One Gold Ring He Won't Grasp

Steve Forbes

Last month President Bush presided over a meeting of world leaders to come up with global solutions to the credit crisis. Not much was achieved beyond more pledges of closer cooperation in getting the global banking system functioning again. Maybe Bush's soon-to-be successor, Barack Obama, can reconvene this gathering early next year and make a simple but crucially important proposal: Resurrect - in modern garb - the essence of the Bretton Woods monetary system, which was conceived in 1944 at a meeting in Bretton Woods, N.H. with finance ministers and delegates from Allied nations. Bretton Woods fixed the dollar to gold, and other currencies were fixed to the dollar. Devaluations and revaluations were resisted and thus rare. There were no more floating currencies. No more beggar-thy-neighbor devaluations rampant erecting of trade barriers that so hideously pockmarked the purgatory of the 1930s. If a country's money got in trouble, immediate measures were taken. A new agency, the International Monetary Fund, was formed to make emergency short-term loans to allow governments to put their house in order without resorting to destabilizing devaluations.

The system worked. By today's standards currencies were indeed made remarkably stable. The occasional change in value was headline-worthy stuff. Trade blossomed. Europe and Japan made astonishingly swift recoveries from the rubble of World War II.

Unfortunately, the system was undermined in the late 1960s and destroyed altogether in the early 1970s. Why? Because of a misbegotten theory that stable exchange rates hurt economic growth. When a country's currency got into trouble, the government would raise interest rates to attract foreign exchange, which would in turn prop up the value of the currency. Higher rates dampened economic growth; this would reduce imports and thus help improve a country's trade balance. However, because of this, preserving currency stability came to be seen as something that curbed the economy.

Instead of fixing rates, revisionists asked, why not float them? A currency's value would change, and the government wouldn't have to throttle economic growth. Floating money would automatically adjust those pesky trade and capital imbalances.

Beguiling thoughts, but the theory was fatally flawed. It ignored why a currency got into trouble in the first place, which economic policymakers then and now haven't fully grasped: Its central bank was printing too much money. Austerity was not the cure for inflation. Less money-printing was - and is. A recession might result because of the investment and spending distortions inflation invariably introduces into an economy.

Britain, the "sick man" of Europe, was a classic example of this in the 1960s and 1970s. Crushing tax rates (the top income tax levy was 98%, the lowest 33%) and too powerful unions (whose destructive power was curbed by Prime Minister Margaret Thatcher in the 1980s) made Britain a chronic economic underachiever. London would stimulate the economy by repeatedly priming the monetary printing press. Economic growth would come - to be followed by the inevitable inflation. The pound would weaken, which would mean austerity measures and recession. This phenomenon came to be known as "stop-go."

The U.S. dollar was prey to periodic rounds of weakness. Politicians and even economists blamed this on all the money we spent on our overseas military, particularly the cost of stationing hundreds of thousands of our troops in Europe to deter the Soviet Union. In a foreshadowing of our recent hectoring of the Chinese, we badgered Germany and Japan about their deutsche mark and yen being "undervalued." Given such junk thinking, it's no surprise that in the early 1970s we severed the dollar's link to gold and churned out dollars as promiscuously as we would subprime mortgages decades later. Everyone else followed out bad example to varying degrees. The result was a decade of ever wilder inflation and economic chaos.

In the early 1980s the U.S. and other governments clamped down - money became tight. Inflation was curbed. But the tie to gold was not reforged. Thus, we've had periodic rounds of monetary instability. One example was 1997's Asian Contagion, which unnecessarily sent Pacific Rim countries into bone-crunching recession.

So here is what President-elect Obama should - but won't - propose early next year: that the U.S. tie the dollar to gold. But unlike under Bretton Woods or the traditional gold standard, countries wouldn't promise to pay out gold from their vaults when people turn in dollars, euros or whatever. Instead, the Fed would conduct monetary operations to keep the dollar within a gold-price range of, say, $500 to $550. We would invite other countries to follow suit.

The resulting global monetary stability would do wonders for getting the global financial markets working again, as well as for getting businesses to make capital expenditures and entrepreneurs to take risks in things other than commodities and currencies. But this won't happen. In economists' and central bankers' minds gold is a relic of a bygone era. Indeed, in their mistaken thinking, the yellow metal somehow caused - or at least prolonged - the Great Depression. But gold was, if anything, the victim of trade wars and onerous taxation. Yet the myth persists.

This credit crisis will subside, but, like the bubonic plague before rudimentary sanitation reduced the flea-hosting rats' breeding grounds, it will eventually flare up again.

Steve Forbes, President and CEO of Forbes and Editor-in-Chief of Forbes Magazine
Copyright 2008. All Rights Reserved.

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