Wednesday, October 19, 2011

Economic Basics: Gold as a Stabilizer

Over the years I've found that economists (typically those with a PhD) tend to complicate the basics of economy to the point of absurdity and incoherence. In this entry I'll touch on a simple idea: "How Gold Remedies Trade Imbalances."

The market is a complex system that functions based on simple underlying principles. With that said, a complex system can be built using simple concepts. In contrast, corruption of the underlying principles ultimately results in an unstable and imbalanced system. Though many would have you believe that economy is primarily about consumption, this is incorrect and does not lead to long-term prosperity. Consumption can only occur with sufficient production. When consumption overwhelms production, it inevitably leads to imbalances.

As an example, it is well known that the United States carries a large trade deficit with China, meaning, the US is a net consumer of Chinese goods. The US benefits by acquiring cheap products and China benefits by creating low-paying jobs at home. This has resulted in many manufacturing and production jobs being located overseas. Some will attribute this to a myriad of policies on both the Chinese and US side, but when it comes down to it, it's rooted in the monetary system. For example, if the US dollar was backed by gold the deficit would naturally arbitrage itself away. Instead of holding US dollars the Chinese would begin to redeem gold from the Federal Reserve. This would reduce the amount of gold backing the dollar, ultimately devaluing the currency. The devaluation would reduce the cost of US labor and goods, increasing the competitiveness of US exports. Of course, devaluation of the dollar is not a good thing, but it would force trade to balance before it got out of hand. 

This is a quick example of how sound money naturally stabilizes trade relations. Without sound money the deficits are allowed to grow without consequence until they reach disastrous proportions. Currency manipulation mounts, jobs transfer to the lowest bidder, and trade wars begin.