The True Gold Standard (Second Edition)
When it meets next week, the Federal Open Market Committee (FOMC) is widely expected to signal its desire to increase the rate of inflation by providing additional monetary stimulus. This policy is based on a false—and dangerous—premise: that manipulating the dollar's buying power will lead to higher employment and economic growth. But the experience of the past 40 years points to the opposite conclusion: that guaranteeing a stable value for the dollar by restoring dollar-gold convertibility would be the surest way for the Federal Reserve to achieve its dual mandate of maximum employment and price stability.
From 1947 through 1967, the year before the U.S. began to weasel out of its commitment to dollar-gold convertibility, unemployment averaged only 4.7% and never rose above 7%. Real growth averaged 4% a year. Low unemployment and high growth coincided with low inflation. During the 21 years ending in 1967, consumer-price inflation averaged just 1.9% a year. Interest rates, too, were low and stable—the yield on triple-A corporate bonds averaged less than 4% and never rose above 6%.
What's happened since 1971, when President Nixon formally broke the link between the dollar and gold? Higher average unemployment, slower growth, greater instability and a decline in the economy's resilience. For the period 1971 through 2009, unemployment averaged 6.2%, a full 1.5 percentage points above the 1947-67 average, and real growth rates averaged less than 3%. We have since experienced the three worst recessions since the end of World War II, with the unemployment rate averaging 8.5% in 1975, 9.7% in 1982, and above 9.5% for the past 14 months. During these 39 years in which the Fed was free to manipulate the value of the dollar, the consumer-price index rose, on average, 4.4% a year. That means that a dollar today buys only about one-sixth of the consumer goods it purchased in 1971.
Interest rates, too, have been high and highly volatile, with the yield on triple-A corporate bonds averaging more than 8% and, until 2003, never falling below 6%. High and highly volatile interest rates are symptomatic of the monetary uncertainty that has reduced the economy's ability to recover from external shocks and led directly to one financial crisis after another. During these four decades of discretionary monetary policies, the world suffered no fewer than 10 major financial crises, beginning with the oil crisis of 1973 and culminating in the financial crisis of 2008-09, and now the sovereign debt crisis and potential currency war of 2010. There were no world-wide financial crises of similar magnitude between 1947 and 1971.
Monetary fragmentation is inconsistent with the globalization of business.
It is ironic that the international monetary system of floating currencies is based on a theory called the "Optimal Currency Area" that celebrates the freedom of central banks to print money at will. The idea is that total freedom to create money would promote global progress and employment, smooth out business cycles, and prevent bubbles and their associated crises.
Gold hasn't reinvented itself as a currency yet. But it is getting closer.
J.P. Morgan Chase & Co. said it will allow clients to use the metal as collateral in some transactions. For example, a hedge fund wanting to borrow money for a short period can put up gold as collateral and use the borrowings to invest elsewhere, betting on making a better return. Typically, banks accept only Treasury bonds and stocks in such agreements.
Not having a real budget means the Federal Reserve doesn't have to compete with anyone for scarce resources. What the central bank needs is a little money competition.
'I will maintain to my deathbed that we made every effort to save Lehman, but we were just unable to do so because of a lack of legal authority." So said Federal Reserve Chairman Ben Bernanke in 2009. The statement was striking—not because it was false, but because the Fed lacked explicit legal authority to do so much of what it did during the financial crisis. Drawing the line at Lehman seemed arbitrary, and it proved that the Fed has become an unaccountable power within American government.
Paul Ryan's plan won't succeed without legislation to prevent the Federal Reserve from monetizing the national debt.
No man in America is a match for House Budget Committee Chairman Paul Ryan on the federal budget. No congressman in my lifetime has been more determined to cut government spending. No one is better informed for the task he has set himself. Nor has anyone developed a more comprehensive plan to reduce, and ultimately eliminate, the federal budget deficit than the House Budget Resolution submitted by Mr. Ryan on April 5.
But experience and the operations of the Federal Reserve system compel me to predict that Mr. Ryan's heroic efforts to balance the budget by 2015 without raising taxes will not end in success—even with a Republican majority in both Houses and a Republican president in 2012.
Why? Because the House Budget Resolution fails to reform the Federal Reserve system that supplies the new money and credit to finance both the budget deficit and the balance-of-payments deficit. So long as the Treasury deficit can be financed with discretionary money and credit—newly created by the Federal Reserve, by the banking system, and by foreign central banks—the federal budget deficit will persist.
It is true that federal deficits will rise more or less with the business cycle, leading previous deficit hawks such as Sens. Phil Gramm and Warren Rudman to believe that if we just reined in federal spending and increased economic growth we'd have a balanced budget. Indeed, for two generations, fiscal conservatives and Democratic and Republican presidents alike have pledged to balance the budget and bring an end to ever-rising government spending.
They, too, were informed, determined and sincere leaders. But they did not succeed because of institutional defects in the monetary system that have never been remedied.
President Reagan was aware of the need to reform the monetary system in the 1980s, but circumstances and time permitted only tax-rate reform, deregulation efforts, and rebuilding a strong defense. And so the monetary problem remains.
The problem is simple. Because of the official reserve currency status of the dollar, combined with discretionary new Federal Reserve and foreign central bank credit, the federal government is always able to finance the Treasury deficit, even though net national savings are insufficient for the purpose.
What persistent debtor could resist permanent credit financing? For a government, an individual or an enterprise, "a deficit without tears" leads to the corrupt euphoria of limitless spending. For example, with new credit, the Fed will have bought $600 billion of U.S. Treasurys between November 2010 and June 2011, a rate of purchase that approximates the annualized budget deficit. Commodity, equity and emerging-market inflation are only a few of the volatile consequences of this Fed credit policy.
The solution to the problem is equally simple. First, in order to limit Fed discretion, the dollar must be made convertible to a weight unit of gold by congressional statute—at a price that preserves the level of nominal wages in order to avoid the threat of deflation. Second, the government must at the same time be prohibited from financing its deficit at the Fed or in the banks—both at home or abroad. Third, only in the free market for true savings—undisguised by inflationary new Federal Reserve money and banking system credit—will interest rates signal to voters the consequences of growing federal government deficits.
Unrestricted convertibility of the dollar to gold at the statutory price restricts Federal Reserve creation of excess dollars and the inflation caused by Fed financing of the deficit. This is so because excess dollars in the financial markets, at home or abroad, would lead to redemption of the undesired dollars into gold at the statutory parity price, thus requiring the Fed to reduce the expansion of credit in order to preserve the lawful convertibility parity of the dollar-gold relationship, thereby reducing the threat of inflation.
This monetary reform would provide an indispensable restraint, not only on the Federal Reserve, but also on the global banking system—based as the system now is on the dollar standard and foreign official dollar reserves. Establishing dollar convertibility to a weight unit of gold, and ending the dollar's reserve currency role, constitute the dual institutional mechanisms by which sustained, systemic inflation is ruled out of the integrated world trading system. It would also prevent access to unlimited Fed credit by which to finance ever-growing government.
By adding these monetary reforms to his House Budget Resolution, Mr. Ryan has a chance to succeed where previous deficit hawks have failed. As today's stalwart of a balanced budget, he must now become a monetary-reform statesman if he is to attain his admirable goal of balancing the federal budget by 2015 without raising taxes.