The Dangerous Idea of Going Back to Gold Standard

There has been a recent upswing in conservative articles discussing the idea of going back to some sort of gold standard.  I don’t think people realize how dangerous this idea is.  You can’t just “give it a shot” and see how it works out.  It’s like marrying the daughter of a Mafia chieftain–you need to be very sure you are willing to commit.

A true gold standard (not Bretton Woods) allows Americans to buy or sell gold.  If you are not 100% committed to staying on gold, but instead hint you might devalue the dollar at some point, people will dump dollars and buy gold.  The increase in demand for gold will raise its value, or purchasing power.  This is deflationary under a gold standard, where the nominal price of gold is fixed.

Nor is this merely a theoretical problem.  There were large bouts of private gold hoarding during four periods of the Great Depression, all associated with devaluation fears; the last half of 1931, spring 1932, February 1933, and late 1937.  All four were associated with economic distress, falling stock and commodity prices, etc.  And there is event studies-type evidence showing causation going from gold hoarding to deflation.

It’s not easy to know which price of gold would be appropriate.  Perhaps market gold prices would go to the right level after an “announcement” of a return to gold, but even that depends on the announcement being 100% credible.  But after you re-peg, the real value of gold can change due to industrial demand shifts, even if there is no monetary hoarding of gold.  Furthermore, all countries are not likely to follow the US back on gold, so you might have monetary gold hoarding in Europe, as people feared for the euro.  Booming Asia might increase the industrial demand for gold, just as it has raised the demand for many other metals.

And there is little room for error.  A 10% increase or decrease in the real value of gold seems very small when it is just a commodity.  But under a gold standard that sort of shift can be accommodated only by changing the overall price level by 10%.  A sudden 10% rise or fall in the price level is very destabilizing to the economy.

Even if the government is committed to gold, investors may fear the next government won’t be (remember FDR?)  In that case the promise to stay on gold may not be credible.  In the old days there was a powerful emotional attachment to gold, as paper money was feared as inevitably leading to hyperinflation.  Only then will voters be willing to suffer austerity to stay on gold.  A modern analogy is the long painful struggle of Argentina to stay on its currency board during the 1998-2001 deflation, attributable to a fear they would return to hyperinflation.  But we now know that fiat money can produce modest inflation rates, so our voters won’t undergo the pain of the mid-1890s, or early 1930s, just to stay on gold.  And if you aren’t willing to undergo that pain, the system won’t work.

Some supporters point to Bretton Woods, but that “worked” in direct proportion to the extent that the gold constraints were ignored.  Gold was highly overvalued after the 1933 devaluation, and then the US grabbed a huge share of the world’s gold in the run-up to WWII.  After the war those two factors gave us an unprecedented amount of slack, where we could mildly inflate until gold was no longer overvalued.  Once we reached that point in the late 1960s, the system immediately fell apart.  It would have collapsed even sooner if Americans had been allowed to own gold.  And if LBJ had tried to deflate to stay on gold, Americans (if allowed to) would have hoarded gold in the (correct) expectation that the next president would devalue the dollar, putting expediency ahead of principle.  That hoarding would have had the same effect as the hoarding of the early 1930s–deflation and depression.

HT:  Bruce Bartlett

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