Stable Money Is the Key to Recovery

The Wall Street Journal 14th November 2008

Stable Money Is the Key to Recovery

How the G-20 can rebuild the ‘capitalism of the future ’.

Tomorrow's "Summit on Financial Markets and the World Economy" in
Washington will have a stellar cast. Leaders of the Group of 20 industrialized
and emerging nations will be there, including Chinese President Hu Jintao,
Brazilian President Luiz Inacio Lula da Silva, King Abdullah of Saudi Arabia
and Russian President Dmitry Medvedev. French President Nicolas Sarkozy,
who initiated the whole affair, in order, as he put it, "to build together the
capitalism of the future," will be in attendance, along with the host, our own
President George W. Bush, and the chiefs of the World Bank, the
International Monetary Fund and the United Nations.

One thing is guaranteed: Most attendees will take the view that Wall Street
greed and inadequate regulatory oversight by U.S. authorities caused the
global financial crisis -- never mind that their own regulatory agencies missed
the boat and that their own governments eagerly bought up Fannie Mae and
Freddie Mac securities for the higher yield over Treasurys.

But whatever they agree to pursue, whether new transnational regulatory
authority or globally mandated limits on executive remuneration, would only
stultify prospects for economic recovery -- and completely miss the point.

At the bottom of the world financial crisis is international monetary disorder.
Ever since the post-World War II Bretton Woods system -- anchored by a
gold-convertible dollar -- ended in August 1971, the cause of free trade has
been compromised by sovereign monetary-policy indulgence.

Today, a soupy mix of currencies sloshes investment capital around the
world, channeling it into stagnant pools while productive endeavor is left high
and dry. Entrepreneurs in countries with overvalued currencies are unable to
attract the foreign investment that should logically flow in their direction, while
scam artists in countries with undervalued currencies lure global financial
resources into brackish puddles.

To speak of "overvalued" or "undervalued" currencies is to raise the question:
Why can't we just have money that works -- a meaningful unit of account to
provide accurate price signals to producers and consumers across the globe?

Consider this: The total outstanding notional amount of financial derivatives,
according to the Bank for International Settlements, is $684 trillion (as of June
2008) -- over 12 times the world's nominal gross domestic product.
Derivatives make it possible to place bets on future monetary policy or
exchange-rate movements. More than 66% of those financial derivatives are
interest-rate contracts: swaps, options or forward-rate agreements. Another
9% are foreign-exchange contracts.


In other words, some three-quarters of the massive derivatives market, which
has wreaked the most havoc across global financial markets, derives its
investment allure from the capricious monetary policies of central banks and
the chaotic movements of currencies.

In the absence of a rational monetary system, investment responds to the
perverse incentives of paper profits. Meanwhile, price signals in the global
marketplace are hopelessly distorted.

For his part, British Prime Minister Gordon Brown says his essential goal is "to
root out the irresponsible and often undisclosed lending at the heart of our
problems." But if anyone has demonstrated irresponsibility, it is not those who
chased misleading price signals in pursuit of false profits -- but rather global
authorities who have failed to provide an appropriate international monetary
system to serve the needs of honest entrepreneurs in an open world
economy.

When President Richard Nixon closed the gold window some 37 years ago, it
marked the end of a golden age of robust trade and unprecedented global
economic growth. The Bretton Woods system derived its strength from a
commitment by the U.S. to redeem dollars for gold on demand.

True, the right of convertibility at a pre-established rate was granted only to
foreign central banks, not to individual dollar holders; therein lies the
distinction between the Bretton Woods gold exchange system and a classical
gold standard. Under Bretton Woods, participating nations agreed to maintain
their own currencies at a fixed exchange rate relative to the dollar.

Since the value of the dollar was fixed to gold at $35 per ounce of gold -guaranteed
by the redemption privilege -- it was as if all currencies were
anchored to gold. It also meant all currencies were convertible into each other
at fixed rates.

Paul Volcker, former Fed chairman, was at Camp David with Nixon on that
fateful day, Aug. 15, when the system was ended. Mr. Volcker, serving as
Treasury undersecretary for monetary affairs at the time, had misgivings; and
he has since noted that the inflationary pressures which caused us to go off
the gold standard in the first place have only worsened. Moreover, he
suggests, floating rates undermine the fundamental tenets of comparative
advantage.

"What can an exchange rate really mean," he wrote in "Changing Fortunes"
(1992), "in terms of everything a textbook teaches about rational economic
decision making, when it changes by 30% or more in the space of 12 months
only to reverse itself? What kind of signals does that send about where a
businessman should intelligently invest his capital for long-term profitability?
In the grand scheme of economic life first described by Adam Smith, in which
nations like individuals should concentrate on the things they do best, how
can anyone decide which country produces what most efficiently when the


prices change so fast? The answer, to me, must be that such large swings are
a symptom of a system in disarray."

If we are to "build together the capitalism of the future," as Mr. Sarkozy puts it,
the world needs sound money. Does that mean going back to a gold
standard, or gold-based international monetary system? Perhaps so; it's hard
to imagine a more universally accepted standard of value.

Gold has occupied a primary place in the world's monetary history and
continues to be widely held as a reserve asset. The central banks of the G-20
nations hold two-thirds of official world gold reserves; include the gold
reserves of the International Monetary Fund, the European Central Bank and
the Bank for International Settlements, and the figure goes to nearly 80%,
representing about 15% of all the gold ever mined.

Ironically, it was French President Charles de Gaulle who best made the case
in the 1960s. Worried that the U.S. would be tempted to abuse its role as key
currency issuer by exporting domestic inflation, he called for the return to a
classical international gold standard. "Gold," he observed, "has no nationality."

Mr. Sarkozy might build on that legacy if he can look beyond the immediacy of
the crisis and work toward a future global economy based on monetary
integrity. This would indeed help to restore the values of democratic
capitalism. And Mr. Volcker, an influential adviser to President-elect Barack
Obama, could turn out to be a powerful ally in the pursuit of a new stable
monetary order.

Ms. Shelton, an economist, is author of "Money Meltdown: Restoring Order to
the Global Currency System" (Free Press, 1994).