Memo To: John Spiers
From: Jude Wanniski
Re: A Strict Gold Standard
This question from John Spiers came in through our office back door and I initially thought I would deal with it separately, but because of its importance I decided to elevate it to a "Memo on the Margin."
I was asked: "Do I correctly read you to say in essence a strict gold standard is uninformed 19th century thinking? That currency in excess of gold reserves value is not only allowable but to be encouraged? If so, then this is my problem: Is currency not a derivative, like interest rate swap instruments or anything else paper that refers to something held in security? If so, then ought that derivative be kept at true value? For if not, don't we have an inherently less stable m derivative? And the boom and bust credit cycle?"
This is an excellent question, my answer to which I hope helps clear up differences between the Austrian school and the classical supply-siders. There are few theoretical schools to which I feel not only affinity, but admiration, than that of the Austrian school founded by Ludwig von Mises. F. A. von Hayek and Murray Rothbard represent their own branches of this school. At Polyconomics, we call ourselves the New Jersey school, a new school that stands on the shoulders of these great theorists.
To those of you who already feel lost, let me at least tell you about the term "derivative." It sounds complicated but it is simple. A share of stock in a company is primary, in that it represents "a piece of the business." If you own a share of stock, you do not own a derivative, but a piece of the business. If you own a share of a mutual fund, you own a piece of many pieces of many businesses. The share in the mutual fund has value that derives from its underlying value. Owning a share in a mutual fund does not allow you to vote at the annual meetings of the companies whose shares are owned by the fund. The managers of the fund can do so, but you can't. You only own a derivative. The question from John Spiers suggests that the idea I presented in my WSJournal op-ed last week involves equating our currency to a derivative. Not so.
Currency is not a derivative. It is primary debt of the U.S. government, which, like gold, pays no interest. Credit-card money is derivative. Eurodollars are derivative. They represent self-liquidating bills of exchange that enable people to transact without actually using U.S. base money. The financial press routinely reports on trillions of dollars being traded on the forex markets, but almost all of that is in derivative form. There is only about $495 billion in primary dollars. Only these dollars are liabilities of the U.S. government. Because the world has more confidence in the United States than in any other country, it has more confidence in our publicly held debt, which is why the dollar has won the worldwide competition as a reserve currency and as a secondary medium of exchange in most countries of the world.
A "strict" gold standard is not uninformed 19th century thinking. It is uninformed 20th century thinking. The gold standard worked in the 19th century not because banks held gold in equal reserves to the notes they issued, but because the United States government guaranteed its national debt in dollars at a specified weight of gold. The establishment of the government standard is what enabled the private banks to issue notes that could circulate from one sphere to another, although their primary function was to intermediate bills of exchange denominated in dollars, even though those dollars technically did not exist. The great classical economists of the 19th century, from David Ricardo through Karl Marx, understood that gold's principle function as money was to provide a numeraire through which the markets could infer all other exchange rates, i.e., "prices." Money is functioning at the peak of efficiency when the bank need hold no gold. That is, as long as the bank has assets that enable it to acquire gold at a moment's notice, it does not have to hold the specie itself.
It makes perfect sense that if the Federal Reserve keeps the dollar as good as gold it is keeping the dollar value of the national debt as good as gold. The dollar reserves held by the banks are as good as gold if the Federal Reserve limits its creation of currency and bank reserves to the amount demanded at a fixed gold price. It does not take Albert Einstein to figure out that while Smith, Ricardo, Marx and Walras may not have imagined this mechanism, once they looked it over they would approve. I can't imagine Von Mises or Rothbard would disapprove either. Their central principle is gold money, the only possible exchange rate that makes sense in linking paper money to the planet.