Without Stable Currency Values, There Is No Trust

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by John Tamny,  Toreador Research and Trading (Guest Contributor)

Imagine being contacted by a real estate agent about a 5,000-square-foot house, only to show up and find a home half the size. Off the bat, the prospective purchaser would have very little trust.

Of course the above scenario is purely hypothetical given that a foot is a foot. Since its definition is unchanging, 5,000 square feet means the same today as it did 20 years ago. Whatever the level of trust home buyers have in their real estate agents, square footage will never be a factor; that is, unless the length of the foot is allowed to "float," and its length declines. Suddenly, 5,000 square feet could very well mean 2,500 square feet in "real terms," and trust in real estate agents will plummet.

Sadly, this is the case with the world's currencies. Debased currencies without definition are what the world has suffered since August of 1971, when President Richard Nixon severed the dollar's link to gold. No longer defined in terms of the most stable commodity on earth, the dollar has been left to fluctuate without a golden anchor, its value changing minute by minute, hour by hour, and day by day.

Most problematically for savers and investors, the dollar's value since 1971 has collapsed. While a dollar bought 1/35th of an ounce of gold back then, today it purchases roughly 1/1200th.

Is it any wonder then that today, particularly since the dollar's value has fallen from 1/250th of an ounce of gold since 2001, that trust among Americans in our government has declined? At its core the dollar is a concept of value issued by our federal government, but Washington has let it collapse, and in the process the savings and wages of most Americans have been eviscerated.

How about trust between borrowers and lenders? When creditors loan us money, they hope to get the principle back, along with interest payments compensating them for delaying their own consumption. But when money loses value, the lender is paid back cheapened dollars, and no surprise at all, trust between both parties weakens.

This should be remembered during a period like the present in which banks are reluctant to lend. With our government systematically devaluing money in concert with interest rate meddling that doesn't compensate them for offering up savings, their trust is necessarily low, and money tight.

In his Tract On Monetary Reform, John Maynard Keynes observed that "If the fall in the value of money discourages investment, it also discredits enterprise." Sadly, though not surprisingly, we've seen both during periods of monetary debasement since 1971.

In the 1970s and the decade just passed, the dollar went into freefall as evidenced by the rising gold price, and investment dried up. Those with exposure to the S&P 500 in the '70s experienced flat returns (negative if we factor in the dollar's decline), and during the most recent decade they lost money. Investment is about trust, but if investors feel the dollars they're committing to company growth will be devalued, they necessarily go on strike.

Considering the reputation of enterprise more broadly, when the dollar declined in the early '70s, all commodities priced in dollars, including oil, spiked. And returning to Keynes's point about enterprise being discredited, oil executives were regularly brought before Congress in the '70s to be grilled about nosebleed oil prices that they did not control. Much the same occurred in the most recent decade when oil went skyward thanks to a dollar cascading downward.

Many decry the proliferation of derivatives, but the simple truth is that if they didn't exist, a floating dollar means we would have to invent them. In what is effectively a dollarized world, as long as the money measure fluctuates in value, producers will have to hedge the price of everything given how little they can trust any commodity to hold its price over long periods. For those who doubt the floating dollar's substantial role here, they need only ask why futures trading was so quiet prior to 1971, not to mention why the price of oil was flat right up to 1971.

International trade is the wealth-enhancing process whereby individuals the world over engage in their economic specialties, and exchange the fruits of their labor for the goods that others specialize in. To put it in simple terms, the baker exchanges his bread for the vintner's wine, and money facilitates the transaction.

But with the world's currencies nothing if not volatile, international trade in particular has been reduced to a legal form of gambling. No one can trust the currency they're getting in return for the goods they sell. Is it any surprise then what Stanford economist Ronald McKinnon has long noted, that ever since the introduction of floating currencies in 1971, formerly harmonious trading relationships between countries have become increasingly antagonistic?

With trade, individuals are exchanging products for products with money as the lubricant. But with currencies constantly rising and falling against each other, cross border transactions today invariably involve winners and losers, as opposed to two individuals exchanging surplus goods of specific value for something else they desire of similar value. Floating money values retard that trust, and give rise to protectionist impulses that always end in tears.

The answer to all of this is simple, however, and it involves returning to fixed exchange rates with money defined in terms of gold. Absent such a policy change, we'll still get by and even thrive at times, but we'll do so in a world of declining levels of trust, which unstable money fosters.

About John Tamny:
Mr. Tamny is a senior economic advisor to Toreador Research & Trading, columnist for Forbes and editor of RealClearMarkets.com. Mr. Tamny frequently writes about the securities markets, along with tax, trade and monetary policy issues that impact those markets for a variety of publications including the Wall Street Journal, National Review and the Washington Times. He’s also a frequent guest on CNBC’s Kudlow & Co. along with the Fox Business Channel.