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Musings Report 2017-6 2-11-17 Why Gold-Backed Currencies Don't Work
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Why Gold-Backed Currencies Don't Work
There is something intuitively appealing about the idea of a gold-backed currency--money backed by the tangible value of gold, i.e. "the gold standard."
Instead of intrinsically worthless paper money (fiat currency), gold-backed money would have real, enduring value--it would be "hard currency", i.e. sound money.
Many proponents of sound money identify President Nixon's ending of the U.S. dollar's gold standard in 1971 as the cause of the nation's financial decline. If our currency was still convertible to gold, the thinking goes, we'd all be better off.
The problem with this line of thinking is that it is disconnected from the real world of trade, and from the actual mechanisms of capital flows and the way money is created in our financial system.
This article explains why Nixon took the USD off the gold standard: since the U.S. was running trade deficits, all of America's gold would have been transferred to the exporting nation. America's gold reserves would have trickled overseas, leaving nothing to back the dollar.
The U.S. Empire Would Have Collapsed Decades Ago If It Didn’t Abandon The Gold Standard
To sound-money proponents, the problem is running trade deficits: if the U.S. only had trade surpluses, then the gold would not drain away.
But Triffin's Paradox explains why this doesn't work for a reserve currency: a reserve currency has two distinct sets of users: domestic users and global users. Each has different needs, so there is a built-in conflict between the two sets of users.
Global users of the USD need enormous quanitities of dollars to use as reserves, to pay debts denominated in USD and to facilitate international trade.
The only way the issuing nation can provide enough currency to meet this global demand is to run large, permanent trade deficits--in effect, "exporting" dollars in exchange for goods and services.
This is the paradox: to maintain the "exorbitant privilege" of a reserve currency, a nation must "export" its currency in size; a nation that runs trade surpluses cannot supply the world with enough of its currency to act as a reserve currency.
People try to argue about this, but it isn't a matter of opinion, it's a matter of capital/trade flows.
I've also found that people are confused by convertibility: a gold-backed currency means the currency is convertible into gold; the convertibility is what makes it "as good as gold."
If there is no convertibility to gold, the currency isn't backed by gold at all.
But when this is mentioned in regards to the oft-mentioned notion that China will "back the yuan with gold" (and thereby reach global currency supremacy, the argument goes), then proponents backslide on convertibility and claim a currency can be backed by gold even if it isn't convertible to gold.
The flaw here is the conversion rate between the currency and gold is still fiat, i.e. completely at the whim of the national government/bank issuing the currency.
For example, let's say Lower Slobovia issues its currency, the quatloo, at 100 to an ounce of gold. If gold is $1200/ounce, each quatloo is worth $12. So far so good.
But then the government of Lower Slobovia encounters a spot of bother, and it announces overnight, without warning, that the exchange rate is now 1000 quatloos to an ounce of gold. Oops. Now the "gold-backed" quatloo is worth only $1.20. Everybody holding "good as gold" quatloos just took a 90% haircut on the value of their quatloos.
So either a currency is convertible into gold, or it isn't gold backed. If the conversion rate is set by the government, then it's subject to sudden revaluations, just like any other fiat currency.
Even a gold-backed currency is based on demand and trust. For example, let's say the wealthy residents of Lower Slobovia sense that capital is flowing out of the country, and a financial crisis looms. They convert their quatloos into gold and ship the gold overseas.
What happens to lower Slobovia's gold reserves? They are slowly but surely shipped overseas, leaving a diminishing amount to back the remaning money supply.
When people claim China is poised to back its currency, the RMB/yuan with gold, I point out that China has created $30 trillion in new money in the past decade, which is ten times the value of all the world's gold ($3 trillion).
In a true gold-backed currency, every new $1 in currency must be backed by an additional reserve of $1 of gold. If the gold supply remains constant but the supply of currency expands, the value of all the currency declines.
For example, if I issue 100 quatloos based on one ounce of gold, and then I issue another 100 quatloos without adding to my gold reserve, the value of each quatloo measured in gold falls in half.
This is the insurmountable problem with any gold-backed currency in the modern world. Money is created in a fractional reserve system in this fashion: $1 in cash acts as the collateral for $20 in new money issuance. This leverage of 20-to-1 is actually conservative; many banks around the world have 30-to-1 leverage or more.
So a bank holding $10,000 in cash deposits can originate a $200,000 home mortgage. The $180,000 difference is new money. The money supply just increased by $180,000.
In theory, that money vanishes when the mortgage is paid off. But in the current system, the total sum of debt never shrinks, even as debt is paid off, because new loans are being issued that far exceed the modest sums of existing debt being paid off.
So when China creates $30 trillion in new money via debt, it would need $30 trillion in gold to maintain convertibility. As debt was paid off, China could sell some of its gold reserves to match the decline in money supply.
If it maintained $30 trillion in gold reserves (which would require gold to be valued at tens of thousands of dollars per ounce, given the quantities available for purchase), then any reduction in the money supply would act to increase the value of the remaining currency.
You see the problem: no nation can back its fractional-reserve generated money supply with gold at current prices.
A gold-backed currency only works if money is created in tandem with the growth of the gold reserves. If no new gold is added to the reserves, then there is very little new credit issued, as the only money that can be lent is money deposited in the bank.
Proponents of gold-backed currencies might welcome this, but you can forget "growth" based on ever-rising credit/debt in a gold-backed system. Credit would scarce and costly, and the nation would have to strictly control imports to match exports, so its gold reserve would not flow overseas via trade deficits.
Such an economy would have a number of strict governors on trade, capital flows and credit. Any rise in distrust or fear would cause holders of the currency to rush to the safety of "the real deal," gold, by converting their currency into gold. Such "runs on the bank" could empty the reserves in short order, crippling the entire system.
Gold-backed currency may sound good in theory, but when we look at the real world limitations and risks, this form of "sound money" comes with severe limitations that we have to ask: is it worth it?
It's easy to say that a world with very little credit would be a good world, but it would be a world with limited trade or debt-based consumption, i.e. a world like the Middle Ages.
I would welcome a truly gold-backed currency somewhere in the world, but I doubt it would last, unless it was a private currency that could not be diluted at will. Why hold a gold-backed currency that can be diluted overnight by the issuing government/bank?
Personally, I think the flexibility of cryptocurrencies is a better fit for a dynamic economy than a gold-backed currency--but perhaps the ideal is a mix of a variety of currencies that are transparently priced by the open market.
But why hold a piece of paper convertible to gold rather than the gold itself? The only reason is convenience. What's to stop the government issuing the gold-backed currency from changing the rules or convertibility by fiat? As discord and disorder rise, history suggests the temptation to alter the deal in favor of the government will only rise.
In other words, there is no such thing as a risk-free gold-backed currency. The risk is always present but difficult to measure.
Summary of the Blog This Past Week
Loving Our Servitude in America's Plantation Economy 2/10/17
The Colonization of Local-Business Main Street by Corporate America 2/9/17
The Nitty-Gritty of Financial Independence: The Self-Employed Mobile Creative 2/8/17
Expropriation and Impoverishment: "Capitalist" Greece and "Socialist" Venezuela 2/7/17
Which Assets Are Most Likely to Survive the Inevitable "System Re-Set"? 2/6/17
Best Thing That Happened To Me This Week
Made a bed frame from scratch (clear douglas fir), turned out OK.
Market Musings: Correction on the USD and a note on Gold
OOPS! Last week I wrote: The USD seems to trace out these long-term wedges before breaking out to the upside. It would surprise me if it traced out another wedge here in Q1 and Q2 2017."
I intended to say "it wouldn't surprise me" if the USD followed the same pattern....
Gold hovers somewhere between religion and politics in terms of the emotions and loyalties it evokes. I don't have any convictions to defend one way or another. Gold is a commodity that has market value and symbolic value.
Gold tends to decline in value as yields rise, as the opportunity cost of holding gold rather than earning interest rises.
Gold tends to increase in value when fear and uncertainty increase.
So what happens if both yields and uncertainty rise? That's a question we may yet see answered in the decade ahead.
From Left Field
Sex doesn’t sell any more, activism does. And don’t the big brands know it
"Bad Schools" Will Just Not Die -- accredit the student, not the school....
Legalizing Marijuana Would Hurt Mexican Drug Cartels More Than Trump's Border Wall -- exactly...
The Megacity Economy: How Seven Types Of Global Cities Stack Up -- interesting categories of mega-cities...
This philosopher predicted Trump's rise in 1998 — and he has another warning for the left (via Bill S.)
Forget super-AI. Crappy AI is more likely to be our downfall, argues researcher
The Illusion of Asymmetric Insight (via Ryan R.)
This is how people can truly take back control: from the bottom up: Without community, politics is dead. But communities have been scattered like dust in the wind. At work, at home, both practically and imaginatively, we are atomised.
Mark Blyth--"Liberalisms' great trick has been to naturalize very difficult political contests." (27 min)
Cryptocurrency Can Shift the Balance of Power Between Cities, States and Nation
Hannah Arendt Final Speech (7:31) (via LaserLefty) -- from a film about Arendt....
Does Depression Have an Evolutionary Purpose?
"This is the true joy in life, the being used for a purpose recognized by yourself as a mighty one; the being thoroughly worn out before you are thrown on the scrap heap; the being a force of Nature instead of a feverish selfish little clod of ailments and grievances complaining that the world will not devote itself to making you happy." George Bernard Shaw
Thanks for reading--
charles |
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