Tuesday, June 3, 2008

Explaining the Gold Standard

During the Republican primaries, Rep. Ron Paul talked at length about the need to return to the Gold Standard. Steve Forbes, former Republican Candidate for President and publisher of Forbes Magazine has mentioned recently his desire to return to the Gold Standard. What exactly is the Gold Standard and what are its advantages?

From what I have read, there are generally two definitions of a gold standard. Most people think of the gold standard being when the currency is backed by gold. That is, every dollar bill is effectively a voucher for gold. If you desired, you could go down to the Federal Reserve Bank nearest you and exchange your dollar for some amount of gold printed on the bill. This is the 100% reserve gold standard. Every dollar promises to be exchangeable for a certain amount of gold, and the government would have on hand, that amount of gold. This is the kind of gold standard supported by Ron Paul, although he supports this through privately printed currencies, which I will not go into now.

Another kind of gold standard is merely pegging the dollar to a certain price of gold. Currently the price of gold is around $880. If we pegged the dollar to $880/oz., the Federal Reserve would simply print or destroy dollars until the price of gold moved back towards the pegged price of $880/oz. If the price of gold went up to $900/oz. this would imply that there too many dollars out there. The Federal Reserve would print fewer dollars and start destroying older ones. If the price of gold went down to $860/oz. this would imply that there are too few dollars. At that point, the Fed would start printing dollars to move the price back up. Under a dollar pegged to gold, the government does not actually have to hold any gold.

The downside to the 100% reserve gold standard is holding the enormous amount of gold and trying to set the value of the dollar. There is an enormous amount of currency in the United States and we do not currently have enough gold to back all of it. The adjustment period between our current system and this system could be traumatic, as prices would swing significantly. However, under a dollar pegged to gold, this is not a problem. As long as the dollar is pegged at a price of gold near its current price, the transition should be a seamless one.

Why a Gold Standard?

Recently, the dollar has been losing an immense amount of value. A number of economists (but I would not say the majority) believe that most of the rise in the price of oil and other commodities is because of a weak dollar. When the dollar is weak, it buys fewer imported foreign goods. Most oil has to be imported, thus the rising price. The dollar loses value when the Federal Reserve increases our money supply faster than other countries. I feel that this likely explains about half of the rise in oil prices, but that is just a gut feeling.

The amount of gold in the world is slowly increasing, and no new massive supplies are expected to be found. Because the supply of gold is stable, pegging the value of the dollar to gold would generally lead to a stable supply of money. A stable supply of money would mean little inflation and less risk for investments. More certainty leads to a better allocation of resources and more economic growth.

A Gold Standard prevents the Federal Reserve from arbitrarily creating new money. Congress has given the Fed authority to fight inflation, maximize employment, and smooth out economic panics. It needs to be pointed out that the Fed only tries to do this, and often does not succeed. In my opinion, the Fed makes far too many mistakes, not out of incompetence, but from the impossibility of herding the financial behavior of 300 million Americans.

Historically, while the U.S. was under a Gold Standard, interest rates stayed low and long-term inflation was virtually non-existent. Some economists do not like a dollar peg for the sole reason that it limits the government’s ability to “fix” the economy. I find little proof that they are very adept at this.

I am still learning and reading on this topic, but I feel comfortable stating that I support pegging the dollar to a certain price of gold. In recent years, the Fed has caused a number of problems by trying to do too many things. Discipline and stability need to be reestablished, and a gold standard pegging the dollar to a certain price of gold would be a great help.


Unpretentious Diva said...

The price of gold can rise and fall, but you can’t print more gold to temporarily float an economy, at the cost of later, catastrophic inflation.
Gold backed currency is the most stable, most immune to inflation, and most representative of the actual value of an economy. The fiat system (described in all its horrible failure in the previous two posts) can never even begin to match the stability, honesty, and genius of the gold-backed currency system.

I have discussed Gold standard versus Fiat Money here Fiat Money Versus Gold Standard, Privatization of Currency!!

Brian Shelley said...

While a gold-backed currency system seems ideal and a relatively good case has been made by a number of Mises enthusiasts, I'm not sold on the pragmatic reality of what it would take.

Nathan Lewis had a good article a few days ago located here.