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It’s Time for Pro-Growth Monetary Reform

Monday, August 15, 2011

Nixon’s decision four decades ago to end the gold-exchange standard was a catastrophic error. Today, sustainable global prosperity requires the restoration of sound money.

Forty years ago, on August 15, 1971, President Nixon took to the airwaves to declare that the U.S. Treasury would no longer redeem foreign demand for gold in exchange for dollars. Because the United States was the last country with a currency defined by gold, it represented a historic decoupling of the globe’s currencies—literally the money of the entire world—from the yellow metal. For the first time in at least 2,700 years, dating to the Lydian coinage of now modern-day Turkey, gold was money nowhere in the world. And for the first time ever, the world’s monetary affairs were defined by a system of politically managed fiat currencies—that is, paper money run by governments or their central banks. Four decades on, a comparative review shows Nixon’s decision to have been a catastrophic error, and indicates the need for fundamental monetary reform.

The Importance of Money to Sustainable Economic Growth

Rather than being a source of macro-stability, central banks that manage fiat currencies are themselves the causal agents of repeated boom-and-bust business cycles.

Economies grow via three interconnected phenomena, none of which would be possible without a well-functioning monetary unit: (1) the division of labor, specialization, and exchange; (2) saving and the accumulation of capital for investment; and, (3) efficient allocation of scarce resources via a system of prices and profit-and-loss.

We would all be poor if we had to produce our own food, housing, clothing, and other necessities. But as Adam Smith described, a pin factory’s specialized metal-straightening, wire-cutting, grinding, pin-head fashioning, and other operations increased the productivity of labor, output, and real wages dramatically. And for society at large, specialization and cost-lowering scale economies were not confined to single factories, but spread across industries and agriculture: the baker, the butcher, the brewer, and the cobbler all focused on productive specialties for a market wherein they exchanged with other specialists for desired goods.

Monetary policy must once again animate our national debates because the Great Recession and its ensuing torpor are the direct consequence of fiat money management by politicized central banking.

Absent sound money, this division of labor with its specialized knowledge and skills could hardly be exploited because, say, a neurosurgeon would have to find a grocer who coincidentally needed brain surgery whenever the neurosurgeon wanted food.

Similarly, explosive economic progress after 1750 was propelled by the accumulation of capital, the tools and machinery that increase output and are responsible for improved living standards. Here again, a dependable money unit facilitates the saving that allows for capital accumulation: income need not be consumed immediately, but can be transferred to others to invest productively, in return for future interest. Sound money enhances the wealth-creating exchange of resources between present and future, and in doing so assists in the development of higher output capacity.

Third, by providing a common denominator for all exchange prices between goods, money facilitates trade. Think about it: without a monetary unit of account, there would be an infinite array of prices for one good against all other goods, e.g., the bread-price-of-shoes, or the book-price-of-apples. Calculation of profit and loss, upon which effective allocation of scarce resources so critically depends, would be impossible.

Sound money enhances the wealth-creating exchange of resources between present and future, and in doing so assists in development of higher output capacity.

The institutional development and use of money has been as important as language, property rights, the rule of law, and entrepreneurship in the advancement of human civilization. And while everything from fish to cigarettes were tried as monetary media over time, the precious metals, and especially gold, were most effective, as they are intrinsically valuable, highly divisible, durable, uniform-in-composition, easily assayable, transportable, high value-to-bulk, and relatively stable in annual supply. In an ever-changing world of imperfection, gold has been found to be a near perfect, and certainly dependably valued, monetary unit.

Sound and Unsound Money, International Trade, and Economic Growth

Money is literally one-half of every purchase transaction, so when its value becomes volatile, exchange breaks down. At the least, distortive malinvestment of assets, due to falsified interest rates, leads to waste of scarce resources.

In an ever-changing world of imperfection, gold has been found to be a near perfect, and certainly dependably valued, monetary unit.

Germany’s hyperinflation of 1923 starkly illustrates this. War reparations had so burdened their economy that the German government took to printing the currency, known as the Papiermark, en masse. This rapidly depreciated the value of the currency until workers were paid in wheelbarrows of cash daily. Saving and investment were stunted, inflation soared out of control, and civil society lurched toward complete breakdown by the end of 1923, when $1, which bought 5.21 Marks in 1918, bought 4.2 trillion of them.

The German hyperinflation is an example of a “virus” infecting the economy, which distorts every transaction price, investment decision, and bank account value. In a 1970s-style inflation, a 1930s-style deflation, or a 2000s-style housing bubble fueled by Fed monetary policy, the welfare loss caused by unsound money may be lesser in magnitude than 1923 Germany, but it’s no less real.

The institutional development and use of money has been as important as language, property rights, the rule of law, and entrepreneurship in the advancement of human civilization.

Conversely it was sound money, based on the international gold standard, which greatly impelled the fantastic rise in prosperity in the 19th century across many parts of the globe by facilitating dramatic increases in integrating trade, secure investment, and the international division of labor. The century up to 1914 was a “golden age” of prosperity and harmony among nations, and while not devoid of war or recession, was comparatively more peaceful and productive than any period in history.

Politically Managed Money and the End of Gold

Beginning with World War I and continuing through the Great Depression and the Second World War, links to gold were often severed from currencies. In an attempt to resurrect the prosperity induced by the 19th century’s classical gold standard, the postwar monetary system was designed at Bretton Woods, New Hampshire in 1944. The resulting mechanism, known as the gold-exchange standard, lasted until Nixon’s vitiation of it in 1971. Under Bretton Woods, the U.S. defined the dollar in gold, maintaining convertibility at $35/oz. for foreign institutions (but not U.S. citizens). Free nations pegged their currency’s value to the dollar, thereby preserving a regime of fixed exchange rates, so as to promote certainty and encourage cross-border trade and investment.

It was sound money, based on the international gold standard, which greatly impelled the fantastic rise in prosperity in the 19th century across many parts of the globe.

By the 1960s this system broke down. Foreign governments announced periodic devaluations to promote exports and allow for domestic spending, and the U.S. ramped up “guns-and-butter” federal spending for both the Great Society and the Vietnam War. Inflation slowly crept into the U.S. economy, and gold redemption requests spiked by 1968.

President Nixon thus took his fateful decision in 1971, freeing the United States from any redemption obligations. This had two immediate effects: it amounted to an automatic, if stealthy, repudiation of U.S. debt in real terms, because it devalued all dollar-denominated assets and currency at once; and, it allowed the nominally independent Federal Reserve to manage the U.S. money supply for political ends.

The Predictable Aftermath of 1971 and the Fiat Dollar

Due to hyperinflation in Germany, $1 bought 5.21 Marks in 1918, but 4.2 trillion of them in 1923.

An era of massive instability has been the result: a trenchant stagflation in the 1970s; banking and Savings and Loan crises in the 1980s; Latin American, Asian, and Russian banking crises in the 1980s-1990s; overleveraged financial institutions and bailouts of firms too-big-to-fail in the 1990s-2000s; and, since 2000, two Fed-induced bubbles and subsequent crashes, the second one based in the housing sector that went global thanks to implicit guarantees of U.S. mortgage debt.

Here’s the key policy insight: rather than being a source of macro-stability, central banks that manage fiat currencies are themselves the causal agents of repeated boom-and-bust business cycles. By increasing the base money supply costlessly, central banks not only encourage government spending, they also permit the pyramiding of credit that guarantees leverage-driven booms: interest rates fall below their natural rate, which induces private investment and a temporary expansion. But this boom, usually in interest-sensitive capital goods, is not based on real savings of individuals and institutions, but rather on artificially created credit. By definition, such a boom is inherently unstable, and must end in a bust and painful retrenchment. The greater and longer the creation of fiat money by the central bank, the larger the pyramiding of credit, and the harder and longer will be the ensuing recession.

We would all be poor if we had to produce our own food, housing, clothing, and other necessities.

Monetary policy has not been a dominating political issue since the presidential election of 1896, when the pro-inflation William Jennings Bryan railed against a “cross of gold,” only to lose to the sound money advocate William McKinley. But it must once again animate our national debates because the Great Recession and its ensuing torpor are the direct consequence of fiat money management by politicized central banking. The restoration of sound money, that is to say, depoliticized and honest money, is a necessary step to a return to sustainable global prosperity. Specifically, a gold dollar that promotes the long-horizon investment that, almost by itself, leads to strong job creation at the same time as it restrains government profligacy, is an essential part of a brighter future for the entire world.

John Allison, a professor in the business school at Wake Forest University, is former chairman and CEO of BB&T Corporation, one of the largest U.S. financial services holding companies.  John Chapman is chief economist at Hill & Cutler Co. and an advisor to Alhambra Investment Partners.

FURTHER READING: Read an opposing viewpoint in, “Fool's Gold” by Jay Weiser. The American Enterprise Institute’s Alex J. Pollock writes on central banks in “The Federal Reserve’s Real Mandates” and economic forecasting in “Why the Fed Cannot Regulate ‘Systemic Risk.’” Daniel Ben-Ami discussed the importance of economic growth in “Let It Grow, Let It Grow, Let It Grow.

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