In recent weeks, as prices have surged higher, "revived" inflation has become the topic du jour among establishment writers. Unfortunately, these writers point to the usual suspects, i.e. higher energy costs, higher interest rates, etc. In fact, the cause of inflation is the United States' abandonment of the gold standard.
The United States' abandonment of gold as the foundation of its monetary system came in two steps. In 1933, President Franklin Roosevelt ended Americans' right to surrender paper dollars for gold and even to own gold bullion. Step two came in 1971 when President Richard Nixon "closed the gold window" and denied foreign governments the right to turn in paper dollars for gold.
Roosevelt's move was a major step in shifting the world from the gold standard to the gold exchange standard. Under the gold standard, governments fixed the prices of their currencies in terms of a specified amount of gold and stood ready to convert their currencies into gold at the fixed prices.
Under the gold exchange standard, governments could hold U.S. dollars and British sterling as reserves because those currencies were "exchangeable for gold." The move to the gold exchange standard became official with the adoption of the 1944 Bretton Woods Agreement. When Nixon closed the gold window, those nations counting paper dollars as reserves found themselves holding paper instead of gold.
Although in 1974 President Gerald Ford signed legislation that permitted Americans again to own gold bullion, that legislation did not put the United States back on the gold standard.
Under the gold standard, a government is limited both legally and practically as to how much paper money it can print. As recently as the Lyndon Johnson administration, the U.S. could print paper dollars equal only to four times the value of the nation's gold reserves.
Under the gold standard, governments that print too much paper money risk runs on their gold reserves. Runs occur as holders of the paper seek to convert to gold before the vaults are empty. A run on the dollar is what happened in the late 1960s, which culminated in President Richard Nixon closing the gold window in 1971.
"Closing the gold window" is a euphemism for the U.S. defaulting on its promise to other countries to redeem dollars for gold. As an alternative, Nixon could have devalued the dollar and continued to redeem. In effect, he chose a one hundred percent devaluation, a de facto default on the promise to redeem.
In the 34 years before Nixon closed the gold window, the money supply in the U.S. grew less than two fold. In the 34 years after Nixon's action, the money supply expanded 13 fold. The Fed's massive inflation of the 1990s resulted in the greatest advance in stock market history. Continued inflation is now pushing housing prices to record levels. Automobiles now cost more than houses did only thirty years ago.
Despite establishment assertions that the dollar is "sound," investors should prepare for further declines in the value of the dollar and plan their investments accordingly. History shows that no government, after going on a fiat monetary system, ever reverses course until its paper currency is destroyed. There is no reason to believe this time will be any different.
May 28, 2005