Here's why you should stop wanting a gold standard (Part 3)

Part 3: Trade & Exchange rates

Trade. It makes the world go round. Canada has maple syrup, America has Hollywood movies. America exports one movie and imports a couple gallons of syrup and everyone is a little bit happier.

However, international trade isn't based on a barter system. When I create a product, and someone in another country wants to buy it, they need to give me cold, hard cash or they don't get my product. In fact, they need to give me cold, hard, green, 25% linen 75% cotton American cash if they want my stuff. I'm not accepting any of those monopoly money Canadian dollars; I can't use them at the corner store to buy my bread.

So what does the gold standard have anything to do with this? Let's head back to Bananastan to find out.

• Bananastan isn't the only country in our imaginary world. Right next store are two other nations called Yoyopia and Duckstein.

• Yoyopia and Duckstein are both industrialized nations who have factories that output products.
• Yoyopia produces yoyo's
• Duckstein produces rubber duckies
• There's lots of trade between all three countries. Bananastan imports yoyos and duckies from each respective country, and exports bananas to both countries. 

Now, remember how I wanted American dollars when someone from outside the US wants to buy my stuff? The citizens of these three countries are the same way. If someone in Bananastan wants to purchase a duckie, he or she needs to find some Ducky Dollars to pay the local producer with. The best way to do this is the same way we do it in the real world: take some Banana Bills (BB) to the bank and exchange them for Ducky Dollars (DD). Same goes for Yoyo Yen (YY).

Let's assume that our new world starts with everyone trading happily and equally. One banana is sold, one duckie is sold and one yoyo is sold every day. And because of the equality, it just so happens (in our imaginary world) that 1 Banana Bill = 1 Ducky Dollar = 1 Yoyo Yen, and I can go and trade these at the bank any time I want.

But what happens when demand changes? Let's say that there was a mass environmental movement in Bananastan to conserve water and everyone started taking short showers instead of long relaxing, candle-lit bubble baths. And since they aren't taking baths, they don't really need rubber duckies anymore. Well, demand just plummeted for duckies. 

And since the people of Bananastan no longer need duckies - and that's the only thing they buy from Duckstein - then they don't really need Ducky Dollars anymore. So demand for Ducky Dollars just plummeted too. But bananas are still in demand all over the world, so demand for Banana Bills is as high as ever. 

In both our imaginary world and the real world, this situation leads to a change in the exchange rate. Because less people want Ducky Dollars, the value of a Ducky Dollar might decrease to 0.50 Banana Bills per Ducky Dollar (or 2 Ducky Dollars per Banana Bill).

This is actually a really awesome mechanism. When the value of a local currency goes down, it makes their exports more attractive assuming wages don't adjust perfectly with the exchange rate (they never do). People in Bananastan used to pay 1 Banana Bill for a duckie, but now they can get it for 50 Banana Cents, and that might look like a pretty good deal. And the people in Yoyopia never adopted water conservation and they definitely want more duckies at the reduced price (why have one ducky when you can afford two?).

On the other side, people in Duckstein used to pay 1 Ducky Dollar for a banana, but now that price has risen to 2 DD because the bank only gives them 0.50 BB for their Ducky Dollar (1/0.5=2). This means that people in Duckstein will buy less bananas because they are too expensive... reducing demand for bananas... reducing demand for Banana Bills... lowering the value of banana bills... etc. until it all equilibrates at the "optimal" market price.

"AHHHHHH... So much going on!". OK, moving on. 

If you grasped that overcomplicated explanation, maybe you can see where I'm headed with this. If a gold standard existed in this imaginary world, it would break the dynamic exchange rate system. If all three countries pegged to gold and 1BB = 1DD = 1YY = 1 Ounce of Gold, then the exchange rate would never change because they all MUST equal one ounce of gold at any given point. If, for whatever reason, demand for a country's exports fell, the currency would not be able to adjust and the currency would be overvalued.

Overvalued currencies lead to countries importing more stuff than they can reliably sustain over a long period of time. If my country isn't productive, but I keep importing stuff, that is called running a current account deficit. China is doing the opposite of this, keeping their currency artificially low so that their exports look more attractive to the outside world (while keeping imports are abnormally expensive for the in the local market).

If I am buying stuff and not producing stuff, I must be paying for my new imports somehow. Well the US has been running a current account deficit for 40 years. How do they do it? Debt! The longer a currency is overvalued, the more debt will build in the country until something gives.

So the exchange rate system allows the natural mechanisms of markets to work efficiently. Countries that mismanage their production get a hit to the value of their currency and countries that do a good job of growing production are "rewarded" with a higher value currency with which they can buy more things. Gold standards break the system.