Inflation, quantitative easing and devaluation is nothing new. Economist, government adviser and author of Paper Money Collapse, Detlev Schlichter writes for Glint on why gold, not fiat, is a better yardstick of value
In this day and age when most money is not even a physical substance anymore but simply a digital code in a computer network, most people will probably find the idea of gold as money somewhat anachronistic. Dealing with money today means using online banking, credit cards and smartphones — technological devices that are making it ever easier, cheaper and quicker to conduct monetary transactions. Gold must appear positively medieval in this context.
The historical perspective
However, if convenience of use were the sole criterion of successful money, cheaply printable and easy-to-carry paper money would have replaced gold long ago. The Chinese experimented with pure paper money arrangements as early as the 12th century and the Western world has done so repeatedly for more than the past 300 years. Yet, remarkably, gold has, throughout history and across the globe, retained a unique position as money.
As recently as 1971 the global financial system had a gold anchor. The ‘Bretton Woods’ system, established in 1944, was an international monetary arrangement whose central feature was the strict convertibility of US-dollars into physical gold at a fixed price, at least those dollars that were held by foreign central banks. Such an anchor was widely deemed necessary to provide monetary stability. This system was only a weak copy of its more impressive precursor, the Classical Gold Standard, which was in place from about the last third of the 19th century to 1914, the outbreak of World War I, and which encompassed pretty much the entire industrialized world of its day.
The function of gold in such systems is always the same: to limit the amount of money that can be created by both the state central bank and the private banks, which can, under normal conditions, create certain forms of money as part of their lending activities. As the quantity of gold cannot be changed by political will and is essentially fixed in the short run, a gold-based monetary system puts strict limits on the issuance of new money and thus also limits the ability of states to run deficits.
Such curbs appear to be of vital importance in the long run because the historic record of non-gold- based system has been dismal indeed. All such ‘elastic’ money systems, such as complete paper money systems, ended in failure — the present system being, so far at least, the sole exception. The temptation to print more money as a quick ‘fix’ for other problems, whether political or economic, has always been too overwhelming, and the result has always been a rapid expansion of the money supply, and eventually inflation and economic chaos. The majority of paper money systems ended in complete currency collapse and the rest were abandoned voluntarily as a return to some form of gold- (or silver-) based currency was achieved before monetary breakdown occurred.
In contrast to paper money systems, gold-backed systems have never truly failed. For a gold standard to end in hyperinflation is practically impossible. But the strictures that a gold standard imposes — on the state in particular, but also on the banks — have frequently become politically undesirable. While all paper standards ended in chaos, all gold standards were abandoned by decree, always motivated by the political desire to allow more borrowing, usually to fund a war.
The Classical Gold Standard ended when governments borrowed heavily to fund World War I, the Bretton Woods system when the US government funded the Vietnam War and the rapid expansion of the US welfare state.
We now live in a world of universal ‘paper money’, even if most money does not even get printed on paper anymore. Such a system is sometimes called a ‘fiat’ money system — ‘fiat’ meaning by order of the state — because at its core is a politically granted privilege to create money out of nothing. Who enjoys that privilege? First and foremost, the central bank. It can create state paper notes and, more importantly, bank reserves at practically zero cost and therefore without inherent limit. Bank reserves are a special form of money. They are deposits that the private banks hold with the central bank, and they come into existence when the central bank buys financial assets for which it pays with newly created deposits. Bank reserves are the raw material for additional money creation by the private banks, that is, for the creation of the deposit money used by the wider public — the money that exists solely as a book-entry on a bank balance sheet and constitutes the dominant form of money today.
Money of no authority
Gold’s unique advantage is simply this: It offers a form of money that is not under anybody’s control. Nobody can increase the supply of gold at a whim. No central bank and no government can arbitrarily inject new money into the economy to the benefit of any special interest group, be they over-stretched banks, distressed property owners, or the highly indebted government itself. (That money injections are beneficial for everyone is a myth touted most persistently by those who control the levers of the money printing press.)
Using gold as money evidently involves a social convention but this is not unique to gold. Every kind of money is only money because the wider public uses it as money, and it is only money for as long as the public does so. Money is a tool for social cooperation — cooperation on decentralized markets — and it therefore always requires a wide acceptance by market-participants, although such a convention can be arrived at spontaneously, that is, without a decree of the state. Money does not require support from the state to exist, just as support from the state is no guarantee that a specific kind of money will remain in usage.
Gold has undoubtedly had an illustrious millennia-spanning career as money because the public has reverted again and again to gold as money for one reason: it is inelastic and outside the realm of politics. That means it is practically incorruptible. It is honest money. As such it keeps banking and public finances honest in every society in which it is widely used as money.
The error of ‘intrinsic value’
It is sometimes argued that gold’s scarcity, its physical properties and its use in industrial application give it ‘inherent value’ that paper money and immaterial digital money lack, and that is what makes it superior. This is incorrect. The term ‘inherent value’ has no place in modern economics. Nothing is inherently valuable. If something has economic value it is only because consumers find it valuable. It is ultimately always the consumers with their subjective preferences who bestow value on anything. Modern digital money is certainly deemed useful by the millions of people who use it daily for monetary purposes. Therefore it has value, and that value is not inferior to that of gold coins or bars.
The question is rather if this money can sustain its value in the assessment of the consumer in the long run if it is issued — potentially in large quantities — for the attainment of political goals, such as ‘stimulating’ the economy, sustaining additional bank credit creation and funding an ever larger debt pile.
It is however true that gold does have physical characteristics that make it particularly useful as money. Gold does not decay and is almost perfectly divisible. It is fairly homogeneous and relatively scarce. However, modern digital money is also perfectly divisible, it is certainly homogeneous, and for all we know it does not decay either. The crucial difference is that one is restricted in its supply by nature while the other can be (and in fact already is being) created in abundance to meet political objectives.
The benefits of inelastic money
The supply of gold is not fixed. But mining gold is time-consuming and expensive. Bringing new money into circulation is therefore not a free lunch — as it is for those who enjoy the privilege of creating our modern fiat money out of nothing. The inherent rigidity of a gold standard is not a bug; it is a feature. In fact, it is its central feature. It is its very raison d’etre. Thus a gold standard limits budget deficits, bank credit expansion, and the growth in debt. Under a gold standard there will be lending and borrowing (and, yes, there will be economic growth), but the extension of new credit is more closely aligned with the growth in true savings. An international gold standard furthermore limits the degree to which international trade and payment imbalances can accumulate.
We can summarize gold’s particular appeal in three attributes: gold is money that is apolitical, whose supply is inelastic (at least over the short run) and money that is potentially international, as opposed to today’s forms of state money that are necessarily regional and always tied to political entities.
Under a proper gold standard there is no room for monetary policy. Interest rates are set by the market, reflecting demand for and supply of funds; they are not administratively set by a monetary policy committee. Nobody manages the ‘overall price level’ — complete price level ‘stability’ being a chimera anyway in a dynamic economy — but most prices can reasonably be expected to be broadly stable to slightly downwards drifting over time (moderate, secular deflation, which means things get slowly cheaper).
Whenever the demand for money declines there will be inflation (the purchasing power of every monetary unit will drop), and when demand for money rises, there will be deflation (the purchasing power of the monetary unit will rise). But the economically crippling deflations that most economists now associate with depressions are absent. They only occur when an artificially extended credit boom comes to a crashing halt, as in the Great Depression of the 1930s or potentially in the wake of the recent financial crisis of 2008. (The US was nominally still under a gold standard in the 1920s and up to 1933, but the traditional strictures of a proper gold standard were already substantially loosened by the establishment of a central bank in 1914, extensive war financing during World War I, and massive credit creation afterwards.) A proper gold standard should prevent the credit boom before it can turn into a debilitating crash.
Stability through absence of policy
This last point deserves special emphasis as most modern economists will recoil in horror from the idea that active monetary policy should cease to exist. Have central banks not saved the day after the 2008 crisis? Have their interventions in form of super-low rates and money-printing (‘quantitative easing’) not stabilized the banks, stimulated the economy, and helped avoid a sharper downturn? The short answer to these questions is that under a proper gold standard such a crisis would have been unlikely to occur in the first place.
The imbalances that set the economy up for the crisis require an unconstrained monetary system that allows for long spells of persistent and fast monetary expansion. The dislocations in the housing and credit markets that were the real cause of the crisis, and that in fact made a crisis inevitable at some point, had their origin in the excessive credit growth of the decade before 2008. It is precisely the role of a gold standard to prevent the build-up of such destabilizing imbalances. The ‘ultra-easy’ monetary policy of today thus has its dangerous precursor in the ‘unnaturally easy’ monetary policy (William White) of 1997-2008.
And, just as ‘unnaturally easy’ money then bought us only fleeting growth at the price of substantial instability, so today’s ultra-easy monetary policy is likely to create equally fleeting growth at the price of even more instability in the future. Those who advocate active monetary policy as a kind of economic medicine need to explain why the treatment never ends, and why ever larger doses of the same medicine are needed.
A look into the future
Politicians, central bankers and most economists appear reluctant to give up the idea that ‘elastic’ and politically controlled money has finally been made to work lastingly. Unfortunately, they are unlikely to be advocates of a return to sound money anytime soon. And the masses of money users will probably support present arrangements through daily practice until the dislocations created by elastic money in the wider economy begin to disrupt the very functionality of today’s payment systems. High inflation, bank defaults, and government-introduced capital controls are likely candidates for such disruptions. Those who understand that additional disturbances in our economy are only a question of time, will hold some gold as a hedge. Gold, in the meantime, is waiting on the sidelines as always, ready to be called to duty again, in its eternal role as sound money.
© 2017 Detlev Schlichter
Detlev Schlichter is an investment manager and the author of Paper Money Collapse – The Folly of Elastic Money (John Wiley & Sons, 2011/2014)
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