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The Underground Gold Standard

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FOR SOME YEARS NOW the other side of the "falling Dollar" problem has been the problem of a "rising Euro" or "rising Pound" or even a "rising Brazilian Real".

   The exchange rate of the US Dollar has been falling in value against all other paper currencies, and this affects all kinds of business arrangements – thus getting lots of press attention.

   European tourists flood into Manhattan, for example, giving the locals an inferiority complex. But European exports also become less competitive against Dollar-denominated goods, giving the tourists good reason to spend their cash quick. Because we may now be nearing an end to this process.

   Non-US currencies – and non-Dollar-pegged currencies most especially – have risen against the Dollar to the point where European companies, for example, are feeling unfairly disadvantaged. Germany's trade surplus almost halved in December, and its manufacturing output has sharply slowed.

   And just where are all the domestic tourists?

   This "competitive disadvantage" is unpleasant at any time, but it is particularly unwelcome when there is a slowdown due to other reasons, like the property and financial bust which has become a worldwide phenomenon.

   So what can these foreign central banks do? They can actually kill two birds with one stone. They can handle the uncomfortably high currency, and the domestic softness, with what amounts to an "easy" monetary policy of their own.

   Thus, we see the Bank of England and Bank of Canada cutting their policy rates recently. The Bank of Japan is still stuck at a puny 0.5%, and while the European Central Bank has been speechifying about inflation recently, the pressure is on to do something about today's growth slowdown instead.

   Yes, the official CPI might be rising faster than they'd like – now at a 14-year record, and with the Eurozone money supply growing four times faster than the official annualized target – but it's not enough of a problem yet that anyone is willing to suffer higher interest rates or a further rise in the currency to do something about it.

   Besides, isn't inflation caused by China?

   Thus we come to the point where all currencies decline in value together, while the exchange rates between them remain relatively stable. Think of it sort of like today's one-dollar bill, ten-dollar bill, and the quarter. While they all decline in purchasing power together, their comparative values remain stable.

   This is what happened in the early 1970s. The world's currencies were pegged at fixed exchange rates to the Dollar back in those days, while the Dollar itself was pegged to gold at a rate of $35 per ounce.

   After the Dollar left gold in 1971, and its value declined, other countries' governments said: "Hey, wait a second! I'm not sure of what you're trying to do with this cheap-Dollar stuff, but we don't want any part of it."

   Sort of like the Middle Eastern Dollar-pegged currencies today, or the Chinese Yuan recently.

   So, in the spring of 1973, they all de-pegged from the Dollar. See ya later, greenback! And that was the beginning of the floating currency system we have today.

   Immediately after the de-pegging and then floating, the Dollar fell against all major currencies (and the minor ones, too). The Fed's Dollar index, which remains a useful gauge today, shows this drop.

   (This index, by the way, starts in 1973 because it was not necessary before then.)

   Then what happened? Governments of the time began to chew over the Dollar-led problems that emerged, and came to the same conclusion as governments today.

   Damn the inflation – we have to keep these foreign exchange rates under control!

   So the Dollar index stopped falling, for a while at least. And all in all during the 1970s, it only lost about 20% of its value as all world governments inflated together. During the great Dollar collapse of 1978-1979 – a collapse in terms of purchasing power – many foreign exchange rates were nearly unchanged.

   The Dollar actually fell in real terms by about 10:1 during that decade, at least according to the Gold Price. It took only $35 to buy an ounce of gold in 1970. In the 1980s and 1990s, it took more like $350.

   However, this decline became invisible to a lot of people, since the Dollar/Euro rate now affects almost everybody, but the Dollar/Gold rate directly affects almost nobody.

   It was no longer so obvious that inflation was being caused by a "falling Dollar". When it took more dollars to buy things, most people did not figure out that the Dollar – and the Deutschemark, Franc, Pound, and Yen – was simply losing value. On November 19, 1973, Newsweek magazine proclaimed on its cover that the world was "Running Out of Everything".

   Either that, or you could blame those horrible Arabs! It's true, there were some oil disruptions during the decade. Many people still blame these for the inflation of the time. None of these people has an explanation of why, years after the crises had passed, oil prices didn't fall back to their 1960s levels around $2.50 a barrel, however.

   A few people saw the way that currencies were losing value compared to Gold Bullion, the timeless standard of value. They understood instinctively where the inflation was coming from. The government economists, however, didn't see it that way. They couldn't quite figure it out, but they were pretty sure that they didn't want to add to the growing problems with a restrictive monetary policy.

   The Fed remained "accommodative" until finally the crisis reached a point where Paul Volcker gained a political mandate to do something about it. That something? Volcker chose sharply higher interest rates – a move that finally stemmed the Dollar's decline in terms of purchasing power and Gold Prices.

   If there is a difference between those times and today, it must certainly be the amazing deterioration of financial conditions around the world. This is matched by a consensus on what to do about it: central bank policy rates that are low, low, low. The big yield curve inversions of the 1970s aren't coming back right away. Barring some unexpected twist – the Chinese pegging the Yuan to gold for example – it looks likely that currencies will all go down together, as they did in the 1970s.

   The only place to hide would be in physical things: cattle, corn, steel, and eventually property.

   For the 1980 presidential elections, Ronald Reagan actually recorded a television advertisement that promised a return to the gold standard. Why? Because the departure from gold in 1971 had led to the first major inflationary episode in modern US history. So wasn't it obvious?

   The ad didn't run; Reagan was talked out of it. But soon, politicians will have another chance to re-think the Gold Standard.

   I think the next gold standard will appear in a place that nobody expects, like Moldova, Morocco or Vietnam. Home mortgages denominated in gold have already been available in Vietnam for some time, and apparently some shopkeepers there are already adjusting retail prices according to gold exchange rates, too.

   They are, in effect, already applying a sort of underground gold standard. Not everybody in this world is quite so benighted as our friends at the United States Federal Reserve.

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Formerly a chief economist providing advice to institutional investors, Nathan Lewis now runs a private investing partnership in New York state. Published in the Financial Times, Asian Wall Street Journal, Huffington Post, Daily Yomiuri, The Daily Reckoning, Pravda, Forbes magazine, and by Dow Jones Newswires, he is also the author – with Addison Wiggin – of Gold: The Once and Future Money (John Wiley & Sons, 2007), as well as the essays and thoughts at New World Economics.

See the full archive of Nathan Lewis articles.

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