Republican presidential longshot: Ditch Fed, go back to gold

By Simon Constable
TheStreet.com
Tuesday, June 19, 2007

http://www.thestreet.com/_tscrss/markets/commodities/10363490.html

Anyone planning a long career at the Federal Reserve better think again if Republican presidential hopeful U.S. Rep. Ron Paul makes it to the White House in 2008.

Paul, R-Texas, is so disgusted with the Fed and its role in failing to stem inflation that he wants to eliminate the entire institution, including its army of economics Ph.D.s and other money wizards.

In its place, he proposes returning to a system of money abandoned more than three decades ago, after slowly falling out of favor for much of the 20th century: the gold standard, or backing paper currency with bars of the precious metal.

"Once you have a central bank" like the Fed, "they can't resist the temptation to create excessive volumes of money," says Paul, a longshot for the GOP nomination who leapt into the limelight this year when he clashed in a debate with former New York City Mayor Rudy Giuliani over past U.S. foreign policy actions in the Middle East. "And the consequence" of printing money "is rising prices or inflation."

Axing the Fed and introducing a new monetary regime is Paul's answer to what he sees as unsustainable fiscal imbalances and inflationary pressures in the U.S. economy.

Because no personnel appointments at the Fed would satisfy him -- no matter how hawkish on inflation they might be -- he says it's just better to do away with the institution.

The new money system would involve competing private banks like American Express issuing their own paper money backed by gold bars, Paul said. Holders of paper currency could redeem the notes for gold at the issuing bank or exchange them for notes printed by different institutions.

The idea of the gold standard is neither new nor without merit. It had its heyday in the 19th century with Britain's Bank of England at the center of the world financial order. Under the system, each country's money supply expanded or contracted depending on how much gold its monetary authority held.

Because there is little or no flexibility to the arrangement, money can't be created at government's discretion, keeping inflation in check.

For all its merits, however, the system broke down around the advent of World War I. Repeated tries at keeping a gold standard were made, but each eventually failed, most recently in 1971 when President Richard Nixon made the decision to leave the system.

While the gold standard's inflexibility is often touted as a strength, others view it as a hindrance to economic growth.

"Under the traditional gold standard, you have fixed exchange rates and free mobility of capital, but you give up domestic monetary policy," says Robert Wright, professor of economic history at New York University's Stern School of Business. "That's why the 19th century is the heyday of the financial panic."

Or in other words, the absence of a central bank like the Fed would leave the government with few tools to stop a market crash turning into a real depression.

Another problem Wright points to is the phenomenon of falling nominal wages.

Many of the conflicts between labor and factory owners in the 1800s had more to do with adjusting workers' wages downward in line with the overall price level than they did with owner-inspired greed, as is popularly perceived, he says.

Even so, salary cuts are not something most Americans would readily accept today.

Another practical consideration is where to set the gold price. Set it too low, and the mining industry could start hurting. That's what happened last time when the price was set at $35 an ounce, explains Jeff Christian, managing director of New York-based specialty commodities firm CPM Group.

That may go a long way to explaining opposition to Paul's plan from a very unlikely source: the gold industry itself.

"I believe that a return to a gold standard for the U.S. is [neither] advisable nor practical," says Pierre Lassonde, chairman of the World Gold Council and former president of Newmont Mining. "The best way for people to protect themselves worldwide against inflation or deflation is by owning gold directly through a gold [exchange-traded fund]," such as streetTracks Gold Shares.

Although Lassonde doesn't elaborate, one other problem might be the lack of gold itself. If the $5 trillion of global central bank reserves was backed by the 1 billion ounces of gold they owned, then the price would end up at $5,000 an ounce, compared to around $650 an ounce today, explains CPM's Christian.

Christian adds that Paul's proposal also plays directly into the hands of those who believe in conspiracies -- especially if the mechanics of the system are left to private banks.

"If the government gave over the management of the currency to the banks, then the conspiracy theorists would have a field day," says Christian, as now they'd have "evidence" that the banks had the government in their pocket.

And even those who believe that the problems of a gold standard can be worked out say that the political realities of U.S. politics mean that only the brave or foolhardy would raise the issue.

Michael Darda, chief economist at MKM Partners in Greenwich, Conn., says Paul may have achieved the best he could hope for as a minor candidate: getting the topic of monetary policy into the wider debate.

"It's really too bad, but nobody is going to touch it," Darda laments. "There is a definite place for it in the monetary system."

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