Judy Shelton’s Op-Ed in the WSJ today echoes many of the same themes of my recent post, A New Bretton Woods. Like me, she sees the current crisis as being rooted in the monetary system (via WSJ):

At the bottom of the world financial crisis is international monetary disorder. Ever since the post-World War II Bretton Woods system — anchored by a gold-convertible dollar — ended in August 1971, the cause of free trade has been compromised by sovereign monetary-policy indulgence.

Today, a soupy mix of currencies sloshes investment capital around the world, channeling it into stagnant pools while productive endeavor is left high and dry. Entrepreneurs in countries with overvalued currencies are unable to attract the foreign investment that should logically flow in their direction, while scam artists in countries with undervalued currencies lure global financial resources into brackish puddles.

The point is that the current monetary system misallocates capital. As I did, Shelton connects the dots between the use of derivatives and a volatile currency system:

Consider this: The total outstanding notional amount of financial derivatives, according to the Bank for International Settlements, is $684 trillion (as of June 2008) — over 12 times the world’s nominal gross domestic product. Derivatives make it possible to place bets on future monetary policy or exchange-rate movements. More than 66% of those financial derivatives are interest-rate contracts: swaps, options or forward-rate agreements. Another 9% are foreign-exchange contracts.

In other words, some three-quarters of the massive derivatives market, which has wreaked the most havoc across global financial markets, derives its investment allure from the capricious monetary policies of central banks and the chaotic movements of currencies.

In the absence of a rational monetary system, investment responds to the perverse incentives of paper profits. Meanwhile, price signals in the global marketplace are hopelessly distorted.

Distorting the price signals of the market is what causes the malinvestment that Austrians spend so much time talking about. Again, that is obvious from the massive amount of capital that is being destroyed as housinng prices (and now other asset prices) fall.

Shelton also quotes Paul Volcker extensively:

“What can an exchange rate really mean,” he wrote in “Changing Fortunes” (1992), “in terms of everything a textbook teaches about rational economic decision making, when it changes by 30% or more in the space of 12 months only to reverse itself? What kind of signals does that send about where a businessman should intelligently invest his capital for long-term profitability? In the grand scheme of economic life first described by Adam Smith, in which nations like individuals should concentrate on the things they do best, how can anyone decide which country produces what most efficiently when the prices change so fast? The answer, to me, must be that such large swings are a symptom of a system in disarray.”

That is hopeful since Volcker is an advisor to President elect Obama. Let’s hope that Obama listens to him. Finally, Shelton provides the answer – gold:

Gold has occupied a primary place in the world’s monetary history and continues to be widely held as a reserve asset. The central banks of the G-20 nations hold two-thirds of official world gold reserves; include the gold reserves of the International Monetary Fund, the European Central Bank and the Bank for International Settlements, and the figure goes to nearly 80%, representing about 15% of all the gold ever mined.

Ironically, it was French President Charles de Gaulle who best made the case in the 1960s. Worried that the U.S. would be tempted to abuse its role as key currency issuer by exporting domestic inflation, he called for the return to a classical international gold standard. “Gold,” he observed, “has no nationality.”

I didn’t specifically mention a gold standard in “A New Bretton Woods” but I have endorsed a form of it in the past. It matters a great deal how a new gold standard is structured and I don’t know the best way to accomplish it. I suspect that Judy Shelton knows a lot more about it than I do; maybe Mr. Obama should have a discussion with her and Volcker.

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