I made the case in my first post on money that we are willing to be paid in dollars simply because we can swap the dollars for something else. The paper has no intrinsic value. Coin has value as scrap metal, but less than the face value. (There’s one exception here: The copper in each pre-1982 penny is worth 2.8 cents at $4.32 per pound, the current price of copper. Pennies are now mostly zinc.)
Money when trust isn’t enough
“Fiat” currency—currency without intrinsic value—is relatively new. In the absence of stable monetary “sponsors” to issue currency, trust wasn’t enough. Money had to have intrinsic value. This is one step removed from barter—in an agrarian society, livestock would often serve as payment. Farmer A might swap a pig for a pair of shoes from Cobbler A. That’s often impractical, so other commodities like animal skins, shells or olive oil were also employed, giving rise to “commodity money.” A famous paper by R.O. Radford, an economist who’d been a prisoner of war during World War II, noted that cigarettes served as money in POW camps.
Metals—first copper and bronze, then precious metals like gold and silver—were more practical than other commodities. The value of a gold coin was substantially independent of the stability of the issuing government. A British gold sovereign—still produced today for investors—was first minted at the direction of Henry VII in 1489. Fixed at 7.322 grams in 1816, the gold sovereign has intrinsic value that transcends national borders. As precious metals were widely used as money, such coins were a better store of value, too.
Precious-metal money posed a range of practical problems—coins could be shaved or clipped; proportions of precious and base metals could be altered; supplies of precious metals fluctuated, leading to shortages or surpluses. Small denominations were impractical for precious metals, leading nations to issue money with symbolic, versus intrinsic, value. Paper money exemplifies this trend: Issuers commit to converting paper into precious metal on demand.
The gold standard
The U.S. dollar was once tied to gold. Citizens could trade greenbacks for gold or silver; foreign governments could settle trade imbalances with gold. As discussed by Geoff Rosenberger in his Aug. 12 post, convertibility of the dollar ended for U.S. citizens in 1933 and for foreign claimants in 1971.
What happened? Prior to World War I, most of our trading partners maintained a fixed rate of exchange between their currencies and gold. As a paper published in 1989 by the Federal Reserve of St. Louis notes: “Internationally, the gold standard committed the United States to maintain a fixed exchange rate in relation to other countries on the gold standard, a commitment that facilitated the flow of goods and capital among countries.”
This didn’t always work smoothly. In 1914, as World War I began, global markets entered a period of turmoil. In a normal year, U.S. firms borrowed British pounds in London markets to finance exports early in the year, then paid off the loans with pounds earned from sales of grains in the summer. The war disrupted these markets, forcing U.S. investors to settle their debts without the offsetting revenue. The price of pounds in dollars rose nearly 40 percent. As the price of pounds in gold was unchanged by law, it was highly profitable to export gold to the U.K. to settle these debts.
Foreign sales of U.S. securities drove down the value of U.S. stock market, forcing the New York Stock Exchange to halt trading in July. The crisis was resolved through a variety of actions, not the least of which was a suspension of the gold standard. Most World War I combatants, having too little gold to trade for needed goods and services, chose to issue debt to finance the war effort, significantly increasing inflation.
The path back to the gold standard during the 1920s was rocky. Britain, seeking to retain the pivotal position of the pound sterling as the world’s reserve currency, spent the period from 1925 to 1931 returning the pound to its pre-war gold price. In addition to triggering a punishing deflation, average unemployment for the period was nearly 13 percent, rising to 21 percent in 1931. Admitting defeat, the U.K. abandoned the gold standard that year.
The Great Depression exacerbated the challenges facing the global financial system. From late 1929 to early 1933, wholesale prices in the U.S. fell 37 percent and farm prices fell 65 percent. Bank closures topped 5,000 by the end of 1932.
Following the U.K.’s action, speculators focused attention on the dollar, believing that a devaluation seemed imminent. A feverish exchange of dollars for gold late in 1931, both by investors and ordinary citizens, triggered a massive outflow of gold from U.S. reserves. Committed to preserving the gold standard, the Federal Reserve raised interest rates to boost demand for dollar securities. While the dollar’s value in terms of gold was preserved, the sharp increase in interest rates dealt a severe blow to the weakened economy. (Read an informative discussion of the causes of the Depression and the policies employed to combat it in a 2004 speech by former Federal Reserve chairman Ben Bernanke.)
The outflow of reserves from the banking system also reduced the money supply. As noted in my previous post, coin and currency are only a small part of what we call “money.” Currency in circulation totals about $2.2 trillion, only a fraction of our purchasing power. Banks “create” money by lending out the unused reserves. The withdrawal of reserves and the hoarding of gold put the money-creation machine into reverse, accelerating the nation’s economic collapse. U.S. gold reserves fell $300 million in February and March of 1933 (roughly $6.3 billion in current dollars).
Franklin Delano Roosevelt took office on March 4, 1933, inheriting a global financial crisis topping that facing Barack Obama in 2008. Nearly the entire financial system—financial exchanges, Federal Reserve banks, and state banking—had suspended operations. His administration ended temporarily the conversion of the dollar to gold and stopped gold exports.
Although the formal end of the gold standard would wait until Richard Nixon’s declaration on Aug. 15, 1971, the world continued to shift from a foundation based on the British pound sterling—supported by a peg to gold—to a foundation built on the U.S. dollar, albeit still connected to gold. Establishment of the post-World War II Bretton Woods system also coincided with a belief among economists, associated with British economist John Maynard Keynes, that there was a place for a more activist role for government. Keynes argued that the experience of the Depression demonstrated that the economy would not automatically right itself, as the classical school maintained.
The gold standard served global price stability at the expense of domestic economic policy. It shackled the U.S. money supply to global conditions affecting the supply and demand for gold, as the events of 1914 to 1933 graphically illustrated. In the words of FDR: “The world will not long be lulled by the specious fallacy of achieving a temporary and probably an artificial stability in foreign exchange on the part of a few large countries only.” Not bad for a politician.
Freed from its shotgun marriage to gold, monetary policy has contributed to reducing the frequency and depth of recession in the U.S. After the OPEC-fueled inflation of the 1970s, the Federal Reserve and its fellow central banks have done a remarkable job of maintaining relative price stability, seeking low and steady inflation. One of the many lessons of the Depression is that deflation has far more serious implications than modest inflation: When prices are declining, consumers have an incentive to delay purchases, creating a vicious cycle of economic shrinkage.
Nor has the price of gold been stable since the demise of the gold standard. As reported by Timothy Hulbert of Hulbert Ratings in a recent Wall Street Journal essay, gold’s volatility has been greater than that of the Consumer Price Index. Moreover, Hulbert points out that the S&P 500 has been a better investment than gold or gold-based assets.
Gold has a role to play in an individual investment portfolio, just as a balanced portfolio might include assets like stocks, bonds and real estate. But there is very little support for a return to the gold standard among economists. I understand and share the distrust of many toward institutions like the Federal Reserve, Congress and the executive branch. Both political parties own a share of the massive increase in the national debt already enacted or envisioned, a level of obligation unprecedented outside of wartime. These are uncharted waters for economic policy.
Arbitrarily tying the money supply to a commodity, however, will not reduce uncertainty. Consider Bitcoin: It is independent of the influence of mendacious monetary meddlers. And, unlike gold, it is truly scarce. Yet I’ve not been hearing calls for a Bitcoin peg. The logic for gold is no more persuasive.
Originally titled “Making sense of digital money,” this series will continue with further discussion of cryptocurrencies and the role of the fintech sector.
Kent Gardner is Rochester Beacon opinion editor.