On The Dollar, Exchange Rates, And Gold

This is actually a continuation of the discussion of my last article, "Are The Fiat and Gold Standards Converging". I tried to make the case that the new interest in gold by individuals and central banks alike has brought both monetary systems closer together. And that the need to reform the financial system is a need to move closer to the leverage ratios that were prevalent under the gold standard. To extend this discussion I want to touch on the dollar, exchange rates, and the present international monetary system. Being for a return to the gold standard, most of you probably believe I am for fixed exchange rates. I am not. At least not under our present situation.

There is a myth that is constantly repeated by gold advocates that we "abandoned the gold standard in 1971 when Nixon severed the tie between the dollar and gold". The Bretton woods system that existed between 1944 and 1971 was not a gold standard. In those years gold was illegal for Americans to own. You can not have a gold standard without gold being used by its country's citizens as money. A monetary system that only allows foreign governments to convert their dollars to gold, and not it's citizens, is not a gold standard.

The system of fixed exchange rates adopted at that time ended up being a dismal failure. (See my article on the death of Bretton Woods by clicking "More Articles" at the top of this page). It was a system completely devoid of the fiscal and monetary discipline which is required by nations to preserve a monetary system of integrity. It was a system of "fixed" exchange rates that ended up in hundreds of competitive devaluations in an attempt by nations to gain a competitive trade advantage.

With the inevitable death of Bretton Woods a new system was adopted — a system of floating exchange rates. Its foremost advocate was Milton Friedman. He argued that under a system of fixed exchange rates the natural flows of money between nations, as some nations ran surpluses and others ran deficits, required that economies adjust dramatically. As money flowed out of deficit nations a mild deflation occurred. And as money flowed into surplus nations a mild inflation occurred.

Friedman argued that trade imbalances led to disruptions and even recessions at times as entire economies and price levels had to adjust to trade flows. He argued that this was like the tail wagging the dog. Wouldn't it be less disruptive to allow the exchange rates of nations to adjust rather than economies? He advocated allowing the market to determine the value of currencies rather than midnight devaluations that only created uncertainty and speculation.

The argument was accepted and in the 70's the world adopted a free market exchange rate system. Since that time floating exchange rates have worked well to reflect the policies of nations, both good and bad. Where the system has had problems is where exchange rates were not allow to adjust.

A good example of this is the artificial peg of the Chinese Yaun. This has led to an undervalued currency that has helped create huge artificial trade surpluses for China. It is not an accident that the greatest imbalance of trade and the greatest problem of excessive trade surpluses has occurred between the US and a major trading partner that artificially pegs its currency to the US dollar – China. Dollars have moved, en masse, into the Chinese Central Bank. Under a system where free trade and the free flow of capital were permitted those dollars would be used by Chinese citizens to import American goods. They would be "recycled".

But China prevents free trade from occurring to a large extent. The Government not only restricts what its citizens can own but has also restricted their ability to invest abroad. This leaves only the Chinese government to invest or use the bulk of its trade surplus. The result is the creation of quasi government wealth funds running rampant in the world buying needed assets and making investments instead of its citizens. The government has chosen to invest huge amounts of dollars into US government bonds. This tends to reduce interest rates artificially lower than they would otherwise be. This has led to such problems as the world real estate boom and bust and has helped contribute to the present credit crisis and recessions throughout the world.

Eventually, China will have to un-peg its currency to the dollar and allow it to seek it's true market price. Either that or free its citizens to use their money to buy and invest abroad. Preferably China will choose to do both, un-peg its currency and allows its citizens to engage in free trade, including the free movement of capital. Only then will the problem of excess surplus dollars truly be solved.

The gold standard was a system of fixed exchange rates that worked for centuries precisely because governments throughout the world allowed free trade between nations, practiced fiscal responsibility, and allowed their price levels to adjust up and down to compensate for trade surpluses and deficits. In today's world this degree of freedom, honest money, and fiscal responsibility is considered "passe". Because of this it would be impossible to go back to a hard peg against any currency, let alone gold. The system would simply break down again as did the Bretton Woods System.

During the gold standard, free markets, free trade, and the automatic rules of the gold standard led to the swift clearing of markets and inexorable readjustments of balance of payments between nations. Equilibrium was always at play. Today, in the absence of fiscal responsibility, and where deflation is prevented by nations, and monetary policy is not fixed, a system of fixed exchange rates would be incompatible with free markets. Since discipline is absent, the market must be free to reflect the true fundamentals at play. The pat statement by the Treasury that "a strong dollar is in the national interest of the United States" is wrong. It is a dollar that is market oriented that is to our interest. The dollar must be allowed to seek its market level to properly reflect the domestic and trade policies of governments. The rise and fall of currencies provides a reflection of the underlying policies of governments. It is a market signal for all to see — good and bad.

So, once again I conclude that for the foreseeable future we are moving toward a hybrid of the gold standard and the fiat standard. We should push for freely floating exchange rates for all nations, the end of protectionist trade policies around the world, and a return to fiscal and monetary discipline. To the degree the world moves in this direction lies stability. To the degree it moves away from it lies chaos.

One last point. I find it ironic that those that argue against the gold standard still argue that it was abandoned because it failed. The fact is it had a two century track record to its credit.

The value of the dollar was more stable during those years than anytime since. It was also said to be the cause of the panic of 1907 and that gold's "rigidity" was the cause of subsequent banking crises. Yet, we have had an almost exact replay of 1907 and the past banking crises today within our "enlightened" monetary system.

All of the reforms, including the replacement of the automatic market mechanisms of the gold standard with the Federal Reserve System was suppose to protect us from that kind of financial crisis ever happening again. It has not. When the crash of '29 occurred resulting in the banking crisis of '33 and the Great Depression of the 30's, once again gold got the blame and was confiscated and replaced with government controlled money. That was also suppose to prevent a future melt down. It has not. The "New Deal" regulations of the past have given us the same deal today.

Take the creation of the Securities and Exchange Commission. The SEC was suppose to be the "cop on the beat". It was charged with protecting us all from fraud. How did this agency that has cost the tax payers hundreds of billions of dollars over the years do? For one thing we know it audited Bernard Madoff many, many times. It had the biggest Ponzi scheme ever created in history right under its nose and yet, could not detect what was going on. For another, it was missing in action during the biggest financial crisis in years. In effect, it failed. It was useless. Regulation in and of itself guarantees nothing. All of the problems we have had throughout history have never been solved by greater government intervention. Today's mess is a testimony to that fact.

Today, we have the same problems we had in 1907, the late 20's, and decade of the 30's in spite of all the "New Deal's" efforts to control and regulate the financial system. We have more government regulation than at any time in our history. It should be obvious to any objective observer that it was not the gold standard that failed in those years. It was a combination of fraud, deceit, excess leverage, together with both irrational investment decisions and counter-productive interventions into the economy by governments to "help" individuals and the economy that accompanied all of those crises.

For those that call for a return of "king dollar", a more stable monetary system, and regulatory reform in order to bring greater stability to the economic system, I suggest they start with a call for fiscal responsibility. From my article "Bretton Woods: 1944 to 1971"…

"The framers of Bretton Woods knew that governments had no intention of preserving the value of their currencies, that, in fact, they planned to deficit spend and inflate in order to pay for their domestic economic programs.

"No international monetary system — not the gold standard nor any form of standard less fiat system, nor any combination thereof — can insure stability given unsound domestic policies. The fundamental economic issue today is not the kind of international monetary system (we end up with)…, but whether the domestic policies of the nations involved will permit any international monetary system to last."

I am for regulatory reform. I think most of the reforms being proposed by Congress are needed. But regulatory reform can not be divorced from monetary reform or fiscal responsibility. All must be employed together to achieve a lasting stability. The knowledge of this fact is not hidden. It is well known among the academic community. We know what causes inflation and how to prevent it. We know that fiscal irresponsibility will lead to ruin. We know that protectionism doesn't work and that free markets, free trade, a stable dollar are necessary for a nation to prosper. Now all we need is the political will and courage to achieve those goals. As we enter the twenty-first century, the task before us is to fight for real fiscal, monetary, and regulatory reforms, so that common sense triumphs over politics. Unfortunately, the outcome of such a fight is still too close to call.

Paul Nathan
December 2009


Paul Nathan has written in the field of economics since 1968. In the seventies he wrote several articles on gold for a national, international magazine. Since then he has become a full time investor and has resumed his witting, focusing on gold and current events. Contact Paul Nathan: [email protected]