August 27, 2012

Going for Gold

Posted in Sunday Business Post · 221 comments ·
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Last Friday’s Financial Times contained an article which suggested that the Republican Party is seriously thinking of returning the US to the gold standard, and that it will discuss this idea at the annual party convention in Tampa this week.
Many people will react to this radical idea by asking if the Republicans have learned anything at all from history. But do they actually have a point?
Surely anyone with a grasp of economic history knows that strict adherence to the gold standard, with the balanced budget mantra, at a time of asset price deflation in the early 1930s exacerbated the recession, which morphed into the Great Depression. But is the case as open and shut as that?
While the lessons of that era are reasonably well accepted, there are also those who will rightly point out that, whatever about the 1930s, anyone with a grasp of recent economic history can see that the massive quantitative easing of the past five years has had little or no effect, other than facilitating a massive increase in the US’s national debt.
This is the heart of the matter, and there are two legitimate sides to the argument.
On one side, you have Barack Obama and most moderate to slightly left-of-centre economists, led by Paul Krugman, who believe that the way to jolt the US economy back to life is with as much credit as possible. They contend that the economy is suffering from a liquidity trap, because the banks are not lending money.
Therefore, orthodox monetary policy, where you cut interest rates and the economy recovers on its own, can’t work.
This school of economics – to which I subscribe – sees the recession in the US as a balance-sheet recession, and believe those broken balance sheets are forcing the central banks into more unorthodox policies.
On the other side, you have those who believe that all this printing of money will lead to massive inflation in the US; that the bond market will collapse; and that the US will descend into hyper-inflation, driven by far too much paper money sloshing around the economy, which is the direct result of too much of it being printed in the first place.

By picking Paul Ryan (a budget hawk and admirer of Ayn Rand) as his running mate and paying homage to Ron Paul (an interesting thinker and a man who believes that the Federal Reserve is destroying the US by printing too much cash), Mitt Romney hopes to define the central debate of the US presidential election.

This debate will be over big government versus small government, and the gold standard is emerging as a central plank for the small government side.
The advocates of this side believe that linking the dollar in this way would prevent the government and the central bank from printing money to finance deficits.
This would stop the US budget deficit in its tracks and – they claim – put the US economy back on a solid footing.

How would it work? And what is meant by “returning to the gold standard”?

The gold standard was an exchange rate system that worked very well from 1860 to 1914. It tied all major currencies to gold. If gold reserves began to fall, the country would have to raise interest rates and deflate, with wages and prices falling in order to get gold flowing back into the country, attracted by the high real interest rates.

The currency parity was maintained, but the entire adjustment fell on workers’ wages. As long as workers’ wages were flexible downwards, a country that was experiencing an outflow of gold could rectify itself.
So if a country was experiencing a boom, and its people were buying imports, the amount of gold in the country’s reserves would fall. This would have to be replaced quickly by offering investors a higher interest rate. The higher interest rate would grind down wages, and the economy would deflate.

As long as inflation wasn’t too different between the countries, and workers had few rights, this all worked. But when the big powers went to war with each other, the central banks (to varying degrees) started printing money to pay for guns, and all countries came off the gold standard.

Then, after the First World War, inflation rates were massively different in many countries, so going back to old exchange rates meant huge deflation in countries. This obviously drove up unemployment.

After the crash of 1929 – triggered by an increase in US interest rates – all countries that wanted to stay on the gold standard had to deflate their own economies in the face of collapsing demand. Obviously, wages would only fall if trade unions (which had largely been absent in the period 1860-1914) allowed this to happen. However, they wouldn’t, as they wanted to maintain the wages of their members. The result was that unemployment rose rapidly.

As it went on, deflation fed on itself, while the policy of letting the banks go to the wall caused the amount of credit to fall further, reinforcing this.

Without the government stepping in and boosting demand, the countries of first Europe, then Latin America and then ultimately the US, contracted further. The gold standard, because it implied that you could only increase the money supply if you increased actual gold in the vaults, prevented any reflation.

Ultimately, all countries, when faced with deep recessions, abandoned the gold standard. The US, the last to ditch it, came off gold in 1933. Now Mitt Romney’s team want it to go back to gold, to force the Fed to stop printing money without a corresponding infusion of gold.

The implications of this would, I believe, be a massive recession in the US and massive deflation with it. The gold standard advocates dispute this, though. They say there is no bond crisis on the horizon, and point to the fact that bond yields have never been lower – indicative of a demand for US government paper.

In fact, with yields so low, the gold standards advocates claim that there is no value in US bonds, particularly if the Federal Reserve keeps printing more and more money to finance more and more government programmes.

This is not an academic debate, and it is not going away. For now, the ones in power are those who believe that reflation – via the government and the central bank, using fiat money or created money – is the logical way to go (because there is a balance sheet recession, a liquidity trap and the economy is still very weak). But that might not last.

The US presidential election looks set to pit two big ideologies against each other, and there can only be one winner.


  1. King of Ardagh Gold Chalices

    I am surprised that Paul Moriarty ( aka Maurice Artois ) has not contributed to this article given his extraordinary powers of transportation to locate Gold Chalices.

  2. The reason there was a famine in Ireland had nothing to do with pricing and everything to do with the British Regime exporting all the food bar the rotting spud.

    It was not economic but genocidal.

    Josey

  3. Yes and No .

    The Feudal System in Britain was breaking up unlike the rest of Europe and workers in UK were in revolt seeking more wages unlike in Ireland . Thus the Irish Prices for Corn were cheaper and the Greedy Irish Landlords exported it to make Fat Profits.This was confined to a few landlords .

    I would liken it today to the Irish Financial Regulator who displayed a blind eye to the Crime in his midst in the recent Irish Bank Scandals and the Bankers robbing the country .

    • oh yes the corn wars John. It forced the majority off the land in scotland, undercut by cheaper foreign imports, and into the cities and into the hands of the factory industrialists.

      Very similar to modern day china.

      The Brits though us and the scots an inferior race, Darwin even wrote that for a scandanavian, german or englander to breed with us would be a retrograde evolutionary act.

      Not very Christian of the Pastor now was it.

      Josey

    • I’m glad I’m a least half right :)

  4. bonbon

    Another Wall Street Voice for Glass-Steagall

    In US News & World Report for Aug. 27, another known Wall Street voice emphatically calls for Glass-Steagall restoration, in the person of James Rickards, a hedge fund manager and lawyer for 35 years who at one time was general counsel for Long-Term Capital Management (LTCM), the Greenwich, Conn., hedge fund that in the Fall of 1998 revealed losses on major bets on a Friday and forced emergency weekend meetings internationally for a multi-billion-dollar rescue to a prevent global “reverse leverage” disaster on Monday morning. Rickards is the author of the 2011 book, Currency Wars. “Repeal of Glass-Steagall Caused the Financial Crisis” is the headline of his valuable op-ed.

    “In fact, the financial crisis might not have happened at all but for the 1999 repeal of the Glass-Steagall law that separated commercial and investment banking for seven decades,” Rickards writes. “If there is any hope of avoiding another meltdown, it’s critical to understand why Glass-Steagall repeal helped to cause the crisis.”

    After explaining that the 1920s plunge of the biggest commercial banks, like Chase Bank and National City Bank, into stock and securities dealing, using their depositors’ money, led to the 1929-31 blowout; and that Glass-Steagall then prevented bank panics for 70 years, Rickards takes on the arguments of Tim Geithner and fellow Wall Street apologists against Glass-Steagall.

    “One bank supporter says you cannot blame banks for fraudulent loan originations because that was done by unscrupulous mortgage brokers. This is nonsense. The brokers would not have been able to fund the loans in the first place if the banks had not been buying their production. Another apologist says the fact that no big banks failed in the crisis proves they were not the cause of the problem. This is also ludicrous. The reason the big banks did not fail was because they were bailed out by the government…. Yet another big bank spokesman says that nonbanks such as Lehman and Bear Stearns were more to blame for the crisis. This ignores the fact that nonbanks get their funding from banks in the form of mortgages, repurchase agreements, and lines of credit. Without the big banks providing easy credit on bad collateral like structured products, the nonbanks would not have been able to leverage themselves.”

    Rickards is 100% right on all these points. He concludes, “Without the banks providing financing to the mortgage brokers and Wall Street while underwriting their own issues of toxic securities, the entire pyramid scheme would never have got off the ground. It was Glass-Steagall that prevented the banks from using insured depositories to underwrite private securities and dump them on their own customers. This ability, along with financing provided to all the other players, was what kept the bubble-machine going for so long.

    “Now, when memories are fresh, is the time to reinstate Glass-Steagall to prevent a third cycle of fraud on [bank] customers.”

    • Tony Brogan

      Rickards knows too that in currency wars the last man standing is gold the ultimate money. he recommends a large share of a portfolio to be precious metals.

      • bonbon

        We do not intend to go to a “last man standing” scenario. We are going to a future which von Hayek could not possibly conceive of with his smallness of mind.

        What is blocking the future is now being identified, and Glass-Steagall is the door to open. Then it is immediately clear, once we shrug off this financial chain, a totally different Public Credit system based on the Nation State committed to science-driven economics.

        Science-driven, not gold-enchained.

  5. Philip

    Extending the thinking on funny money and monopolistic control of commodities, you can see that if you double the number of dollars out of nowhere, prices for CRITICAL commodities will increase accordingly. Why?

    Well, with all that extra funny money people will be prepared to pay more to a monopoly who fully knows that the ability to pay the higher price is there.

    By the way, futures in commodities are being bought long. That means they are hogging it until you starve or pay up.

    http://www.foreignpolicy.com/articles/2011/04/27/how_goldman_sachs_created_the_food_crisis?page=0,1

    http://www.nytimes.com/2012/04/11/opinion/ban-pure-speculators-of-oil-futures.html?_r=2

    http://www.guardian.co.uk/global-development/poverty-matters/2012/may/10/stop-banks-gambling-food-prices

    The markets are not working a proper futures should.

    This now might explain the poor lending performance of banks. If I am getting more funny money to clean by balance sheet, what would you do as a typical banker…give it to a small business OR stick it in futures what are ballooning courtesy of our monopoly hoggers.

    Scary times guys…

    • Tony Brogan

      “Extending the thinking on funny money and monopolistic control of commodities, you can see that if you double the number of dollars out of nowhere, prices for CRITICAL commodities will increase accordingly. Why?”

      Increasing the money supply is the inflationary event.In your example. If everyone woke up tomorrow with double the amount of currency. Nobody would be better off as the value of goods and services remain the same while the value of the money would now be half what it was. (Same amount of goods and services but double the money)

      Adding to the money supply does not increase or create wealth.

      do the same thing but give it all to 10% of the population and what happens.
      The first recipients of the money can spend it at par. Then the demand for those things puchased goes up and the price rises. Assume the 10% spend all the money. They get to aquire goods at the original prices and so can aquire more and become more wealthy. As the money circulates through the economy the earlier recipiants do better than the later. those that receive none of the new money find that their money is devalued in buying power and they can’t afford what they used to.
      The rich get richer and the poor get poorer. Explained is why inflation is bad for society. Why the devide is wider than ever.

      “This now might explain the poor lending performance of banks. If I am getting more funny money to clean by balance sheet, what would you do as a typical banker…give it to a small business OR stick it in futures what are ballooning courtesy of our monopoly hoggers.”

      most bank reserves in the near past were as little as 3-5% If 20% of the loan portfolio has a problem then if banks mark the loans to market have to write down these loans. Say they are worth 50% of face value.

      The bank assets now reduced by 10%. with only 5% reserve they as technically insolvent. That is 5% underwater..
      Central bank issues billions in funds to banks but banks hold the money to try to balance the accounts and get a poitive ans reduce there reserve ratio. no money comes out the other side to lend. We have a credit crunch and more loans default, and more businesses go under. etc.

      blame the hedge funds trying to make a buck in a no interest environment for investing in futures. Blame investment banks too. Goldman sachs has been called the Giant Vampire Squid.

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