How Capitalism Will Save Us (66 page)

The Fed cannot prevent normal business cycles because they result from events that have nothing to do with the money supply—the economy’s natural process of creation and destruction. Some people, like Representative Ron Paul, who made a credible run for president in 2008, question whether we need a central bank in the first place. The Fed was established in 1913 to prevent crises like the banking panic of 1907 from happening again. Ironically, that upheaval was solved by the private sector without the help of government. Financier J. P. Morgan brought together his fellow bankers to shore up beleaguered banks and shutter those beyond saving.

The Federal Reserve’s prime function should be keeping the value of the dollar stable. A sound dollar would go a long way toward achieving the president’s goal of minimizing the kind of violent economic gyrations that we recently experienced.

W
hen governments allow the value of their currencies to fluctuate, it creates uncertainty and inhibits economic activity. Think about
it: how easy would it be for a carpenter to build a two-thousand-square-foot house if the number of inches in a foot shifted frequently—from twelve inches one day to six the next, to eight the day after, et cetera.

It’s as though an economist said:
If we change the size of a foot from twelve to fifteen inches, everyone will have a bigger house
. Really? In the Real World, you’ll likely end up with a lot of confusion and fewer homes being built. Similarly, with a fluctuating dollar, you get less long-term investment, more speculation, and misdirected capital.

Prices are supposed to signal to producers and consumers what is plentiful (cheap) and what is rare (expensive). If prices are constantly changing because of government actions, then markets can’t gauge—or respond to—the desires of consumers.

Economists and politicians complain that fixing the dollar to gold would mean that the Federal Reserve couldn’t play a role in guiding the economy. We agree. However, that’s a good thing. It should not be the Fed’s role to guide the economy. Aside from the upheavals caused by natural disasters, pandemics, or major wars, the most severe economic disruptions—on the level we’ve experienced recently—are invariably the result of government errors. In a healthy democratic capitalist economy, the market is guided not by government fiat but by
people
—their wants, needs, and innovations.

Thanks to the misdiagnoses of economists like John Maynard Keynes, gold has gotten a bad rap, largely based on the mistaken notion that it helped trigger the Great Depression. And it was blamed for unemployment and price deflation after Britain reestablished a gold standard in 1925. The precious metal was also said to have caused a series of downturns in the United States after the Civil War.

We’ve discussed at length, however, that the trigger for the Depression was the calamitous outcome of global trade wars ignited by the Smoot-Hawley Tariff. With economic conditions deteriorating, people and financial institutions around the world became fearful. They began to turn in paper currencies for gold just as they do during wartime, putting pressure on government supplies. Some countries, attempting to maintain the link to gold, raised interest rates to induce people to keep their cash in the bank and not redeem their currency. But this only worsened the economic crisis. The British government, fearing it would run out of the precious metal, went off the gold standard in August 1931. Other
countries followed. Gold was a victim of the Depression, not the cause. In the same way that a gold standard is suspended in a major war, it became impossible to maintain in the devastating global trade war that the United States unleashed in 1929–30.

What about the deflation that occurred after Britain returned to gold in the 1920s—and the misery that ensued after the United States went back to gold after the Civil War? Friedrich Hayek and his mentor, Ludwig von Mises, both pointed out that in each case, the mistake was incorrectly valuing currency in relation to gold.

In the case of the United States, we pegged the dollar to gold based on pre–Civil War price levels. But in the interim, the government had expanded the money supply to help pay for the war. When the value of the dollar was set according to preinflation prices, the result was a traumatic deflation.

Hayek wrote that Britain made a similar error in setting the pound-to-gold ratio after World War I. Prices by then had more than doubled. The British government should have reestablished the link at the new price level. Instead, the pound was relinked to gold at the pre–World War I level—the equivalent of $4.86 to the pound, instead of, say, $2.80. The drop in the money supply produced a severe recession, leading to a general nationwide strike. Millions of workers walked off their jobs. For over a week, economic activity came to a halt. The strikes were ultimately broken, but the anger and bitterness lingered.

Again, the wiser, less destructive course for the United States and Britain would have been to link the dollar and the pound to gold based on the existing postwar price levels. As the economist Ludwig von Mises pointed out, you don’t undo the bad of an inflation by a subsequent deflation. Just accept that there is a new price level because of a crisis.

The United States could successfully return to a gold standard as long as we don’t repeat those earlier mistakes. At this writing, the price of gold is around nine hundred dollars an ounce. The dollar-to-gold ratio when we last employed a gold standard in 1971 was thirty-five dollars an ounce. Pricing gold at that level today would produce a tsunamisized depression and a massive deflation, with prices dive-bombing to 1971 levels. Even pricing gold at what it was in the early 1990s and in 2003—when it was around three hundred and fifty dollars an ounce—would produce a disruptive economic contraction.

However, if we went to a gold standard at a realistic dollar price—and not what it was years or decades ago—we could avoid such an economic upheaval. Bottom line: we should go to gold but do it wisely.