A lesson from the gold standard

2011-JUN-19

Sir Isaac Newton invented the gold standard circa 1700. The gold standard undoubtedly ranks as one of his greatest achievements given that it became the backbone of the British Empire.

The pound was “as good as gold”, as the saying went, and the pound banknote was accepted around the globe as a substitute for gold itself – but not always. The paper-pound was willingly accepted until there was a banking or financial crisis, which meant the quality of the currency and the reliability of banks became questioned.

At those moments – which occurred with surprising frequency – there was a rush to gold because of its safe haven attributes. Gold is a tangible asset, and with tangible assets one does not have any risk of default. The value of a tangible asset is not dependent upon a bank or government promise.

Even though paper currency was more convenient to use in commerce than heavy gold coins, during a crisis convenience did not matter. But safety did.

As people frantically converted their paper pounds into tangible gold, a panic inevitably ensued because there never was enough gold to satisfy the redemption demands. Too much paper had been issued, causing losses by those who held this paper, which in many cases became worthless.

These panics served a useful purpose. They acted as a periodic throttle on bank credit expansion and the speculation that follows from easy money policies during the boom times when credit is cheap, plentiful, and available from the banks with few questions asked. Do you recognise a pattern here?

The present financial crisis is not unlike those previous panics recurring throughout monetary history. Even though the pound, euro, dollar and other national currencies are no longer redeemable into gold, these paper currencies can be exchanged for gold 24 hours a day.

People vote with their pocketbooks. In the months since the collapse of Lehman Brothers in September 2008, people everywhere have been exchanging their paper money for physical gold.

This trend that favours physical metal in preference to paper currency is well established. It is one that is likely to continue. The clamour for physical metal will continue until debt is brought under control, and it is here where the gold standard is sorely missed. It no longer imposes an essential discipline on bankers who don’t know when to stop lending and politicians who don’t know when to stop spending.

We can learn from the numerous episodes of monetary history in which banks and currencies fail. We can put into practice today the simple strategy that enabled people to successfully weather the financial storm. They did it by owning physical gold and silver. This same time-proven strategy is helping people today.