By Nathan Lewis
The dollar-centric world currency system, which appeared after World War II, is likely to come to an end. This implies, of course, the emergence of a new system. Forward-thinking governments should be preparing for this eventuality. According to recent rumors, plans for new, gold-linked currencies are already being made.
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The post-WWII system, known as the Bretton Woods system, was also a gold-linked system. After the war, with Europe and Japan in ruins, the U.S. dollar was the sole remaining gold-linked currency of international stature. In time, other countries linked their currencies to the dollar, like planets revolving around a golden sun.
Good intentions alone are not enough to manage a currency. These new currency managers must be intimately familiar with the proper methods of maintaining a currency-gold link. Without this knowledge, their experiments are likely to end in tragedy.
We have seen that formal, mechanistic currency-board systems -- as are used by Hong Kong or Estonia -- work well. However, the informal, ad-hoc "currency pegs" used in the past by Thailand or Malaysia have blown up over and over. A gold-linked currency should operate like a "currency board with gold," with all the reliability and automatic functionality of currency boards today.
Currency boards work because they are based on a simple principle -- supply and demand. When the currency's value is a bit above its target, the currency board system automatically adds a little base money, which tends to depress the currency's value. When the currency is a bit below its value target, the automatic currency board system reduces the supply of base money, leading to a rise in currency value. This happens on a daily basis.
Notice that there is no central bank governing board. There are no interest rate targets, monetary aggregate targets, or CPI targets. There is no "monetary policy" at all.
One reason the dollar left gold in 1971 is that the Bretton Woods gold link was not a currency board-type system. It had more in common with the ad-hoc "currency pegs" that failed so spectacularly in 1997-1998. The Federal Reserve was fooling around with interest rate targets and economic manipulation just as it is today. This is directly contrary to the type of supply adjustments a currency board-type link would perform. Eventual failure of the gold link was inevitable.
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