Gold…Gold?Gold!

We’ve talked about gold before, so lets talk some more and add a few graphs to complete the story.

Gold is stable in value, its value doesn’t change. That’s why gold appeared naturally from the market as a means of exchange, because it had the necessary characteristic that money should have, stability. You don’t want your money to be changing value all the time do you? Imagine the chaos.

Here’s a graph:

Shabaaam!  As we can see here, during the gold standard era, beginning in 1500, the value of the dollar maintained a stable value, evidenced here by the straight line we see. The period of 1860 reflects the period when the U.S. government, under Lincoln, began issuing greenbacks to finance the war. Later, the peg on gold was recovered and in 1934 the U.S. devalued their currency to 35$ per ounce of gold. As we can see on the graph, this peg was loosely maintained until 1971, when the Nixon administration completely abandoned the whole idea. Since most currencies in the world were tied to the dollar, therefore operating a gold standard indirectly, the abandoning of the gold standard by the U.S., almost by accident, created the world of floating exchange-rates we have today.

The evidence clearly shows that the gold standard worked. Furthermore, the stable value of the dollar, also worked at keeping inflation at around 0%, since inflation and deflation occur because of changes in the value of currency, though few textbooks will explain the issue like this.

Here are some more misconceptions:

Many people say that a gold standard, limits the money supply to gold mining or something like that. This is of course nonsense, the supply of money adjusts to maintain the value of the currency stable in terms of gold, which is stable in value, making the currency stable, get it?.The money supply is simply a residual of this operation.

As we can see, the evidence supports our theory. During this period, base money increased by 41x. During the same period, the total amount of gold in the world rose by 6.5%(as shown on the chart below). There is no correlation whatsoever. The quantity of money doesn’t depend on the quantity of gold.

This brings us to the next point, which is that people sometimes say that there is not enough gold in the world to operate a gold standard today.

This graph shows all the gold in the world. If we were to color in the proportion of gold owned by the bank of England, who managed the worlds premier currency during that time, we wouldn’t even be able to see it. The total amount of gold held at the BoE represented about 1.2% of all the above ground gold, and as I said, this was the worlds largest currency at the time.

Finally, some economists might even argue that the gold standard wouldn’t allow us to manipulate interest rates, and this might be bad. Setting aside the fact that interest rate manipulation can do little to stimulate the economy, it is well known that under the gold standard, interest rates converged at all time lows. Indeed, England could issue bonds of infinite maturity at around 3% interest, that’s low even for any low interest rate advocate.

Is this relevant today? Of course it is, just look at what’s happening in Argentina and Venezuela. All these currency crisis would be easily avoided if they were using a gold standard. In fact, this is is exactly what Germany did to end their terrible episode of hyperinflation. In 1923, the new Rentenmark was issued, surprisingly, and many Germans called this a miracle, the Rentenmark maintained a stable value. Why? Because it had a link to gold. And what did it take for this to happen? Simply one guy with the knowledge, Hans Luther, and his secretary. That’s really how simple it is.

The problem is, the Argentinian government wouldn’t be able to finance its own deficit by printing money (which is what brought about the currency collapse, loss of value) and maintain a gold peg.

Realistically, we can only expect a government who has monopoly control of currency issuing to abuse this power, specially the case in Latin American countries, where governments have been traditionally more unstable.

The solution is simple, and many initiatives are being made in the right direction. The monopoly power of governments over currency issuing must be eliminated. Some countries, such as Switzerland, are already proposing a parallel currency and this new currency would be linked to gold probably.

A more “extreme” method would be to allow each bank to issue their own currency, as was the system in the 19th century U.S. Why would people take these currencies? Because they are linked to gold.

In fact, any bank that deviated from this and engaged in the keynesian practices of money devaluation that governments today use, would soon be squeezed out of the market. No one likes his money losing value, and with many other bank issuers around competing, this would not be an issue anymore.

This may sound outlandish, but it really isn’t.

Adhesion to the gold standard is in fact listed on the U.S. constitution. Because a stable currency is a right, its actually a form of property right. But that doesn’t seem to matter anymore.

 

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