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A Gold Exchange Standard

Back money with gold? Why not back money with other money, backed by gold...?

SOMETIMES you hear about the "Gold Exchange Standard," writes Nathan Lewis at New World Economics. This is really just one of many varieties of gold standard systems.

A gold standard system, according to me, is a system with a certain policy goal: to maintain the value of the currency at a fixed parity with Gold Bullion. Then, you need to have some sort of operating mechanism to achieve this goal.

This operating mechanism has to work – that is, it has to actually achieve the goal – in a reliable fashion, for the indefinite future. Just crossing your fingers and mumbling in public doesn't work. Just selling gold at a certain price doesn't work. We looked at many such operating systems earlier this year.

A "Gold Exchange Standard" is one where the currency manager doesn't have an independent peg to Gold Bullion. Rather, the currency is pegged to another international, gold-linked currency, such as the British Pound or US Dollar. Obviously, if the British Pound is pegged to gold and your currency is pegged to the British Pound, then your currency is also pegged to gold. So this is a variety of a gold standard system.

As for an operating mechanism, we have an automatic currency board. Nothing wrong with that. Currency boards work fine. Indeed, a direct bullion link is really no different than a currency board, where the exchange rate is kept in a tight range against another, target currency. You just use gold instead of some other currency.

Because the currency in a Gold Exchange Standard is pegged to a target currency, like the British Pound, the primary reserve asset in this case is high-quality British Pound bonds. The central bank doesn't need to hold any Gold Bullion. It might hold some anyway, as European central banks did during the Bretton Woods period after World War II, even though they were pegged to the Dollar with a "Gold Exchange Standard" type arrangement, not to bullion directly.

There are some nice things about this arrangement. If, perhaps after a war for example, you don't really have very much Gold Bullion, you can establish something like this pretty quickly without having to accumulate bullion. Also, virtually all gold standard systems do not have a 100% bullion reserve. The primary reason is that it is unprofitable. It costs a little money to run a currency system, and without a profit, the currency system becomes a money-loser. The only entity that can operate a money-losing system is the government. However, for the last two hundred years, it has been mostly private entities, first commercial banks and then central banks, which have operated monetary systems. So, they want to make a profit.

To make a profit, you have to hold, as a reserve asset, some interest-bearing bonds or loans. The more bonds you have, the higher the profit. Thus, a system with no gold holdings, and 100% bond holdings, is the most profitable. Also, you many want to make your reserve asset independent of the domestic government, particularly if the government has a recent history of pressuring the central bank into financing government deficits. If 100% of your reserve assets are foreign government bonds, then the central bank does not deal in domestic bonds, and is relatively immune to "finance my deficit" arguments. You don't have to deal with all the problems of storing and shipping Gold Bullion, or meeting redemption requests.

One drawback of such a system is that you are reliant upon the target currency remaining pegged to gold. This didn't work out so well for those linked to the British Pound, which was devalued in 1914, 1931, and numerous times thereafter. Or, for those linked to the US Dollar, which was devalued in 1933 and then in 1971. Even in this case, it is not strictly necessary that a central bank follow the devaluation of the target currency. Indeed, in 1971, when the US Dollar officially went off gold, most other major governments also severed their Dollar ties. They could have, from that point forward, established an independent gold link. But there is some inertia in these things, and once pegged to a target currency, the country is almost certain to follow that target currency's devaluation, in one way or another.

The point of all this is, a "Gold Exchange Standard" is a perfectly usable gold standard system, with some advantages and disadvantages, just like any other system you could devise. There is nothing inherently wrong with it. Although the term "Gold Exchange Standard" is usually applied to the 1920s, in fact this system was in use throughout the 19th century as well by some governments. It became more common after 1920, as governments dealt with the process of re-establishing their gold pegs after virtually everyone left gold in World War I.

There was never, in the pre-1914 era, in the 1920s, or in the 1950s, a one-size-fits-all solution that everyone used. Some governments used a "Gold Exchange Standard", i.e. a currency board with a major international gold-linked currency, and other governments used a different system.

A few funny things have popped up over the years. First, some people want to blame supposed problems with the "Gold Exchange Standard" for causing or exacerbating the Great Depression of the 1930s. And any gold standard system is a pretty simple thing. You could have some potential problems.

The value of gold itself could change. There isn't much evidence that this has happened, which is why we continue to use gold as a basis for monetary systems, but it is conceivable. In that case, the value of currencies pegged to gold would also change alongside, with potential consequences.

The second thing that can happen is that a country is not properly observing the appropriate operating mechanisms – in other words, engaging in some sort of domestic "monetary policy" or maybe just being incompetent – and thus the currency's value diverges from its gold peg, or, in this case, peg with the major international gold-linked currency.

Those are pretty much the only two things that can happen. Did either of those happen in the 1920s?

The question of whether gold itself changed value, dramatically enough to cause some meaningful effects, is a little too complex for this time. I think this idea is much too popular, among those eager to blame the Great Depression upon the gold standard itself, and not backed up by much if any evidence at all. I looked at it in considerable depth in the past, and found nothing of importance.

What did happen in the 1920s is that countries like Britain repegged to gold at the prewar parity, which involved a substantial deflation (rise in currency value against the cost of living) from the devalued state at which their currencies ended the war. This had recessionary implications, especially when exacerbated by other problems, as was the case in Britain. Keynes complained about this. However, this was not a problem of gold itself failing in its role as a standard of stable monetary value, but rather the process of returning to the gold standard policy. In other words, dealing with the consequences of the wartime devaluation.

The other question is: did countries properly manage their currencies, using the proper operating mechanisms, to maintain their gold links? For the most part, it appears to me that they did. There is no great record of currency difficulties during the 1920s. There was a little fussing around the edges, but nothing of great import.

As the Great Depression began, the Keynesians of course wanted a currency they could manipulate to help ameliorate the economic difficulties. Thus, the gold standard was blamed for preventing this manipulation. These are the "golden fetters" some people talk about, a "fetter" being a device that prevents movement. This was no failure of gold, to serve as a standard of stable monetary value, but rather a change in policy goals.

With all that in mind, let's take a closer look at the 1920s, by way of the book Golden Fetters: the Gold Standard and the Great Depression 1919-1939, by Barry Eichengreen. Eichengreen is a career Keynesian, so he has that outlook. A lot of his analysis is rather laughable in my opinion. Nevertheless, the book has quite a lot of good historical material, and thus, like most books, serve as a good resource in that regard.

In Chapter 13, 'Conclusion', Eichengreen sums up his arguments. He starts by accusing the post-WWI gold standard system of being subject to various "imbalances in international settlements." This is always a focus of the Keynesian types, going back to the days of David Hume, but it means nothing. "International settlements" are in fact irrelevent for maintenance of a gold standard system, which depends solely upon the proper management of base money supply, which any central bank can do without assistance. The "balance of payments" and "international settlements" are always a red herring, a political football which can be wheeled out at any time to serve practically any political purpose. It doesn't really mean anything at all, but since people are confused by the issue, it is a handy tool to blame anyone for anything, and sound convincing.

However, Eichengreen does bring up another important issue, having more to do with politics than the gold standard system itself. Because World War I transformed those circumstances. The credibility of the commitment to gold was undermined by the erosion of central bankers' insulation from political pressures.

In response to Europe's postwar experience with inflation and stabilization, explicit analyses of the links from restrictive monetary policy to unemployment were articulated and widely circulated. Although the details of those analyses differed across countries, they served to heighten awareness, wherever they appeared, of the impact of monetary policy on domestic economic conditions.

"Restrictive monetary policy", for instance, refers to the process of raising currencies' value to their prewar gold parities, as happened in Britain. Individuals and groups adversely affected by high interest rates and credit restriction increasingly resisted their implementation. The growing political influence of the working classes intensified pressure to adapt monetary policy toward employment targets. Fiscal imbalances (meaning government budget deficits) and distributional conflicts (expansion of welfare policies) magnified the strain felt by monetary policymakers.

A shadow was cast over the credibility of the commitment to gold. The markets, rather than minimizing the need for government intervention, subjected the authorities' stated commitment to Gold Bullion to early and repeated tests.

Now this is a real issue. A gold standard system is going to come under strain when the politicians start to talk about how much they would rather have some other sort of system. You would sell the bonds, sell the currency, and take your money elsewhere. Of course you would. Just like people in Greece today, as they read, day after day in the Financial Times, the apparently unanimous agreement among the elites and intellectuals that Greece should really have its own currency to be devalued as soon as possible.

This process is often interpreted as a "balance of payments imbalance", which is why that always comes up when the private markets start to react to the fact that governments' stated desires are contrary to the proper maintenance of a gold standard policy. The same happened in the 1960s. During this capital flight, maintenance of the gold standard parity (via reductions in base money supply) would likely lead to some increases in interest rates on the short term, while the longer maturities would also have rising rates due to the risk of devaluation. The gold standard system would be blamed for this rise in rates. None of this is particularly surprising, nor does it represent any inherent flaw in the gold standard system of the time. It is exactly what you would expect to happen, and exactly what is supposed to happen. Maybe politicians should keep their mouth shut?

Then, Eichengreen brings up the standard Keynesian complaint, that the gold standard system prevented the kind of money jiggering that had become popular as a way to deal with economic difficulty.

And that's pretty much it from Eichengreen's conclusions. Nothing particularly surprising there. If you account for some Keynesian bias, goofy academic terminology, and some confusion regarding the "balance of payments" and "international cooperation," it is all pretty much as one would expect it to be.

Unfortunately, most gold standard advocates today haven't really grasped what was going on in those days I think. They hear criticisms like those of Eichengreen, and don't know how to interpret them. Instead of dealing with the issues – as Eichengreen does – they tend to try to escape it by saying that the "Gold Exchange Standard" wasn't really a gold standard system, or had some sort of inherent flaw. The core of this notion seems to be that countries that were pegged to a major international gold-linked currency didn't hold much, if any, Gold Bullion. In the superstitious and atavistic world of people who try to talk about monetary policy without understanding it, less bullion means a "weaker" gold standard system.

This is one reason why, after 1971, we have been subjected to various "100%" or "pure" gold standard system proposals, which demand a 100% bullion reserve holding, something which is historically almost unheard of. As I've noted in the past, the Bank of England maintained the premier international gold-linked currency of its day, the British Pound, for sixty years to 1914 while holding bullion reserves equivalent to an average of about 1.5% of worldwide above-ground gold. That system didn't end because of "not enough gold", but rather because of the turmoil of World War I. The "strength" of a gold standard system comes from the strength of policymakers' commitment to the principles of such as system, plus the observance and understanding of the proper operating mechanisms necessary to sustain the system.

To accusations that the gold standard systems of the 1920s caused or exacerbated the Great Depression, the gold standard advocates often hide behind "but it wasn't really a gold standard system" claims. Well, actually, it was. People of the time thought so. It successfully maintained the policy goal, which was to keep currencies' values at a fixed parity with Gold Bullion. The main problem, from the perspective of the Keynesians, is that this policy goal was contrary to their own goals, to have a manipulable currency to address economic problems.

These conflicts, of a gold standard policy combined with a desire for "domestic" monetary manipulation, continued into the 1950s and 1960s. Thus, we had a good fifty years, 1920-1971, when the experience of a gold standard system was not the smoothly functioning example of the pre-1914 era, when capital moved freely and easily around the world. Rather, it was the era of incessant capital flight and monetary difficulties ("balance of payments imbalances") as politicians from one country or another would say how much they would like to do the things that a gold standard system expressly forbids. Plus, the occasional actual devaluation.

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Formerly a chief economist providing advice to institutional investors, Nathan Lewis now runs a private investing partnership in New York state. Published in the Financial Times, Asian Wall Street Journal, Huffington Post, Daily Yomiuri, The Daily Reckoning, Pravda, Forbes magazine, and by Dow Jones Newswires, he is also the author – with Addison Wiggin – of Gold: The Once and Future Money (John Wiley & Sons, 2007), as well as the essays and thoughts at New World Economics.

See the full archive of Nathan Lewis articles.

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