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Gold Still the Standard

July 23, 1999

Most economists and financial journalists continue to misidentify the meaning of the fall in the U.S. dollar price of gold. That price has plummeted from about $300 per ounce a year ago to near $250 recently. To most observers, this means gold has "lost its lustre." Some have gone so far as to claim that fiat paper money is now superior to money based on gold. But nothing could be further from the truth: Gold remains the only objective money in the world.

A falling gold price -- in any currency -- is simply another way of saying that such currency has gained value in terms of an objective and tangible form of money ( gold ) that, throughout history, has tended to exhibit stable purchasing power. True, the U.S. dollar, measured in gold, has risen about 20% in the past year. Today each U.S. dollar is worth one 250th of an ounce of gold, up sharply from a year ago, when it was worth one 300th of an ounce. For investors in dollar-denominated assets, that is only good news. Their holdings are worth more. But that does not mean the value of gold as money has fallen, or that its forecasting power is now useless.

In the 1970s, when the price of gold in most currencies was rising, stocks and bonds, denominated as they are in fiat paper money, were falling in value. Why? Because a rising gold price in any currency is the same as an objectively falling value of that currency. Whether a paper money is rising or falling, its gold price tells the most accurate story.

Unfortunately, most analysts of trends in the gold price tend to adopt the narrow perspective of gold investors, and then improperly extend their conclusions to gold's monetary role. It is certainly true that no holder of gold -- including central banks -- ever welcomes a fall in the value of his investment. But the universe of investments denominated in fiat paper dollars -- namely stocks, bonds and money market instruments -- is far greater than the sub-set invested in gold or gold-mining stocks. And that should be the focus of most investment commentary.

What about the role of gold in monetary systems? History -- and particularly the experience of the past few years -- provides valuable monetary lessons that most analysts have missed. In today's world, three schools of economics guide monetary policy, each to a different degree, depending on the country in question. The Keynesian school believes inflation is caused by "excessive" rates of growth in output, or by unemployment rates that are "too low." Keynesian theory has been most dominant in Asia -- specifically in Japan and the Southeast Asian countries. The monetarist school holds that inflation is caused by "excessive" rates of growth in a nation's money supply. Monetarists have been most dominant in British monetary policy. Finally, the "supply-side," or classical school says inflation is caused by a supply of money created in excess of demand for that money. That school has been most dominant in the U.S.

The classical school is the only one that interprets inflation correctly. It agrees with the monetarists that inflation is strictly a monetary phenomenon -- not an affliction brought on by production or hiring, as the Keynesians contend. But the classical school also avoids the error of monetarism, which ignores the demand for money or presumes it to be constant at all times. Monetary policy has been disastrous in countries whose central banks practice Keynesian or monetarist principles. The former school advises devaluations to "stimulate" economies, and interest-rate hikes when an economy is producing and hiring at record levels. The virtual collapse of economic activity and markets in Southeast Asia and in other devaluing nations in 1997-98 reflects the errors of that approach. The latter school also wreaks havoc when it guides policy-makers. In recent years, the Bank of England, fearing high money supply growth despite a strong pound, caused huge gyrations in interest rates that sabotaged Britain's growth.

In the 1990s, only the U.S. has come close to making its currency "as good as gold" (or better) . But this is not proof, as some observers claim, that fiat paper money systems are superior to gold-based systems, or that gold has had its day. On the contrary, it means fiat paper monies can command respect in world markets only to the extent they retain their value in terms of gold. And only paper monies that remain valuable in terms of gold can have rising stock and bond markets. Devaluers, in contrast, cause local-currency gold prices to skyrocket, and local markets to plummet.

Even though no central bank still redeems its money in gold -- and indeed, most central banks are selling it -- gold itself remains one of the most liquid and stable assets in the world. The entire stock of gold in the world changes hands, on average, every eight months, and more of those hands are private. Individuals today hold about 80% of the world gold stock, up from 38% after World War II. As well, increasing volumes of "e-commerce" are being settled in gold. With every passing year, gold is becoming more relevant, not less. The reason is clear. As Alan Greenspan, the Federal Reserve Chairman, observed last May, "gold still represents the ultimate form of payment in the world . . . and is always accepted." Moreover, he said: "Gold is perceived to be an element of stability in the currency, and the ultimate value of a currency."

Although Mr. Greenspan sometimes also gives voice to Keynesian and monetarist myths, his underlying view of money reflects the classical school. But even Mr. Greenspan, in his use of gold as a currency gauge and a guide to monetary policy, cannot mimic the beneficial results of a system of complete laissez-faire money, as most of the world used in the 19th century. In that era, private banks issued gold-convertible currency at a fixed rate. Inflation was non-existent, and compared with today, interest rates were far lower and economic growth and employment far higher.

Experience shows that a system of free banking and gold-based money is superior to a system of central banking and fiat paper money -- that is, if a nation's prosperity and protection of property rights are one's ultimate aims. These lessons are confirmed today, since the best results come from nations whose currencies -- albeit fiat paper -- have held their value v. gold. The "Greenspan standard" is better than the standards of the Keynesians or monetarists -- but not as good as a true gold standard.

In 1933 President Franklin Roosevelt signed Executive Order 6102 which outlawed U.S. citizens from hoarding gold.
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