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A Road to Prosperity

The case for a modernized gold standard.

By From the October 2012 issue

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The overall balance-of-payments of a country, or a currency area, is in deficit when more money is paid abroad than received; a surplus occurs when more money is received than paid abroad. The United States, because of the dollar’s role as the reserve currency of the world, has experienced an overall balance-of-payments deficit most of the past half-century and, over that full period, systemic inflation.

Under both the Bretton Woods agreement (1944–71) and the subsequent floating, dollar-based, global reserve currency system, the U.S. budget and balance-of-payments deficits have been financed substantially by U.S. government trust funds, the Federal Reserve, and foreign purchases of dollars abroad. Since 2008, these deficits have been accompanied by unprecedented quantitative easing, a euphemism for large-scale central bank money and credit creation (or “money printing”). By this means the Fed finances not only the government budget and balance-of-payments deficits, but also overleveraged banks, insolvent debtors, and other wards of the state. The issue of new money by the central bank unaccompanied by the production of new goods and services leads ultimately to inflation because total demand in the market will exceed total supply.

With the dollar as the reserve currency, the U.S. balance-of-payments deficit causes Fed-created dollars to rush abroad, directed there by relative price differences. In foreign countries, many of these excess dollars are monetized by foreign authorities and held as official foreign exchange reserves. But these reserves are not inert. They do not lie around in bank vaults. They are in fact reinvested in the U.S. dollar market—especially in U.S. government securities sold to finance the federal budget deficit. In effect, the United States exports its debt securities, thus receiving back the dollars it created and used to settle its balance-of-payments deficits abroad. Everything goes on as if the deficits didn’t exist. No adjustment is required of the United States to settle its debts, or to rebalance the deficits with surpluses. Thus again, total demand is enabled to exceed total supply.  In a word, the world dollar standard enables America to buy without really paying, a fundamental cause of inflation. But when the Federal Reserve slows or ends quantitative easing, or money printing, total monetary demand declines and deflation threatens.

Rebalancing world trade is impossible under an official reserve currency system. (The International Monetary Fund and the central banks are pathetic shadows of “all the king’s men” trying to put Humpty Dumpty—that is, global rebalancing—back together again.) This perverse international monetary system, whereby the reserve currency country issues its own money to finance and refinance its increasing deficits and debts, augments global purchasing power and potential worldwide inflation, because the newly issued central bank money is not associated with newly produced goods and services. Total demand has been divorced from supply. When total demand exceeds total supply, inflation usually occurs first in marketable, scarce commodities, equities, and inflation hedges (2009–2012); other more general price level effects may be deferred because of unemployed labor and other unutilized resources in excess supply. But ultimately, the general price level will rise as the economy approaches full employment. (The worldwide panic demand for the dollar over the past two years, during the European crisis, has mitigated the general price level effect of quantitative easing. The desire to hold the dollar in cash equivalents rather than to spend or invest it defers inflation.)

Under the rule-based gold standard, the regular settlement of balance-of-payments deficits eliminates a root cause of global imbalances, re-establishing equilibrium among trading nations. Under the true gold standard, residual payments deficits could no longer be settled in newly issued national paper and credit monies, such as the reserve currencies of the dollar or euro. Instead, these deficits would be settled with an impartial, non-national monetary standard: gold. The requirement to settle in gold rules out the exponential debt increases of flawed reserve currency systems. A famous example of this is the flawed gold-exchange-reserve currency system of the 1920s, the collapse of which turned a recession into the Great Depression. Another case is the financial bubble and its collapse during the past decade (2002–2012).

Moreover, it is very much in the American national interest to terminate the reserve currency role of the dollar. This role is an insupportable burden borne by the United States since the end of World War II (even since the great powers’ Genoa agreement of 1922). The U.S. taxpayer should no longer go further into debt in order to supply the world with dollar reserves denominated in U.S. debt. Terminating this burdensome “privilege,” combined with the restoration of dollar convertibility to gold, will gradually end the long era of extreme global trade imbalances, secular debt accumulation and inflation, and currency depreciation. Furthermore, because the reserves of monetary authorities will be held only in gold and domestic currency claims, the exchange-rate risk will be eliminated in all national banking systems.

The rule-based, true gold standard not only would end the official reserve currency role of the dollar, but also limit arbitrary Federal Reserve money issuance secured by spurious, defective, and illiquid collateral. Unstable mutations in the gold standard of the past—including the failed reserve currency–based “gold-exchange” system of Bretton Woods and the collapse of its predecessor, the reserve currency–based “gold-exchange system” of the 1920s and 1930s—must be ruled out. So, too, must floating exchange rates. For almost a century, policymakers, politicians, historians, and economists have confused the flawed, interwar gold-exchange standard, based on official reserve currencies, with the true or classical gold standard. They have mistakenly blamed the Great Depression on the gold standard, instead of on the liquidation of the official reserve currencies underpinning the gold-exchange system established at Genoa in 1922, which, like Banquo’s ghost, reappeared in 1944 in the form of the Bretton Woods system.

The Bretton Woods pegged exchange rate system, based on the official reserve currency role of the dollar, collapsed in 1971 because the United States had accumulated more short-term debt to foreigners than it was willing to redeem in gold. Its collapse ushered in the worst American economic decade since the 1930s. The unemployment rate in 1982 was higher even than the unemployment rate occasioned by the collapse of the Fed-induced real estate bubble of 2007–09. Similarly, the recession of 1929–30 became the Great Depression of the 1930s because of the collapse and liquidation of the interwar official reserve currency system, based as it was on the pound and the dollar. The liquidation of official sterling and dollar currency reserves deflated the world banking system: Without these foreign currency reserves the banks were forced to deleverage, call in loans, or go bankrupt. They did all three.

Since 1971, the floating exchange rate system, or the world dollar standard, has been even more perverse and crisis-prone than Bretton Woods and the Genoa interwar system. The dollar’s role as the reserve currency has caused not only extreme inflation and the subsequent threat of deflation, but also industrial and manufacturing displacement in the United States. It has resulted in declining American competitiveness, one witness of which is the collapse of the international net investment position of the United States (essentially, U.S. assets held abroad, less foreign assets held in the United States). In 1980, the U.S. net international investment position was 10 percent of GDP. In 2010 it was negative 20 percent of GDP. The difference was equal to the increase of foreign-held official dollar reserves, arising from continuous U.S. balance-of-payments deficits under the dollar-based official reserve currency system.

Under the present system, the perennial U.S. balance-of-payments deficit will, more often than not, continue to flood foreign financial systems and central banks with undesired dollars, followed by brief periods of dollar scarcity, the threat of deflation, and a cyclical rise of the dollar on foreign exchanges. Foreign authorities may continue to purchase excess dollars against the issue of new domestic money. This duplicates potential purchasing power unassociated with the production of new goods, causing total demand to exceed total supply—thus tending to sustain worldwide inflation, generally followed by recession and the threat of deflation. So-called sterilization techniques designed to neutralize central-bank money printing are not fully effective. Without monetary reform, the excess dollars purchased by foreign central banks, reinvested in U.S. government securities and other dollar debt, will continue to finance excess consumption and rising government spending in the United States.

Today inflation of the general price level (or CPI) proceeds gradually in the United States because of unemployed resources, combined with the panic demand worldwide to hold the dollar rather than spend it, or to repay debt with the money rather than to consume. At full employment, inflation will pick up. Because the reserve currency system generally leads to a rapid increase in global purchasing power, without a commensurate increase in the supply of goods and services, the systemic tendency of the reserve currency system is monetary expansion or inflation. Yet the process can work dangerously in reverse, causing deflation, especially when the Fed tightens, or there is panic out of foreign currencies into the dollar (the Asian crisis, 1996–2002, and the euro crisis, 2012). Illiquidity abroad can cause foreign official dollar reserves to be resold or liquidated in very large quantities, reducing the global monetary base, as occurred in 1929–33 and recently in 2007–09.

In the absence of government rules that favor inconvertible paper and credit money, the historical evidence shows that gold, or paper and credit money convertible to gold, was preferred and accepted in trade and exchange from time immemorial. Until recent times the gold standard also underwrote, indeed required, global trade rebalancing, now the subject of empty exhortations by the International Monetary Fund and political authorities. But to desire a goal without the effective means to attain it—namely, the true gold standard—is to court political and financial disaster. In the absence of prompt balance-of-payments settlements in gold, the undisciplined official reserve currency systems have immobilized the international adjustment mechanism. The result has been increasing trade imbalances, ever-rising debt, and credit leverage at home and abroad. Under the world dollar standard, other nations have gained desired dollar reserves only as the United States becomes an increasingly leveraged debtor through balance-of-payments deficits. Whereas under the gold standard, the global economy may actually attain balance-of-payments surplus as a whole vis-à-vis worldwide gold producers.

Among its monetary virtues as the least imperfect monetary system of civilization, the true gold standard, without official reserve currencies, is the sole rule-based monetary order that reliably and systematically rebalances worldwide trade and exchange among all participating nations.

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About the Author

Lewis E. Lehrman is a senior partner at L. E. Lehrman & Co. and chairman of the Lehrman Institute.