James Poulos has a piece at Forbes speculating on the relationship between an asset’s complexity and financial bubbles and panics. If the value of an underlying asset is not tangible, he argues, then it is”capable of denominating value that had been wildly abstracted and exaggerated from the value’s underlying assets”.  These would be things like derivatives and other complex financial instruments. He contrasts this to a mortgage whose value comes from land and an underlying structure, which are clear and tangible assets. This may be a true enough on the margin; the more complex the relationship is between a piece of paper and the underlying source of cash flow from which it derives value, it is probably more susceptible to a bubble. However, good old fashioned highly tangible assets are quite capable of experiencing massive bubbles.

Take, for example, the tangible example James provides of a house.  You can point to the various complex financial instruments which provided funding for housing markets as the area of complexity and problem in the market. But the fact housing is a tangible asset that you can walk up to, poke at, and even stroll around in, and in the end home buyers themselves had come to believe that their values were much more than they in fact turned out to be. Despite the very tangibleness of the asset, beliefs about their values were completely inflated even by those who understood them as well as they could be understood. And in any case, the causality of this most recent housing bubble aside, there have been many housing and land bubbles before this, and in times that predated complex financial instruments only a quant can understand. Complexity and lack of clear tangible assets may makes bubbles easier, but it is far from a necessary condition.

He is also appears to be floating the idea that currencies not being pegged to some underlying asset leads to bubbles as well. Here again I would point to history, by the end of the 1920s most countries had returned to the gold standard after abandoning convertibility during WWI. Then during the onset of the Great Depression, which the gold standard did not prevent, those who exited the gold standard fastest recovered the quickest. It is hard to understand given this history how one might suppose a currency pegged to a tangible asset is going to prevent financial crisis. Aside from all the reasons why a gold standard is a bad idea and won’t prevent financial panics, as James Hamilton points out, the peg is only as good as the government’s promise:

A gold standard only works when everybody believes in the overall fiscal and monetary responsibility of the major world governments and the relative price of gold is fairly stable. And yet a lack of such faith was the precise reason the world returned to gold in the late 1920’s and the reason many argue for a return to gold today. Saying you’re on a gold standard does not suddenly make you credible. But it does set you up for some ferocious problems if people still doubt whether you’ve set your house in order.

I can understand why in times like these when governments seem so inept it is tempting to think that tying ourselves to something like gold that appears sound can provide discipline, safety, and stability. But a government cannot buy credibility by promising to crucify their nation’s economy on a cross of gold.

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