by D.J. Webb
I don’t have time for a full blog on the gold standard, but I would like to address that subject in the New Year. However, the issue is so timely that I’m commenting briefly here, with some focus on Russia.
By far the best books explaining the gold standard are written by Nathan Lewis. His Gold: the Once and Future Money and his more recent Gold: the Monetary Polaris (available in PDF at http://newworldeconomics.com/GTMPpage.html) are unusual in that they explain the mechanisms—the actual central bank mechanisms—of the operation of the gold standard. I’m deep into the PDF, taking notes as I write, and I hope to upload a long blog article over the next couple of weeks on this subject. However, I strongly recommend all libertarians to download and start reading it, and upload your own blogs on this subject too. We need to get the discussion moving. I will focus on finishing the PDF first and not on answering comments here.
They key point Lewis makes is that “base money” is the only real money. Base money is notes and coins and reserves held by commercial banks at the central bank. If you buy a pint of milk with notes, you are using base money. If you pay for something electronically or by direct debit, that transaction is also ultimately accomplished using base money. You may think that the payment comes out of your personal bank account, but the bank doesn’t have notes and coins that represent your deposit in the bank held in a safe somewhere. Your “demand deposit” is strictly speaking a loan to the bank, a form of credit, and is just ones and noughts on a screen. What happens is that at the end of the day banks settle up all their transactions. If Barclays Bank receives 1 million transaction orders totalling £2bn to pay money into personal accounts held with NatWest, and NatWest receives 800,000 transaction orders totalling £1.5bn to pay money into personal accounts held with Barclays, those transactions are netted out at the end of the day, and £500m of Barclays Bank’s base money held with the Bank of England is transferred to NatWest. The ones and noughts on the screen in the individual bank accounts are all adjusted, but the real payment is in base money. If a business holds an account with Lloyds and pays £2000 to a worker who banks with Lloyds, then both accounts (the ones and noughts on the screen for both accounts) are adjusted, and in this case the net movement in base money is zero, because there is no net settlement required between banks at the end of the day.
Claims by some libertarians that in a gold standard system every penny of the broader definition of money supply would need to be backed by gold reserves are foolish. Lewis indicates in his book that most “gold bugs” don’t understand the gold standard either, or how it used to work before August 15th 1971. If such an approach were taken, it would indeed be the case that there would not be enough gold in the world to run a gold standard and that economic growth had become, by definition, impossible. In fact, it was never the case that the entire quantity of money in the economy, including base money and broader forms of money including demand deposits and loans, was limited by the amount of physical gold held by the central bank. Because “gold bugs” often take such a mulish view, they open themselves immediately to the accusation that their gold standard would be unworkable due to the insufficiency of gold supply.
In fact, Lewis shows that no gold is needed to run a gold standard, although it would be a more credible system to have some gold and to allow payments in specie. He explains that the gold standard can be run as a gold peg, with the quantity of base money being managed in such a way as to keep the currency stable against gold. This is workable because each country (apart from those who foolishly entered the euro) does control its own money supply: in the case of Russia, Russia does control the supply of rouble base money, so why wouldn’t they be able to keep the rouble stable? They can expand or contract base money at will.
Lewis also explains that many of the original principles of central banking have been forgotten, and that, for instance, in the 1997 Asian financial crisis, the Thai government defended the baht and ran down foreign-exchange reserves to do so—but did not shrink the monetary base. When the central bank sold gold or foreign exchange to buy baht, it should have removed those baht from circulation, thus eventually creating a scarcity of baht. Even in a severe run on the currency, only a certain amount of base money can ever be dumped—Lewis says 20% is an effective maximum—as base money cannot be run down to zero, and so by defending the baht at a certain parity and withdrawing the baht so purchased from circulation they would have eventually stabilised the baht.
In Russia’s case, they have sufficient gold to run a gold standard: Russia’s gold reserves already cover a much larger proportion of the monetary base than was usual in the pre-1971 period, and they have been buying gold all year, leading some to wonder if a gold-backed rouble is being planned. An alternative rumour on Bloomberg had it that Russia was so desperate it had been selling off the rouble—an absurd rumour as they have all year been buying gold, and they have recently confirmed they’ve increased their gold holdings yet again.
However, Lewis’ book also shows that, even if you’re not aiming to keep the currency stable against gold, you can still use traditional central banking principles to keep it stable against other fiat currencies, namely, that the monetary base needs to be shrunk to defend the currency. Russia has blown more than US$100bn this year on defending the rouble, only to see the rouble fall sharply. Yet the irony is that the rouble monetary base is only equivalent to US$125bn at currency exchange rates. (The figures are given at http://www.cbr.ru/eng/statistics/credit_statistics/mb.asp.) This is for the reasons given above, that the monetary base (the real money with which all broader transactions are ultimately conducted) is much smaller than the so-called broad money supply, including credit and other things. Why wouldn’t they be able to stabilise the rouble when foreign-exchange reserves including gold are more than US$400bn? The monetary base is more than 300% backed by foreign-exchange reserves. Every single rouble note and coin could be handed in and exchanged at the parity defended by the government—and it wouldn’t come close to making a serious dent in the country’s foreign-exchange reserves. In fact, even the entire monetary base (including bank reserves) could be exchanged at the desired parity and still see Russia hold on to the vast bulk of its foreign-exchange reserves.
In practice, you could not have 100% of base money being dumped, as some base money is always required: people need a certain amount of notes and coins and commercial banks need a certain amount of bank reserves. So Lewis theorises only one-fifth of base money would ever be dumped: defend the existing parity with less than one-tenth of foreign-exchange reserves, and the crisis would be over.
However, it only works if the monetary base is then shrunk. Yet, as Lewis shows in his Forbes article at http://www.forbes.com/sites/nathanlewis/2014/12/19/its-official-elvira-nabiullina-wins-the-tall-pointy-hat-award-for-mismanagement-of-the-ruble/, US$100bn has been wasted by the Russian central bank this year to defend the exchange rate, but all the while the monetary base has been expanded, replicating the error of the Thais in 1997. (The monetary base is subject to some seaonality; year-on-year increases can be seen in the monetary base once the figures are compared to the same month in 2013.)
Think about it: it is said that capital flight from Russia may reach US$125bn next year (less than one-third of foreign-exchange reserves). But with the monetary base at US$125bn, this would be impossible if the Russian central bank followed a consistent policy of removing from circulation each rouble they bought to defend the currency. Instead, they are more likely to burn through in excess of US$100bn in foreign-exchange reserves to allow more than US$100bn to flow out of the country, leaving the monetary base unchanged, and the nation’s currency reserves much depleted.
There are no two ways about it: they have sufficient gold and currency reserves to defend the rouble. They need to dump the central bank governor, Elvira Nabiullina, as the first move in a fightback against Western attempts to destroy the rouble.
