Some conversations are never finished. Although the United States said adios to the gold standard in 1971, that doesn’t mean the debate died. In fact, it has new life this election season.
What’s all the fuss about? Way back when, the gold standard ruled. When gold is the standard, a country’s currency is convertible on demand to its face value of gold.
The gold standard establishes a ratio by which the federal government (in the case of the United States) would convert paper money into gold (coins, bars, or dust) or vice versa, explains Professor Jeff Born, PhD, of the D’Amore-McKim School of Business at Northeastern University. Where this conversion could take place would have to be part of the political process that re-establishes the relationship between paper money and gold. "For example, could an individual expect to be able to convert paper money into gold in any bank or regulated financial institution, or only at one of the 12 Federal Reserve Banks, or something in between?" asks Born.
In theory, the gold standard ratio establishes a link between the money supply and the amount of gold bullion owned by the federal government. Effectively, this means that changes in the country’s money supply would be driven by changes in the federal government’s gold holdings.
Born explains, "If gold was suddenly discovered on federal park lands in Massachusetts, the money supply could increase. This tight linkage means that monetary authorities could not print money without gold holdings. Many believe that this would make money supply driven inflation virtually impossible. In addition, some believe this would cement the role of the U.S. dollar as the reserve currency for the rest of the world."
Proponents of the gold standard typically contend that it creates "sound" fiscal policies, because it does not allow the government the opportunity to devalue the currency. Truth is, the translation is simple: some folks don’t like the power the Fed has. Decades ago, Joseph Salerno, an assistant professor of economics at Rutgers University, wrote in his paper, The Gold Standard: An Analysis of Some Recent Proposals, "the virtue of a genuine, 100-percent gold standard, is precisely that it establishes a free market in the supply of money, and in doing so, brings about a complete abolition of the governmental monopoly in this most sensitive and vital area of the market economy."
He said the complete "denationalization" of money, which occurs under a genuine gold standard, yields money whose value is fully secured against arbitrary political manipulation of its supply. The quantity of money and hence its value, is determined solely by market forces, such as the demands of the public for money and the costs associated with digging up gold. "While the purchasing power of a pure commodity money such as gold, like the price of any commodity on the free market, tends to fluctuate according to changes in its supply and demand, there exists an inherent long-run tendency to stability in the value of money," Salerno wrote. He concluded that government-monopolized fiat money (dollars) is inherently inflationary and subject to large, unpredictable fluctuations in value over both the short and long-terms.
However, the drawback of the gold standard, says Born, is that monetary authorities cannot print money to stimulate the economy during a recession without simultaneously increasing the amount of gold that is held by the federal government. "Gold discoveries tend to be ‘lumpy’ (lots of years with virtually no discoveries, combined with a small number of years with ‘large’ discoveries)," says Born.
This means that the money supply would follow the same hot/cold pattern, which could have direct (and unpleasant) impacts on economic activity, he adds.
Society has to spend real resources to dig up gold (to create paper money), only to store the gold in bank vaults awaiting the possibility that some individuals might want to convert their paper into the metal. Mining activity would be increased, diverting resources that might to other more productive activities, says Born, who adds, "Many people (including me), believe that these drawbacks are far worse than any benefits than the gold standard might provide. Politicians in favor of the gold standard don’t usually talk about its problems. For those that are naturally distrustful of authority/authorities, the gold standard provides a way to marginalize the Federal Reserve Board/System."