Is there any such thing as the truth? If two people view an incident, chances are you’ll get two different versions of that one event. Truth is subjective…open to interpretation, recollection and prejudice. One person’s fact is another’s fiction.
We raise the topic because Ben Bernanke, Chairman of the US Federal Reserve, is back on the lecture circuit. He recently gave the first of four lectures to the poor kids of George Washington University, giving his version of how the Fed came into existence and what the Fed’s purpose is. He also gave his version about the gold standard. Is it a truthful recollection of events?
Before we try to answer that question – giving our own subjective version of the role of the gold standard – let’s take a quick look at the bond market.
Bond yields have jumped in recent weeks. When yields rise, prices fall. Many are now proclaiming an end to the great bond bull market, which got underway in the early 1980s.
Is this really the case? We think the bond bubble will eventually pop. But thinking it is happening now might be jumping the gun.
Check out the following chart of the US 10-year bond yield. In recent weeks, yields have jumped from around 2 per cent to 2.3 per cent. Yet in early 2011, the last time everyone was bullish on the prospects of the US and global economies, yields were nearing 3.75 per cent.
And a year earlier, when the ‘green shoots’ from the coordinated 2009 stimulus were, apparently, everywhere, yields hit 4 per cent.
Treasury yields are meant to reflect a country’s nominal economic growth potential. If you think the bond market is overvalued, you think the US economy is starting to recover and inflation will be an issue later this year and beyond.
With yields just over 2 per cent, the bond market is saying the US economy is not recovering and inflation won’t be a problem for the foreseeable future. The Fed’s latest QE experiment is due to expire in June. The prospect of more monetary stimulus in the lead up to an election is very slim. Despite the recent sell-off, it looks to us like the bond market is still betting on renewed economic weakness ahead.
The US bond market is much bigger and usually much smarter than the equity market. At the moment both have diametrically opposed views of US and global economic prospects. Who is right? We guess bonds.
Right, let’s get back to Bernanke and his interpretation of the gold standard. If you click on the link above, all the action starts around the 28-minute mark.
Bernanke wastes no time in cracking the standard joke favoured by gold ignoramuses. That is, a whole lot of resources are wasted in digging gold up from South Africa or somewhere and putting it into another hole in a New York vault. Boom-tish!
He also says a problem with the gold standard is that when economic activity heats up, the money supply increases and interest rates go down – ‘the reverse of what the central bank would normally do today’.
Bernanke needs to read Bastiat’s What is Seen and What is Unseen. Bernanke sees the cost of the gold standard, but doesn’t see the benefit. In this case, the benefit is having the market set the price of money, NOT central bankers. (So it’s hardly surprising he chooses not to see that.)
Under a gold standard, when economic activity heats up, gold migrates to the growing economy. Because gold is money under a gold standard, the money supply increases, which pushes the price of money (the interest rate) down.
Bernanke thinks this is a bad thing. It’s the opposite of what he’d do. That’s why the world is in such a mess.
But his thinking is completely wrong.
You see, Bernanke ignores the other side of the equation. If gold migrates to the growing economy, it is fleeing somewhere else. If gold pushes up the money supply and pushes the market rate of interest down in one country, it is contracting the money supply and forcing interest rates up in another country.
Bernanke does see the truth of the gold standard…that it is a natural balancing mechanism imposing constant discipline on countries. It helps establish a market rate of interest, which bestows no favours on any special interest group…be it bankers, farmers, consumers or savers.
When the money supply increases (as a result of gold inflows) it represents an increase in savings. When savings are abundant, of course interest rates should fall. This is to encourage the spending of those savings, or discourage further saving and investment.
On the other side of the coin, the country with gold outflows and higher interest rates experiences an economic contraction. The higher rates discourage excess consumption and encourage a rebuilding of savings and therefore investment.
When interest rates rise in a free market, it’s sending a signal that something is wrong. It’s saying there is a lack of real savings in the economy. Higher rates and an economic contraction is the market’s way of rebuilding savings, encouraging a new round of investment and innovation and setting the foundations for the next expansion.
Bernanke thinks he can promote constant expansion by fiddling with the money supply. His perpetually low rates discourage saving and investment. They encourage consumption. He’s doing precisely the opposite of what the market would do under a gold standard.
Is one person smarter than the collective wisdom of millions?
As Bernanke’s lecture continues, he discusses how the ‘gold standard’ caused a run on the Bank of England in 1931. Fellow Daily Reckoning editor Nick Hubble tells me George Washington University is one of the most expensive uni’s to go to in the world. Well, after listening to this bit – if we were a student – we’d ask for a refund.
There was a ‘run’ on the Bank of England because after WWI, England created a ‘gold-exchange standard’ to replace the old gold standard. This new system ensured that England could print money to prop up its ailing post-war economy. The system effectively made the pound ‘as good as gold’ and other nations accumulated pounds (instead of gold) for payment of goods.
The gold-exchange standard contained none of the discipline required by the traditional gold standard. It facilitated the boom of the late 1920s and when the bust came, countries holding too many pounds wanted to exchange them for gold.
Of course, the Bank of England didn’t have enough gold to make good on its promises so Britain went off the gold standard. And of course, Bernanke blames gold. He doesn’t even distinguish between the two types of gold standards…a crucial factor in any study of depression-era economics.
We suppose when an inanimate object can do your job, you may as well disparage it. That Bernanke does it so badly in front of a bunch of kids is a sad indictment on our financial and education systems.
Ignorance breeds ignorance.
for The Daily Reckoning Australia