A gold exchange standard is comprised of the following elements. The new issues of state denominated currency must be covered pro rata by additional physical gold, and it must be fully interchangeable at the public’s option. The state is not required at the outset to cover every existing banknote in circulation, but depending on the situation, perhaps a minimum of one-third of the issue should be covered by physical gold at the outset when setting a fixed conversion ratio. The point is that further note issues must be covered by the issuer acquiring physical gold.
Banknotes which are “as good as gold” are a practical means of using gold as the medium of exchange. Electronic money, being fully convertible into bank notes must also be convertible into gold.
A gold exchange standard also requires the state to radically alter course from its customary inflationary financing. The economy, which has similarly become accustomed to future flows of apparently free money, will have to adjust to their future absence. Consequently, the state has to reduce its burden on the economy, such that its activities become a minimal part of the whole; the smaller the better. It must privatise industries in its possession, because it cannot afford to absorb any losses and inefficient state businesses detract from overall economic performance. At the same time, the state must not hamper wealth creation and accumulation by producers and savers as the means to provide investment in production. Government policy must be to stop all socialism, allowing charities to fulfil the role of welfare provision, and let free markets have full rein.
Broadly, this was how British government policy developed following the Napoleonic wars until the First World War, and the proof of its success was Britain’s commercial and technological development, entirely due to free markets. But the British made one important mistake, and that was in the Bank Charter Act of 1844, which in England and Wales permitted the expansion of unbacked bank credit. For this reason, a cycle of credit expansion developed, punctuated by sharp contractions, the boom and bust that led to a series of banking crises. A future gold exchange standard must address this issue, by separating deposit-taking into a custodial role and the financing of investment into an agency function.
It is a common error of neo-Keynesian economists to believe gold is an unsuitable medium for financing modern trade and investment, because, it is often alleged, it lacks an interest rate. Since interest rates existed throughout gold standards, the confusion arises from assuming an interest rate attaches to paper currency. But if a paper currency is fully convertible into gold, then interest rates are effectively for borrowing and lending gold, and do not apply to the currency. The best measure of what savers may gain by lending their gold savings risk-free is the yield on government debt, repayable in gold and realisable in the market at any time. This is illustrated in Figure 1.
Shortly after the introduction of the gold sovereign in 1817, the yield on undated government debt gradually fell to 2.3% in 1898. This reflected a natural decline in time preference as free markets delivered increasing benefits and accumulating wealth for the British population. Following the gold discoveries in South Africa, between the early-1880s and the First World War global above-ground stocks of gold doubled, and the inflationary effects led to a rise in government Consols yields to 3.4%.
The encouragement to investors to provide financial capital for investment in industry and technology was two-fold. A family’s investment in 1824 rose in value due to the long-term fall in Consols yields. By 1898, invested in Consols it would have appreciated by 65%. At the same time, the rise in the purchasing power of gold-backed sterling increased approximately 20%. Saving and family inheritance were rewarded.
Importantly, above ground gold stocks have grown at approximately the rate of that of the global population, imparting a long-term stability to prices in gold. For this reason, it is often said that measured in gold the cost of a Roman toga is not much different from that of a modern lounge suit. Other money-related benefits of gold and gold exchange standards compared with those of pure fiat also follow from this stability.
Between countries that use gold and gold substitutes as money, except for short-term settlement differences covered by trade finance, balance of payments imbalances only existed to adjust price levels between different nations. If a country exports more goods and services than it imports, it imports gold or gold substitutes on a net basis. The increased quantity of gold in that country tends to adjust the general level of prices upwards to the general level of prices in countries that are net importers of goods and services, which find the outflow of gold has moved their prices correspondingly lower. The ability to issue unbacked currency has been removed, so net balance of payment flows become a pure price arbitrage. This is in accordance with classical economic theory and has its remnants today in concepts such as purchasing power parity.
In summary, gold retains the qualities that ensure it will always be the commodity selected by people to act as their medium of exchange. It offers long term price stability and is the ultimate fiscal and monetary discipline on governments, forcing them to reduce socialist ambitions, to accept the primacy of free markets, and to permit acting individuals to earn and accumulate wealth. Being fully fungible, gold is suitable backing for substitute coins and banknotes. It is an efficient medium for providing savings for the purpose of capital investment. And the tendency for prices measured in gold to fall over time driven by natural competition and technology ensures a low and stable originary rate of interest.
- Source, James Turk's Goldmoney
