The SEER

By Dr. Richard S. Appel

On March 14, 1900, the Congress of the United States passed the Gold Standard Act. This placed our nation on an official gold standard and mandated that the issuance of “greenbacks”, or Treasury notes, could only occur if they were backed by gold. Further, Congress created a gold reserve of $150 million that was to be expressly used for the redemption of gold-backed greenbacks. Henceforth, under the gold standard, our politicians were to be limited in the ability to issue new banknotes by the amount of physical gold that was set aside to redeem them.

When dollar creation was governed by this law, the dollar’s strength or weakness was determined by the health of our economy, interest rates and our monetary gold stock. The stronger that our country appeared to the rest of the world, the more desirous was our dollar. During this era, the gold standard acted as a self-regulating mechanism by dictating the size of our money supply. The larger our gold stock, the greater the amount of notes that our country could issue. Conversely, if our nation’s gold supply dwindled, it was forced to reduce our money in circulation. Further, the gold standard functioned to moderate and control the expansion and contraction of the business cycle.

In 1934, President Roosevelt revalued gold from its earlier official price of $20.67 to $35 an ounce. When that occurred the gold standard redefined the dollar as being worth 1/35th of an ounce of gold. Because the government could only create as many dollars as their gold stock would provide, this “official” rise in the gold price simultaneously allowed our leaders to “legally” increase our money supply. Our then current store of gold would support a far greater dollar amount of paper money. In effect, they devalued the dollar by reducing the quantity of gold that was necessary to redeem it. This allowed our politicians to increase our money supply with the hope that it would help our country extricate itself from the throes of the Great Depression

The gold standard formed the foundation of a sound domestic monetary system. It prevented government officials from arbitrarily increasing the dollars in circulation as it limited their ability to create money from “thin air”. This fostered greater confidence for our trading partners in holding our dollars, as they knew that their value was stable and that they could redeem them for gold.

The gold standard also facilitated smooth business transactions between foreign nations. When the gold standard was adhered to by our trading partners, gold was used to settle balance of payments deficits between countries. When one nation, the debtor, bought more goods and services from another than it sold to it, the creditor, the former incurred a balance of payments deficit. The net effect was the return of the debtor country’s money and a transfer of some of its gold stock to its creditor.

A growing American economy generates greater wealth for both our domestic companies and our citizens. Further, this condition increases the desire of foreigners to purchase and invest in our nation. They are more confident in holding our currency and they see value in doing business with us. During periods when both our dollar was widely desired and our economy was strong, U.S. companies imported greater quantities of foreign goods than they sold. This was the result of our citizens and enterprises using some of their increased income to purchase more products from beyond our borders.

Under these circumstances dollars left our shores and accumulated in foreign lands. As this process continued a point was reached when we created a U.S. Balance of Payments deficit. As stated earlier under the Gold Standard, if a foreign nation desired to redeem their acquired dollars they could receive gold in exchange. When this occurred, the transfer of gold from the U.S. caused a decrease in our gold stock, and forced a simultaneous reduction in our money supply. Thus, the dollar’s increased value would make our goods progressively more expensive in other currencies. This acted to curtail foreign purchases in the U.S. The resultant decline in foreign demand, and our reduced money supply, would act as a brake to slow the economic expansion. It would also act to reign in any inflationary pressures that were fostered by our strong economy.

In contrast, during periods of weak U.S. business conditions the dollar fell in value, and U.S. consumption of foreign goods declined. The weakened dollar raised the price of alien goods to Americans. Eventually, the cheaper dollar and the greater bargains that our products represented encouraged foreigners to consume a relatively greater amount of U.S. goods and services. This caused a U.S. Balance of Payments surplus as our trading partners acquired more of our products than they sold us. When this occurred their accumulated currencies were exchanged for gold by our country. The result was a net increase in our governments’s gold stock. This in turn would generate a rise in our money supply which would stimulate business, help end the recession, and the process would repeat itself.

THE REMOVAL OF THE LAST RESTRAINTS
UPON MONETARY CREATION

In 1944, the Bretton Woods Agreement was signed by the U.S. and 43 other nations. This created the gold exchange standard. Under this accord, these countries agreed to treat the dollar as a substitute for gold in settling their Balance of Payments deficits; both gold and the dollar could be used interchangeably. Under the earlier gold standard these foreign nations also utilized their gold hoards in determining the size of their individual money supplies.

The gold exchange standard opened the door for excessive world monetary creation and the inflation that it inevitably produced. No longer would the money supplies of the major countries be controlled by the amount of gold in their depositories. Now, they could increase their local money stocks by issuing additional amounts of their native currencies based upon both their U.S. dollar holdings and their gold reserves.

Finally, in August, 1971, President Richard M. Nixon closed the gold window. This removed the last vestige of gold backing from our currency and the final restraint on our politician’s ability to arbitrarily create money. Thus, the era of fiat money entered its heyday, and the dollar became doomed.

Subsequent to President Nixon’s refusal to exchange gold for foreign U.S. dollar claims, the dollar became the primary item that was used to back the currencies of the world. Under the gold exchange standard our trading partners gained great confidence in the dollar. This was the result of the long period in which they could confidently exchange it for gold. It is the prime reason that the U.S. was able to convince the world to move from the gold standard to a system which allowed a dollar substitute. This placed the U.S. in an enviable position, and allowed it to wield great power. It provided our country with the ability to settle our balance of payments deficits with dollars that the Federal Reserve could create at will. They no longer had to back the dollar with gold. Had our leaders acted responsibly to limit the creation of dollars, we would not be in the precarious condition that the U.S. and the balance of the world now finds itself.

During the ensuing four decades after the dollar replaced gold, the U.S. has registered an enormous cumulative balance of payments deficit. These dollars left our country to acquire valuable goods and service which were gladly sold to us. Many of these dollar credits then returned to the U.S. and were invested in U.S. Treasuries which helped reduce our interest rates. A substantial number of the dollars that went overseas found their way into the coffers of the various central banks. This kept them out of our money supply and reduced pressure on our prices, thereby limiting domestic inflation. Simultaneously, the dollar build up in foreign lands fostered large increases in the money supplies of those nations.

All of these factors worked well for quite some time. In the U.S., it allowed our citizens to lead a far better lifestyle and enjoy a higher standard of living than would have otherwise been the case. We did not have to sacrifice our precious gold hoard, as we would have under the gold standard, in order to settle our balance of payments deficits. We not only weren’t forced to reduce our money supply, but were able to expand it. Foreigners continued to treat the dollar as if it remained as good as gold. We simply transferred electronic dollar credits to pay for our foreign purchases. Additionally, the abrogation of the gold standard forestalled a serious economic decline that would have been mandatory under its rule. Each time our economy has contracted the Fed effortlessly expanded the money supply and reduced interest rates. Even today this method appears to be working. However, the time will come when the piper will have to be paid, and time may be running out.

The other nations are beginning to recognize the trap into which they have fallen. They see the dollar declining and gold rising in value and have heard from the lips of Fed Chairman Alan Greenspan and Fed Governor Ben Bernanke that the U.S. has the ability to create dollars at will. Large foreign dollar holdings have been converted into euros and some into gold. Further, there is talk of not only repricing oil in euros but in the creation of new gold backed currencies. Either of these events will play havoc on the dollar as its usefulness to the rest of the world will decline, and with it both the dollar’s desirability and worth. For these reasons, I believe that the dollar is destined to gradually lose its global importance.

Additionally, Japan is aggressively purchasing dollars with newly created yen credits. They are attempting to support the dollar in an effort to maintain their competitive trade advantage. This is acting to limit an increase in the U.S. money supply because the dollars purchased are removed from our domestic measures of money. Instead, the dollars are used by Japan to acquire U.S. Treasuries. This is likely the primary reason for our surprisingly strong bond market.

At some juncture I believe that it is inevitable that the U.S. will be forced to again back the dollar with gold. It will not likely occur until the dollar appears to be in the process of or loses its status as the world’s reserve currency. Or, if this is preempted by an economic accident. That is likely the only fashion in which the dollar will have the opportunity to again become universally desirable. This will not occur overnight! Until that time comes, gold and secondarily silver and gold and silver stocks, as well as tangibles, will be the prime beneficiaries of the termination of the gold standard.

Investing in Precious Metals

Many Investment advisors recommend precious metals as part of a properly diversified portfolio to provide capital appreciation, liquidity, and a hedge against conventional paper assets. Because precious metals are counter-cyclical to paper assets, a diversification into gold, silver, and platinum can therefore reduce the total risk of your overall portfolio and preserve your wealth. History supports the premise that investment in precious metals is the best protection against uncertainties in the future.

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