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Saturday, August 6, 2011

The Nixon Shock: Going off the Gold Standard... Forever

Roger Lowenstein at Bloomberg Business just wrote an interesting account of how Richard Nixon ended up taking the United States off the gold standard back in 1971.

Bloomberg Business:
The Nixon Shock -- How Nixon stopped backing the dollar with gold and changed global finance, a 40-year-old decision that still echoes in Greece, Ireland, and the U.S. ...

Lowenstein's conclusion:
The Nixon Shock was a central cause of the Great Inflation. It also spelled the end of the fixed relationships that had governed the financial universe. Previously, people took out mortgages for set periods and at fixed rates. They had virtually no options for saving money other than in banks, and the interest rates that banks could pay were capped. Floating currencies unleashed a new world of risk and instability. For the first time, investors could bet on the direction of interest rates or the Swiss franc. New financial instruments, new speculative tools, proliferated. The world gravitated from the certainties of Bretton Woods to the dizzying market cycles we’ve lived with since. Donald Kohn, who joined the Fed in 1970 and retired last year as vice-chairman, thinks Bretton Woods was doomed. But bankers have yet to find as rigorous a standard as gold. And they have become ever more apt to please politicians, deferring recessions at the risk of inflating asset bubbles...
The "dizzying market cycles" of the recent past are not going to be quelled by going back to the gold standard. The gold standard era is over for good. Gold is too scarce to support a new monetary standard. Instead it has become another currency on to itself, which offers a store of value.


Gold Standard --
The gold standard is a monetary system in which the standard economic unit of account is a fixed mass of gold...
Nixon Shock --
The Nixon Shock was a series of economic measures taken by U.S. President Richard Nixon in 1971 including unilaterally cancelling the direct convertibility of the United States dollar to gold that essentially ended the existing Bretton Woods system of international financial exchange...
Economist Paul Krugman summarized the post-Nixon Shock era as follows:
The current world monetary system assigns no special role to gold; indeed, the Federal Reserve is not obliged to tie the dollar to anything. It can print as much or as little money as it deems appropriate. There are powerful advantages to such an unconstrained system. Above all, the Fed is free to respond to actual or threatened recessions by pumping in money. To take only one example, that flexibility is the reason the stock market crash of 1987—which started out every bit as frightening as that of 1929—did not cause a slump in the real economy.

While a freely floating national money has advantages, however, it also has risks. For one thing, it can create uncertainties for international traders and investors. Over the past five years, the dollar has been worth as much as 120 yen and as little as 80. The costs of this volatility are hard to measure (partly because sophisticated financial markets allow businesses to hedge much of that risk), but they must be significant. Furthermore, a system that leaves monetary managers free to do good also leaves them free to be irresponsible—and, in some countries, they have been quick to take the opportunity.
Naturally, the gold bugs would like to see us return to the gold standard. However, on July 14, 2011, former Fed Chairman Paul Volcker, dismissed the possibility of a return to the gold standard, saying that, among other things, "I don't think there's enough gold in the world."

That's the big problem: the supply of gold is simply not large enough and growing fast enough to support a world with 6.79 billion people, growing 1.14% a year. Gold production peaked at 2,600 tonnes in 2001. It has been sliding down since then, despite rising prices. A total of 165,000 tonnes of gold have been mined in human history, as of 2009. That works out to about 0.85 ounces of gold per person in the world. This quick calculation does not even subtract the gold that has been lost or used for industrial applications like catalytic converters. Also, for the sake of argument ignore all the gold that went into jewelry. So at today's price of gold ($1663.40), that works out to about $1,425 worth of gold that has been mined for every person on earth. Even if all that gold was in bullion form, that is clearly not enough "money" to run the world economy.

The other side of this argument is taken by Robert Murphy, who would like to see the U.S. go back on the gold standard. At the Ludwig von Mises Institute blog Murphy recently posted: Putting the Country Back on Gold. His conclusion proclaims: "Ludwig von Mises's proposal for a return to a gold standard is theoretically elegant and eminently practical." It's not. If you can decipher Ludwig's turgid writing it looks like his idea would violate Gresham's law:
when government compulsorily overvalues one money and undervalues another, the undervalued money (gold backed) will leave the country or disappear from circulation into hoards, while the overvalued money (non-gold backed) will flood into circulation...
The bottom line is that the world economies and their money supply will continue to be controlled by those who have been given the license to print money. Actually, we know from Modern Monetary Theory (MMT) that most money today is not printed, but simply created via computer credits. So how the U.S. manages its 'money computer' or the keeper of the credits will be one of the most hotly debated topics for a very long time.

If you want to get a get an understanding of how the modern money machine really works, it is recommended that you read Warren Mosler's, Seven Deadly Frauds of Economic Policy. It is an eye opening look at the world of fiat currency.

The Trader's Crucible blog asks:
Would the China economic miracle been possible under a gold standard? --
What China did was to put vast amounts of people to work through massive government spending in a currency that had little or no value to the outside world. Even today, the Yuan/Renminbi isn’t freely exchangeable.

Could China have done what it did under a pure gold standard? I think not.

Calculated Risk

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