Earlier this week, I mentioned that US President Donald Trump and a few of his potential appointees to the US Federal Reserve were fans of the gold standard.
I’m not sure if I can pull this off in less than 1,000 words. But the task of today’s Rum Rebellion is to explain why a gold standard will never make a return in a modern economy controlled by government and elites.
That’s not to say I’m not a fan of gold or don’t believe it can play a very effective role in imposing financial discipline on the world’s free spending politicians and bureaucrats. It’s just that it won’t happen in the form of a gold standard.
The history of gold
To understand why, let’s take a quick trip back in history.
The ‘classical gold standard’ operated from around 1870–1914. This was a period when most developed nations fixed their currencies to gold. Gold was money in that citizens could redeem banknotes for gold if they wanted to.
Banknotes — money — were therefore as good as gold.
But that didn’t mean there was enough gold to cover the amount of banknotes in existence. There was just an understanding that you could convert your banknotes into gold and that provided confidence.
This system ended in 1914 at the onset of The Great War. A war machine needs money and credit. And it needs it much faster than a gold standard monetary system can deliver.
What I mean by that is that the supply of gold (and therefore money) had a natural growth rate of around 2%. When you’re gearing up for, and engaging in war, you need to create money at much faster clip. And when you do that, you don’t want your citizens taking these freshly printed banknotes straight back to the bank in return for gold.
That’s why the gold standard was shut down.
Otherwise, there would’ve been a run on the banks. Swapping banknotes for gold is the same thing as a modern day bank run where people line up to take their cash out. A bank has only so many cash reserves. When it runs out of reserves, it needs to start liquidating (selling) assets to raise more cash.
So you can see why the classical gold standard ended with the war. It was done to avert a run on the global banking system.
Prior to that though, there were certainly panics that led to sharp stock market falls and nasty economic adjustments. And much of it had to do with the rigidity of the gold standard.
Why gold will never make a return
Let me explain. If you understand this, you’ll see why we won’t get another gold standard in the future.
The amount of loans that banks could create under a gold standard was constrained by the amount of gold in the banking system. But this didn’t mean banks only created loans on a dollar for dollar basis with the amount of gold they held.
Gold was simply the reserve base for the banks, and they created loans on this gold base. When times were good, some banks, like they still do, stretched their loan books and created and extended money they shouldn’t have extended.
This point of the cycle (when banks are lending freely and stupidly) is usually about the time when interest rates start to rise.
But the dubious loans — made at the top of the cycle — were still in ‘the system’. When a bank made increasingly dubious loans back then (before central bank bailouts were the norm) and interest rates started to rise, word got out about the fragile financial strength of said bank.
People would then start withdrawing cash and/or gold from the bank, draining it of its reserves. In order to fund these withdrawals, the bank would sell assets. This would dent confidence and, combined with the rising rate scenario, lead to more people wanting to move to the safety of cash.
But here’s the problem. In a gold standard, cash is gold (or as good as gold) and there is only so much of it around. In order to match supply with demand then, the price of assets had to fall sharply in order to make them attractive relative to gold.
This bit is pretty confusing. So let me say it again. In a gold standard monetary system, there is only so much cash around. Its supply is inelastic. In order to balance the limited supply of cash in the banking system against the panic level demand, you have to increase the price of it.
How do you increase the price of cash/gold when it is fixed? You increase it in a relative sense against other assets. That is, other asset prices fall relative to cash.
This is what happened in the US in the lead up to the Great Depression. Banks expanded credit way beyond what they should have done, no doubt due to the recent existence of a central bank (Federal Reserve) that encouraged them to do so.
Then, went the bust came, the US banking system suffered a run. Everyone wanted to sell stocks and get cash/gold. The only way the system could match supply and demand was via sharply falling stock prices.
Prior to 1914, the stock market suffered some major panics and big corrections. While this wasn’t caused by the gold standard, it was certainly amplified by the inelasticity of money.
While the corrections were large though, they were generally short lived. It was the same with economic corrections. They were short and sharp. The bad investments were mercilessly liquidated and the economy recovered, unencumbered by bad debt.
Today though, when a panic hits the market, central banks stand ready to supply as much cash as possible to absorb the increase in demand. As a result, asset prices don’t have to fall too much to provide balance.
Everyone’s happy, except the poor shmucks earning an abused currency for a living and spending it all on food and mortgage repayments.
On the other hand, a gold standard imposes discipline on politicians, bankers and asset holders, while allowing citizens to retain the value of their labour and savings via a stable currency.
Now can you see why it will never come back?
Editor, The Rum Rebellion
PS: Three Aussie gold Stocks to watch in 2019. Click here to find out more.