Monday, October 19, 2009

A return to the gold standard

A return to the gold standard by Sauvik Chakraverti

The rupee must be anchored to a tangible commodity. For the Indian economy, the benefits would be great

Posted: Thu, Oct 15 2009. 8:44 PM IST

To classical liberals, money was gold, and gold was money. There is a letter David Hume wrote Adam Smith dated 1776, wherein Hume berates his friend for writing in his recent great book that the king of France took a seignorage of 8% for minting coins. Hume writes that if this were true, Frenchmen would take their gold to Belgium or Holland, whose monarchs minted coins for 2%. This was the limited role of the monarch vis-à-vis money then. The monarch did not manufacture money; it was a world of “private money”. In his Wealth of Nations, Smith lists the “three duties of the sovereign”; there is no mention of money. If Hume or Smith were to visit the modern world, they would consider our fiat paper system a scandal, and heap derision and scorn on our professional economists.

How did it all go so wrong? Without getting into the gross errors that have taken over economic theory, I would like to focus here on legal issues. Money has no legal definition anywhere in the world today. This was never the case before. In 1776, the King’s coin was defined as containing a specific quantity of gold of prescribed fineness. In 1776, when the constitution of the US was being drafted, the federal government was granted the power to mint coinage, not create paper money. If we look at the India of those days, Smith himself was picked to lead a Commission to Bengal—to suggest a reform of the coinage.

Our first effort today, therefore, must be towards once again defining money in law. A rupee must be so much gold. If we do not anchor money to a tangible commodity, we will forever be using a measuring rod for economic calculation that is ever-changing and flexible, thereby throwing all economic decision making astray. This means a return to gold and silver coinage. This must be the real, legal money.

Let us turn to paper notes. In Smith’s time, these were redeemable in gold on demand. Smith and Hume both admired the Bank of Amsterdam, which maintained a 100% reserve against deposits then. But neither understood fractional reserve banking or central banking —the scourge of the modern world. Yet, the common masses of those days, untutored in political economy, would never accept irredeemable paper as money. This explains Sir Robert Peel’s Banking Act of 1844, which sought to make Bank of England notes redeemable in gold on demand but failed, because neither the great prime minister nor his government understood the mystery of banking.

The extremely shallow debates of those days between the currency and banking schools have been adequately detailed in Murray Rothbard’s magisterial history of economic thought, which is exceptionally unjust to the memory of Smith; but that aside, the point that needs to be emphasized is this: Because of the deficiencies in Peel’s Banking Act of 1844, both money and banking operate outside the law today. Money has no legal definition, and banking is, therefore, a fraud. Central bankers run unaccountable and illegal monetary systems. This is fatal for the economic health of all nations, especially poor nations.

The crux of the matter is that currency has become a “property title without property”. Now, this little deception by which profits could be hugely augmented was known to the goldsmiths of yore. If their notes “gained currency”, they would lend out notes on interest, thereby rendering their gold reserves a “fraction” of their outstandings. Profits were earned by lending out paper, not gold. But this was still legal, and such notes are called “fiduciary media” in the old textbooks, or “money held on trust”. But this is how the problem of “property titles without property” first appeared. It is intimately connected with fractional reserve banking and is a practice based on fraud. If this is outlawed, we can have sound, private money, including paper, and free banking under law. It is either that or unaccountable central bankers.

This will be of great succour to the average bank customer. He can then make two kinds of contracts with his bank—“demand deposits” and “term deposits”. Against the former, the bank will have to keep aside a 100% reserve, for property has not been transferred. The latter will be a loan to the bank, earning interest, which the banker can lend out, provided he returns it at the end of the stipulated time. Without any “lender of last resort”, every bank depositor will be secure. This is actually ancient commercial law.

When paper money is a “property title without property”, and “legal tender” forces its exchange in markets for real goods and services, nothing is exchanged for something. When these propertyless notes multiply, while the real goods and services do not, there is only redistribution in society, away from savers, away from fixed-income earners, in favour of borrowers—all perverse incentives that destroy the character of society and promote “decivilization”. Unsound money is terrible.

Any nation can unilaterally revert to the gold standard whenever it chooses. If we do so, our rupee, now pegged to gold, will always appreciate against the rest of the world’s fiat papers. This will help us become big importers. And cheap imports, including of capital goods and components, will make our manufactured exports competitive in terms of technology, quality and price. Our banks will attract the world’s savings, and we will possess capital, the vital ingredient of “capitalism”. All prices will steadily fall and the consumption of the poor will rise in leaps and bounds. This is the power of “sound money”.

Sauvik Chakraverti is an author and columnist.

He blogs at Comment at