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Gold Standard Made Simple

Running a Gold Standard doesn't actually require any gold...

RUNNING A NATIONAL CURRENCY is simple if you understand the fundamental principle, writes Nathan Lewis for The Daily Reckoning.

   It just comes down to supply and demand

There, I told you it was simple.

The "supply" comes from the currency manager. Today, that's the central bank and Treasury Department or Ministry of Finance. They produce base money, which is actually the only money in existence. Base money is mostly coins and bills, and a little bit electronic bank reserves.

Every other sort of "money" is actually credit, not money.

The "demand" comes from everyone else, who is holding the currency, or – as is sometimes the case with the US Dollar today – choosing not to hold the currency.

Gold Standard: Currency Pegs

I bring this up because, at some point in the not too distant future, people may begin to clamor for a solution to the world's worsening monetary problems. Perhaps, as inflation worsens, there will even be interest in a Gold standard system.

   At that point, there will have to be someone who can actually solve the monetary problems. That person will have to understand the fundamental principle of currency management – supply and demand.

   Because if they don't, their system will eventually collapse as well. Probably sooner rather than later.

   People have long believed that a currency "backed by Gold" will remain stable, but there is no such guarantee. If you take a mammoth amount of gold, and lock it in a vault, it does not emit magical energy waves that automatically manages the value of otherwise worthless paper currencies.

   You still need to manage the currency, simply by sticking to the principle of demand and supply.

   There are many methods of keeping a currency pegged to gold. Some of them involve large hoards of Gold, or even making coins of gold, and some do not. However, all of them, if they are to be successful, have at their core the fundamental principle.

   Which, as I mentioned, is supply and demand.

   Indeed, if you understand this fundamental principle, you can peg a currency to gold even if there are no gold reserves at all.

   Everyone knows that a central bank, or other currency manager, can "print money" either electronically or physically. It is not as well recognized that a currency manager can "unprint money", or remove base money from circulation, too. The currency manager does this by selling something, typically a government bond, and making the money received in payment disappear.

   This happens nearly every day in the course of the Fed's regular operations. For example, the Fed has been rather vigorously lending money to banks. The Fed "prints money" and lends it to the banks. However, the overall supply of base money, according to the Fed's statistics, hasn't changed much. This is because the Fed is "unprinting money" elsewhere to compensate for its direct lending.

Gold Standard: Central Bank Control

   Central banks don't really control interest rates. What they do is to print money and unprint money in a fashion that influences interest rates. A central bank could adopt a different operating mechanism if it chose. During the early 1980s, the Fed printed money and unprinted money – in other words, altered the supply of money – in an effort to influence various credit statistics such as M1 or M2, so-called "money aggregates" that measure how much money and credit exists at any one time.

   Then there's pegging. A currency board system prints money and unprints money in an automatic fashion that keeps the currency pegged to another currency. Typically, a currency board has a "reserve" of foreign currency, but this reserve is not necessary if supply is being properly managed. If supply is not being properly managed, then the foreign exchange reserve is typically depleted in short order, and a crisis results.

   A gold standard is essentially a currency board linked to Gold. And doesn't it make more sense to peg to gold, the ultimate currency of mankind, rather than some government's paper plaything? This used to be very obvious.

   It seems that every gold standard advocate has their own special system, involving some idiosyncratic policy of reserve holdings or coin issuance. They will work just so long as they are based on the fundamental principle. If not, they would soon collapse.

   My own idiosyncratic system is the gold standard that involves no gold at all. There are no gold coins, and no government gold reserves. Gold Bullion is freely traded on the open market, just as it is today.

Gold Standard: The Bank of England

   In my system, the currency manager (today that means government) would adjust the supply of currency on a daily basis to maintain its value at the gold peg. When the value is a little low, you unprint money. When the value is a little high, you print money. In effect, it is a currency board linked to gold.

   The idea of a gold standard with no gold usually drives the traditional "gold bug" insane. They are very attached to their piles of ingots and eagles. I use it mainly as a teaching device. When a person fully understands the fundamental principle – supply and demand – they say: "Yes, of course that would work."

   In 1910, the gold standard that was centered on the British Pound and its manager – the Bank of England – encompassed the whole world. Yet at the time, the Bank of England held only 7.2 million ounces of gold. That was only 4% of all the gold held by governments and central banks in 1910, and only about 1.2% of all the gold in the world.

   The Bank of England didn't have much gold, because they didn't need it. They understood the principle of supply and demand.

   When the United States left the gold standard in 1971, the government held 291 million ounces of Gold. This had been depleted from 630 million ounces in 1942. Unfortunately, the Fed did not understand the principle of supply and demand. They were printing money aggressively to pump up the economy, with the result that everyone (especially the Bank of England and the Bank of France) wanted to dump the excess paper back on the Fed and get their Gold in return.

   The system failed, even though the US held forty times more gold than the Bank of England did in 1910.

   In a fairly short time, as central bankers' embarrassment becomes total, people may again seek out someone who can manage a currency like the Bank of England did in 1910. Prepare now, or we will have to bear further decades of monetary chaos and ignorance.

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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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