Building a Better Gold Standard

09/13/2012 9:15 am EST

Focus: MARKETS

While there has been a growing amount of talk coming from Republican circles about returning to the gold standard, there's a better way to do it without all the trouble of actually doing it, observes Martin Hutchinson of Permanent Wealth Investor.

Thanks largely to Ron Paul, the Republicans have suddenly become enamored of gold. And why not? It is real money.

These newly-born gold bugs have even gone so far as to include a call for a commission to examine a return to the gold standard in the party platform.

Needless to say, we've come a long way since President Richard Nixon "closed the gold window" in 1971. Forty-one years, and a few financial disasters later, the debate has begun anew.

But it begs the question: How would the gold standard work? What's more, what would the economic implications be, and is it likely to happen—or is it all just a gold bug's dream?

In ancient and medieval times, the answers were quite a bit more simple. Since there was no real banking system, there was also no argument. Kings coined money with gold, silver, or copper, and the people accepted the money at a price based on its metal content. The idea of taking paper instead would have been thought of as sheer madness.

Only in China, an isolated and stable society, was paper money used during the Song Dynasty of the 10th through 13th centuries, but even there the Mongol invasion and fall of the Song regime caused the paper money system to collapse.

Paper money (still backed by gold) only became possible once modern banking got going in Europe in the 16th and 17th centuries. In fact, the British Gold Standard was devised in 1717 by no less than Isaac Newton, then Master of the Mint. Other countries soon joined Britain in linking their currencies to gold, including the United States from 1878 until its abandonment in 1933.

Of course, countries claimed to be on a gold standard under the Bretton Woods Agreement from 1944 to 1971, but gold was only exchangeable between governments. Indeed, holding gold was prohibited in the US for private individuals. But inevitably, the Bretton Woods monetary system itself became manipulated and collapsed in inflation.

That brings us to today....

The Problem With the Gold Standard
As I see it, there are two problems with instituting a new gold standard.

First, gold supplies can only be increased by around 1% annually, if that. Currently, the annual new supply of gold is around $200 billion, compared to a gold "stock" of about $9 trillion. That means the expansion rate of gold in circulation is only about 0.22%.

However if world population increases by 1% annually and global economic growth averages even 2%, the need for money expands by 3%, minus any increase in its "velocity."

That makes a gold standard impossibly deflationary—which is why the system collapsed after 1900, as population growth accelerated. Currently, annual global population growth is around 1.1%, far too fast for a renewed gold standard.

The good news is that population growth is slowing. By about 2039, it will fall below 0.5% annually, the growth rate in the second half of the nineteenth century. So if we want a gold standard, we may have to wait for it.

The second problem with a gold standard is the existence of central banks and the banks themselves. This is best illustrated by the pitiful performance of the Fed from its 1913 inception until 1933, when it is generally held to have greatly worsened the Great Depression by getting the money supply completely wrong.

Banks overleveraged during the 1920s (while the Fed kept interest rates too low), then were forced to deleverage after 1930, which reduced the money supply sharply even while the volume of gold in circulation was constant.

The Bank of England, in existence since 1694, from time to time caused similar problems, but tight British regulation of bank leverage during the nineteenth century kept crises under control.

The solution is to run a "free banking" system with no central bank (or bank deposit insurance), which existed in the United States only between 1837 and 1862 (after 1862 the Treasury issued banknotes and leverage rose).

Next: Citigroup and JPMorgan Chase

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After a few panics and crashes, this would put the fear of God into the likes of Citigroup (C) and JPMorgan Chase (JPM), and leverage throughout the banking system would decline to a level at which crashes did not occur.

However, given the current US demand for loans and transactions, this would be extremely expensive in capital—the banks would have to keep at least ten times their current capital ratio of roughly 3% of assets.

Meanwhile, loan rates would also need to increase, as would the fees for credit card payments, etc. Some of this excess demand could be accommodated by "shadow banks," such as money market funds and securitization vehicles. But these, too, would have to be run much more conservatively than at present.

Better Than a Gold Standard
So realistically, it's pretty unlikely that the US will ever re-adopt the gold standard, both because of the cost and because of the vested interests opposed to it. Only after a currency collapse like that of Germany's Weimar Republic would confidence in paper money be shaken to such an extent that gold might be the only alternative.

However, most of the benefits of a gold standard can be attained without actually moving to one.

The Fed's dual mandate to control both inflation and unemployment should be narrowed to a single mandate, to control inflation. A Fed chairman like Paul Volcker should be chosen who manages monetary policy through allowing only a low rate of increase in the major money supply measures—a policy Alan Greenspan abandoned in 1993.

By this means, interest rates would be forced up until they were comfortably above the inflation level, so that savers achieved a proper reward for the time value of their money. As a result, US savings would be rebuilt, the current drain of US capital overseas would be reversed, there would once again be more capital available to support the US workforce, and true prosperity and full employment would return.

If Republicans were serious about sound money, that would be the place to start.

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Related Reading:

Central Bankers Can't Save Us Now
Mitt Romney's 12 Million Jobs Fantasy
Japan Is Surprising to the Upside

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