PracticalDad:  Just What Is A Gold Standard?

Listen to AM talk radio nowadays and you’ll hear hosts rave on about the value of gold in your portfolio.  I buy it and you should too.  Protection in the face of a declining dollar.  Buy now and don’t be priced out.  Most people can see the value to purchasing precious metals in today’s financial environment but now pundits are tossing around "gold standard" like a football and you have to question, what is a gold standard and what does it mean?

To understand the gold standard, you first have to understand that we live with a fiat currency monetary system.  Excepting those countries who tie their currency to the value of another’s currency – think China and the United States – currencies "float" in value versus one another and it’s the collective global concensus that evaluates which countries have stronger currencies.  There is nothing backing any currency except for the economic policies and tax revenues of that nation.  The Norwegian Kroner – remember that Norway is not a part of the Euro – represents a nation that’s the #3 oil producer in the world, started the world’s first Sovereign Wealth Fund to cushion against the day that the North Sea oil runs out, and keeps it’s public debt under control.  Now consider the Mexican Peso.  The country is in year three of a vicious fight against drug lords, has a depleting oil supply and never fully recovered from the currency crisis of the 1990s.  When the global currency market considers these factors, it values the Kroner higher against the peso so that it takes far more pesos to purchase one kroner.  If the Mexicans could magically deport the drug lords to Norway, find another huge oil field and the Norwegians shot through five years of oil revenues on a month-long binge of hookers and blow, then the world will re-evaluate the peso as worth far more than the kroner.  Not that the typical Norwegian male would be in any condition to care.

Cut through the mustard and that’s about where it comes down.

Countries compete against each other in multiple ways but one of the long-term keys is via national interest rates, as set by both the particular central bank and the assessment of the global investment community.  In the ideal world, interest rates supposedly act as a crude governor to the economic engine so when things start to heat up, the national rates are raised, credit demand declines and things slow down.  When things are slow, rates are dropped and credit is more available so that things pick up.  The market also has an impact on rates however via a risk premium on top of the set national rate.  When things are copacetic and the investment assessment actually matches reality, the risk premium is small and other factors are allowed to help set a country’s course.  When things aren’t copacetic however, then the risk premium rises so that a country has to pay far more for capital than others. 

In today’s world, we’re awash with debt at all levels – personal, municipal, state, national (sovereign).  Because we’re a fiat currency, the only way to handle governmental debt is to either raise taxes on a strapped citizenry or else cut spending.  The reality is that our political leaders haven’t been willing or able to cut spending and raising taxes isn’t seen as an option.  Our monetary authorities – the Federal Reserve System – have opted to address the debt by devaluing the currency.  This has been done by keeping interest rates at historic lows for long periods of time and also by purchasing lousy assets from the banks at rates that are far better than the underlying asset is worth. The end result is that huge amounts of liquidity have been injected into the system and at this moment, there’s no evidence that that’s going to be brought under control.  The long and short is that the political and financial classes appear to have lost the will to do what’s in the best interest of the country, assuming that we could all agree on the definition of "best interest". 

It’s this sense that certain members of the financial and political community – both in and out of the US – can’t be counted on to control themselves that’s led to the rising talk of a return to the gold standard.  When countries agreed to operate on a gold standard – whose best days were from about 1880 to 1914 – the operation was almost mechanical.  In a sense, each country’s bank vault was akin to a giant bucket and international trade was the liquid that flowed between the various buckets.  When a bucket became too full, the country took the currencies filling it to the various currency owners and turned them in for gold to fill the national bullion vault.  Because the amount of a country’s money circulating was a function of the amount of gold in the vaults, more gold led to easier credit and more money circulating.  Those with less gold had tighter credit and higher interest rates until such a time as they adjusted their policies enough to balance the system so that increased trade brought gold back to their own vaults. 

In a way, the system was self-regulating amongst the countries and eliminated the vagaries that arose from the decisions of individuals regarding their particular currencies.  It was consequently a mechanism that imposed discipline among the member nations so that no one country could run chronic trade and budget deficits or debase their currency. 

That’s the theory behind the argument on behalf of a gold standard and the reason that more voices, domestically and internationally, are being raised.  Just bear in mind that there’s no such thing as a hands-off mechanism that’s flawless when it comes to the interactions and foibles of people.



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