Under a proper gold standard, the rate of interest is kept in a band that is not only narrow, but which is also stable over long periods of time. This is the principle virtue of the gold standard. It does not fix the level of prices, which would be neither possible nor desirable. It keeps the rate of interest consistent, which serves the interests of wage earners, pensioners, and other savers, and of entrepreneurs whose work provides the goods, services, jobs, and interest payments that on which everyone else depends (and which they take for granted).
Today, short-term interest rates are set by the diktats of the central bank. And long-term interest rates are set in a “market” in which the central bank is obliged to keep coming back to buy ever more bonds, and speculators front-run the central banks to buy ahead of them. The result has been that, for 30 years and counting, the bond price has been rising, which is the same as to say that the rate of interest has been spiraling into the black hole of zero. When it gets there (and probably sooner) the entire monetary system will collapse.
This is the terminal stage of the disease of irredeemable paper currency. They have banished money (gold) from the monetary system, and the result is a positive-feedback-loop that destabilizes the rate of interest. The rate of interest has a propensity to fall, just like the value of the paper currency itself.
This leads to the question of how interest rates are set by a free market under a gold standard. This is a non-trivial question, and the answer is profoundly important as we debate what sort of role gold ought to play and evaluate the various gold standards being proposed.
If people are free to own gold coins directly, then the mechanics of setting the rate of interest are simple. Let’s define a term. The marginal saver is the saver who could go either way, either holding a bond or a gold coin. If the rate of interest ticks downward, he will sell the bond (or withdraw his money from the bank, thus forcing the bank to sell the bond) and buy the gold coin. He would rather hold the gold than commit to the time and risk for such a low interest rate. If the rate of interest ticks upward, he will buy the bond (or deposit his coin in the bank).
The marginal saver sets the floor under the rate of interest. It cannot fall below his preference or else he will vote with his gold. His preference has real teeth (unlike today).
Now let’s define one more term. The marginal entrepreneur is the entrepreneur whose rate of profit is the lowest possible, while still being viable. If his profit falls for any reason, such as due to a rise in costs, he will shut down his enterprise. One cost is the cost of capital, i.e. the rate of interest. No entrepreneur can borrow at a rate higher than his rate of profit, and the marginal entrepreneur is the first to buy the bond and sell his capital stock at an uptick in the rate of interest. He is the first to sell a bond and buy capital stock at a downtick in the rate.
The marginal entrepreneur sets the ceiling over the rate of interest. It cannot rise above his ability to pay, or else he will vote with his capital stock. He also has teeth.
Under a proper gold standard, the rate of interest is kept in a band that is not only narrow, but which is also stable over long periods of time. This is the principle virtue of the gold standard. It does not fix the level of prices, which would be neither possible nor desirable. It keeps the rate of interest consistent, which serves the interests of wage earners, pensioners, and other savers, and of entrepreneurs whose work provides the goods, services, jobs, and interest payments that on which everyone else depends (and which they take for granted).
When evaluating any proposed gold standard, one should ask the question: how will it determine the rate of interest?
Keith Weiner is the founder DiamondWare, a VoIP software company, and is a PhD student at Antal Fekete’s New Austrian School of Economics in Munich. He is now a trader and market analyst in precious metals and commodities. He is also president of the Gold Standard Institute USA.
© 2012 by Keith Weiner
Right on Keith …
I have a question for you on Gold — I have heard that China will be opening a “gold’ exchange to go in competition with London and New york. If that accrues in August as I have also heard just as the US US Nation Debt is getting close to the current debt limit (at the current rate of growth) won’t that have a tendency to destabilize the dollar?
David: Yes, in one sense, the dollar is already destabilizing itself and obviously every incremental move towards gold (and permanent gold backwardation!)
In another sense, I don’t think this gold exchange will do much by itself. I am sure it will pull some trading accounts out of London and NY, but of course there will be arbitrage between the China gold market and the NY and London gold markets (as there is today between NY and London). I would expect it to incrementally increase demand, as some investors now have access to trade gold for the first time or feel more comfortable than they did with NY or London (Chinese citizens, presumably).
The debt limit is meaningless, and the ferocious rally in Treasury bonds that occurred since the US debt downgrade shows that of the factors that drive the bond market, the debt limit and the rating are not among them. Of course, it will matter someday. Just as Spain now cannot attract bidders to their bond market, one day this disease will afflict the US Treasury market. But today is not that day!
“A Gold Standard Stabilizes Interest Rates And Avoids Booms And Busts”
justaluckyfool has a foolish question,”Does a gold standard avoid booms and busts “?
Is the article based upon fact, or a presummed condition
that perhaps is false?
I await a profund reply.
Justaluckyfool-”Anyone that attempts to predict a future event is a fool,if by chance (luck) correctly then they are just a lucky fool, albeit still a fool”
LuckyFool: I am sure you are familiar with the concept “necessary but not sufficient”? Having a car is necessary, but not sufficient, to drive 50 miles. One other necessary ingredient is that there must be gasoline in the tank.
A gold standard is necessary, but not sufficient, for stable and prosperous growth. By this, of course I mean a proper, unadulterated gold standard in which every citizen is free to choose to hold the gold coin or the bond. This rules out the so-called gold bullion standard and the so-called gold exchange standard.
A few other necessary conditions include:
– There is no duration mismatch
– Prices, especially including the prices of bonds and of other monetary assets such as silver, are set in a free market
– There is no government-backed central bank
– There is no national policy of subsidizing preferred industries for the sake of “national prestige” or any other sake, such as railroads
– There is no regulatory or tax uncertainty
Keith, No disagreement with the theory I should have stated my question better.
Since the dollar is the “reserve” currency and it is not backed by gold and China seems to be trying to set itself up as a reserve currency backed by gold (rumor only at this time), if done, that would destabilize the dollar and drive up internal US costs significantly. Which would be very bad for us. Or for those that are not prepared I should say.
However, China does not allow gold to flow out of the country and if you are backing your currency with Gold then it must flow both ways. And then you have the Triffin dilemma where a country with a reserve currency must be a net importer of goods, which China is not so none of this makes any sense … lol
I realize this is a vast simplification of the actual situation but I think you should get the conflict that appears to be developing here.
I intend to write a piece about reserve currency and what it means. Suffice to say that I don’t think China is doing any such thing. They have a pegged exchange rate and capital controls, for starters. And as an export-driven mercantilist country the last thing they want is to lose their trade surplus and face the real prospect of revolution by a 100M newly unemployed people…
Also, I don’t think the rest of the world would agree to accept China’s currency that way anyways. Unhappy though they may be with the US dollar, the Chinese yuan would not be preferable.
I wondered about that myself but then times are strange and that is exactly what some major investor groups are saving.
I hope that the United States is considering backing their money by gold in the near future. i think that is going to be one of our only ways to keep the U.S. dollar as the leading world currency.