Comments on Gold for Currency Purposes

In a private communication with our friend JR we wrote

Again we go back to people with an agenda or bias – they don’t think. The article [http://www.theburningplatform.com/?p=37942] identifies the single advantage fiat currency has over a fixed base currency – the ability to create more on demand. Fiat currencies collapse when the multiplication gets out of control. Until that point they are fine. Gold-backed currencies collapse when the sovereign has a sudden need for more money and the fixed-base doesn’t have the flexibility to allow this. Look at the last hundred or so years of the so-called gold standard. Countries were forced off it when they needed a sudden expansion of the money supply to fight a war. Both the US and Europe have this in their past.

As we have observed before, every PM-based [precious metals] currency has collapsed because the sovereign has always found a way to expand the supply (debase it). This should give the advocates looking for a golden nirvana pause – but it doesn’t. They don’t think. The empirical evidence is that ALL currencies collapse. Some survive longer than others but they all go to that currency graveyard in the sky.

In this post we answer some of his subsequent questions and then move onto some current thoughts on PM-backed currencies.

A Few Questions

JR: Doesn’t multiplication have to get out of control, given the obligations we have on the books?

POOG: Money multiplication can be controlled by government regulation. Indeed we were considering, today, the idea that the rampant credit expansion in the US (money creation) was the result of regulatory failure and repeal and had nothing to do with going off the gold standard (a post for another day). But money multiplication has an inherent limit that we explore in a post we hope to release shortly.

JR: This seems to be an ancillary argument of the libertarians – that the gold standard keeps us out of wars of choice. And wars seem to be the primary occasion for the “sudden need” for bucks.

POOG: The counter to this argument is that WWI was precipitated while the world was on a gold standard. The post-WWI period saw a return to the gold standard until the financial chaos of the depression years forced countries to abandon it (see also Gold standard) with WWII being the conclusion to this period. In other words, great events occur while a gold standard is in place and the latter is unable to prevent their happening.

JR: So, my question is, why not do a PM based currency – like the US started – with the admission right out front that this will be tried to be manipulated. Transparency is “job #1” in this world. Thus, when the manipulation starts, everyone will know.

POOG: The empirical evidence against this and any other proposed currency, PM-backed or no, is that it will fail. The sovereign always wins which is why it is sovereign. Once something is constructed, better minds have the blueprint to study and develop strategies for defeating it.

Gold As a Reserve Currency

During the time of the gold standard, gold was the basis or backing for sovereign currencies. This in fact meant that every currency was able to be valued in terms of gold. The supply of gold any country owned was a variable that fluctuated with the country’s balance of trade. The global supply of gold was relatively constant (it grows slowly). Gold in effect acted not as a reserve currency but a reserve currency referent.

Since gold, not a single specified currency, was the basis for international trade, a country with a positive balance of trade experienced a net inflow of gold and the economy was stimulated to grow. Countries experiencing a negative balance of trade experienced a net outflow of gold becoming poorer with a consequent austerity regime until the balance was reversed. Trade can still be conducted in local currencies with the understanding of referential valuation and convertibility.

How Would We Get There?

There would have to be an international convention  – say Basel IV. The problem that would have to be faced is that some countries such as Canada have a negligible gold reserve. Their FX reserves if in currencies that became gold-backed, could presumably be converted into gold, but if global FX reserves were converted to gold, China and countries with a huge FX reserve would recieve most of it.

Further, since all sovereign debt is equivalent to the currency behind it, the conversion of a currency to one that is gold-backed is more than simply currency in circulation. It is the broader money supply that has to be converted. This is not likely to happen without a massive default.

In other words, don’t hold your breath.

Addendum

We would refer readers to an article by Richard Mills on the use of gold as collateral or as a tier 1 asset: Sprout-less Gold Tier 1 Capital?

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