How The Gold Standard Is Supposed To Work

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There are those out there who believe that the best way thing for the world economy would be to go “back” onto a Gold Standard, with gold acting as a sort of worldwide currency, or at least as a currency-regulator.

In truth, the world has rarely been on a Gold Standard.  The only time the Gold Standard really flourished was for a few decades before and after 1900.  Otherwise, it’s either been a bi-metallic world (with silver also in use as a “world currency”), or else there’s been no real world currency at all.

Before we decide if we are for against a move to the Gold Standard, we must ask ourselves two questions… 1) What do we want the Gold Standard to do?   2) Is the Gold Standard capable of achieving the goal we set for it?

Economists pretty much agree that the main job of a Gold Standard is to keep the various currencies of participating countries locked into a stable exchange rate system.  And that is the ONLY thing we should ask a Gold Standard to do.  All other economic concerns should be addressed via other methods.  The Gold Standard, directly, will not usher in a new age of prosperity or ensure a just distribution of incomes.  It’s only job is to stabilize the currencies of international exchange.

Under a Gold Standard, each country pegs the value of its base-unit of currency to a certain amount of gold.  This allows international merchants, bankers, and investors to know reasonably well the value of each country’s currency– and just as importantly… to know that the value will be about the same tomorrow, next week, and probably even next year.  Conversely, if there were no confidence in the value of a currency, trade– international or domestic– would be all but impossible.  We’d be reduced to bartering.

So, we know what we want the Gold Standard to do… to provide stable exchange rates between the currencies of different countries.  But what about the second question we must ask…  Is the Gold Standard capable of achieving this?

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There are several main theories as to how the Gold Standard would work to keep exchange rates stable.  I’ll briefly list them now, and then go on to explain them…

1) the Discipline of Cash-in Risk

2) Marketplace Adjustments

3) Interest Rate Adjustments

Each of these methods work, each in their own way, to do one of two things…

a] force the downward re-evalution of “over-valued” currency

b] force the upward re-evaluation of “under-valued” currency

1) The Discipline of Cash-In Risk

The key to the Gold Theory is that holders of a country’s currency can always demand to exchange their money holdings for the assigned gold-value of the currency.  For this purpose, the government will keep on hand Gold Reserves so that they can exchange gold for currency when called upon to do so.

1a]  OVER-VALUED CURRENCY

To say that a currency is “over-valued ” usually implies that, relative to the amount of its Gold Reserves, the currency has been “over-printed” (my old-fashioned way of saying that the money supply, digital or otherwise, is too large).  As each new bill is “printed” against the same amount of Gold Reserves, each bill starts to represent a smaller and smaller percentage of the horde of gold backing it all.  Unless the government downgrades the valuation of its currency to represent the new, larger population of bills, the currency will enter a state of over-valuation.

A country could actually do this on purpose– illegitimately pumping-up the value of its currency in world markets.  However, the Cash-In Risk is always in play… The risk here is that people will call the country’s bluff… they will go to the “Mint” (the place where currency is printed and exchanged) and demand to have their bills redeemed for gold at the bills’ legally assigned gold value.  Since the currency is over-valued, if enough people do this, the government could bankrupt itself of its Gold Reserves.  Once a government starts having trouble meeting its Cash-In obligation, faith in the currency would begin to collapse, and the economy would likely become a shambles.

2b] UNDER-VALUED CURRENCY

One risk of under-valuing currency as far as the Cash-In Risk is the OPPOSITE of the bankruptcy danger of over-valuing.  With under-valued currency, no one will be turning-in cash for gold.  Why?  Because the government has set the valuation too low– people can buy more gold in international markets than they can get from cashing-in their bills at the Mint [there is the limiting factor of transaction costs associated with buying, selling, and shipping/travel in international markets].

In a situation in which the currency is under-valued, the government will find itself sitting on idle heaps of excess Gold Reserves.  In this way, under-valuation harms the domestic economy by keeping the country from deploying all the resources at its disposal.

For other results of both over- and under- valuation, we to examine the other two of the three major regulating mechanisms at work under a gold standard…

2) Marketplace Adjustments

2a] OVER-VALUED CURRENCY

I’ve been racking my little brain trying to figure out how excess money gets into the market…  Sure, one can say, “the government prints too much money”… but after it’s printed and setting there in stacks… by what path does it actually get into the market?  They don’t drop it from planes.  They don’t even give tax rebates (usually).  Banks are not under direct government control, so the Mint just doesn’t handover the money to banks with the order to distribute it.

The best I can come-up-with are the following two methods…

1) the government prints up a bunch of money and starts buying back any government bonds it has outstanding, thus flooding the economy with new cash

2) the government could drastically drop the interest rate it charges banks to borrow money from the Fed and allow banks to borrow all they want (or at least, quite a lot); along with this, the government could create a lax legal regime and bail-out friendly environment which would encourage banks to lend recklessly (for instance, the government could reduce the amount of reserves that banks are required to keep on hand);  with what would amount to a blank check from the government, and with little legal incentive to lend conservatively…  banks could risk “creating” a lot of loans– and as I understand this, this is what banks do… they just create lines of credit with a few strokes of the computer keys and– voila!– the system is injected with money

However the money gets into the market, once it’s there…  there will be a lot more money in a lot more people’s hands — but with no additional gold backing it up.  At this point, the currency could now be said to be over-valued-/slash/-over-printed.

In such an environment, sellers, seeing their products flying off the shelves, would naturally begin RAISING their prices in order to increase profits.  By the way… this is the only practical mechanism I can come up with as to why prices go up in an economy awash with funds… I mean, no one is out there holding up signs stating– “Hey businesspeople!  The currency is over-valued now!  Raise your prices!”

When domestic prices go up, a couple of market-related things will follow…

Domestic residents will start buying less goods at home and more goods abroad (where goods are suddenly relatively cheaper).  This will have the effect of sending money out of the country, thus reducing the money supply at home, thus helping to correct the problem of having too much money around relative to the amount of Gold Reserves.  When enough money moves out and it become scarce enough, the real value of currency will begin to approach its stated value vis-a-vis Gold Reserves.  Thus, Gold Standard theory predicts marketplace mechanisms will work to correct over-valued currencies.  [BTW:  Additionally, the reduction in money supply will have the effect of reducing the upward pressure on prices].

My problem here is… won’t that exported money eventually come back into the economy?  Especially if you’re a major economy like the U.S.?  I mean, are dollars abroad really no longer part of the money supply?   Perhaps just the DELAY in having the money take the long way home is enough to reduce the money multiplier effect and reduce the money supply that way.  [I don’t want to go into how the multiplier effect works right now].  Furthermore, I suspect that the multiplier effect would be farther slowed by all those business people whose income becomes reduced because sales drop off.  This will go all the way up the supply chain.  If bad enough, I’d say expect a recession to kick in.

2b] UNDER-VALUED CURRENCY

If a currency is under-valued, that means that not enough of it is being printed– it’s scarcity relative to the Gold Reserves backing it up will cause each bill to rise in value.  The flipside of rising money-worth is falling prices… what two dollars bought yesterday, today one (more valuable) dollar will buy.  With falling prices, the country’s export economy will begin booming since its exports will appear relatively cheap in world markets, drawing money in—until the currency crunch is alleviated.

3)  Interest Rate Adjustments

3a] OVER-VALUED CURRENCY

When too much money is printed and the currency is thus over-valued, banks have to raise the interest-rate-returns the offer on their investments in order to keep pace with the price-inflation rate… for no one would save or invest money if, at the end of the saving/investment term, the money they withdrew– even with the addition of interest payments– bought LESS than it would have before the time spent parked in the investment.

Higher interest rates should begin to bring in more money from abroad… thus increasing the money supply even more.  Prices will thus begin to climb.  Additionally, higher interest rates will likely stall the economy as investors may feel that they cannot justify borrowing at such high rates.

Thus, if a currency is over-valued/printed, after an initial burst of mucho money and an economy on fire– mechanisms will kick in– in the form of higher prices and higher lending rates– that will drag the economy back down from peak to trough.  In this way the Gold Standard is supposed to affect one of its self-regulating mechanisms.

3b] UNDER-VALUED CURRENCY

I find the interest rate scenario a little cloudy under a scenario of scarce money.

It seems to me that under-printed money will have the same effect on interest rates as over-printed– namely, to drive them up.  Why?…

Because if money is scarce, banks will have to ratchet up interest rates in order to draw in money so that they can lend it (or in today’s crazy world– leverage it).  On the other hand, with stagnant or dropping prices, the banks won’t have to offer as high of returns on money saved or invested since the money will be holding it value– or even gaining value– while it’s in savings.

All in all, I’m not convinced the Interest Rate mechanisms of the Gold Standard will work all that well as a deterrent to a country’s under-valuation of its currency.  The other mechanisms would probably do more.

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