The Gold Standard
Mr. Bernanke is entirely right about the return of the Gold Standard, as it was implemented then could not work now. In its day, it was appropriate and worked well for many years, but the circumstances it worked in changed. The system did not change with those changes. Bear in mind that the world was at a stage where it believed in gold as the only money that one could trust. That's why governments and their central banks issued notes against it and not un-backed currencies. The notes represented an amount of gold that could be trusted. Of themselves government notes represented not governments but their gold.
Eventually, when Britain under a Gold Standard issued more notes than there was gold, the system failed and government notes were dubious as the gold backing had gone. Today it is 'normal' to issue more credit and more currencies than there are assets to back them. The same danger of the gold standard faces the current system as we have seen in the banking/debt crises on both sides of the Atlantic in the last few years. The concept of Quantitative Easing is similar to devaluing the dollar against gold, but taking worthless assets that banks depended on for backing their credit and replacing them with freshly printed ones. Desperate, the world financial system is now clinging to those to 'stabilize' the system.
All monetary systems have to contain a measure of flexibility that adjusts to circumstances. These circumstances are entwined in politics, power and control, aimed at keeping citizens trusting and reliant on the systems provided by governments.
For instance, the abandonment of gold in the system was followed by the "floating" of exchange rates. Previously fixed exchange rates between nations had worked under the gold standard, but as the world changed so any nation that held to a fixed exchange rate found themselves battered by speculators. As George Soros attacked a pound that refused to devalue, so the Bank of England was forced to do so, making George Soros a billion pounds overnight. The signal for a German Deutschemark revaluation was the Bundesbank's denial that it was going to happen. The problem was resolved by nations "floating" their exchange rates. Now speculators had no fixed target to attack, so when they did, they found that the "floating" rate became a "dirty floating rate" as central banks moved surreptitiously into the market to move the rate themselves when and where they wanted.
The concept of protecting value was slowly abandoned, and now we see nations moving their exchange rates so that there economies can retain global trade competitiveness. The leaders in this are currently the Japanese yen and the Swiss franc, two of the currencies that investors believed would hold their value. We are now at the stage where governments argue with each other over exchange rates. The U.S. against China and China against the U.S. are the leaders in this battle. Neither is attentive to their currencies being a measure of value, but solely as a means of exchange that should work in their favor.
Today, we live in an entirely different world in terms of monetary structures, controls and power. So what changed? To understand the current system one has to go back to 1971. Prior to that if you had argued that gold was not the 'real' money you would have been described as an idiot.
Gold was the foundation of the monetary system even after the abandonment of the Gold Standard when it was primarily the domain of government dealings. That's why they banned U.S. citizens from owning gold right up to 1974. It's clear that the difficulty lay in gold failing to reflect the power, control and wealth of the U.S. then and showing a weakening U.S. on the monetary front. How could the world's leading military, commercial and economic nation reflect a rapidly weakening financial power and control?
So an adjustment had to be made. The moves that the U.S. made then were brilliant and wrested that financial power from the rest of the world in one effective stroke. In 1968 to 1971, European nations were taking the trade surpluses of U.S. dollars and converting them by selling them to the U.S. for gold. U.S. gold reserves had shrunk from a peak of around 26,000 tonnes of gold to just under 9,000 tonnes and the slide had to be stopped. But how?
"How could a government under President Nixon persuade other governments to stop changing their dollars into gold?"
European nations did not trust the issue of dollars by the government of the day, which is why exchange of dollars for American gold was taking place. So what changed their attitude and so quickly? It had to be something capable of overturning strongly held views that had dominated almost the entire existence of financial man. The U.S. dollar as everybody knew was being over-issued and did not represent value, which is why the dollar had been devalued from $35 to over $42 just before that. When gold 'floated' away from the dollar, it rose over the next fourteen years to $850 expressing the market's view of the value of the dollar. So what was in the formula that persuaded a cantankerous President Charles de Gaulle to accept the dollar after he had discarded as many as he could for gold?
The Definition of Money had Changed!
Let's go back to that famous essay by Alan Greenspan in which he expressed his view on what money should constitute.
In that essay he wrote:
"Money is the common denominator of all economic transactions. It is that commodity which serves as a medium of exchange, is universally acceptable to all participants in an exchange economy as payment for their goods or services, and can, therefore, be used as a standard of market value and as a store of value, i.e., as a means of saving.
As such it had to be based on a desired commodity,
"The existence of such a commodity is a precondition of a division of labor economy. If men did not have some commodity of objective value which was generally acceptable as money, they would have to resort to primitive barter or be forced to live on self-sufficient farms and forgo the inestimable advantages of specialization. If men had no means to store value, i.e., to save, neither long-range planning nor exchange would be possible.
"What medium of exchange will be acceptable to all participants in an economy is not determined arbitrarily.
- "First, the medium of exchange should be durable. The medium of exchange must be a durable commodity, usually a metal. A metal is generally chosen because it is homogeneous and divisible: every unit is the same as every other and it can be blended or formed in any quantity. Precious jewels, for example, are neither homogeneous nor divisible.
- "More important, the commodity chosen as a medium must be a luxury. Human desires for luxuries are unlimited and, therefore, luxury goods are always in demand and will always be acceptable. Wheat is a luxury in underfed civilizations, but not in a prosperous society. Cigarettes ordinarily would not serve as money, but they did in post-World War II Europe where they were considered a luxury. The term "luxury good" implies scarcity and high unit value. Having a high unit value, such a good is easily portable; for instance, an ounce of gold is worth a half-ton of pig iron.
- "However, one of the commodities will gradually displace all others, by being more widely acceptable. Preferences on what to hold as a store of value will shift to the most widely acceptable commodity, which, in turn, will make it still more acceptable. The shift is progressive until that commodity becomes the sole medium of exchange. The use of a single medium is highly advantageous for the same reasons that a money economy is superior to a barter economy: it makes exchanges possible on an incalculably wider scale.
- "Gold, having both artistic and functional uses and being relatively scarce, has always been considered a luxury good. It is durable, portable, homogeneous, divisible, and, therefore, has significant advantages over all other media of exchange. Since the beginning of Would War I, it has been virtually the sole international standard of exchange.
- "Thus a logical extension of the creation of a medium of exchange is the development of a banking system and credit instruments (bank notes and deposits) which act as a substitute for, but are convertible into, gold. A free banking system based on gold is able to extend credit and thus to create bank notes (currency) and deposits, according to the production requirements of the economy. Individual owners of gold are induced, by payments of interest, to deposit their gold in a bank (against which they can draw checks).
- "If banks can continue to loan money indefinitely, it was claimed, there need never be any slumps in business. And so the Federal Reserve System was organized in 1913. It consisted of twelve regional Federal Reserve banks nominally owned by private bankers, but in fact government sponsored, controlled, and supported. Credit extended by these banks is in practice (though not legally) backed by the taxing power of the federal government. Technically, we remained on the gold standard; individuals were still free to own gold, and gold continued to be used as bank reserves. But now, in addition to gold, credit extended by the Federal Reserve banks (paper reserves) could serve as legal tender to pay depositors.
- "The realization that the gold standard is incompatible with chronic deficit spending (the hallmark of the welfare state). Stripped of its academic jargon, the welfare state is nothing more than a mechanism by which governments confiscate the wealth of the productive members of a society to support a wide variety of welfare schemes. A substantial part of the confiscation is effected by taxation. But the welfare statists were quick to recognize that if they wished to retain political power, the amount of taxation had to be limited and they had to resort to programs of massive deficit spending, i.e., they had to borrow money, by issuing government bonds, to finance welfare expenditures on a large scale."
The Dollar Dominates Oil
Of course this definition of money led to the U.S. profligacy being punished outside the jurisdiction of the U.S. The selling of dollars for gold was just that. So, this definition had to embrace U.S. might, worldwide. In reinforcing U.S. power worldwide, the U.S. had made it clear to the oil producing states of the Middle East that they were vulnerable and dependent on the U.S. for their future tenancy on power. The House of Saud was assured that their reign would be guaranteed by the U.S. as were all the Persian Gulf states, including Persia. The Shah was more than happy to accede to U.S. demands. In turn all of them agreed to accept the U.S. dollar, alone. In payment for their oil, despite that fact they had their own currencies. Their future depended on it.
(The next part of the series will look at two critical factors that will decide the future of the dollar and gold and oil.)
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Julian Phillips, Gold Forecaster