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Importance of the Gold Standard - US Economy: Deficits, Foreign Debt and Monetary Policy

Economics / Money Supply Dec 04, 2007 - 09:48 AM GMT

By: Gerard_Jackson

Economics Best Financial Markets Analysis ArticleIt seems that it was only yesterday that economic commentators were almost hysterical over the US economy's trade deficit. Added to that was the view that the country's growing foreign debt would bring the economy down. Now that the deficit is shrinking fewer people are drawing attention to it, though they still harp on about the foreign debt


While all this wailing was going on the optimists were assuring the public that there was nothing to worry about because the country was "borrowing to expand its productive capacity. As evidence of this view they pointed out that the US stock market had risen relative to the rest of the world, inferring that the rise is a reflection of increased investment.

They also correctly pointed out that the US had deficits throughout the nineteenth century. In fact, from the end of the War of Independence in 1784 right up to 1914 America was a debtor nation, running an annual deficit on its balance of trade until the 1870s 1 , even though she had built a tariff wall. (Protectionists invariably argue that tariffs will cure the alleged ills of trade deficits).

What the optimists missed is that the forces driving the country's foreign debt in the nineteenth century were of a different nature. In this case most of the debt was incurred by individuals who used it to import capital goods, mainly from Britain. In other words, American entrepreneurs used British savings to expand America's productive capacity. During this period thousands of these entrepreneurs repaid their British loans, others took out new loans while thousands more borrowed for the first time.

And this process went on decade after decade and each decade saw the American economy expand and living standards rise. Of course, some entrepreneurs failed. But the consequences of failure were shared between the American borrower and the British investor and not their respective governments.

It ought to be clear that the so-called debt problem is really a non-problem in the sense that what really matters is not debt but how it is acquired. Therefore, running a trade surplus is not necessarily a sign of economic health. Those who think otherwise have forgotten that during the depressed 1930s when tariffs were strongly defended and unemployment averaged 17 per cent America was still a creditor nation with a trade surplus.

What economic commentators overlook is that the gold was king during the nineteenth century, which meant that countries that deviated from the standard soon found themselves having to make the necessary monetary corrections. The importance of the gold standard lies in the fact that when the US borrowed from, for example, British investors it was borrowing real savings and not phony back deposits. That is to say, these saving actually consisted of deferred consumption in favour of greater consumption in the future thanks to an extended capital structure.

Once Keynes persuaded politicians to abandon gold, that "barbarous relic", as he called it, countries had to rely entirely on fiat money. This created unprecedented inflation on a global scale. It also generated bad deficits. These occur when central banks let loose with the money supply, usually through our old enemy credit expansion, the same process that triggers booms and inflates asset values. The older economists were fully aware of this process. As one economist put it:

In a free economy the principal cause of a cumulative deficit in a country's international payments is to be found in inflation. . . In a country whose currency is not convertible into gold, inflation leads to its continuous devaluation in terms of foreign currencies. (Michael A. Heilperin, International Monetary Economics , Longman?s, Green and Co., 1939, p. 123).

But there is another side to credit expansion and that is its effect on the trade balance. Monetary expansion inflates domestic spending which in turn raises the demand for imports. This demand continues to grow until the deficit reaches a point where the central bank sees it as another warning signal that monetary policy needs to be tightened. Now the central bank brings about credit expansion by forcing down interest rates. This eventually causes businesses expand their demand for loans for investment purposes. There is no reason that some of these loans should not be used to import capital goods.

These imports would be seen by the optimists as evidence that the deficit didn't matter because it was adding to the nation's productive capacity. As the Keynesians say, it merely shows that investment exceeded savings. This view only demonstrates that they are oblivious to the fact that investment in excess of savings is just another way of saying that the country is suffering from inflation. Therefore, what the optimists call evidence of a healthy demand for capital goods was really a symptom of an inflationary process.

Using the Austrian definition 2 of the money supply we find that from December 2000 to June 2004 annual monetary expansion averaged 7.5 per cent. The problem, therefore, was not foreign debt or trade deficits but a loose monetary policy, a policy that has laid down the foundations for another recession.

Even though monetary growth has slowed considerably we cannot ignore the distinct possibility that Bernanke will open up the Fed's monetary spigots. It's true that this could avert a recession, but only temporarily. Sooner or later real factors would make themselves felt. The question, therefore, is just how far is Bernanke is prepared to go. Bear in mind the fact that he is still strongly influenced by Keynesian dogma.

1. From the early 1870s interest and dividends payable to foreigners kept the current account more or less in balance. The capital account was also kept in balance by lending to foreigners offsetting foreign loans.

2. AMS: Currency outside Treasury, Federal Reserve Banks and the vaults of depository institutions.

Demand deposits at commercial banks and foreign-related institutions other than those due to depository institutions, the U.S. government and foreign banks and official institutions, less cash items in the process of collection and Federal Reserve float.

NOW (negotiable order of withdrawal) and ATS (automatic transfer service) balances at commercial banks, U.S. branches and agencies of foreign banks, and Edge Act corporations.

NOW balances at thrifts, credit union share draft balances, and demand deposits at thrifts. AMS definition therefore equals cash plus demand deposits with commercial banks and thrift institutions plus saving deposits plus government deposits with banks and the central bank.

By Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes' economics editor.

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