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Interest Rates: The Golden Connection

December 30, 1999

The absence of an international monetary order rooted in gold makes the century now ending unique. Professor Robert H. Mundell emphasized this point in accepting the 1999 Nobel Prize in Economics a couple of weeks ago. See R. L. Bartley, "Money: The Century's Agony," The Wall Street Journal, Dec. 10, 1999, p. A18. Cf. A. Swoboda, "Robert Mundell and the Theoretical Foundation for the European Monetary Union," IMF Views and Commentaries for 1999,

Gold's propensity to retain over long periods of time a reasonably constant purchasing power is widely recognized. Less widely appreciated but just as significant is the long term stability of gold interest rates. Both together are the defining attributes of gold money, features which governments have heretofore proven incapable of replicating with their fiat money substitutes.

Relatively low and stable interest rates under the gold standard were the product of measuring economic value by a shared and real international yardstick. Money -- dollars, pounds, francs, etc. -- was a certain weight of gold, not an artifice of bankers or governments. A lawful dollar had a real cost of manufacture, related to the cost of producing gold. Seigniorage was close to zero, not virtually 100%. Money was not simply a means to facilitate exchanges; it was both a store and standard of value.

Because international balances were settled in gold, small countries could trade on relatively equal terms with larger ones. Trade deficits could be offset by capital flows, but no country was required to hold large amounts of another's paper in its reserves. Any country, small as well as large, could achieve monetary sovereignty and a sound currency simply by following the prudential rules imposed by gold. Quality of monetary policy and banking practices mattered more than economic size, permitting Switzerland, one of Europe's smaller countries, to become a banking and financial powerhouse.

Of course, the gold standard was not perfect, and some of today's monetary problems were also issues a century ago. For example, excessive credit inflation was always a potential problem under the gold standard, and many were the panics resulting from over-exuberance in this regard. So too, in the area of productivity, whether the gold supply could grow sufficiently to provide adequate increases in the monetary base remained a constant concern, particularly for expanding industrial economies.

As it turned out, gold discoveries in California, Alaska, and later South Africa were adequate to the task, enabling most major countries to maintain substantially unchanged gold parities from the early eighteenth century to the outbreak of World War I. Indeed, the gold discoveries in South Africa were large enough to cause a short but unusual period of U.S. peacetime wholesale price inflation averaging 2.5% annually from 1897-1914. See M. Friedman et al., Monetary History of the United States (Princeton Univ. Press, 1963), p. 135.

World War I so shaped the history of the twentieth century that it is hard to imagine what it would have been like without this almost inadvertent cataclysm. The classical gold standard could not accommodate at existing gold parities the wartime financing requirements of the principal belligerents. Considerable gold flowed to the United States, swelling its money supply and raising the general price level. After the war, the British made a critical error in trying to return to gold at the prewar parity, effectively forcing a severe deflation. France, which devalued after the war, faired somewhat better.

The gold standard, in a sense, fell victim after the war to its own earlier success, for a century of largely stable gold parities rendered the notion of a "good" or "necessary" devaluation anathema to many. Economists who assign major blame for the Great Depression to the effort to stay on gold are partly correct. But it was not so much the effort to stay on gold as Anglo-American policies aimed at preserving prewar parities that lay at the root of the difficulty. The enormous credit expansion associated with World War I was beyond remedy by a mere panic; it simply could not be handled other than by severe deflation or devaluation.

Although the gold standard could not prevent excessive credit expansions or even fix permanently appropriate gold exchange rates, it did effectively set interest rates within a rather narrow range. Under the classical gold standard prior to World War I, short term interest rates in both the United States and Britain tended to cycle between 2% and 5%. Very rarely and never for long did they breach these limits. S. Homer et al., A History of Interest Rates(Rutgers Univ. Press, 3d ed., 1996), pp. 207, 321, 357, 364-365. For a brief graphic history of real and nominal long term interest rates, see P. Brimelow, "What Drives Interest Rates," Forbes, Dec. 27, 1999, pp. 218-219.

Under the gold standard, business and credit expansions were typically associated with higher interest rates. Panics normally brought lower rates as fear reduced both willingness to lend and demand for credit. Prior to the stock market crash in 1929, short term rates moved over 5% as they had prior to the Panic of 1907 and during the war years. What was different in the 1930's was that short rates not only fell, but also remained stuck under 1% for several years. Central banking under the Fed, exacerbated by the monetary excesses of World War I, managed to accomplish what free banking and the Civil War never could: a severe multi-year national bust.

Today what was once simply banking is "gold" banking. Interest rates on gold are now "lease" rates. Yet their levels cycle within substantially the same range as before. Last fall's gold banking crisis demonstrated 5% gold lease rates to be as much a harbinger of trouble as 5% short term interest rates under the gold standard. Both signaled too much paper gold -- too much gold credit -- relative to available physical gold.

The question now is whether the recent gold banking panic will prove a relatively brief episode caused largely by temporary factors, or whether more fundamental distortions were at work. In the latter event, the 1929 experience suggests that gold lending and gold interest rates could remain depressed for a considerable period of time, and that a fundamental revaluation of gold may be necessary before the gold credit market can fully recover.

As the millennium turns, U.S. economists hail the "Goldilocks" economy. The Fed, originally formed to stabilize the gold value of the dollar, instead wages an undeclared hidden war on the discipline of gold. And for now, at least, relegated to the realm of quaint ideas from long ago is John Stuart Mill's admonition (Principles of Political Economy (orig. ed. 1848, 5th ed. 1877), Bk. III, Ch. XIII, s. 3):

Although no doctrine in political economy rests on more obvious grounds than the mischief of a paper currency not maintained at the same value with a metallic, either by convertibility, or by some principle of limitation equivalent to it; and although, accordingly, this doctrine has, though not till after the discussions of many years, been tolerably effectually drummed into the public mind; yet dissentients are still numerous, and projectors every now and then start up, with plans for curing all the economical evils of society by means of an unlimited issue of inconvertible paper. There is, in truth, a great charm to the idea. To be able to pay off the national debt, defray the expenses of government without taxation, and in fine, to make the fortunes of the whole community, is a brilliant prospect, when once a man is capable of believing that printing a few characters on bits of paper will do it. The philosopher's stone could not be expected to do more.

For almost 70 years, the United States -- contrary to its own Constitution and the most deeply held beliefs of its Founding Fathers -- has led the world down the path of unlimited fiat money. Its paper dollar has become the de facto international monetary standard; its debt the world's principal international reserve asset; and its trade deficits the world's main source of international liquidity. As a result, some 40% of outstanding U.S. marketable debt securities are now held by foreigners, up from 20% just five years ago. See M. M. Phillips, "Foreigners' Share of Treasurys Is Growing," The Wall Street Journal, Dec. 20, 1999, p. A2. And the U.S. trade deficit is now running at an annual rate exceeding $300 billion, a level previously quite unimaginable.

This situation would be dangerous under any circumstances. An historic U.S. stock market bubble fueled in large part by an out-of-control domestic credit expansion makes it explosive. Why? Because a simultaneous decline in the stock market and the dollar could cause interest rates to rise sharply rather than decline. The Fed cannot simultaneously support the domestic financial structure with lower rates and defend the dollar with higher ones. Its vaunted domestic powers could be checkmated by international demands, heightened by the dollar's role as the world's main reserve currency.

Under the severest strains, a system of unlimited paper money backed by a lender of last resort behaves quite differently from a system based on gold -- the money of last resort. Ultimately neither system can save imprudent lenders or borrowers from the consequences of their acts. But whereas the latter will stabilize at lower interest rates with the underlying monetary system still intact, a system based on unlimited paper will tend toward hyperinflation unless checked by very high interest rates, themselves business killers which will prolong and intensify the economic downturn.

In recent years many small countries have learned this lesson the hard way as international capital fled their currencies and financial markets. Boom has turned to bust, often quite suddenly. Few illusions are as dangerous as: "It's different this time." Except, perhaps: "It can't happen here."

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