Gold Standard Solution

Those who try to chart the course of our credit downgrade will blame Barack Obama’s profligacy or Republicans’ brinksmanship, or maybe even Standard & Poor’s callousness. But these can be no more than ancillary factors. The rejection of America as a top-tier credit is the outcome of a commitment broken 40 years ago that we have never figured out how to live with: money with no guaranteed value.

On Aug. 15, 1971, President Richard Nixon announced a stunning reversal in American economic policy. Dollars held by foreign governments and central banks would no longer be redeemed with gold. The Bretton Woods monetary system, devised by the free world near the end of World War II, was finished.

Nixon had no rudder when it came to economic theory, and the fact that these decisions were anathema to his party’s philosophy did not bother him. “I am now a Keynesian in economics,” he had announced earlier that year as if he were endorsing a fad.

Nixon did face an inflection point. Dollars, the world’s main reserve currency, were piling up in foreign hands as the U.S. became an international debtor starting in the 1960s. The Vietnam War and Great Society were blamed for necessitating new money printing, but that was the fate of Bretton Woods with America as the banker to the world. Then just like today, our currency was exported to foreigners who financed U.S. budget and trade deficits.

Just as a bank is liable for the deposits it loans out, the U.S. had to meet its dollar obligations with gold at 1/35 of an ounce. Arrangements made to stop redemptions proved futile. By August 1971 the Treasury was down to $10 billion in gold, half of what it had in 1960. The Bank of England’s signal that it would redeem more pushed Nixon to announce his decision several weeks ahead of schedule.

By cutting the tie between the dollar and gold, Nixon doubled down on the malignant reserve currency feature of the Bretton Woods system. He made the dollar the world’s final money with no guaranteed exchange value. Walter Wriston, then the chief executive of Citibank, said that the world had traded up from the gold standard.

History has shown otherwise. Since August 1971 the dollar has lost 82 percent of its domestic purchasing power. Internationally it has come to embody what Robert Mundell called the central characteristic of a reserve currency — weakness.

Debt-based money has produced a debt-based financial system. Levels of indebtedness — government, corporate, household — have soared in the last 40 years.

Abroad sits $4.5 trillion in U.S. Treasury securities, much of which is used by central banks as an interest-earning substitute for dollar reserves. They also own at least $734 billion in mortgage bonds from federal agencies like Fannie Mae and Freddie Mac, down from nearly $1 trillion in 2008, according to the Federal Reserve. Foreign central banks, not just overzealous speculators, drove the housing bubble. The persistent boom-bust pattern in modern finance — whether in stocks, real estate, or some other asset class — stems from the unlimited capacity for dollar creation by the Fed and the seemingly unlimited places for those dollars to land.

A monetary system biased toward debt accumulation emboldens the spending ambitions of all presidents and Congresses. It even provides solace when things go wrong, as White House budget director Jack Lew evoked the other day when he pointed to a rally in Treasury securities as a reason not to worry about the S&P downgrade. But investors weren’t endorsing America’s credit; they were doing what the monetary system dictates in panics: hold dollar-denominated debt.

But just like Bretton Woods, the dollar standard contains the seeds of its own destruction. After a long enough time, investors get sick of holding depreciating paper. Foreign central banks, especially those in emerging markets like China and Russia, are loading up on gold instead. The long, steady rise in the price of gold is indicative not of a bubble but rather its growing acceptance as the replacement for the dollar as the final money of the world.

Of course, the U.S. can’t get rid of paper money overnight the way it abandoned gold 40 years ago. Establishing a functioning and sustainable international gold standard will require several major steps, such as making the dollar convertible to gold, enabling gold to be used as money, and working with other nations to facilitate the switch of gold for dollars in settling international payments.

But it is doable within the span of a presidential term.

Herbert Stein, one of the economic advisers in Nixon’s counsel in 1971, famously said that “If something cannot go on forever, it will stop.”

America without the gold standard couldn’t keep its triple-A credit rating. What else will we have to trade away before this experiment, 40 years of disorder, stops?