Keynes referred to gold as a ‘barbarous relic’ and he was right. Gold works really well as a store of value and as a yardstick but it is not very good to keep an economy healthy. First, there is a finite supply of it which immediately places a cap on a nation’s wealth. No matter what the value of gold may be you only have what you have so the incentive is to hoard it instead of spend it. Economies cannot flourish if there is no movement of money. Central banks cannot be the lender of last resort if they do not have any gold to lend in times of stress. The central banks would be picking winners and losers out due to scarcity. If the first reaction of owners of gold or a gold-based currency is to hold it then producers must lower prices to make sales. There would be no reason to buy something now because the price will be higher next year. The opposite will be true. The buyer would be better off to wait because the price will be lower in the future. The whole world would become a zero-sum game. Your gain would come from someone else’s loss.
Gold and gold-based currencies have a nasty habit of leaving the country where they are minted and printed. So even if the government makes the responsible move to create a currency that is backed dollar-for-dollar by gold and can be converted into physical bullion upon demand it could easily disappear. It could end up in someone’s back yard or in a foreign bank. Now the country with the economy that was capped by the fixed amount of gold in the treasury is struggling to operate because there is less of it to go around. This encourages hoarding, deflation, and becomes a death spiral for the economy. Again, it is hard to prosper when there is less and less currency to go around. Gold provides a lot of stability but very little flexibility.
Detractors of fiat currencies say that all fiat currencies fail eventually. This is true. In the history of world most fiat currencies only last a few years. Fraud, corruption, and political necessity lead to the devaluation of a nation’s currency. Even privately issued currencies from pre-Civil War banks had a short life expectancy. The detractors say that fiat currencies are intentionally devalued so the government can meet its obligations and issue even more bonds. Good. Can you imagine what taxes would be like when another country forecloses on the U.S.? Detractors say that things like real estate do not really go up in value but rather the number of dollars required to buy them does because each dollar is worth a little less year after year. Good. What better reason to buy a house (or anything) now than wait until next year when it is higher? Housing creates downstream economic benefits because homes need mortgages, insurance, furnishings, landscaping, paint, and much more. If a robust, growing economy is the goal, then a fiat currency is required. Fiat currencies work better than gold-based currencies when they are responsibly managed. Fiat currencies are more flexible and can respond to changes in the economic landscape better than gold. For all the negative press about the health of the US dollar, dollars still exist. The same cannot be said for the mark, franc, peso, and lira.
There is the fear that fiat currencies will lead to inflation and history is littered with plenty of examples. Upon closer examination inflation was usually caused by some form of central government mismanagement like losing a war, paying off high-dollar contributors, or ambitious projects that could never paid for. Roman emperors were able to keep the amount of their coinage in check for decades. It was only when a newly crowned emperor had to buy the loyalty of the army every few years that things got out of control and even then it took decades before Rome completely fell. For all the heat that major banks get for taking advantage of the cheap money from the Federal Reserve they have actually been responsible and not contributed to out of control inflation. Instead of lending out the billions they could get at dirt-cheap interest rates they simply turned around and bought Treasury bonds and earned the difference in interest rates. True, like most government programs, it probably would have been easier and cheaper just to give the big bankers this risk-free money directly but compared to failing outright it ends up being better for the nation’s economic health. Government mismanagement, corruption, and ambition will be the sources of the inflation not the excess of pieces of paper with holograms and watermarks.
What is the solution? How about creating a fiat currency with a lot of gold-like features that is managed by an elite group of men whose only purpose in life is protect the integrity of this fiat currency? The amount of the fiat currency would be initially fixed and then grow 1-2% per year to encourage borrowing and spending. The fiat currency would be partially backed by a basket of commodities and only convertible after a 180 day cooling-off period. This would put a damper on the commodities leaving the country since the fiat currency would only represent a fraction of the commodities. The men who manage this fiat currency would be like the Knights Templar guarding the Holy Grail. They would be selected after a rigorous screening and paid well so that they would not be subject to financial temptations themselves. They would be sequestered like monks for their whole careers which would be time-limited as well. Best of all this new fiat currency would be financed with current US dollars. Just like after the Civil War when excess greenbacks were withdrawn from circulation by the government issuing a high-interest rate bond the same could be done today and it would only have to earn 4 to 5% to attract buyers. Inflation is too many dollars chasing too few goods. At any time this fiat currency could simply issue more bonds with an attractive interest rate to keep too many dollars away from too few things.
The end result would be a fiat currency that had the stability of a commodity-based currency but also had the ability to solve financial problems as they occur. Keynes did not have a problem with loaning money to well-run banks that were temporarily in a crisis. Keeping these banks alive and well would keep the whole financial system manageable and able to respond intelligently to stresses. Gold is great as a measuring stick but as a financial tool it just cannot compete with nimble fiat currencies.
As an aside, be careful what you wish for. There is evidence that the Great Depression was caused by mark-to-the-market accounting. This meant that an otherwise sound bank could suddenly be considered troubled if the stock market, real estate, and other assets unexpectedly collapsed in price. This recently healthy bank would be forced to sell assets at depressed prices causing further declines in the market and additional bank failures. We obviously did not learn our lesson because there was another call recently to require mark-to-the-market accounting in banks. The Sorbanes-Oxley Act legislated for mark-to-the-market accounting and when the mortgage meltdown in 2008 occurred it had the exact same effect on otherwise strong banks. Selling begat more selling and everyone suffered. The people that are demanding for a return to the gold standard to save our economy could actually be planning to do more harm. A gold standard would slow down economic activity to a crawl. He who has the gold not only makes the rules he decides who gets his gold if ever. So beware of the gold standard campaign. It will stop runaway inflation but the resulting deflation will cripple the economy far worse. Neither system of paper or gold is perfect but a well-managed fiat currency is better suited for modern times.
Brad Hartung is a Vice President of Investments at Ocotillo Mining Co., Inc and the author of this blog.
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