By James H. Nolt
This past Monday I was invited to speak about China’s current debt problem at a meeting of the Committee for Monetary Research and Education. The group was founded in 1970, just before the demise of the Bretton Woods system, the last global monetary system that linked the value of the dollar to gold. Most CMRE members are “gold bugs,” meaning they want to restore a gold standard value for the U.S. dollar and other world currencies.
Most economists today are against restoring the gold standard, but my reasons for being skeptical about gold are different from those of most economists. Many textbooks argue that international monetary systems vary along three characteristics: 1) whether exchange rates are fixed, 2) whether currencies are freely convertible from one to another, and 3) whether governments are able to manage monetary policy autonomously according to national economic priorities. According to conventional wisdom, no monetary system can achieve all three. Most achieve two of the three.
Monetary systems based on fixing the values of various major currencies to a set quantity of gold achieve the first two only: fixed exchange rates (most of the time) and free convertibility of gold-based currencies. During major wars, such gold standard systems always break down because of efforts to prevent trading with the enemy and to conserve scarce foreign exchange for war priorities. Just as many goods are rationed during major wars, so are currencies.
Rationing of currencies is achieved using exchange controls whereby the government licenses all foreign exchange transactions. Anyone wishing to move money abroad or to repatriate funds back home must apply for a government license for each specific currency exchange. Exchange rates often differ according to the uses or sources of the foreign currency, allowing government planners the ability to reallocate foreign currencies toward priority needs. Such controlled monetary systems sacrifice free convertibility, but typically retain fixed exchange rates and of course grant officials considerable autonomy to manage their economies according to national priorities.
Exchange controls were common during the two world wars and their aftermath, the Great Depression of the 1930s, and typical of socialist economies and developing countries until the 1970s. Today, no major countries and only a few smaller ones maintain exchange control systems.
The contemporary floating exchange rate system has been in operation among most currencies around the globe since 1973. This system sacrifices fixed exchange rates but maintains free currency convertibility and monetary autonomy for governments to manage their economies.
Gold bugs contend that the world monetary system that has prevailed since 1973 has been a disaster. They blame it for inflation, rapid growth of debt, economic instability, and sometimes even wars. However, my view is that they fundamentally misunderstand the nature of money, credit, and economic history. They base their arguments more on textbook myths than on real economic history.
There have been various metallic monetary systems through history. The classical gold standard is one of them, but silver standards were more common until the last third of the 19th century. The specific metal chosen as the standard matters a lot, because various metals change in value relative to each other. For example, over the course of the 19th century, gold approximately doubled in value relative to silver. Great Britain, then the world’s largest economy, was on the gold standard from 1818 to 1914, but most of the rest of the world was not firmly committed to gold until the last half century of that period. Other currencies, pegged to silver, tended to fall in value relative to the British pound until they too were pegged to gold.
The pound was therefore an exceptionally strong currency during the first half of that period, which meant British exports rose in relative price. But as it was also the high point of the first industrial revolution, centered in Britain, this rise was counteracted by the cheapening of British manufactured goods as productive technology raced ahead. Consequently, British exports flourished despite a strong pound; in fact, the strength of the pound helped Britain import the raw materials it needed, such as cotton, increasingly cheaply.
Even more important than the trade effect of the strong pound was its impact on investments. Because the gold pound tended to hold its value better than silver currencies, foreign investors loved to buy bonds and bills denominated in pounds. This helped make London the world’s biggest market for financial securities by far. Even transactions not involving British subjects on either side often passed through London markets. For example, Italian merchants trading with Swedish ones might finance their operations by issuing pound-denominated bills in London because such bills reliably held their value and the London market was so active and thus liquid. Governments around the world often preferred to borrow by issuing bonds in London. The city was indisputably the world financial center from 1818 to 1914.
However, being dependent on the London market also made creditors worldwide vulnerable to any disruptions in it. Textbook economics and many free market proponents pretend that economic crises originate with bad government policy and are not intrinsic to markets themselves. Yet this period, often known as the heyday of laissez-faire economics, was punctuated by frequent and severe economic crises. Many of these crises originated in markets for circulating credit, especially the London bill market. Because of its worldwide importance, any problem there was propagated everywhere.
All the problems characteristic of the current floating exchange rate system—rapid accumulation of debt, financial crises, a boom and bust business cycle, widespread bankruptcies, and wars—occurred under the gold standard system no less frequently and severely than today. The reason is that gold as a standard of value facilitated a flourishing private credit system comparable to today’s system. Chronic cyclical instability is a feature not of any specific monetary system but of all private credit systems, with their tendency to create and polarize bears and bulls, as I have argued since the inception of this blog series.
Gold bugs disparage excessive creation of “fiat money,” paper money created by governments or their central banks, while in fact most expansion of credit throughout history has been according to the collective whims of private creditors, not governments. A private financier throwing speculative bills onto the market (a common element of every financial bubble in history) is able to create such “fiat money” no less readily than governments might, if it suits his interest.
Broadly speaking, expansion of purchasing power occurs from the private expansion of credit, not principally from the actions of governments, although occasionally governments do issue credit profligately. Governments are somewhat more constrained from doing so as long as they are trying to maintain a fixed gold currency value. Nevertheless, throughout history, in the absence of government regulation and interference, private bulls have always shown themselves capable of blowing bubbles in their own selfish interest. Pegging a currency to gold in no way restrains this.
James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.
[Photo courtesy of Agnico-Eagle]