There Are Only Three Ways To Reinstate a Gold Standard



November 10, 2011

(This item originally appeared in Forbes.com on November 10, 2011.)

http://www.forbes.com/sites/nathanlewis/2011/11/10/there-are-only-three-ways-to-institute-a-gold-standard/


For some reason, the question of what price or parity at which to reinstate a gold standard system inspires people to new heights of creativity and innovation. Some of these proposals make good comedy. Most are bad comedy.

This is not something we have never done before. Britain reinstated a gold standard system in 1698, 1821 and 1925. The United States did it in 1789 and 1879. Also, there were some minor incidents, in 1816, 1920 and 1953 which might count, depending on how picky you want to be.

Other countries have their own history of going on and off gold. Japan reinstated a gold standard in 1871, 1897, 1930 and 1949, each time after extended periods of a floating currency and sometimes hyperinflation. You could find similar dates for France, Germany, Italy, China, Russia and any other country that catches your interest. Governments have gone on and off gold periodically for the last three thousand years.

Historically, there have been three basic methods. The first is to return to a prior parity. This is only feasible if the prior deviation from this parity is relatively small, and the time since that parity was used relatively short.

For example, the U.S. dollar reached a nadir of roughly $57 per ounce in 1864 during the “greenback” devaluation of the Civil War, from its prewar parity of $20.67/ounce. This is almost a 3:1 devaluation. However, the trailing one-year average at that point was about $32.67/oz. So, things hadn’t gotten too far from the prewar parity at that point, if we smooth a bit of the daily volatility. The U.S returned to the prewar parity at $20.67/oz. in 1879.

The second method is to take a figure close to where the floating currency is presently trading. Today, that might be $1,600 to $1,800 per oz. This is what France did after their World War I devaluation, which reduced the value of the franc by about a factor of five. This is common where there is no feasible way to return to the prior parity.

The third method is to simply replace the old currency with a new one, which has no direct relationship to the old. Then, you can pick whatever parity you like for the new currency. The old currency is, in effect, abandoned completely. This is common only after total destruction of the old currency, in a hyperinflation or collapse of the issuing government, perhaps after a foreign military invasion.

Today, in the U.S., we are so far from the Bretton Woods parity of $35/oz. that of course we are not going to return to that level unless perhaps we have a “revaluation” in which $1,600 “old dollars” are replaced by $35 “new dollars,” or something of that sort. We are also much too far from the $350/oz. plateau of the 1980s and 1990s.

Things have not gotten to the point yet where the “old dollar” has lost all viability, and replacing it with a completely new currency becomes an attractive option.

That leaves us with the second option, which is to just take a nice round number close to where we are already. Today, that might be around $1,700/oz., but when the time comes it would be some other value. As a minor variant of this, especially if there has been a dramatic recent move in currency value, you could pick something closer to the 1-year trailing moving average. That average today is about $1530/oz.

This might irk some people who understand that linking the dollar to gold at $1,700/oz. today would insure a long price adjustment, as prices gradually rose to reflect the new dollar value. Prices today reflect a dollar value of more like $600/oz. or so.

However, to raise the value of the dollar significantly, to $800/oz. for example, would probably cause a recession. The recession in 1982 came about in similar circumstances. With this in mind, some people might want to spread this adjustment period out over several years, in effect mimicking the 1865-1879 period. The problem here is that, not only would this dollar rise be persistently recessionary, you’d have to wait fifteen years before you have a gold standard system!

A brisk dollar rise to $800/oz. or so – in effect, a doubling of its value – might be feasible if it were paired with dramatic pro-growth tax reforms, which would counter the recessionary effects. Practically speaking, however, governments are rarely capable of this level of sophistication and planning.

Unfortunately, currency devaluation tends to be a one-way street. Once things reach a certain point, you can’t go back. Those countries that repegged to gold at the prevailing levels usually had good results.

In 1926, France repegged to gold at the prevailing rate, in effect locking in a 5:1 devaluation compared to the prewar gold parity. Nevertheless, when combined with some large tax rate reductions, France had a booming economy. More recently, Russia had a wonderful run after introducing its 13% flat tax in 2001, and stabilizing the ruble against the dollar at the prevailing rate of about 28/dollar. Nobody saw the need to return to the 5/dollar rate from before the 1998 devaluation.

What’s past is past. Governments usually decide to repeg or restabilize their currency around the prevailing rate, and go on from there. The Magic Formula is: Stable Money and Low Taxes. If the Magic Formula is good, it is good now. The resulting economic improvement is so great that, after ten or even five years, people can barely remember the bad old days.