Currency Wars: Why The United States Cannot Return To A Gold Standard


From Victor The Cleaner also featured in Fofoa

The book Currency Wars by James G. Rickards (Penguin, 2011) quickly became a bestseller not only in goldbug circles. One of the main theses presented by Rickards is that the United States ought to return to a Gold Standard.

Have you ever wondered whether this would be possible? The answer is No. But why not? The reason we give might strike you as rather unexpected, but it leads you right into the question of what will be the future international monetary system. The answer is that it is the existence of the Euro that prevents the United States from returning to a gold standard.

The Euro zone is set up in such a way that it values gold at its free market price. Since the Euro zone is a major global trade hub, they are in fact in a strong position to block any attempt by the United States at returning to a gold standard. They can rather force the US to value gold at its free market price, too. Any attempt at linking the US dollar to a fixed weight of gold is futile in the long run because this would eventually lead to an under-valuation of gold in US$ and thereby irreversibly drain gold reserves from the United States. In the present article, we explain these ideas in greater detail.

1. Gold Standard

In order to understand the question of returning to a gold standard, we first need to understand how gold can be valued in terms of a currency. Let us therefore summarize the main results of Sections 5 to 9 of our article The Many Values of Gold.

In the following, it does not matter much whether the proposed gold standard is modelled after the Gold Coin Standard that existed in the United States until 1922, after the Gold Exchange Standard that lasted until 1933 or after the system that used to be in place between 1933 and 1971, including the Bretton Woods period, in which only foreigners or only foreign central banks and governments were allowed to redeem US dollars for gold while domestically in the United States, private gold ownership was illegal.

In each of these flavours of what is commonly called a Gold Standard, there existed credit money with deposits, loans, account balances and bank notes. This credit money circulated as currency and was generally accepted as a form of payment, for example, in the form of cash, i.e. tangible bank notes, or in the form of cheques. Today, it would be accepted as payment in the form of electronic account-to-account balance transfers, too.

In addition to the use of such credit money as currency, some institution, either the local banks, the central bank, or a government department, kept a gold reserve in stock and promised to exchange one unit of currency for a certain fixed weight of gold. In other words, all of the circulating currency, including the credit money created by the banking system, was denominated in a weight of gold. Before 1933, gold coins freely circulated along with various forms of credit money. Between 1933 and 1968, although private gold ownership was illegal in the United States, foreigners could still redeem US dollars for gold bullion. Between 1968 and 1971, redemption was possible only for foreign central banks and governments, but not for foreign private entities.

During each of these periods, the banking system was able to create credit, i.e. the total volume of currency units in circulation was variable, but the amount of gold held in reserve, was almost fixed or even declined substantially. As long as one currency unit could still be exchanged for a fixed weight of gold, both credit money and physical gold traded at the same price. Both are very different things though:

  • Physical gold is a tangible asset, free of counterparty risk if in your possession, and it forms an excellent long-term store of value. The globally available quantity changes very little.
  • Credit money, in contrast, is a contract and does involve counterparty risk. Its volume keeps changing, depending on the credit creation in the banking system, for example, depending on GDP, on the variations in economic activity, and on the prevalent debt level.

Let us assume that at some point in time, the value of the currency unit agrees precisely with the intrinsic value of the corresponding weight of gold. The parameters of the new gold standard that we are designing, are therefore fine-tuned in the optimum way. Rickards proposes to determine this value and then to return to the gold standard at this fixed exchange rate between credit money and gold. He mentions backing one US$ by 1/7000 of an ounce of gold as a good guess for this initial value.

Once this new gold standard has been established, GDP, economic conditions and debt levels change. The banking system creates new credit, some existing credit is paid back, defaulted on or is bailed out. The total volume of currency units in circulation which includes both the circulating gold coins (if there are any) and the circulating credit money, therefore keeps changing. This means that over time, the currency unit might be worth either less or more than the intrinsic value of the weight of gold to which it is linked.

In the former case, it would be profitable to redeem credit money for gold and hoard the gold because as part of the currency, it can be acquired at a discount to its intrinsic value. This can be seen as a variant of Gresham’s Law. In the latter case, it would be profitable to purchase gold bullion in the free market and to deposit it with the central bank in exchange for credit money because its value as currency is higher than its intrinsic value.

Firstly, let us recall which one was the prevalent situation in the history of the gold standard. How often have you seen people purchase gold bullion in the free market, take it to the central bank and deposit it there for newly issued bank notes? Never? At least not in a century? This is no surprise because the banking system typically creates additional credit over time – this is their job after all. When the total volume of credit expands, the real value of the currency unit is devalued, and so the currency unit will eventually be worth less than the intrinsic value of the weight of gold to which it is linked. Periods of shrinking credit volume, in contrast, have been the exception and have typically been brief. So we have to accept the fact that, historically, the currency unit was often cheaper than the corresponding weight of gold would have been, had it not been linked to the currency.

Secondly, one can nevertheless still argue that just the option of redeeming credit money for gold inspires confidence in the credit money, enough confidence in order to avert a run on the physical gold. In other words, one might acknowledge that the banking system creates credit over time while the amount of gold is fixed or changes little, and that the redemption of all credit for gold would eventually be impossible to guarantee. But one may still argue that just by allowing redemption at the margin, i.e. in not too large quantities at any time, one might be able to protect the currency from a loss of confidence.

The question we wish to answer is whether this is possible for the United States as of 2012, i.e. whether they can succeed in backing the US dollar with a fixed weight of gold per unit of credit money, even if this would undervalue gold in terms of the currency unit during some periods in the future. The answer will be a clear ‘No‘ as long as there exists a major competing currency which values gold at its free market price: the Euro (€). The existence of the Euro will eventually force the United States to value gold at its free market price, too, and to let the price of gold in US dollars float freely. The mechanism by which this is enforced is a kind of arbitrage using international trade. But let us first consider the question of whether a new gold standard is necessary in order to inspire confidence in the US dollar and what the United States can possibly gain from this step.

2. Confidence from ‘Gold Backing’

One primary argument for the gold backing proposed by Rickards is confidence. As long as the banks, the Federal Reserve or the United States Government guarantee that one US$ can be redeemed for a fixed weight of gold, say 1/7000 of an ounce as suggested by Rickards, no market participant should need to fear holding US dollars for the long run.

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