January 23rd, 2008

The Case for the Gold Standard


photo credit: LilB

With pundits pondering whether we’re headed for a recession or if we’re in one already, the cautious investor finds himself sitting on the edge of his seat, monitoring his charts and wondering how best to invest his hard-earned money. Does he wait for a dip and then buy, or does he take the plunge and invest in some low-risk funds hoping to see his wealth grow?

It is to such an investor that I would like to address myself.

We live in a day of widespread uncertainty. Global markets have essentially become fused together, with each market reacting to the ups and downs of another. The dollar, considered to be the main world reserve currency, is rapidly decreasing in value. Many foreign currencies are either pegged to the dollar or closely dependent thereto, as this article explains:

The U.S. dollar serves as international money in the world economy in general, and as the dominant currency in East Asia in particular. Because of this dominance, financial regulation to prevent banking and currency crises can be much more difficult in countries on the periphery of the dollar standard than in the center country itself. Although the United States has never imposed the dollar standard on other countries, markets naturally choose one national currency as a facilitator of international exchange and safe haven store of value. Thus international debt contracts are typically denominated in dollars even if the loan proceeds are switched into the domestic currency of the borrowing country. This natural asymmetry among national monies, between a “center” and a “periphery,” is key to understanding how financial crises occur and may be dealt with when economies are ever more globalized.

While historically seen as solid and desirable, the dollar today is worth 4% of its original value, and continues to decrease. Foreign markets are now abandoning the dollar in favor of stronger currencies such as the Euro.

How can it be that a currency once considered “as good as gold” has become worth less than the paper it is printed upon? The answer to this question lies in the understanding of fiat currency. The dollar (or Federal Reserve Note, more precisely) is nothing more than a piece of paper deemed “legal tender” by the government. Uncle Sam demands that merchants accept this paper as money, thus sanctioning its use as if it were actually a store of value. In fact, the paper has no inherent store of value, but only is propped up by the faith of the average consumer.

When that faith begins to wane (whether due to overall market conditions, foreign policy implications, price inflation, etc.), the person’s confidence in the dollar diminishes. On a grand scale, paper currencies hyperinflate (sometimes rapidly, sometimes over many years) as the central bank continues to print more money out of thin air. When this occurs, every dollar in the economy decreases in price due to an inflated money supply. People who own dollars (or dollar-based investments) have now lost a portion of their wealth.

This is of crucial importance in the investment world, since any dollar-based investment is affected by the value of the dollar itself. While a 401(k) or savings fund may yield a return of 5% per year, this is largely worthless if the currency itself is devalued by 10% during that same year. In essence, dollar-based investments slow down the rate at which your savings is being eroded, for the dollars you have earned in interest are worth less than those you initially invested.

The author of this excellent article agrees:

So why have investors been abandoning conventional assets, such as government bonds and stakes in blue-chip businesses, in favour of a metal that appears to offer no reward for holding it? The answer, I’m afraid, is crumbling faith in the world’s central banks, and in particular the US Federal Reserve, where the presses have been working overtime.

Some argue that the soaring gold price has been driven by temporary anxiety over global instability. The metal is a safe haven in troubled times. But answer me this: when was the last time the world felt like a cosy hideaway? Ever since mankind turned up, Planet Earth has never been a safe place.

In times of economic instability, the eager investor looks for a safe storehouse for his wealth. Where is one to find such a reliable investment? As this author notes, gold has proven millennium after millennium to be a safe haven in troubled times.

Note that gold is not an investment in the Wall Street sense—you will most certainly see a return in terms of more dollars, but the value of those dollars will be decreased. Instead, gold is a wealth preservation tool, enabling a person to maintain the value of his earned money. The success of any investment in a paper currency is largely contingent upon the actions of whoever controls the printing presses. In contrast, gold answers to no man but its owner, retaining its value despite the actions of any other person.

Gold, unlike paper (or digital currency), keeps men honest. One of the principal reasons that politicians wanted to move off of the gold standard was so that they would be able to finance their desired deficit spending merely by issuing treasury bills—in other words, signing a ledger book and creating money out of thin air for whatever they desired. This was not possible with a gold-backed dollar, for there was a limit on how many dollars could circulate based on the size of the nation’s gold supply. When the inflation tax (as a resulting of printing new fiat currency) was not available to them, the politician’s only option was to directly tax the citizens for any programs they desired to create. Instead, we now have a 9 trillion dollar debt where the inflation tax payments are deferred to the raising generation—forcing our children to pay for our fiscal follies.

Congressman Ron Paul, an ardent advocate of sound money, agrees:

Make no mistake, the problems faced by the American people are not caused by unscrupulous mortgage brokers or the rising price of oil. These are symptoms of an economic disease caused by a spendthrift Congress enabled by loose monetary policy. Too many pundits praise the weak dollar as benefiting exporters, but they fail to see the harm done to thrifty, hard-working Americans. Rather than continuing to pursue a policy of easy credit and increasing debt, we need to return to a sound monetary system.”

Alan Greenspan, prior to his days at the helm of the Federal Reserve, was likewise a champion of sound money and the honesty gold produces in a man. Four decades ago, he said:

This is the shabby secret of the welfare statists’ tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists’ antagonism toward the gold standard.

This tirade Greenspan mentions has been, at various times, an all out war against gold, whether regarding the status of its association with the Federal Reserve Note, or its private ownership in the hands of the public at large. As this article explains, there is one effective weapon that we can wield in this battle for economic self-preservation:

There are few things that federal big spenders hate more than gold. Why? Because they know that, historically, gold has provided the best means by which people could protect themselves against the ravages of a rapidly depreciating currency.

Ayn Rand likewise noted the way this war is waged:

Whenever destroyers appear among men, they start by destroying money, for money is men’s protection and the base of a moral existence. Destroyers seize gold and leave to its owners a counterfeit pile of paper. This kills all objective standards and delivers men into the arbitrary power of an arbitrary setter of values. Gold was an objective value, an equivalent of wealth produced. Paper is a mortgage on wealth that does not exist, backed by a gun aimed at those who are expected to produce it. Paper is a check drawn by legal looters upon an account which is not theirs: upon the virtue of the victims. (Ayn Rand, via Quoty)

Despite its evident necessity in light of recent economic turmoil, the return to a gold standard would not be without its complications. The crucial importance, however, is the elimination of the Federal Reserve’s monopoly on money. Allowing a privately held corporation to print up whatever money it desires is nothing more than legal counterfeiting. Were I to do the same, I would be jailed. The government is not entitled to any power that its citizens would not inherently possess themselves, and thus the creation of new money to satisfy debt is immoral, illegal, and downright dishonest.

The legalization of competing currencies (in effect, allowing gold and silver—the Constitutionally mandated currencies—to be considered legal tender) would reign in rampant deficit spending, as politicians eager to keep the dollar afloat would have to act in such a way that would bolster its value when compared to stores of inherent value such as precious medals.

Regardless of what occurs on a national level, the average investor would be unwise to dismiss the benefits offered by gold. The investment of any fiat paper currency is little more than gambling—betting that the money you will receive in interest will be of enough value to compensate the loss in overall value due to the inflation that has likely occurred within the given time frame.

The 10 year history of gold might seem, to the amateur investor, like a great investment. It should be noted however, that the value of gold is often reflective of the inverse value of the dollar. While there are many other factors involved, the value of gold almost always increases as the dollar’s value decreases. Thus, the new dollars one receives after years of gold ownership all have a diminished purchasing power.

The case for a return to sound money is not hard to make when the average consumer goes to the local market and sees evidence of skyrocketing price inflation. It becomes easier after studying the history of banking, understanding how much each person’s share of the national debt is, and observing the ongoing loss of faith in the dollar worldwide.

Today, more than ever before, our economy needs a return to sound money. Gold, a historically-proven store of value, is the right choice for any investor desiring to maintain his wealth and free himself from the inflationary decisions of central bankers and politicians.

18 Responses to “The Case for the Gold Standard”

  1. Mark Herpel
    January 23, 2008 at 3:30 pm #

    Excellent, post, great information. I’m already using digital gold currency 100% backed by gold and its getting very popular.
    Mark

  2. doug
    January 23, 2008 at 5:39 pm #

    In contrast, gold answers to no man but its owner, retaining its value despite the actions of any other person.

    In economic terms, that is not true.

    As an aside, ask yourself what would happen if every country in the world went to a gold or silver standard for their currency.

    Sounds like a real peaceful world, no? ;)

  3. Connor
    January 23, 2008 at 6:35 pm #

    In economic terms, that is not true.

    To a large extent, it is true. Gold has been seen for the past few thousand years as a source of inherent wealth, being valued as a limited-supply commodity. Were the world at large to lose interest in gold (as it has with previous sub-standard methods of exchange, such as seashells or tree bark), then the gold itself would lose value because its demand would decrease.

    However, historical trends don’t show that happening anytime soon, so as long as gold is perceived as a desirable commodity, few things anybody else does will have an impact on the wealth stored in an ounce of gold.

    As an aside, ask yourself what would happen if every country in the world went to a gold or silver standard for their currency.

    This is an interesting scenario to consider. If every nation tied their currency to gold, the demand would skyrocket (as each nation would need a supply of gold sufficient to store in reserves), thus increasing the value of all existing gold in the market. Not a bad situation for gold owners, if you ask me.

  4. Scott
    January 23, 2008 at 8:04 pm #

    I’m all for the competing currency idea. All the arguments I’ve seen against it are flimsy. In fact, I’m all for privatizing money and getting the government out of controlling money altogether.

  5. doug
    January 23, 2008 at 11:11 pm #

    Connor,

    It looks like you are conflating the gold standard with investing in gold. Now that I’ve re-read your original post, I notice that it sways from side-to-side between the two topics; entitled The Case for the Gold Standard the post is barely to the second paragraph when you say, “It is to such an investor that I would like to address myself.”

    You then delve into a discussion of currency,

    The answer to this question lies in the understanding of fiat currency. The dollar (or Federal Reserve Note, more precisely) is nothing more than a piece of paper deemed “legal tender” by the government.

    before returning again to gold promotion:

    This is of crucial importance in the investment world, since any dollar-based investment is affected by the value of the dollar itself. While a 401(k) or savings fund may yield a return of 5% per year, this is largely worthless if the currency itself is devalued by 10% during that same year.

    This general lack of direction continues throughout the post.

    So, as for investing in gold, go for it. Like any investment, you can find thousands of folks who have as many strategies when it comes to investments and wealth preservation/growth.

    As for returning to the gold standard, I’ll offer just a quick thought to ponder:

    The vast majority of economists are against it.

    That doesn’t mean that the argument is “over”. That’s not to say that they are right and you are wrong. But I do get the sense that you haven’t read much on the topic outside of gold standard boosterism [editor: Why do you say that? me: Because in a rather long and detailed post, he doesn’t address a single criticism of the gold standard.]

    A couple short critiques, for your perusal, can be found here and here.

  6. Connor
    January 23, 2008 at 11:48 pm #

    Doug,

    The purpose of my weaving back and forth between discussing a national gold standard (for the economy) and a personal gold standard (for personal investment) was an intentional one. I’m recommending here not only a gold standard for the economy itself, but also for any investor within that economy wondering how best to retain his wealth.

    Confusing, perhaps. But it makes sense in my mind. :)

    You are correct that I did not raise and rebut criticisms of the standards. Honestly, this post was intended to be three or four times its current length, and I decided to push it out as is. I just read both the articles you linked to, and if I have enough time tomorrow, I’ll respond w/ some of my thoughts.

  7. Dan
    January 24, 2008 at 4:02 am #

    I’m looking to invest in the Euro. Sounds like a more sound investment right now than a run on gold. Gold is a commodity like any other. It fluctuates with time. It doesn’t make any sense to make a run on it as a long-term investment. And in fact, compared to historical numbers after being adjusted for inflation, the price of gold hasn’t really changed all that much.

  8. Benson
    January 24, 2008 at 11:20 am #

    This is an ace article on what’s happening in the real situation that the US citizens are facing.

    “Government printing more money is nothing different from counterfeiting, except its legal since it’s coming from the Government” – You are absolutely right.

  9. Josh Williams
    January 24, 2008 at 9:51 pm #

    You’re assuming here that a low to moderate, constant rate of inflation is a bad thing.

    At least for the average American, it isn’t.

    If you, Connor own your own house, and the majority of your income goes to mortgage payments, (for example,) a constant moderate inflation very much works in your favor. This means that the value of your debt goes down, while both the exchange rate, and the actual value of your property increases, as the supply of land decreases.

    Furthermore, as you gain job experience, and assuming the demand for employees stays the same on average, you can ask a higher salary for your services, and your ability to pay off your debt increases.

    On the other hand even a small amount of recession and deflation, which is often the case with the gold standard, can be absolutely crippling to the average American.

    Paradoxically, it reduces consumer confidence, reduces disposable income, thereby reducing demand for goods and services, which slaughters wages, and employment rates, while at the same time increasing both the value and the demand for debts. Basically, deflation causes your labor to become less valuable, while making your debts more valuable.

    All this is a vicious cycle, which, if your money is essentially pegged to the demand for gold, the government can do little to abrogate.

  10. Connor
    January 24, 2008 at 9:57 pm #

    If you, Connor own your own house, and the majority of your income goes to mortgage payments, (for example,) a constant moderate inflation very much works in your favor.

    Ah, but you see, this is a sinister side effect of inflation/deflation. When I took out a mortgage on my home, I agreed to a specific amount at a specific rate. Granted, that’s not to say that I demand the 30 years of payment be at the exact value of the currency at the time of closing, but any change in inflation, while it does indeed benefit me, was not part of the agreement.

    Imagine finding $20 on the road. You are now more wealthy because of the find, but what’s not immediately apparent (or perhaps what our mind is not always willing to consciously accept) is that somebody else had to lose $20 for you to gain it.

    Bastiat discussed this in his Broken Window Fallacy.

    Any gain in my favor regarding inflation comes at somebody else’s expense, since the inflation tax must rob from one person to give to another.

  11. Josh Williams
    January 24, 2008 at 10:04 pm #

    I think it’s a fair statement, that those who advocate the gold standard, are otherwise intelligent people, but they don’t know enough about economics, finances, or the history thereof. Ron Paul is an Obstetrician by trade, so I think in this situation suffers from “Deformation Professionelle”

    It just goes to show that at little knowledge, when combined with a large amount of ignorance is can be a very dangerous thing………consider me, for example.

  12. Connor
    January 24, 2008 at 10:47 pm #

    Ron Paul is an Obstetrician by trade, so I think in this situation suffers from “Deformation Professionelle”

    …and obstetrician who has co-authored a book titled The Case for Gold (PDF), authored a few other books on finances and monetary policy, served on several financial congressional committees, and studied Austrian economics for several decades. Methinks he’s not that ignorant on the matter. :)

  13. Josh Williams
    January 24, 2008 at 10:50 pm #

    *thinks for a minute*

    Any gain in my favor regarding inflation comes at somebody else’s expense, since the inflation tax must rob from one person to give to another.

    I think you are trying to argue here, that inflation robs from the rich (the bank), and gives to the poor (you.)

    Which is true in in a certain sense. But that depends on how you define “robbery.” It might be more true, if money had anything other than arbitrary value, gold for example.

    In the case of inflation, the bank charges interest; which if the interest rate is greater than inflation rate, they still see a net return on the value their investment in you. As long as inflation is moderate, it’s still a win/win situation.

    Sure, interest isn’t part of the original agreement, but the banks know that and allow you to get a loan anyway.

    On the other hand during a recession, now, like always, people tend to default on their loans more often, which usually causes both parties to lose money. You could also define defaulting on a loan to be “robbery.”

    To imply that banks have anything to gain from recession is clearly not accurate.

    Money is inherently meaningless. Some compare it to the flow of energy in society, though I think even that’s an unfair comparison.

    Unlike a window or a flood damaged city, which requires actual work to repair. Inflation doesn’t directly equate to a net loss of real world assets. In a sense, it only means that you the consumer have more money and are willing to spend more of it. In another sense, it means that people tend to want to be paid more for goods and services than they are willing to spend on them.

  14. Connor
    January 24, 2008 at 10:55 pm #

    I think you are trying to argue here, that inflation robs from the rich (the bank), and gives to the poor (you.)

    Quite the opposite, actually. The inflation tax is paid primarily by consumers who need to purchase items with the currency. When the currency is inflated, their purchasing power drops, and thus their wealth is being taxed to create the new money. When inflation rises and my debt becomes easier to pay, it is at the expense of the economy at large.

  15. Josh Williams
    January 24, 2008 at 10:56 pm #

    Got to go to bed now, thanks for the thought provoking discussion.

    feel free to delete this post.

  16. Scott
    January 25, 2008 at 10:01 am #

    Please note that the value of gold is also simply an arbitrary construct — a social agreement. While it is true that it cannot be manufactured ex nihilio as the government does with paper money, it only has value because people believe it to be so. Part of the reason for that is relative scarcity. But any society could use anything that has relative scarcity for trading. Some societies have used shells or rocks.

    The argument for a gold standard is that any purveyor of money (be it a government or a private entity) is prohibited from arbitrarily expanding the amount of money in the system. It can only come by acquiring actual additional quantities of the precious commodity.

    The argument against such a standard is that it assumes that the conglomorate trading value of goods and services in a system is limited to the sum of all gold held in the system. In other words, it assumes that the total value of all goods/services in the system is capped at the amount of gold in the system. One of the reasons the gold standard was dropped is because there was no effective way to expand the supply of gold at the rate of the expansion of goods/services. The fact is that there is no intrinsic correlation between goods/services produced and the amount of any given scarce commodity.

    In other words, there are also decent arguments against a gold (or some other limited commodity) standard.

    In any extended order, people need some kind of reliable mechanism for trading their specialized goods/services/knowledge for goods/services/knowledge that they want or need. Right now, the US Dollar isn’t looking terribly reliable. Precious commodities can be reliable, but they have their limitations. I am in favor of competing currencies to help ameliorate the shortfalls of either system.

  17. Dan
    January 25, 2008 at 12:50 pm #

    Scott,

    While it is true that it cannot be manufactured ex nihilio as the government does with paper money, it only has value because people believe it to be so. Part of the reason for that is relative scarcity. But any society could use anything that has relative scarcity for trading. Some societies have used shells or rocks.

    Excellent point. During the Yukon gold rush of 1898, the city of Dawson, far up in the north had so much gold that its value was really worth little of anything. When a shipment came in with eggs, gold diggers were giving out pounds of gold for a few eggs. Eggs and chickens were worth far more to the diggers of Dawson than the gold they spent their hours digging for.

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