Go Forward to Gold - How to Lift the Reserve Currency Curse

Ben Bernanke, for example, was a respected economics professor who specialized in the Great Depression before becoming a member, and now chairman, of the Federal Reserve's board of governors. Responding to Milton Friedman's thesis that the Federal Reserve had turned a mild recession into the Great Depression by permitting the U.S. domestic money supply to decline. in 2002 Bernanke addressed Friedman with these words: "Regarding the Great Depression: You're right, we [the Federal Reserve] did it. We're very sorry. But thanks to you, we won't do it again." However, with all respect to that great economist, it must be said that Friedman was wrong on a crucial point: believing that only domestic official monetary liabilities (currency and commercial-hank reserves) matter — a view that Bemanke and Tim Geithner, the New York Fed president and Barack Obama's nominee for treasury secretary, seem so far to share. Excluding the role of foreign dollar reserves assumes the model of a closed economy, not an integrated global trading system.

The evidence we have reviewed shows that, exactly as Rueff argued, official dollar reserves are a form of high-powered money — adding up to a sum now several times the Fed's own holdings. The Treasury and federal-agency debt securities held by foreign monetary authorities substantially exceed those held by the Federal Reserve itself, approximately by a factor of five.



How can we end the reserve-currency curse? While acknowledging the complexity of the century-old problem, we must in this article simplify the necessary remedies. The essential requirement for restoring a stable international monetary system is that the major countries agree to replace all official foreign-exchange reserves with an independent monetary asset that is not ultimately some particular nation's liability. Many standards are theoretically possible. but monetary authorities still hold nearly 900 million ounces of gold, and the simplest, most effective, and most tested solution is a modernized international gold standard. This would require changes in U.S. law and an international monetary agreement.

There are two primary conditions for the success of such a reform. First, the gold values of all national currencies must be properly chosen to preclude the deflationary mistakes of the 1920s and 1930s. This requirement now suggests a gold price not less than $1,000, but a more precise calculation will be necessary when the reform is to take effect. Second, existing foreign- exchange reserves must be removed from the balance sheets of national monetary authorities by consolidating them into long-term government-to-government debts that will be repaid over several decades — much as the Washington-Hamilton administration funded domestic and
foreign Revolutionary War debt.

Similar proposals have been made repeatedly — in the 1920s, in the 1960s, and in the 1980s — but in each case they were rejected by "experts" who predicted that raising the gold "price" (from $20 to $35 in the 1920s, from $35 to $70 in the 1960s, or, still later, from $300 to $500 in the 1980s) would be wildly inflationary. The deflationary collapse of the 1930s, the inflationary collapse of the Bretton Woods system in 1971, and the recent financial crisis were all consequences of this shortsightedness. The gold price soared from $35 in 1971 to nearly $200 by the end of 1974, and hit $1,000 an ounce in March 2008 (it is now around $800).

The proposed reform would bring many advantages. First, it is worth remembering that convertibility of major currencies to gold produced by far the best performance of price stability in American history. From 1879 to 1914, average annual CPT inflation was 0.2 percent, with average annual volatility (up or down) of only 2.2 percent. No other standard comes close in combining low average inflation with low volatility. The volatility in the period from 1971 to the present (2.8 percent) is a close second to the classical gold standard, but it has had the worst average inflation: 4.6 percent. The 1862-79 Greenback period had the lowest average inflation (0.1 percent) but the worst volatility (8.8 percent).

Second, the plan would provide not just an American but a vast worldwide countercyclical "stimulus package" — one not financed by yet more government debt — since when all other prices declined, the gold "price" would stay constant, stimulating gold mining (in which America now rivals South Africa). Third, relieved of its reserve-currency burden of being the world's "spender of last resort," America would see the competitiveness of U.S. industry quickly restored and the chronic U.S. trade deficit quickly return to chronic surpluses. Fourth, since the whole world would have what amounts to a trade surplus with itself, equal to the increase in official gold reserves, pressure for trade protectionism would diminish sharply. Fifth, the chaos of floating currencies would end along with the reserve-currency curse. The gold standard best integrates the world trading system, by bringing about prompt adjustment of balance-of-payments deficits.

Sixth, the reform would halt the proliferation of debt resulting from the current currency system. Seventh, not the least benefit would be to recapitalize the balance sheet of the Federal Reserve System itself. In the course of its massive bailout of private institutions, the Federal Reserve's loan-to-capital ratio has risen to about 50 to 1 — worse than the troubled major private banks it is trying to save! Revaluing U.S. gold reserves from the current $42.22 to at least $1,000 an ounce could bring this ratio down to 7 to 1, providing the liquidity necessary to deal effectively with the crisis.


Kathleen M. Packard, Publisher
Ralph J. Benko, Editor

In Memoriam
Professor Jacques Rueff

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