Wednesday, December 9, 2009

Why The Gold Standard Is Obsolete

Despite the critics of the fiat currency system, James Picerno describes the reasons that a gold standard will no longer work for present day financial systems. While the gold standard would reduce risk of massive inflation and banking default, it would limit the ability of government to mitigate a financial crisis. See the following from The Capital Spectator.

The bull market in gold, now in its ninth straight year, is more than one more commodity trading at higher levels—around $1,160 an ounce, as of Friday’s close. Gold being gold, it carries a range of emotional, financial and economic baggage.

That includes the embedded warning that the risk of instability, including future inflation and banking default, is still bubbling around the world as more than a distant threat. The biggest gold bull market in modern history is also stirring arguments anew in favor of returning monetary policy to a gold standard. As alluring as that might be in concept, in practice it would be unworkable in the long run.

The first problem is that there’s not enough gold in official reserves to back the paper money supply. The U.S. gold reserves held at the Federal Reserve—the world’s largest for any central bank—are worth roughly $312 billion, assuming gold prices of $1,200 an ounce, based on Fed holdings totaling 8,133.5 tons of the metal, according to the World Gold Council. That’s less than one-fifth the value of M1 money supply currently in circulation.

The implication: the supply of currency now in circulation would have to fall dramatically, the price of gold would have to rise dramatically, or some combination of both. The net result would likely be a massive overnight surge in interest rates.

Gold bugs would, of course, be in favor of something on that order. And to some extent there’s logic in them thar hills. Interest rates are certainly too low and the U.S. is printing too many dollars. But attempting to fix years of monetary mismanagement overnight is like trying to correct for 20 years of no exercise and deciding one morning to run 20 miles a day. The goal is admirable but implementing the plan would be lethal.

Even if the U.S. could devise a gradual return to the gold standard that doesn’t kill us, there’s still a problem. Indeed, there’s a reason why the gold standard of yore, in all its various forms, was abandoned. It doesn’t work.

Oh, sure, most of the time, when the business cycle is calm, the gold standard is a charm. Tying the supply of currency to a hard asset—real money, so to speak—has merit. But the problem comes in those rare but inevitable moments when the business cycle goes insane. And let’s be honest: that’s never going to change. There’s always going to be a crisis lurking in the future. The underlying catalysts will change, but the economy will invariably hit a wall at times. At such times, a rigid gold standard is unworkable in political terms and perhaps economically as well.

The problem is that there are times when a central bank must step in as lender of last resort and inject liquidity into the system. That’s not possible under a gold standard. As such, the gold standard’s appeal is also its weakness.

You can’t snap your fingers and create gold out of thin air. That’s a valuable tool for preventing central bankers from debasing the currency, as they tend to do over time. But in that rare moment when all hell’s breaking loose and the economy may be poised to implode, a gold standard would almost surely exacerbate the danger. Maintaining the integrity of a currency is the goal 99% of the time, but it’s the 1% that’s the problem for a gold standard.

This is old news, of course. That’s a reason why the gold standard has been abandoned. In fact, there are no silver bullets for monetary policy, at least if we’re trying to design the perfect system. No matter what you come up with, it’s going to have some flaws. Pick your poison. The basic choice: live with inflation, preferably a small but consistent amount, vs. a currency that’s as good as gold but at the risk of one day courting economic disaster.

Of course, central bankers aren’t immune from making mistakes and turning mild problems into much bigger ones. Indeed, we're not shy about pointing out what we perceive to be policy mistakes or the potential for human error that routinely shadows the oversight of paper money. But that doesn’t change the fact that the gold standard could possibly make central banking errors far worse during a crisis.

Yes, there are serious problems with a fiat currency system too, starting with the gray area of deciding how much money to print. A gold standard solves this problem, but ultimately at a dramatic if not obvious or immediate cost. No wonder that the gold standard has been deserted. It’s simply implausible to expect a government to say it’s helpless to intervene in a financial crisis because the gold supply is fixed.

At the same time, the discipline that comes with a gold standard is immensely useful for monetary policy. Figuring out how to promote that discipline while allowing for some flexibility in monetary policy at extreme moments is the challenge. We’re still struggling to find the right balance, and probably always will. Progress comes slowly in monetary policy, if at all. It’s tempting to think that a return to the gold standard will solve all our problems, but that’s a misreading of economic history.

The good news is that anyone can buy gold and hedge their personal wealth. But what’s practical in some degree for individuals and private institutions isn’t a slam dunk for central banks.

This post has been republished from James Picerno's blog, The Capital Spectator.

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