As was discussed in the last post, gold has served as a basis for currency for thousands of years, and up until 1971, it was explicitly used to back the US dollar. This meant that a $1 bill technically represented a promise by the treasury to pay the holder of the note a fixed amount of gold. Prior to the great depression, the US used a mix of gold and silver standards over the years, occasionally changing the exchange rate during times of crisis. During the great depression, the US temporarily left the gold standard by suspending convertibility in an attempt to turn the economy around. In fact, the year in which countries around the world left the gold standard, and the year in which they exited recession are closely correlated. An international agreement formed after the Great Depression which created the system known as “Bretton Woods” basically said that the treasury would offer convertibility of gold to governments and central banks at a rate of $35 per ounce. The basic idea that every dollar represented a fixed amount of gold in the treasury was restored. This system persisted until, in 1971, President Nixon abruptly ended the agreement and suspended convertibility into gold permanently. The reason President Nixon “closed the gold window” was simple, we were broke. In order to fund the war effort in Vietnam, the US was printing more dollars than there was gold in the treasury. The amount of gold the treasury owned relative to the number of dollars printed went from about 55% to 22% during 1970, meaning that if every dollar in existence was turned into the treasury in exchange for gold, only about 22% of the dollars would have gotten paid out. This spooked international investors and central banks around the world quickly moved to make the US live up to its “promise to pay”, requesting gold reserves in exchange for the dollars they were holding. Realizing we didn’t have enough gold to cover the debt, Nixon abruptly ended the fixed exchange rate system and stopped paying out gold. This event came to be known as the “Nixon Shock”, because the decision was made without consulting congress and without notification in order to avoid an all out raid of the treasury. While this was considered radical at the time, and did cause some temporary economic instability, it was a necessary move, and we have never looked back.
You will sometimes hear politicians (such as Ron Paul) advocate that the US return to a true gold standard. The theory behind this is that it prevents the government from printing more dollars that it can pay out in gold, thus fixing the money supply to the amount of gold in the treasury. They argue that in the current system, the government is allowed to steal value away from those who hold the currency by simply printing more of it. When that devaluation causes prices to rise, it is called inflation. A true gold standard, by definition, prevents inflation by limiting the amount of dollars that can be printed. It is also argued that a gold standard would prevent long term trade deficits and surpluses by automatically adjusting the money supply of the deficit or surplus country. Both of these things are true, except that these benefits come at a terrible cost, the total and utter collapse of the economy.
Price stability is essential for an economy because it promotes predictability. If the price of something you buy stays relatively stable over time, you don’t worry about exchanging your money for it. In contrast, if the price of something you buy is going up too quickly you will want to stockpile it, while if price is going down you would want to hold out on purchasing it. The problem with fixing the supply of money to any static amount of physical good is that the supply and demand of that good then affects the price of everything in the economy. This creates price uncertainty and thus dramatic swings in the economy, which is completely avoidable and unnecessary. For example, say that the entire supply of gold in a country made up of four people was $100. Let’s say everyone in the economy starts out with $25. The four people exchange their respective goods and services so that, at the end of a given year, everyone is back to having their original $25. Now, say the next year the farmer is able to produce twice as much food than he did the year before (this is called productivity growth). He goes to the market to sell twice the food, but the other 3 people only have the same amount of money as they did the year before, so they can only buy the same amount as the previous year. In order to sell all the food he produced, the farmer has to decrease the price of food because there is only so much money in the economy to buy it. Well, noticing that food prices are falling, one of the other people decides that he can hold out on his food purchase, and decides to wait until food prices are even lower. Instead, he stockpiles his money and doesn’t spend on anything. This compounds the problem, because now instead of $100 in the economy, there is effectively only $75. This leads to further price cuts, and eventually, everyone is unemployed because everyone else refuses to spend money (which is going up in value) on goods and services (which are going down in value). This is called a deflationary spiral, and is a simplified version of what was happening around the world during the Great Depression. A similar thing happens when a country begins a trade deficit with another country. The outflow of money from the nation in deficit shrinks the money supply of that country. Conversely, the money supply of the exporting nation grows. This creates deflation in the importing country and inflation in the exporting nation. When the domestic price of goods in the importing nation fall below the price paid for the imported goods, the deficit will naturally reverse itself. Though, as we’ve seen, this natural balancing comes at the cost of high unemployment in the importing country during the deflationary period.
The gold standard is an unnecessary relic. If an individual is worried about inflation of their currency, they are perfectly free to buy gold or other stable currencies on the open market. There is absolutely no need to base a sovereign currency on some artificial limit such as the amount of gold in existence. The gold standard has been replaced by a better system of floating exchange rates, where each country can adjust monetary policy to fit the needs of the time. The new system allows the necessary creation of new money to meet the demand caused by productivity growth. Admittedly, while the necessary powers granted to governments and central banks in the floating exchange are to foster growth, they can also be used to cause damage if wielded improperly. For this reason, it becomes increasingly important for the voting public to understand the mechanisms of the monetary system. These mechanisms will be the focus of coming posts.