themselves elevated to the middle class.  The middle class vacationed more.  The already rich got obscenely rich.   I've obviously oversimplified here, but the point is this growth was at least partly a function of America's profligate printing of dollars and the willing purchase of these dollars by foreign countries.  As if by magic, then, the mere [i]presence[/i] of this useless rectangle of paper drove tangible development in almost all sectors of the economy.  To repeat myself, during this period dollars seemed to have in fact created, or at least helped cause the creation, of value.

Again this is an intriguing point, although I’m not sure the facetious tone makes this important point well.  In a nutshell, the question you are posing is: would the world have had an IT revolution without the US leaving the gold standard?  And I would have to say no.  With US productivity and growth declining in the 1970s, there would not have been enough dollars in the world system to support growth in the NICs along with IT development in the US, most of which in fact arose out of deficit military spending made possible by the US leaving the gold standard.  Make of that what you will.  Regardless, throughout capitalist history, Hegemons have often left the gold standard only to return to it after imbalances forced them to.  Here we go again.

But here's where things get paradoxical, and where I get confused, and why I think any good economist needs a degree in psychology as well.  The current economic crisis did not result from some outward catastrophe, from a drought in Southeast Asia that decimated crops or a final depletion of the world's oil reserves.  Rather, it was caused by the financial system imploding on itself. 

The financial system imploded on itself because of massive global over-speculation on housing and exotic new fangled financial instruments.  Like any bubble, it became little more than a poorly regulated pyramid scheme.  Pyramid schemes are built on greed.  Pyramid schemes collapse when everybody who is already in can’t find or get enough new people into the scheme in order to reproduce profits.  Then it all crumbles like a house of cards.  Of course, at the levels of global economy nobody knows when that tipping point will hit.  But when it does, psychology turns from greed to fear, and then the psychology of fear governs the dynamics of the crash.

But lets linger here for a moment.  If nothing outwardly changed,  i.e., if the real economy remained constant, then how could the dollar suddenly cross that tipping point from being a value-creator to literally stealing back its value by closing down factories, turning homes into abandoned boxes, and sapping productivity across the board?

Real economies never remain constant.  The dollar is nothing more than paper.  It doesn’t steal anything.  It represents value based on the amount of dollars in circulation and the desire for dollars globally.  If the dollar declines, it is because the supply and demand matrix for dollars has changed.

Am I wrong in my notion that printing money can actually create value and in fact value, in relation to money, is actually a zero sum game, such that what we perceived as growth over the last 30 years was actually just a grand illusion that is now being dispelled?

I would have to say that this is an interesting point, but misguided.  Commodities have value.  Printing money without increasing the stock of commodities simply means the price of commodities will go up.  Increasing the money supply in an environment where lack of liquidity is holding back potential GDP growth will unleash that GDP growth; potential GDP growth in turn depends upon the institutional and economic dynamics at play in any given period and/or economic system.  As for growth over the last 30 years being an illusion, answer me this: Is the computer you are reading this on an illusion?

Which returns me to my earlier question about value.  It seems the ideal economy has a little more money than the total state of transactions necessitates in order to spur growth, but not too much money to cause it to return to its state as mere material, a shiny chunk of mineral or a flimsy sheet of green.

Precisely.

If even half of what I've written makes the slightest bit of sense, than I'll mark this as a success.

Success indeed.

Joshua Kane