Gold Standard Bullet Points

By Nov 19, 2012, 1:08 PM Author's Blog  

I was asked recently to provide a set of bullet points on the gold standard. What you see below is my first draft on the subject. It’s probably already too long for the purpose it is intended. So if you have any recommendations on what I should add, please let me also know what I should remove!

A Gold Stanard

∙  Under a gold standard, the government promises to exchange its money for gold at a set price. For example, through much of the 19th and early 20th centuries, the U.S. Treasury stood ready to redeem its dollar notes for gold at a set exchange rate of 20.67 dollar bills per ounce of gold. In other words, the price of one dollar was fixed to be worth roughly 1/20 ounces of gold.

∙  For a gold standard to combine the convenience of paper money with the security of gold, people must feel confident in the government’s willingness and ability to redeem paper at the specified exchange rate. One way to build confidence in the ability to meet its commitment is to acquire a reserve of gold, promising to meet all redemptions from its reserve. Under such a policy, the supply of paper money can be expected to move roughly in proportion to the government’s gold reserve. The practical significance of such a policy is to limit the government’s ability to finance its expenditures by printing money. That is, because new money can only be issued against a corresponding purchase of gold, no money is left over for other purposes.

∙  Apart from the effect of removing the “inflation tax” as a method of financing government spending, proponents of the gold standard like to stress the virtues of a “nominal anchor”– a force that keeps the price-level relatively stable over long periods of time. Under a gold standard, the price-level and its path over time (the rate of inflation) is determined by the time path of world gold supply and demand. Because gold is costly to produce, supply generally grows at a modest pace, the effect of which is to provide a check on inflation. Governments not on a gold standard may be tempted to grow their money supplies at a much more rapid pace. At various times in history, this has led to high inflation and even hyperinflation.

Potential costs of a gold standard

∙  In a world connected by international trade and finance, the price of gold is determined largely by world supply and demand conditions. While it may be easy to peg the U.S. dollar to gold, this in no way determines the domestic purchasing power of gold (inversely related to the domestic price-level). In the 19th Century, a world wide shortage of gold caused the U.S. price-level to fall, until major gold discoveries in Australia and the U.S. in the 1890s reversed the trend. Most of the world’s supply of gold today is generated outside the U.S. in countries like China, Australia, Russia and South Africa. Consequently, if the U.S. was to adopt a gold standard today, it would give other countries considerable scope to influence the purchasing power of the U.S. dollar.

∙  While history shows that a gold standard is not inconsistent with rapid economic development (e.g., the postbellum U.S.), it also shows that a gold standard does not render an economy immune from severe recessions (e.g., the postbellum U.S. and the Great Depression). Many economists believe that strict adherence to a gold standard transforms slowdowns in economic activity into full blown recessions. A large component of investment spending is financed with nominal debt–that is, debt obligations that are not indexed to the price-level. Any event that leads to a large and sudden decline in the price-level (e.g., an increase in the demand for gold as investors are drawn to seek a “safe haven” when investment prospects appear to dim) implies an increase in the real burden of the debt. In other words, in a deflation, debtors are forced to repay their nominal obligations with dollars that are suddenly more expensive to acquire. Firms with nominal wage obligations, for example, must satisfy these obligations even as their product prices declines. The result is an economic contraction, as individual and firms restrict their spending to satisfy their creditors. If wage obligations cannot be met, workers lose their jobs. If debt obligations cannot be met, individuals and firms declare bankruptcy–the effects of which continue to ripple through the economy.

The credibility of a gold standard

∙  A gold standard relies on the government’s promise to stand ready to redeem paper for gold at a fixed exchange rate. But promises often lose their currency–governments can manipulate a gold standard regime when they feel it is in their interest to do so. Governments frequently suspend the gold standard during periods of war, allowing war expenditures to be financed through an inflation tax. The United Kingdom, for example, suspended its gold standard for about 30 years during the Napoleonic Wars. The U.S. suspended its gold standard during the Civil War and imposed a gold embargo during World War I. Governments might also consider “one time” devaluations of their currency. For example, President Roosevelt devalued the U.S. dollar in 1933 by raising the dollar price of gold from $20.67 to $35 per ounce. He also issued an executive order requiring all Americans to turn in their gold coins and bullion. U.S. citizens were not legally permitted to own monetary gold again until the 1970s.

An alternative to a gold standard

∙  If the success of a gold standard relies more on the credibility of government promises, as opposed to the physical existence of a gold reserve, then why not design a monetary system that focusses on credibility, rather than gold per se? Many economists believe that it is possible to achieve the advantages of a gold standard while avoiding many of the disavantages by imposing a mandate on a central bank to achieve price-level stability (low and stable inflation) and by giving the central bank the political independence (hence, credibility) to carry out that mission. A commitment to long-run price stability can maintain the purchasing power of fiat money while avoiding the resource cost of acquiring and maintaining idle reserves of gold. At the same time, it leaves the central bank better equipped to respond aggressively to the deflationary effect of an increase in money demand characteristic of many financial crises.

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