Part III – Gold Standards, the good, the bad, and the ugly. Gresham’s law and gold. Is it even possible to return to a gold standard today? Is Russia leading the push, or do we need something else?
What A Gold Standard Isn’t
Can we all recognize the simple fact that every government price-fixing scheme, ever, has failed?
For example, banana republics have declared their pesos to be worth $1. But when the market decides to redeem pesos for dollars 1-to-1, the central bank abandons the peg. A less-understood example is when the Swiss National Bank decided to hold its franc down to €0.77. It boasted it could print as many francs as necessary to keep the franc down. But it hit its stop-loss limit, and was forced to abandon this peg just like all the banana republics.
The gold standard is not a price-fixing scheme.
When Gold Meant a Dollar
In the US, going back even before the Founding and the first Coinage Act of 1792, there was not a price of gold. That is, there was not a monetary thing called “dollar” separate and distinct from gold, and an exchange rate between dollars and gold. The dollar was defined as 24.75 grains of gold (just over 1/20 troy ounce). Dollar meant that amount of gold, and that amount of gold meant a dollar.
Back then, there was no question that if you deposited money (i.e., gold) in the bank in exchange for a bank note, then you had a right to withdraw that same amount of metal later. The unit “dollar” was a standardized unit of deposit. This made it convenient so that people with “dollars” in different banks could compare and even accept each other’s notes. Much like a byte is 8 bits, and a packet sent on the Internet is 1,476 bytes. This does not restrict the size of the file you can transfer over the network. It just says that the file will be transmitted in packets standardized to this size.
Retroactive Gold Redeemability?
So what’s different today? There are no bank notes that were issued upon deposits of gold. All bank notes were issued as irredeemable credits. It would be impossible for the government to retroactively declare them to be redeemable in gold. We don’t just mean that it wouldn’t work (it wouldn’t). We mean that a bank deposit or a bank note is a separate thing from gold.
Gresham’s Law would kick into effect. Whichever had the lower market value, the official government currency or the amount of gold it was declared to be worth, would circulate (i.e., the currency). And the other (i.e. the gold) would not. And runs on the bank would accelerate until the central bank ran out of gold or dishonored its promise.
Which is why no one will trust that promise in the first place. And even the very article making the case for higher gold prices based on the alleged coming of a promise to make rubles redeemable, advises readers not to buy rubles.
A gold standard also isn’t created or defined by having some determined ratio of paper currency to gold. This attempts to reverse cause and effect, as in a ratio of street wetness to rain. We will get back to this, below.
Another Issue to Declaring Redeemability
Let’s make an analogy, which may help shed light on the not-gold-standard from a different angle.
Suppose that people are allowed to live where they want and move to other places without restriction. In a country like this, there is no reason to fear that a city or even a whole region could be depopulated by a population that runs away. This is how America still mostly operates (though this is distorted by zoning restrictions, building permits, etc.)
In other countries, one cannot leave without government permission. In some cases, populations were originally moved for work or punishment. And even today, their descendants are still forced to reside where they don’t want to be. Governments of these countries must fear that if they allow movement without restriction, then there could be massive dislocations.
This applies to bank deposits as well. If everyone has their money where they want it, then there is no reason to fear a sudden mass movement of money. But if several generations have been forced to extend credit to the banks, whether they would or not, whether the interest rate was to their liking or not, then the government fears what would happen if they suddenly allowed movement of money (i.e., bank notes to be redeemed for gold). Even leaving aside the (intractable) question of what the right exchange rate should be, government cannot declare gold redeemability.
It is not a matter of having the right amount of gold. No amount of gold will work, if the government fixes the price too low. Redemptions will be unceasing.
What Is the Gold Standard?
We touched on the key feature earlier. When people deposit gold in a bank, they have the right to get their gold back, plus the agreed interest, per the terms of the contract.
This simple feature relies on the Rule of Law. The government must respect and enforce the right to contract, even if the defendant is a bank.
The government must also respect the right to have gold, which is the right to hold money in its physical form. This is the right to take final payment, to not be a creditor, to not participate in the banking system. When the people have this right, then the banks are honest. President Roosevelt took away this right in his 1933 executive order.
If the people have these rights, then the banking system grows only by earning the trust of each and every depositor. Trust is earned slowly, but it can be squandered in an instant.
Provided that the Rule of Law is not adulterated, and the government is not forcing or nudging people, then there is no reason to fear a run on the bank. For the same reason that a million people won’t decide at the same time to move from New York City to Yuma, Arizona, a million people won’t decide to withdraw their gold, and bury it under their mattresses.
There are more details, but this is the essence of the legal framework. In other words, the gold standard is not something forced down the people’s throat by central planners deciding what people should do, backed by the guns of the state. It is not imposed; it is what emerges when free people have the freedom to freely trade in free markets (did we make it clear that it’s about freedom?)
What About Monetary Policy?
In the gold standard, there is no monetary policy. This means that both the amount of gold mined, and the amount of gold-redeemable credit, depend on profit-seeking entrepreneurs responding to price signals generated, ultimately, by all other market participants. If it costs less than an ounce of gold to mine an ounce, then gold mining will occur. If banks can earn a positive spread between the interest rate it must pay depositors and the interest rate it charges borrowers, then they will lend.
And the individual saver has a choice. By analogy, consider the individual consumer shopping for groceries. He goes into the supermarket, and sees that meat is $99 per pound. He passes it up. If every shopper declines to buy, then the store will have to lower the price. In a free market, consumers do not have the power to dictate meat prices (or vote for a government meat control board to dictate prices). However, they have the power to not buy. To switch to another store, another brand of meat, another cut of meat, or another kind of meat. Or to not buy meat at all, and switch to vegetable protein.
The appetite of the marginal consumer sets the ceiling on the price of meat. If the price of meat goes above this ceiling, this consumer will stop buying meat, thus forcing a downtick in the price.
The Interest Rate and Gold
In a free market, savers can deposit their gold in a bank if they like the interest rate. Or switch to a longer-maturity deposit. Or switch to another bank. Or withdraw their gold and take it home to the ol’ mattress.
This has an important economic consequence. The time preference of the marginal saver sets the floor under the interest rate. If the interest rate goes below this floor, this saver will stop depositing his gold, thus forcing an uptick in the interest rate.
By the way, it was this mechanism—the right of the marginal saver to withdraw his gold if the interest rate got too low (or the banking system risk got too high)—that motivated Roosevelt. The effect of his edict was to disenfranchise the saver.
How Will a New Gold Standard Come About?
The regime of irredeemable currency is slowly failing. We say this in the sense of how Earnest Hemingway once described how bankruptcy occurs: “at first, slowly, then all at once.”
It causes an enormous distortion in the structure—and quantity—of credit which necessarily grows exponentially, but which is impossible to sustain indefinitely. It is killing us and will kill us if we don’t move to a new system.
There’s just one problem.
Is there any government which currently operates by the philosophy of respect—nay deference—for the uncoerced economic decisions of the people? Is there any school of thought, other than we ragtag few libertarians, Objectivists, and Austrian Schoolers, who would call for any government to begin operating this way? Is there any major political party, either in the still-somewhat-free-but-less-free-than-ever West, or in the emerging economies, which has this kind of policy in its platform?
There is not.
Therefore, a new gold standard must come from entrepreneurial efforts. A bottom-up approach by a new company, rather than a top-down gold standard declared by government fiat. A new kind of company, rather than an old kind of company, such as a big ol’ bank whose business model is shaped by compliance, regulatory capture, cartelization, and moral hazard (e.g., Fed bailouts).
Such a company would have a simple mission: to enable gold owners to earn interest by financing productive businesses. The two key ideas are (1) earning interest and (2) financing production. Without interest, there is no reason for anyone to bring their gold to market (other than, when they’re done waiting for the price to go up, they sell it). In other words, there is no way gold could circulate. Without finance, there is no interest. Without interest, there is no gold standard.
© Monetary Metals 2022