The Durable Ethics Behind The Gold Standard

Hello everyone. Welcome back to Breaking the Dollar. I'm your host Everett Millman. And this week we are going to be revisiting the idea of a gold standard. You might call this the gold standard ethics because if you haven't already heard one of my earlier episodes I did a nice quick explainer of how the gold standard worked and when it was in effect. So I won't really be rehashing any of that. Like I said, please go check that out if you haven't already before you listen to this.

But I think it's still a topic that has some more room to explore because I do hear quite a bit of people who are interested in gold. They bring up the gold standard and they often try and make arguments about how much better things were when we were under a gold standard. And my view on this is from a historical perspective. It was sort of a double edged sword. There's both good and bad to how the gold standard worked. At the end of the day, however, it is no longer feasible under our current system. At least not in the form that was classically or traditionally used. If we did have some sort of version of a gold standard in today's world it would have to be very cleverly constructed that somehow adjusts for the fact that a gold standard does put constraints on how much money the government can spend on things and therefore how much the economy can grow. In the modern world that kind of constraint simply doesn't work. It would destroy economic growth and it would lead to all sorts of problems that simply cannot be solved by the classical gold standard.

So if that's the case you might be wondering: well Everett, then what is there to talk about? Why are we bringing up the gold standard again? And the reason why isn't merely to address the abundance of interest out there about the gold standard and whether it could work nowadays. It's also because, sort of as I just described, there is a role for gold in the financial system in our monetary policy. It just may not be the same as it was back during the times under the gold standard. To this day it's undeniable that gold retains some currency-like characteristics and by that I mean that gold trades more like a currency than it does a commodity. With most commodities there are natural resources that we use up in some type of industrial process and that is largely not the case with gold. Most gold is hoarded or recycled and so by a measure called stock-to-flow ratio, which basically means how big is the existing stockpile of the world's gold relative to how much the gold supply is growing with new mining each year. It's a really high ratio. I think right now it's almost 60 to 1. And what that means is that the supply of gold around the world is very stable and it grows very slowly relative to how much there already is. That is not true of virtually every other commodity.

Now this property does give gold a certain advantage in terms of stability and let me give you a brief illustration of what I mean by that. Under the gold standard you generally had to keep 40% of the value of the money you issued as a government in gold. So it wasn't a perfect one-to-one 100% of the money supply had to be backed by gold, but it was significant; it was 40%. Now any time a bank exceeded that percentage where I guess you could say was below that percentage, they had an insufficient amount of gold to back up the value of their balance sheet, all of their assets. When it got below 40% it was described as pyramiding money on top of the base money, and by base money they meant gold. The greater the pyramiding the smaller and smaller that percentage of gold backing of the money became, the more risky the financial situation would become for those banks. Essentially they were insolvent at a certain point. And so when I think of financial stability in the system today you could kind of use credit, the amount of loans that are given out, as a comparison for pyramiding newly created money on top of the base money or the value that is supposed to back that up.

As we've discussed many times on Breaking the Dollar, debt around the world is excessively high. When the world economy is growing rapidly that debt really isn't a problem, it's a good thing. It allows businesses to invest; it allows entrepreneurs to start new businesses. Credit is not inherently a bad thing. But when you have very high levels of it relative to the actual value of the underlying economy you start to get into a precarious situation. In today's world the antidote to that, the stabilizing force, would be something like gold. For that reason I often challenge people who don't believe that gold really serves any purpose in the financial system. I challenge those people to answer: if that is the case why do central banks and other institutional investors like hedge funds and big commercial banks -- why do they hold gold in the first place? And there's really no other good answer to it other than they believe it has a stable value.

In many of the most prosperous countries in the world you see this same type of behavior with gold with the general public. So in Germany and India and China, in all three of those countries the public holds thousands upon thousands of tons of gold. Now are they necessarily doing that because they think the financial system is going to collapse and that they'll have to resort to using their gold as money? I don't think so. I don't think the vast majority of people hold gold with those kind of doomsday plans in mind. Some people certainly do but by and large the vast majority of them are holding gold because it has stable long-term value. And listen, it's not (for lack of a better phrase) a silver bullet. There is more money to be made investing in other things. I mean look at the stock market. You could credibly make the argument that the stock market, because it tends to rise in value over time historically, is the best hedge against inflation possible.

So in the same way that a gold standard placed constraints on governments that perhaps were not feasible or were not always good, the same is true for the average person because there is a certain opportunity cost in keeping your wealth in gold rather than trying to grow it by investing in other things. My point in bringing this up is that ideally there should be a balance between the two. And that's what we see with private citizens holding a lot of gold and it's what we see with financial institutions holding a lot of gold. It has proven to maintain its purchasing power no matter what is going on with the underlying economy or that country's currency. And even as I kind of dispel the notion that this has anything to do with the sort of doomsday collapse of the financial order, it is worth pointing out that instances where a country's sovereign currency is devalued to the point of becoming worthless is not at all uncommon. In fact in many cases it only takes a few generations for this to happen. If you look at the history, you could go as far to say that that is the norm, that that is the rule rather than the exception. It is simply the nature of fiat currencies to depreciate over time relative to other real assets. And that means real estate, that means businesses, any asset of value including gold. You could include gold in that group.

So although I am definitely pushing back on the idea that we will ever see something akin to a gold standard again, I want to emphasize that even under our current financial regime or system, gold sort of already serves that purpose as a hedge against those types of risks. To kind of tie this into what's going on right now in the contemporary financial world, the price of gold has spiked a lot lately and that has been tied directly to the geopolitical tensions and instability created by this back and forth between the United States and Iran. And indeed that is another role that gold has as a safe haven, is that in times of war or instability people tend to seek safety by stocking up on gold.

But it should be pointed out that the gold price was already performing very well before any of that happened. And the reason why had everything to do with monetary policy and the financial system. Now of course war can make that situation even worse. But even in the absence of that type of tension and turmoil there are already many reasons to think that the financial system is suffering from some risks of instability. Pointing out some of those areas of instability is certainly one of the recurring themes on this podcast. And so with that in mind, it is not an accident that the answer to some of those problems of instability always seems to lead back to gold. No matter what anyone tells you, it is undeniable that gold does play a key role in underpinning the financial system. It's simply not done in a legalistic way anymore because that placed too many constraints on the ability of governments to implement fiscal policy and for their central banks to implement monetary policy like interest rates. All of those things have been decoupled from the value of gold in a formal sense.

But that doesn't mean that informally, based on their choices and behavior, as in holding gold, that these institutions don't still have a need for gold to be there. It does in many ways hold the financial system more accountable. I will wrap this up by adding that, as I kind of teased early on in the episode, just because a formal legalistic gold standard is infeasible that doesn't mean in the future we couldn't see gold reassert itself as a sort of neutral reserve asset. And in fact some of the problems with the US dollar serving in that capacity in under our current system, once again leads to gold as a possible alternative. If we end up needing a Plaza Accord 2.0 type of situation where the dollar is radically revalued relative to other currencies and other assets, I firmly believe and I'm convinced that gold would have to be given some consideration in that scenario. Once again, otherwise, why are all these central banks holding so much of it? It simply doesn't make sense otherwise.

And I think that nicely transitions into this week's question from the listeners. This question comes from Craig P and he asks why is the dollar used worldwide? And there are really two main reasons for this. One is that the United States has the largest most powerful economy in the world. We are the world's biggest consumers. So if you are a country and you want Americans to buy something from you, you've got to trade them in dollars. The same is essentially true for much of the banking system. If you want access to banking around the world, you're generally going to have to conduct business in dollars. So the dominance of the US economy is one of those main reasons. The other is simply that following World War II, the US flooded the world with dollars. And the reason that everyone accepted them is because at the time they were exchangeable for gold. Eventually, that promise would be broken by President Richard Nixon and we saw the end of the Bretton Woods system. But nonetheless, that's how all those dollars got out there to begin with. And once everybody is holding your currency, they don't want to take a loss on it. They want that to be worth something and be able to spend it. So here we are.

Honestly, I enjoy that question so much. I think it might even lead into our topic for next week. Tune into next week's episode to find out about how exactly the US dollar became the world's global reserve currency. I will expand upon that brief answer that I gave this time. In any event, thank you so much for listening. We appreciate everybody out there who tunes in. And hopefully you'll gain some more valuable insights into the history of the US dollar on our next episode of Breaking the Dollar.