Saturday, May 8, 2010

From the WSJ (05.07.2010)

The Gold Standard: The Case for Another Look

Washington's elites are quietly preparing a post-election fiscal compromise that will fund much of President Barack Obama's domestic spending agenda with huge tax increases. They aim to create a value-added tax and will argue that there is no alternative even though doing so will leave the United States resembling the stagnant, bureaucratic nations of Western Europe.

But there is an alternative. The U.S. could return to a gold standard, a system that would not only prevent the government from running chronic budget deficits but would also curb attempts to manipulate the value of the dollar for political reasons.

The value of a gold standard was proven in the 19th century. Following the English parliament's passage of the Coinage Act in 1816, which created a gold standard in England in collaboration with the semi-private Bank of England, gold gradually displaced copper and silver to become the world's sole final currency. In doing so, gold established ground rules for international trade and integrated the world's economy. Countries that adopted the international gold standard prospered. This remarkably successful monetary system only blew apart with the outbreak of World War I in 1914.

The reason it came apart then—and not at other times when countries abandoned the gold standard to finance wars with deficit spending—was that World War I was the first conflict to affect every major economically advanced country in the world. The U.S. suspended dollar convertibility to gold to finance the Civil War in the 1860s, but because Britain and other major economies did not suspend convertibility of their currencies there was an existing standard for post-Civil War America to rejoin. This wasn't the case after World War I.

This might not have mattered, and the major economic powers might have re-established a monetary system similar to what existed before the war if not for the central reason why political elites dislike the gold standard: It leaves them little room to run the economy and claim credit for its successes. If you ask political elites why they oppose returning to gold today, they are apt to laugh uproariously and imply that adopting a gold standard is the policy equivalent of reviving the horse-drawn carriage. But their deeper reason is that they prefer to retain power over the economy that they would not have under a gold standard.

Since the crackup of the international gold standard, all subsequent international monetary regimes have elevated dominant paper currencies—first the British pound, later the dollar—as the final money of the world. This set up a critical imbalance of international demand for dominant paper currencies, even while gold remained formally in the system between 1922 and 1973. Following the Nixon administration's decision to end the last vestigial (and exclusively foreign) convertibility of the dollar to gold in 1973, the American dollar has been in demand all over the world both for purposes of international trade and foreign central-bank liquidity.

But foreign central banks don't stack their greenbacks in vaults. They maintain monetary reserves mainly as interest-bearing U.S. government-backed debt securities—in effect, as unsolicited loans to the U.S. government. So by expanding its monetary base, China is both increasing monetized dollars and increasing the borrowing capacity of the U.S. government. That increase in borrowing capacity creates liquidity that is unrelated to any need of Americans involved in economic transactions.

It is little wonder then that in recent decades—beginning most notably in the 1980s—the U.S. has registered far bigger budget deficits, accompanied by far smaller economic strains, than has been the case for countries whose currencies lack the standing of final money. The government of Charles de Gaulle, president of France from 1958 to 1969 and a supporter of returning to the international gold standard, once assailed this American liquidity advantage as an "exorbitant privilege."

But for the U.S., the dollar standard has proven to be less like a bed of roses than a whack-a-mole game. In the 1960s, the mole that popped up was a weak dollar, which triggered accelerated gold outflow from the U.S. to foreign governments. In the 1970s, the mole took the form of high inflation and stagnation. In the 1980s, high interest rates and big budget deficits that reared their heads. In the 1990s, regional or one-sector investment bubbles triggered emergency easing of interest rates by the Federal Reserve. Finally, reacting to deflation fears following the bursting of the dot-com stock-market bubble, the Greenspan Fed pushed the federal-funds rate down to 1% or less and kept it there for far too long.

This brought forth the Mount Everest of bubbles, a boom in U.S. residential real estate derivatives that spread all over the world. When credit-worthy investors and firms can borrow money for virtually nothing and aggressively leverage their investments in a market that seems headed in only one direction, no force on earth—not even an Obama-appointed regulator—is going to stop them from making that bet.

Now Ben Bernanke's Fed is repeating recent patterns of keeping interest rates too low for too long, creating new bubbles and risking a whack-a-mole encore: 1970s-style stagflation. Before that happens, we need to lead the world back to the monetary system that worked better than any other—and, moreover, the one most appropriate for a global economy that is integrating about as rapidly as it was in 1900.

The first step in cutting off the addictive flow of foreign central-bank capital to Washington is an American commitment to a dollar convertible to gold on a date certain. The second step is allowing the market, in the run-up to that date, to find and fix a dollar price of gold that would encourage other nations to replace dollar reserves with gold holdings as their new monetary base, whether or not they choose initially to join the new international gold standard.

These steps alone would put an end to the U.S.'s ability to run painless budget deficits financed by foreign central banks. But we should also provide an insurance policy against the tendency of political elites to fool around with our money. Legislation restoring dollar-gold convertibility should be accompanied by passage of a constitutional amendment guaranteeing the American people a right to conduct their economic affairs in gold, regardless of the future status of gold as the official money of the United States.

The unexpected rise of the tea party movement over the past year should be sobering for Washington's bipartisan elite. It's a sign that many American voters are prepared to consider ambitious, even radical proposals to preserve the system of limited government the Founders created and that gave the U.S. the greatest economy ever to exist. We believe what this country needs most urgently is a dollar worth its weight in gold.

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