A Return To The Gold Standard Could Destroy The Modern Economy

| About: SPDR Gold (GLD)

I've previously written about the framework for a sustainable fiat money in the form of the Modern Monetary Theory. In this article, I will describe the critical deficiencies of a metal-based currency that could, with no exaggeration whatsoever, bring about a permanent decline of our living standards and the end of the economy as we know it.

Private Sector Cannot Save Without Government Dis-saving

First, let's start with a simple thought experiment, where I illustrate one of the most important findings of MMT. Imagine that you live on an island with four other people, and there is a total of $10 in circulation on the entire island.

The five of you form a very "fiscally responsible" government that will not print any new money, and will not run a deficit. So, the total money supply of the island will forever stay at $10, which means each of you will have, on average, $2.

The five of you can never save more money all at once. One of you can save money individually, but each dollar you save must come out of someone else's spending. Some of you may even go into debt (carry a negative balance) to offset another person's abnormally large cash balance, but overall, the sum of everybody's money on the island cannot exceed $10.

In fact, if a couple of you have a child and increase the population to 6 people, all of you (on average) must fund that population growth via dis-saving.

Stretch this example to a national scale and you can see that, in a closed economy, a growing private sector cannot save money without the government simultaneously creating money. This is SO important that I have to repeat it once more before we move forward:

The private sector cannot save without a corresponding dis-saving from the public sector.

The equation changes slightly if we consider an open economy, where it is possible to have both the government and its private citizens save as long as they are financed by another foreign country's net spending (as the U.S. has done for China in most of the past decade).

It's debatable how sustainable this one-way transfer is. However, the conclusion remains the same for the world as a WHOLE (unless we start getting financed by Martians):

The world's private sector cannot save in aggregate without having government entities that create net additional money.

This is not an opinion or interpretation, it is a mathematical certainty.

And given that savings sustain future consumption and investments in the long run, moving towards a static monetary system is catastrophic for the economy. (For a more in-depth analysis on this topic, readers should check out this brilliant article at Pragmatic Capitalism, especially Figure 3 under the sectoral balances section.)

Now getting back to gold (NYSEARCA:GLD). While gold is not completely static because it is still being mined each year, the annual production rate of gold doesn't even begin to keep up with the population growth rate, let alone finance the rise in standards of living that we have come to expect.

Moving to the gold standard will destroy economic progress. In practice, this is how it will unfold if we are foolish enough to go down that path: There is not enough gold in circulation to fuel population and economic growth. The scarcity of gold relative to the increasing amount of goods and services required by a growing economy would either (1) kick the economy into a deadly deflationary spiral, or (2) artificially cap economic/population growth at the rate of which we can dig that metal out of the ground.

A Crisis of Confidence

The second weakness of a gold-backed monetary system is not only equally severe, but perhaps even more urgent and visible than the first one.

For a real-time parallel, look across the pond at Europe, and especially at the peripheral countries such as Greece. The Greek crisis has many causes, but the primary one stems from a fundamental flaw in Greece's monetary system: The Greeks had to manage their fiscal budget in euro and denominate their debt in euro, which is a currency they do not control.

Since its entrance into the eurozone club, Greece has not been able to control its money supply as it is not authorized to "print" its own money. Greece has become a pure "currency-user" rather than a "currency-issuer". This is similar to what the U.S. would become if it were to adopt a currency backed by gold or other physical commodities.

The Greek government is powerless to solve the recurring fiscal nightmare because most of the tools available to a normal currency-issuing nation were taken away from it.

A nation that has sovereign control over its currency, like the U.S., has the option to monetize its debt but does not actually have to constantly do it - merely the threat of being able to print unlimited money scares away bond vigilantes and brings calm to the bond markets.

A great example is Japan - it has had decades of stagnant to falling GDP and a terrible fiscal balance sheet with public debt at 226% of GDP, but yet Japan has a healthy bond market and hasn't experienced any devastating debt crisis.

Until Europe fixes its structural problem by either splitting up or creating a meaningful fiscal union, the crisis will not be over. A nation cannot solve its fiscal problems by relying on austerity measures.

Austerity is a terribly ineffective tool for solving fiscal crises. As a government lowers spending, GDP growth is restricted, hurting tax revenue, which further exacerbates the government's fiscal problem, and triggers even more austerity measures. It is a vicious cycle that is very hard to get out of.

Based on the lessons learned from the eurozone situation, returning to the gold standard will be the worst thing the U.S. can do because it would cause the U.S. to lose control of its own money supply. Ironically, this would exacerbate the very fiscal problem that gold advocates are trying to solve. Without the threat of monetization, U.S. bonds would be attacked by bond vigilantes, causing a crisis of confidence, which would trigger punitive (and empirically ineffective) austerity measures that ultimately bring about the doom of the U.S. economy.

Is Fiat Money Perfect?

The answer is a resounding "no". Its effectiveness depends on a responsible and competent central bank, and ours are seldom either. But even with all of its imperfections, fiat money is the least bad monetary system when compared to all other alternatives.

First, I'd like to debunk the misconception propagated by many hard money advocates that an increase in money supply must inevitably lead to inflation. The truth is it is a balancing act: The growth in the supply of money should match the growth in the demand for money. And in the long run, the demand for money rises in tandem with a population that is getting richer and more numerous.

The money supply is the grease that makes the economic wheels turn, and it must grow - it cannot be static. The trick, and the objective we delegated to our central bankers, is to find the right balance. Too little money creation causes deflation and restricts growth, and too much causes runaway inflation. It is the role of the world's central banks to counter the natural boom and bust of the credit cycles and maintain price stability in the long run.

Are our central bankers doing a perfect job? Hardly, but data shows that they are getting better. A review of NBER's business cycle data shows that the economy is becoming less volatile as we moved away from gold standard, with contraction periods lasting shorter on average.

Ultimately, money is merely a system we design for ourselves to aid us in unleashing our innate productive potential. It would do us well if we focus our efforts in improving and fine-tuning the modern paradigm that brought us unprecedented prosperity since its inception, rather than regressing to a system that has already been disproven by history.

Disclosure: I am short GLD.

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