Review: One Nation Under Gold, part 1

All over the world, the U.S. dollar is a symbol of American strength. As a fiat currency, the value of the dollar is based on the relative strength of the U.S. economy (among other things, yes), so this seems appropriate.

So why, then, did a return to the gold standard come up during the Republican primary debates? What do they have against an independent dollar?

Americans have long regarded gold with a peculiar fascination, and gold's influence is felt throughout much of our history. The earliest Jamestown settlers hoped to find it, gold rushes have fed its mania since the 1790s, and even during the Great Recession it served as the ultimate secure investment.

Even today, there are those who argue that a return to the gold standard would help alleviate many of our economic problems. So then, why does every economist recognize this as a certifiably BAD idea?

To understand the benefits and disadvantages of such a decision, it helps to know the history of America's relationship with gold, and that's what James Ledbetter's One Nation Under Gold is about.

Ledbetter traces the role gold has played since our independence, and in the process shows that the desire to acquire, amass, and control gold has played an powerful role in our economic and political history.

Before reading the book, though, you need to understand three underlying economic principles about currencies.

First is that money serves two functions. It serves a medium of exchange in that it's more useful than lugging around an ox looking for someone to barter with. You need to find something that's valuable to the people you deal with, and your need it in just the right quantities to make it rare but still accessible. Money also serves a store of value, so it needs to be something that's not prone to mold, rust, or decay.

To meet these needs, different things have served as money in different places and times, with corresponding advantages and disadvantages. Rice worked well in 1600s Japan because everyone could use it (land value was even determined by how many koku (石) of rice it could produce), but it didn't work well as a store of value. Wampum worked OK in America's pre-colonial period as a storage of value, they weren't universally accepted.

Precious metals like gold and silver work well for both these functions, but not perfectly. If the world economy completely collapses in a massive, apocalyptic crisis one day, all the gold in the world won't help you find something to eat. It will lose its value. And as a store of value, precious metals are more vulnerable to theft.

The second principle is that no matter what you use as money, you can control only two of three variables: convertibility, interest rate control, and price stability. In the 1980s, Argentina pegged its currency to the U.S. dollar to end its inflation problems. It got convertibility and price stability, but lost its ability to control interest rates. In 1997, prices and interest rates in China were mostly unaffected by the 1997 Asian financial crisis, but this was because it had instituted currency controls (sacrificing convertibility).

And in Japan's "Lost Decade," you can see problems with price stability. Japan maintained convertibility with the world economy, and lowered its interest rates to almost zero. Nevertheless, this wasn't enough, and in the days before "Quantitative Easing" the destruction of capital resulted in deflation.

With a gold standard, a country essentially pegs their currency's value to that of gold. If new gold mines are discovered, the currency experiences inflation. If you raise the interest rate to combat inflation, it may hurt the economy at a really bad time. If there's a discrepancy with the interest rate, gold may flow out of the country. And if you institute currency controls to limit that, you cut yourself off from the global economy. When the U.S. operated on a gold standard, the dollar saw all of those things.

Third is that time will force you to change your choices, and usually at a time that's not of your choice. The Argentinian economy bubbled when the U.S. interest rate was too low for what the Argentine economy needed, and when it crashed it had to break its dollar peg. To better integrate with the world economy, the Chinese did the same, and adjusted their currency controls. And the United States, facing an increasing flow of gold out of the country throughout the 1960s, had to finally drop the gold standard in 1973.

With these principles in mind, the American experience with gold will make a lot more sense. The next post will cover each chapter in One Nation Under Gold, and talk about how developments throughout the world led to changes in the U.S. dollar's relationship with gold.