Should We Return to the Gold Standard or Is Paper Money as Good as Gold?

In honor of the Federal Reserve's100th anniversary on December 23rd, I am planning on dedicating the next few blog entries to the Federal Reserve and monetary policy.

A policy alternative that Republicans occasionally toy with, and one that is especially popular with those within the Austrian school of economics, is a return to the gold standard. A gold standard is a monetary system in which the economic unit of account is based on the quantity of gold. A gold standard is not about a standard of value. Under a true gold standard, the monetary unit is a specific weight of gold. Furthermore, any paper currency that does exist needs to be readily convertible into gold, and vice versa. Although some countries might have sizable gold reserves, there is not a single country that currently use the gold standard as the basis of its monetary policy. Were countries correct in changing out the gold standard for a fiat monetary system, or should there be a reestablishment of the gold standard?

In the United States, there was not a true gold standard for much of America's history, although gold did play a role in monetary policy prior to 1971. From 1792 to 1862, America was on a bimetallic standard, which was currency valued both in silver and gold. Once the Civil War broke out, the country was on fiat currency until 1879, after which the United States adopted a true gold standard. This didn't last because World War One had a deleterious effect on monetary systems, particularly that of Great Britain. By 1925, the gold bullion standard replaced the gold specie standard. The interwar gold standard would be in disarray until the end of the Second World War. After WWII, the Bretton Woods system dominated the scene. Under this post-war system, currencies were not pegged directly to the gold, but rather the US dollar. Even so, the currency would still retain its convertibility [into gold]. It was not a completely flexible monetary system, but it attempted to conserve the best aspects of gold and fiat monetary systems. The compromise system would not last. The strain of the Vietnam War pressured Nixon to close the "gold reserves window" in 1971, in which Nixon severed the last tie between gold and currency by declaring that dollars held by foreign countries could no longer be converted into gold. Ever since, the dollar became a fiat currency that has solely relied on the "full faith and credit" of the United States government. Although the history lesson might have been tedious, it is important to answering our question because we need to determine economic success before and after the implementation of a fiat system.

One of the primary complaints about a gold standard is that there is more price instability under a fiat system. There is some truth to this. An influx of supply (e.g., the California Gold Rush, 16th century Spain) or warfare (e.g., the Civil War) cause some high inflation levels. However, since the money supply can only grow at the rate at which the gold supply increases, hyperinflation is essentially impossible. That is why the inflation rate for fiat money is higher than that of commodity (Rolnick and Weber, 1997, p. 1317). Even the Bank of England (p. 7) recently found that there was higher inflation now than there was during the Gold Standard. The Bank of England also found a lower incident rate for banking and currency crises during the Gold Standard (p. 8). Historically speaking, gold prices were more stable before 1971 (see below). Although the gold standard has long-term price stability, its short-run price volatility is problematic (Bordo et al, 2003). Conversely, since the inception of central banks in the eighteenth century, there has not been a central bank that has had the pleasure of price stability for at least 30 years. That price stability also comes at the price of higher trade deficits.

An argument against the system is that the principle of "full faith and credit" means that the dollar has no backing [of commodities]. With the gold standard, at least currency was backed by gold reserves. Gold might be shiny, divisible, portable, and scarce, but the faith in gold is as much of a social construct as fiat money. The only reason why I deem this argument in favor of gold is because gold has a longer precedence than fiat money, which strengthens its reliability.

Under a gold standard, the value of the dollar would be determined by the markets. Under a fiat system, the supply of money is determined by political appointees in the Federal Open Market Committee. There is nothing to stop the Federal Reserve from printing more money, as can be seen in quantitative easing and the M1 money supply. Combined with the income tax, the government can now fund unprecedented amounts of government programming. Such expansion would not happen under a gold standard because new money could be printed only if there were a corresponding amount of gold. There is the issue of there not being enough gold, which is true with the current gold definition of the dollar. If gold were allowed to be a transactions demand instead of a speculative, then this would not be an issue.

Neither monetary system is perfect. Monetary systems were never meant to be perfect. They each have their tradeoffs. Do you want to eliminate short-term volatility for longer recessions? Do you want smaller deficits for greater autonomy for the Federal Reserve to have sovereignty when times get rough, at, which point they can attempt price stability?

Economists generally think the gold standard is a bad idea. I think the gold standard has lots of appeal. Even if we were serious about reverting back to the gold standard, we do not have the same economic conditions that allow for a gold standard to succeed. It would have been much easier to have maintained a gold standard than it is to return to a gold standard. How so? One, we are currently in a flexible exchange rate system. The transition would need to take place in a fixed exchange rate system, but virtually every major economy has a flexible exchange rate. For this to work, all major economies would need to be in agreement. Two, private citizens own gold. Three, there is no intrinsic connection between gold and standard of living. Finally, there is no link between the central bank's gold holdings and the money supply. A change to the gold standard would be more advantageous for those with larger gold reserves, as well as screw over countries that do not have as many reserves. A return to the gold standard would not be reflective of a country's wealth. Basing the currency on a basket of commodities would be more reflective, but gold, not so much.

For a gold standard to work, the transition back to a gold standard would have to be multilateral. The current macroeconomic conditions make the gold standard untenable. Like it or not, this country will not return to a true gold standard anytime soon. Perhaps there could be a return to convertibility, which would be nice because it would show that the dollar can be traded for more than just other forms of paper money. At this point, I think the best reform is to have the Fed create NGDP futures contracts. That way, monetary policy could automatically adjust the money supply while creating macroeconomic stability.