Thursday, December 15, 2011

"Good as Gold?"

In an article featured today at RealClearMarkets, John Steele Gordon promises to tell us how to make money as good as gold. He starts with a fairly long and mostly accurate synopsis of how and why gold developed into money in the first place but stumbles in his conclusion.
In the late 19th century, when all the world’s important countries were on the gold standard and the world economy and global trade were increasing rapidly, so was the supply of gold. Major gold strikes were found in California, Australia, Nevada, Yukon, Russia, Alaska, and South Africa in that period and much of that new gold ended up in central banks. This allowed for a steady increase in the money supply as the world economy expanded. In 1867 there was about $2.5 billion in monetary gold. By 1893, the figure was $3.75 billion. By 1918, there was over $9 billion.

But in recent years, humans have been pulling only about 50 million ounces a year out of the earth, worth at current prices about $87.5 billion. Even in the current period of sluggish growth, the world economy is expanding by about 2 percent a year. That’s roughly $1.5 trillion in increased global gross product, compounding every year. Barring a highly unlikely massive gold strike, there simply wouldn’t be enough gold to back the needed money supply. The traditional gold standard thus would act as a tremendous drag on the world economy.

That's just not true. Any amount of gold can back any amount of money. The dollar could today, for example, be pegged at 1/1700 of an ounce of gold.. If the price of gold rose to $10,000, we could still define the dollar at 1/10,000 of an ounce and go on a gold standard then. The amount of gold backing a currency matters much less than the fact that each note is defined as a specific weight. Now, Mr. Steele is also worried that the money supply wouldn't grow along with the production of goods and services. He needn't be. As production expanded, the same amount of money would simply cause prices to drop. Or, if you prefer, the purchasing power of each dollar would increase.

Mr. Steele's solution to this supposedly impossible situation is for central banks to simply target the price of gold. If gold rises, the Fed would reduce liquidity and increase it when gold falls. It is, in my opinion, a vastly preferable system to what we have now and might well be as close as we could ever practically come to an ersatz gold system. But it pales against the traditional standard, because it lacks redeemability of dollars for gold.

And it is only that redeemability -- the power of every citizen to trade his paper dollars for a chunk of gold from the central bank's reserves -- that leverages the inflation-fighting qualities of that relic that is perhaps not so barbarous after all.

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