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The Prospects for Sound Money

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A silver lining of the global economic crisis is that millions of people have been awakened to the importance of sound money to a modern economy. The housing bubble and subsequent bust, excessive leveraging, reckless speculation, and the sovereign-debt crisis afflicting Europe and the United States would all have been averted had money been commodity-based (e.g., gold and silver) and therefore not subject to periodic devaluation by political authorities.

Since President Richard Nixon severed the U.S. dollar’s official link to gold on August 15, 1971, the global economy has functioned under a fiat monetary system. Because the United States was then the last major country in the world with a currency redeemable in gold, this represented a complete separation of the world’s currencies from the precious metal. For the first time in history, global monetary affairs were determined by governments and their central banks, enjoying total discretionary power in the issuance of paper currency.

Nixon’s decision was a de facto repudiation of U.S. debt, because the refusal to redeem in gold resulted in the devaluation of all dollar-denominated assets and currency. Basically, politicians in Washington were now able to print their way out of debt. The default also enabled the U.S. government, working in tandem with the Federal Reserve, to manipulate the U.S. money supply in pursuit of its own political objectives, a power greatly magnified by the greenback’s privileged status as the world’s dominant reserve currency.

With the United States inflating to pay for its expanding welfare-warfare state, and with the U.S. dollar having replaced gold as the international standard, foreign central banks inflated along with the Federal Reserve. This global monetary expansion predictably ushered in an era of economic instability punctuated by periods of sharp price inflation and high unemployment (stagflation), international banking crises, manic business cycles, increasing debt burdens, and morally hazardous bailouts of “too-big-to-fail” financial institutions. Indeed, inflation is the primary obstacle to recovery today, as Fed-induced low interest rates continue to distort economic activity and inhibit the painful but necessary liquidation of widespread malinvestment.

My criticism of the post-1971 fiat-dollar standard should not be taken as an endorsement of the Bretton Woods system, the infirmities of which were made evident by its collapse a mere 27 years after its creation. That system may look virtuous by today’s standards because it imposed some restraints on money creation, but in the end it proved to be an inadequate bulwark against inflation. Like the gold-bullion standard of the interwar period, the gold-exchange standard of the postwar era had the fatal flaw of ultimately relying on the judgment and good faith of politicians and central bankers.

This is an important point, because since 2008 there has been increasing talk within mainstream political and economic circles of a return to the gold standard by the United States. Publisher Steve Forbes recently predicted the United States would go back to the yellow metal within a few years, because it would “help the nation solve a variety of economic, fiscal, and monetary ills.” World Bank president Robert Zoellick, writing in the Financial Times in late 2010, called for a “Bretton Woods II” system of floating currencies that would employ gold as a “reference point.”

Now, what Messrs. Forbes and Zoellick and others have in mind is not really a gold standard but a pseudo gold standard whereby central banks would determine monetary policy supposedly by referring to the price of gold. This system would have national currencies exchanging at fixed rates with central banks holding a gold reserve asset well below 100 percent and with no general redemption obligation. Governments would still be able to devalue their own currency relative to the fixed rates and to gold.

As the collapse of Bretton Woods demonstrated forty years ago, such a system would provide no real security from the depredations of politicians and central bankers who, when pressed, always resort to inflation. When Milton Friedman proposed a similar monetary system, Murray Rothbard wrote,

Of course, Friedman would then advise the Fed to use that absolute power wisely, but no libertarian worth the name can have anything but contempt for the very idea of vesting coercive power in any group and then hoping that such group will not use its power to the utmost.

A genuine gold standard would have gold circulating as actual money, most likely in the form of coins, redeemable notes issued by reputable financial institutions, and perhaps electronic debit cards.

History provides empirical evidence of the benefits of such a system. The classical gold standard (1815–1914) allowed for sustained economic growth that resulted in the dramatic rise in living standards in Europe and North America in the 19th century. With the global economy enjoying a dependable medium of exchange, international trade expanded, and businesses engaged in long-term capital investment. This increased productivity and pulled the common man from the depths of grinding poverty that theretofore had been his lot. While this time period certainly had its share of international conflicts, turmoil, and financial panics (mostly caused by government meddling), they pale in comparison to the wars and economic crises that have plagued the world after 1914.

While a return to a genuine gold standard would involve a period of painful adjustment, the benefits would become apparent relatively soon, as capital investment would soar. The end of Fed activism might well result in much higher interest rates initially, but as savings increased and sound money protected lenders from devaluation, interest rates would revert to their historic lows. Moreover, sound money would signal an end to government profligacy, because fiscal laxity would no longer be enabled by the central bank’s debt monetization. The nation’s financial sector would also be stabilized, because it could no longer rely on the Fed as a lender of last resort.

Such a monetary reform program, however beneficial, would undoubtedly be met by fierce opposition. After all, inflation has created a broad and very powerful constituency. The federal government is the biggest debtor in history, and it relies on the inflationary mechanisms of the central-banking system to finance its ever-growing debt. Moreover, fiat money has also brought into being a consumer-oriented, debt-addicted, public-entitlement society, which makes the political environment hostile to a genuine gold standard, at least in the short term.

The ugly truth is that public policy is rarely designed with the general welfare in mind. Rather it is usually determined by special-interest groups who organize to gain influence over the government with the hope of crafting policies for their own benefit, at the expense of the rest of society. Monetary policy is no exception.

Most economists still believe in the indispensability of central banking and the benefits of fiat money; and they continue to disparage gold as a “barbarous relic.” Their faith in the current fiat-money system is apparently unshaken by the fact that the U.S. dollar has lost over 95 percent of its value, and the national debt has grown more than 5000 times, since the Federal Reserve opened its doors in 1913.

The current monetary system is destined for catastrophic failure. Perhaps appeals to history, sound economic theory, moral principles, and basic decency will succeed in averting the disaster.

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    Tim Kelly is a columnist and policy advisor at The Future of Freedom Foundation in Fairfax, Virginia, a correspondent for Radio America’s Special Investigator, and a political cartoonist.