The answer to Why? is: because gold-linked stable money is superior to manipulated funny money.

The answer to How? has two subsections. The first is: How to maintain a gold standard system? The second is: How to transition to a gold standard system?

The answer to “how to maintain a gold standard system” is to understand the process of supply adjustment. This is really not that difficult, but I can see that people have struggled with it for decades, with little apparent progress. A hundred years ago, people knew how to do this – at least the ones that needed to know knew — so it appears that this knowledge has been largely forgotten.

Obviously, you don’t want your gold standard system to blow up in your face – which is what would certainly happen if you left it to today’s typical central banker. The key to this is to begin, conceptually, with the simplest functional system, the “making change” system I have outlined in the past. This system is really too simple for many situations today, but if you can’t figure out the easiest example, how are you going to move on to the more complicated processes?

That now leaves us with the question: “how do we transition to a gold standard system?” This has happened many times historically. The United States transitioned from a devalued/floating currency to a gold standard in 1789 and 1879, and arguably, in a smaller way, in 1816, 1920, 1934 and 1951.

This is not something we haven’t done before. We’ve done this before.

Every other country has its own history of going on and off gold. It happens all the time. It’s not that mysterious.

I summarized this historical record as having three basic patterns. One is to return to some pre-devaluation parity. This is what the United States did after the Civil War and what Britain did after the Napoleonic Wars and the First World War. The second is to stabilize the currency around its prevailing value. This is what France did after the First World War, and what Japan did after World War II. The last is to introduce a whole new currency. This is, arguably, what the United States did in 1789, replacing the Continental Dollar, and what Germany did in 1923, with the rentenmark replacing the devalued paper mark.

Obviously, we aren’t going to return to a pre-devaluation parity today in the U.S. The last gold parity was at $35/oz., in 1971. We won’t return even to the $350/oz. average of the 1980s and 1990s.

Also, there is no need at this time to introduce a whole new currency. This is normally done after the prior currency was so abused that it is best consigned to the trash heap of history, along with the cruzeiros, pengos, and zaires.

This leaves us with some variant of the last option, to repeg the currency to gold at somewhere around prevailing rates.

Now let’s define that problem a little more clearly. What we are trying to do is find a parity value, a ratio between the currency and gold, also known as a “price of gold.” Since this is a number, there is really only the question of arriving at a number that is not too high and not too low, but instead “just right.”

It’s not something complicated, like Medicare reform. It is just one number.

If you pick a value that is very low for the currency (I will use the convention that “low” means a low value, not a low numeric figure), then you are in effect locking in or even exacerbating the devaluation of the currency. For example, if you choose a number of $5000/oz. of gold today, or in other words a dollar worth 1/5000th oz. of gold, that would mean about a threefold devaluation from today’s dollar value of about $1650/oz. of gold.

What is to be gained by devaluing the dollar by an additional factor of three? Not much. So, in general, there is no need to pick any value that is lower than the lowest value experienced thus far.

The other side is a little trickier. You could argue, today, that the general price structure reflects a dollar value of about $500/oz. or so. In other words, most prices haven’t yet adjusted much to the devaluation of the dollar over the past ten years. Certainly wages haven’t moved much. If you chose a parity value around $500/oz., that might mean you wouldn’t have to go through this upward price adjustment process, which is what most people mean by “inflation.”

That is theoretically true, but in practice, to go from $1650/oz. today to $500/oz. would mean increasing the dollar’s value by a factor of more than three, with rather dramatic consequences for the economy. I suppose you could manage some way to do this, involving big tax reforms, an extended adjustment period, and so forth, but I don’t see any advantage that is great enough to warrant all this heavy lifting.

This might seem theoretical, but it was a big deal in the early 1980s. The dollar’s value fell momentarily as low as $850/oz., and then stabilized in 1980 around $600/oz. (The twelve-month moving average reached a high of $612 in December 1980.) Then, the dollar rose to as high as $300/oz. in 1982, a big reason for the bitter recession that year.

Thus, although the dollar had been worth $35/oz. only ten years previous, $300/oz. was much too high a value in 1982. The dollar’s value had doubled from the 12-month average of $612 only eighteen months earlier. (That’s not a bad way to think of it: deviation from the 12-month moving average.)

A gold standard is supposed to be a good thing, not a thing that causes nasty recessions. People might start to blame you for that, just as Keynes blamed Britain’s difficulties in the 1920s on the decision to return to the prewar gold parity in 1925. This valid criticism undermined the legitimacy of the gold standard in Britain, leading then to the devaluation of 1931 and Britain’s abandonment of the monetary principles that made it the world financial leader in the 19th century.

In general, I think a 12-month moving average is probably not a bad place to begin thinking about an appropriate value. Maybe a three-month average would be better, in some situations. Maybe, especially after a very harsh period of currency decline, it it would be easiest just to take the values from the last week or so. In my book Gold: the Once and Future Money, I suggested a ten-year moving average. However, that reflected the time it was written, after two decades of stability around $350/oz.

Once we pick a number, then sometimes the issue comes up of a transition period, from the present floating system to the initiation of the gold standard system.

If your chosen parity value is 20% away from yesterday’s market value, then beginning a gold standard tomorrow might be problematic. The currency’s value would change 20% in one day. In practice, this would never happen, because the market would be expecting the start of the new system, but you get the basic idea.

One advantage of taking a figure near prevailing rates, or using a short-period moving average of three months or even one month (if you want to think of it in those terms), is that you don’t need any sort of transition period. A week or a month is plenty. If you choose a parity that is farther away, that could justify some longer transition period. Between the end of the Civil War in 1865 and the reinstatement of the gold standard in 1879 (at the prewar parity) was a fourteen-year transition period. That was maybe not such a good idea.

In Germany in 1923, the transition period was about one week. It was fine.

Maybe people would want a little time, for appearances’ sake, considering the truly monumental importance of the United States returning to a gold standard system after a four-decades-plus hiatus. But, in general, I think it is best to get it done quickly. No need to dawdle around for years in some sort of monetary limbo.

If a gold standard is a good idea – and it is – then it is a good idea now.

In practice, I think that the advantages gained from having a stable money system for a decade, which could be a time of tremendous economic expansion and improvement, outweigh whatever advantages might be had from some sort of prolonged transition period adjustment.

There is no perfect number. With whatever number you choose, someone could justifiably argue that it would be recessionary (too high a value) or inflationary (too low a value). However, it is not too hard to find a middling value that would balance these concerns, and enable a smooth transition to a new monetary system with no 1982-like recessions. Today, around $1600/oz. seems fine with me. (The 12-month average today is $1640/oz.) But, if you chose $1900/oz., that would be OK too. I don’t think I would go much beyond $1500/oz., although you could make an argument for $1300/oz. or so. If we were to go with $1300, I would want some sort of pro-growth policy like tax reform to counteract the recessionary effects of raising the currency value by that much. It’s possible to do it well, but it gets complicated, which is not such a good idea when dealing with democracies and governments.

For some reason, this process baffles people. They tend to dream up the most complicated, convoluted rationales and procedures for figuring these things out. Most of these excessively novel methods don’t even work; they produce silly conclusions. However, the end result is just a number, and you can get a reasonable, functional, usable number with about ten minutes of thinking about it.

Whatever system you use, it has to come up with a nice “goldilocks” number like this.

Some people suggest “letting the market figure it out.” What this is supposed to mean, I don’t know. The market can value things with fundamental characteristics. I manage a private investment partnership. I know how to value stocks, bonds, options, real estate and so forth. I can also weigh the odds and consequences of various political outcomes, Fed policy, the weather, the possibility of a major asteroid strike, and most anything else you can think of. However, a currency has no intrinsic value. Its value depends on the actions of its managers. If the managers say “we will leave it up to the market,” what does that mean? It means some period of uncertainly and possibly chaos. This seems like a silly way to find the “goldilocks number” parity value.

As a speculator, it suggests to me that the managers of this currency don’t know what they are doing, which then suggests that they don’t know how to maintain the gold standard properly, which then suggests that I should prepare for the system to blow up in their face not too long in the future. Others would come to the same conclusion.

I’ve suggested, in the past, that a committee be formed. Get ten reasonably knowledgeable people in a room, and ask them for a parity value suggestion. Each person will have their own idiosyncratic way of coming up with their number. Some will have an incredibly complicated multi-factor model of some sort. Others will just eyeball it. Some will choose a higher value, and some will choose a lower one. An arithmetic average of these suggestions, which is discussed and found to be acceptable to a majority of the people present, would probably be a pretty good number.

The committee has another advantage: the process itself provides political legitimacy for the number. We got ten good people together, we discussed it, and we came up with a solution. Thus, whatever the good or, in isolated cases, bad consequences of the parity decision, we know that we did the best that we could, and that everyone got their chance to say their piece.

By whatever process is chosen, just take a reasonable number, and then implement it without any long drawn-out intermediate process. It doesn’t have to be complicated.

Nathan Lewis

(This item originally appeared at http://www.newworldeconomics.com/archives/2012/051012.html on May 14, 2012.)