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One of the interesting side-discussions of the current financial mess is whether the fallout from the crisis will lead to a new international currency order. There is worry that the massive spending deficits that the Americans have initiated will undermine confidence in the US dollar (USD). Enormous spending means the creation of more dollars; the creation of more dollars reduces the value of any given dollar; if the value of the dollar goes down, so does the value of anything priced in dollars.

Like any fiat currency, the value of the USD is based upon little more than a promise, by the government, that the currency is worth something. But since the USD is the de facto reserve currency of the global economy, and most commodities (like oil) are priced in dollars, much of global finance and trade is based upon a shared understanding that the currency of the largest, strongest and most open economy has value. It is a global confidence game, and everyone needs to play for it to work. To understand this is to understand why a deterioration of the confidence in the USD would have deep and wide-ranging consequences.

Which is what makes this set of proposals to ditch the dollar, put forward by reps from national governments, so interesting. The Chinese suggestion to switch to the IMF's special drawing right is especially loaded, but that's the subject of another post altogether. What I want to focus on is the recent talk about returning to the gold standard. Oooooh this makes me angry.

Let's take this article by Gillian Tett that lays out the basic idea of a return to the gold standard. She reminds us of the fragility of a fiat currency system that rests solely on government credibility, and quotes an essay from Alan Greenspan written in the 1960s:

Now Tett does suggest that a return to the gold standard is pretty unlikely, but I still find this kind of reporting irresponsible since it makes no effort to point out why we quit the gold standard in the first place.

Let's review the basic points here. Gold is valuable for no other reason than human beings like shiny metal things. If squirrels ran the global economy, they would probably have an acorn-standard because they like nuts - there is no fundamental difference.

Okay, you're right: the value of gold is also based on the finite amount of gold in the world - but that's precisely the problem. The creation of credit is the lifeblood of the global economy; if the amount of credit in the economy is limited to the amount of metal we can dig out of the ground, world trade would become very difficult indeed. Greenspan is wrong when he writes that, under a gold standard, the amount of credit is determined by the economy's tangible assets: it is in fact determined by a tangible asset. Singular.

Greenspan is technically right in arguing that, under a fiat system, there's nothing physically stopping governments from engaging in "wild credit creation." But there are additional considerations, including the fact that inflation creates enormous costs for the economy. Unless the government is insulated from the consequences (Zimbabwe), those costs are a barrier. For some countries, like Germany, historical experience with inflation has led to the creation of social and institutional mechanisms that act as a pretty strong disincentive for inflation. No gold required.

Moreover, "wild credit creation" is sometimes a necessary option. It is no coincidence that the earlier countries abandoned the gold standard in the 1930s, the sooner their recovery from the Great Depression began. If we had a gold standard right now, our central banks would not have the flexibility to adjust monetary policy to the crisis and engage in "non-traditional" activities.

We can argue about how the US government is choosing to spend money to kick-start the economy, and where that money is going. But there is almost no question that monetary expansion is an absolute necessity in a credit crisis. If our currency was tied to a fixed amount of gold reserves, we would have a complete disaster on our hands.

Plenty more reading: a survey of the rise and fall of the gold standard; Eichengreen & Temin on the gold standard mentalité, and Brad DeLong on Why Not the Gold Standard?

(photo from digitalmoneyworld's photostream)