Myth: The gold standard is a better monetary system.
Fact: The gold standard causes deflation and depressions.
Summary
The far right advocates the gold standard because it gets
government out of the business of controlling the money supply.
They fear that printing money creates inflation, and retracting
money causes recessions. But the opposite is also true: printing
money cures recessions, and retracting it cures inflation. Governments
in the last 60 years have used these policies with tremendous
success. There has not been a single depression or bank panic
in any nation anywhere in the world using Keynesian monetary policies.
But during the Gilded Age of the late 19th and early
20th centuries, depressions and bank panics were common.
The historical record is so strong that mainstream economists
reject the gold standard almost universally.
Argument
Once the subject of heated national debate over 100 years
ago, the gold standard today has nearly disappeared as a political
issue. The world has abandoned the gold standard in favor of so-called
"paper money," and only a diminishing group on the far
right continues to call for its return. However, if mainstream
economists (on both the left and the right) have anything
to say about it, there will never be a return to "that barbarous
relic," as John Maynard Keynes called gold over 60 years
ago.
Even so, defenders of the gold standard include such former presidential
candidates as Jack Kemp and Stephen Forbes. Furthermore, the rise
of well-funded, right-wing think tanks in the last few decades
has managed to resurrect the issue. Therefore, reviewing the arguments
of the "gold bugs" -- as they are irreverently known
in academia -- is well worthwhile, if only to screen our presidential
candidates for obsolete economic ideas.
The reason why the far right opposes the current money system
is because it allows the government to control the size of the
money supply. They argue that an unscrupulous government might
pay its bills by printing more money, which would cause inflation.
They also argue that shrinking the money supply allows the government
to create recessions. Under a gold standard, the total value of
money would be fixed (or nearly so), and the market would adjust
itself efficiently around it. In his book, The Theory of Money
and Credit, Ludwig von Mises wrote: "The excellence of
the gold standard is to be seen in the fact that it renders the
determination of the monetary unit's purchasing power independent
of the policies of governments and political parties."
Mainstream economists, however, have a powerful counter-argument.
The current system might, in theory, allow an unscrupulous government
to create inflation or unemployment, but it also allows the government
to fight inflation and unemployment. And that is a tremendous
achievement, because not one nation around the world using Keynesian
monetary policy has experienced a depression in the last six decades.
It appears that we eliminated depressions when we eliminated the
gold standard.
It hasn't been for lack of opportunities. In 1987, the U.S. stock
market crashed, in a "meltdown" that was even worse
than the Crash of 1929. But the Federal Reserve had learned its
lessons from the Great Depression, and this time it responded
correctly: with a sharp expansion of the money supply. And not
only was there no depression, but there was no recession either
-- in fact, the remarkable economic boom of the 80s continued without
even a bump. Under a gold standard, the Fed would have been robbed
of this anti-recessionary weapon.
Of course, the gold bugs have developed a set of apologetics for
arguments like these. To put everything in perspective, it is
helpful to trace the evolution of the monetary system, from its
very beginnings to the rise and fall of the gold standard. The
reason for starting at the beginning is twofold: even the basics
are disputed by people who believe themselves informed on the
issue, and many lay persons might not know them anyway. So, with
apologies, let's start with the invention of money.
The history of monetary systems
The first economic activity was undoubtedly bartering. Two
people would make a direct exchange: say, food for furs. However,
bartering is a most inefficient trading system. If the person
with furs wanted food, but the person with food wanted wood carvings,
they would have to search for a third party with wood carvings before
they could make their trade. And the third party may not want
either of their tradeables, requiring a search for a fourth party
-- as you can see, the process quickly becomes unworkable.
The invention of money solved this problem. As a medium of exchange,
money allows people to conduct multi-person bartering without
all the effort of searching for a hundred people before making
the transaction that everyone wants. True, a hundred people may
indeed be involved in the final transaction -- but no thought
or planning has to go into it, because money, by some miracle
of economics, eliminates such a need. In short, money is a tool
that allows for easy and painless multi-person bartering. In and
of itself it has little or no intrinsic value.
But the invention of money presented a problem of what should
be used for it. Suppose that a common resource like stones was
used for money. The problem is that tradeable goods are limited
-- it may take all day to hunt game or weave a rug. When you put
your final product on the market, buyers will compete for it,
because, after all, everyone desires to hoard wealth. The first
buyer may pick a rock off the ground and offer it to you, whereupon
a second buyer will pick up two rocks and better the offer.
Soon a bidding war erupts, with buyers picking up rocks as fast
they can. In the end you might receive an entire rock quarry for
your marketed good. This example highlights two absurdities. First,
this is the essence of inflation. When there is too much money
available, prices soar, and tons of money are needed to buy things.
Second, it is a waste of human and natural resources to dig up
so much money -- people might as well devote all this effort to
producing the actual goods.
So early money had to be made out of something rare. Silver and
gold met this requirement, although some societies used other
rare materials, like conch shells among African tribes. However,
money that is too rare has the opposite effect described
above. Suppose that a village is using gold for money, but unfortunately
there is only one gold nugget. Whoever possesses that nugget will
be able to buy literally anything in the village -- but only once.
After surrendering the nugget for an item, that person will then
have to turn around and offer literally anything to get it back.
Because the village has numerous people waiting in line to use
the nugget for money, economic activity will slow down to a crawl,
unemployment will rise, and the result is a recession. This example
highlights another principle: money needs to be divisible. The
village's economic activity would be doubled just by cutting the
gold nugget in half. Of course, dividing money is the same thing as
expanding the money supply.
So the amount of money has to be optimal -- not too much, but
not too little, to support the natural amount of trading that
goes on. As you can see, this calls for some knowledge of the
amount of economic activity that normally occurs. An economist
would need to measure this activity, and calculate how many coins
would cover this activity without causing either inflation or
unemployment. One of the practical ways to do this is to watch
the economic indicators: when inflation starts rising, cut back
on the money supply; when unemployment starts rising, expand the
money supply. This approach is called Keynesian monetary policy,
after the British economist who devised it, John Maynard Keynes.
But when the money supply is determined by some completely arbitrary
factor, like the amount of gold that happens to be in the hills,
then the odds that the money supply will match the amount needed
are virtually zero.
An insufficient money supply is not the only thing that can cause a
recession. Recessions commonly occur when people start hoarding money.
In normal economies, there is a circular flow of money, as my spending
becomes part of your earnings, and your spending becomes part of my
earnings. But for some reason, you may see tight times ahead, and
decide to save your money to get through them. But this only makes
things worse on me, because I am depending on your spending. So
I respond to tight times by hoarding my money also. The result is a drop
in economic activity, rising unemployment, and recession. Keynesian
monetary policy calls for expanding the money supply, which puts more
money in the hands of consumers, restores their confidence, and
encourages them to begin spending again.
Gold bugs argue that we don't need to adjust the size of the money
supply to match the level of economic activity -- the value of
money will automatically adjust itself to the level of
economic activity. Here's how it works. Suppose three people live
in a village, and they have 100 gold coins among them. And suppose
this covers 100 units of work. A loaf of bread may require five
units of work, and therefore cost five gold coins. Now suppose
that their economy grows to 120 units of work. There are two ways
for the money supply to adjust to this new activity. The villagers
could simply add 20 more coins to their money supply, so they
now have 120 coins. Or they could let the value of the coins increase.
How would that work? Well, suppose the extra 20 units of work
is being produced by just one of the three villagers. Obviously,
he is eager to sell his product, just as the other two are eager
to buy it. But no one can afford the sale, because there is insufficient
money. So they artificially "create" money by lowering
their prices for all their other goods, to increase their savings
so they can buy it. For example, a loaf of bread still requires five
units of work, but they may lower its price from five to four
gold coins. The extra gold coin can now be used towards the purchase
of the new product. This process is called deflation.
Prices do indeed inflate and deflate in this way. The problem
is that this process is terribly inefficient. In real economies,
prices tend to be "sticky" -- that is, enormously resistant
to change. (At least in a downward direction. In an upward direction,
they climb easily. This is good if you want to fight inflation,
bad if you want to fight unemployment and recessions.)
There are several reasons for price stickiness. One is psychological
-- people hate to cut their prices and wages. Another is that
salaries and wages are often locked into contracts, the average
of which is three years. And for many, raising prices incurs certain
costs (reprinting, recalculating, reprogramming, etc., not to
mention a dip in business) that may not make the price change
seem worth it. Even if they do decide to change prices, it takes
many companies quite some time to put them into effect. Sears,
for example, has to reprint and remail all its catalogues. But
perhaps the most important reason is that in a big and complex
economy, people just don't realize at first when goods start becoming
excessive on the market, and the glut may have to reach severe
proportions before people notice it and take action.
Price stickiness means that the value of money is slow to adapt
to changing economic conditions. Economists have found it much
faster and simpler just to expand the money supply and cut the
recession short. The Great Depression, for example, dragged on
for ten years, with the natural deflation of money proceeding
at a glacial pace. It wasn't until World War II that the government
was forced to conduct a massive monetary expansion (to fund its
defense spending). The result was such explosive economic growth
that the U.S. economy doubled in size between 1940 and 1945, the
fastest period of growth in U.S. history. Another example is
Japan in the 1990s. Its economy has stagnated for five years now,
and many economists have criticized its government for not doing
enough to expand the money supply. But whatever the solution,
the important point is that Japan's government has done very little, and
its economy has not deflated or adjusted itself -- Japan's economic
pain continues five years later.
But let's return now to our history of money. Historians debate
the exact sequence and nature of events that led to our current
monetary system, but the following fictionalized account is often
retold and widely accepted as reasonable.
Suppose that an economy starts by using gold coins. There are
disadvantages to circulating gold: large purchases require lugging
around lots of the heavy metal, and a family might be worried
about protecting its gold reserves from thieves. So people may
decide to store their gold in a secure, centralized location:
perhaps the goldsmith, who already protects his store of gold
in a large safe. The goldsmith accepts their gold, and, to keep
a record of who owns what, writes them a receipt for their deposit.
So the goldsmith has now become a banker.
When the people have spent their pocket change and need to draw
on their gold reserves for more, they can visit the bank and make
a withdrawal. But that wastes a lot of time and effort. Instead,
people can just buy their goods with their receipts for gold,
rather than the gold itself. The seller then becomes the new owner
of the receipt, and the share of gold it represents, and he can
visit the bank and trade the receipt for gold any time he wants.
Of course, he may want to use the receipt himself in another sale.
In this way, people start circulating receipts for money, and
paper money is born.
The banker soon decides to facilitate this system, by issuing
receipts that say, "This bank will pay the bearer of this
note 10 gold units upon demand." Now the receipts have become
banknotes, and the bank has become a bank of issue.
The banknotes, like the gold coins they represent, are called
commodity money, because they are based on commodities
like gold or silver.
But under the new system, the banker notices that people are visiting
his bank much less frequently. His gold stocks are just sitting
around. So he gets a bright idea: he'll print up some new banknotes
and issue them as loans. The new banknotes are not backed up by
actual gold reserves, but he can get away with this because only
a percentage of the note-bearers come in on a given day asking
for their gold. It's profitable for him, because he collects interest
on the loans, and it's profitable for the people, because they
can increase their productivity. So from now on the bank will
issue banknotes on a fractional reserve, and the bank itself
will become a trust, because people must now trust that
the banker will have the gold reserves to cover their withdrawals.
And the banknotes are no longer called commodity money, but
fiduciary money, after the Latin word fide, meaning
trust.
Of course, if too many people come in at once demanding their
gold, the banker is out of luck. Experience may teach him that
he needs to keep a reserve ratio of 1 gold unit to 3 banknotes.
Any more banknotes and he might not be able to cover withdrawals.
Still, this is a somewhat risky business, because it creates the
possibility of a bank run or bank panic. That happens
when people become afraid that a bank may not be in sound condition,
and they start withdrawing their gold to protect themselves. Once
this process starts, however, it becomes a vicious circle, as
disappearing reserves create yet more panic and more customers
running to the bank to be the first to withdraw their gold. The
result is a bank failure, leaving most of the customers holding
worthless banknotes. These sort of bank panics have the effect
of reducing the money supply, which can -- and often did -- result
in higher unemployment, recession and even depression.
Fiduciary money was widespread in Europe by the early 19th
century. During the Napoleonic wars, however, Britain found itself
hard-pressed to fund its war effort. So the Bank of England temporarily
scrapped the fiduciary system and issued fiat money instead
-- money whose value was determined not by gold, but by the command,
or fiat, of the government. After the war, England returned to
a fiduciary gold system, although people were not allowed to cash
in their notes for gold unless it was for very large amounts,
usually for international trade.
Temporarily suspending the gold standard in favor of fiat money
during times of war became common over the next century. During
the American Civil War, the government interrupted its policy
of gold convertibility and issued nonconvertible "greenbacks"
instead. During World War I, all belligerent nations did much
the same. It is interesting to note that during times of war,
when a nation's survival is on the line and it must boost productivity,
the economic policies its leaders resort to are always liberal
ones. Fiat money, tax hikes and Keynesian monetary expansions
result in booming economies, hence the truism that "war is
good for the economy." It took economists and politicians
over a century to learn that these policies could be applied during
times of peace as well.
In 1821, Britain became the first nation to switch to a full gold
standard. Until then, nations had used a bimetallic regime of
gold and silver. In the 1870s, the U.S. and the rest of Europe
followed suit, after the discoveries of huge gold deposits in
the American West. From then until 1914, the world would operate
under a unified gold standard. This era is known as the Gilded
Age, and it offers us a chance to assess the advantages and disadvantages
of the gold standard, or at least an early version of it.
Bitter controversy over the gold standard was a hallmark of the
Gilded Age. It was widely regarded as a tool of the rich. Democratic
presidential candidate William Jennings Bryan spoke for the poor
when he charged, famously, that "You shall not crucify mankind
upon a cross of gold." The U.S. suffered three depressions
during the Gilded Age, and the gold standard and its bank panics
were often held to blame.
Throughout this era, the value of gold was fixed at a certain
price. One U.S. dollar, for example, was defined as 23.22 grains
of pure gold. A British pound sterling was defined as 113.00 grains
of pure gold. This meant that the total value of a nation's money
supply was determined by the size of its gold reserves. Furthermore,
fixed rates meant that international exchange rates were also
fixed. In other words, the world operated under a single, unified
monetary system. One British pound always equaled 4.8665 U.S.
dollars (113.00/23.22), at least according to the official rate.
The actual rates might fluctuate, due to the shifting supply and
demand of international trade, but the nations set up a system
to make sure that they never fluctuated too far from the official
rate. This system was rather complex, but basically it kept exchange
rates stable and close to the official rate by making sure that
nations with trade deficits paid their bills quickly and directly
in gold. (1)
But there were economic consequences to such a system. Suppose
Britain ran up a trade deficit with the U.S., and promptly paid
in gold. The U.S. money supply would expand, and its economy would
experience a mixture of inflation and growth. Conversely, the
British money supply would shrink. Theoretically, this should
have resulted in deflation, but in practice it resulted in widespread
unemployment, due to price stickiness. Therefore, outflows of
gold from a country were often very painful to its economy. And
when people learned that gold was leaving the country, they
often conducted bank runs, trying to withdraw their gold before
it ran out. Thus, the Gilded Age was replete with bank panics
and failures.
The Gilded Age was brief, lasting from the 1870s to 1914, when
World War I broke out. During the war, nearly all nations either
placed restrictions on gold convertibility or issued non-convertible
paper money. But one of their top priorities after the war was
the recreation of the full gold standard. It took several years
before they succeeded. Britain restored its gold standard in 1925,
but in an act of folly, made the pound worth $4.86 again in U.S. dollars --
its old, pre-war parity. Unfortunately, the pound was
overvalued at this price now, due to changes in the price of gold,
and Britain subsequently experienced a drastic outflow of gold.
Again, severe unemployment was the result, not the expected deflation.
Britain would struggle with unemployment for the rest of the decade.
By 1928, all the major currencies and most of the minor ones had
returned to the gold standard. But the coming Great Depression
would lay bare all its disadvantages. A unified monetary system
meant that no nation could protect itself from a disaster that
occurred in another nation. When the depression struck in the
U.S., it quickly ricocheted across the Atlantic. In the U.S.,
two gigantic bank runs caused over 10,000 bank failures. So many
people were left holding worthless banknotes that the money supply
shrank by about a third -- a catastrophic reduction.
When Roosevelt took office in 1933, unemployment had soared to
nearly 25 percent. His inauguration took place literally in the
middle of a third bank panic. Roosevelt stopped it in its tracks
by doing something novel: he intervened. He declared a "banking
holiday" that closed banks to the public for eight days,
to prevent further withdrawals. During that time, the banking
system was reorganized. When banks finally reopened, banks deposits
actually exceeded bank withdrawals. It was a tremendous political
success for Roosevelt, and America's last bank run. Later under
the New Deal, bank deposits would become insured by the federal
government.
After the Great Depression struck, the world wasted little time
severing its ties to gold. Britain left the gold standard in 1931,
as did the U.S. in 1933. By 1937, not a single country remained
on the gold standard. After World War II, the U.S. partially restored
the gold standard for international trade. And to prevent citizens
from bank panics, it made its currency inconvertible at home.
In 1971, a diminishing gold supply and growing deficits caused
the U.S. to suspend the gold standard even for international trade.
Ever since, international trade has been based solely on the dollar
and other paper currencies. Today, there are no mainstream economists
who call for a return to the gold standard; it is widely regarded
as a fringe idea of the radical right.
Modern arguments on the gold standard
Gold bugs cite two reasons in particular for returning to
the gold standard. The first is that it prevents nations from
an irresponsible expansion in the money supply to pay its debts.
This is what happened to Argentina. After printing too much money
and suffering disastrous inflation, Argentina passed a law tying
its currency to the U.S. dollar. This may not be the optimal strategy
for Argentina, but it's far better than what it was doing. Likewise,
Italy has sought a measure of monetary responsibility by tying
its currency to the German mark. So the gold bugs do have a few
case histories to point to.
Even so, this reason is weak. Argentina did not need a gold standard
to tie its currency to a more responsible country and solve its
problems. Furthermore, a monetary policy that's right for one
country might be completely wrong for another. For example, in
the early 1990s, Europe tried to unify its currency by tying it
to the German mark. But subsequently the German economy boomed
while the rest of Europe became mired in double-digit unemployment.
And following Germany's anti-inflationary monetary policy only
made things worse, because it was exactly the opposite policy
they should have been following. Finally, many countries have
established long and sound reputations with fiat money -- Switzerland,
Japan and the U.S., for example.
The second reason cited for a gold standard is because it creates
certainty in international trade by providing a fixed pattern
of exchange rates. The current system contains a degree of uncertainty
-- in the last five years, the dollar has swung between 80 and
120 yen. This tends to make economic analysis and planning difficult
for international traders. The costs of such uncertainty are difficult
to determine, but they are expected to be significant. However,
trade comprises only 10 percent of the U.S. economy, and compared
to the enormous benefits of fiat money, these costs are minuscule
by comparison.
What are the benefits of the current system? The most important
has already been mentioned: the elimination of depressions. Being
able to expand the money supply in times of unemployment and recession
is a critical tool for government. Before World War II, eight
U.S. recessions worsened into depressions (as happened in 1807,
1837, 1873, 1882, 1893, 1920, 1933, and 1937). Since World War
II, under Keynesian monetary policies, there have been nine recessions
(1945-46, 1949, 1954, 1956, 1960-61, 1970, 1973-75, 1980-83, 1990-92
), and not one has turned into a depression. In fact, no nation
in the world has suffered a depression under Keynesian policies.
The current monetary system also gives us protection from less
scrupulous or unfortunate countries. A bank run that starts in
Europe is not going to end up in America, thanks to the flexibility
and autonomy of the Federal Reserve Board.
And fiat money also gives economists a chance to tie the appropriate
size of the money supply to what's actually happening in the economy.
In the end, the amount of gold a nation has is completely irrelevant
to its level of economic activity. Gold is a commodity that experiences
price swings. A change in dentistry or electronics is enough to
change the entire market. To see how unrelated it is, consider
the following trends. Since the U.S. dropped the gold standard
in 1971, the price of gold has risen tenfold. But consumer prices
have risen only two and a half times. If the U.S. had instituted
a full gold standard in 1971, the result would have been the worst
deflation since the Great Depression. And considering that widespread
unemployment is usually the result, not deflation, it is easy
to see the why such a policy would increase the risk of a depression.
Gold bugs also face an enormously challenging question: what kind
of gold standard would they like to create? One based on fractional
reserves? But that led to countless bank runs. Furthermore, as
a practical matter, it doesn't stop banks or governments from
changing the money supply, simply by changing the amount of fiduciary
notes.
So the only purist alternative is a return to commodity money,
where a bill is backed 100 percent by gold. But there is no longer
enough gold in the modern world to cover the needed economic activity.
We have already mined all the major deposits, and without new
discoveries to match the growing economy, a pure gold standard
would see a troublesome fall in commodity prices. Even worse,
industry is also increasing its demand on the gold store. In past
centuries gold had very little secondary use, so it proved useful
as money. Today, modern technology has found a growing number
of applications, and industry is consuming more and more of it.
In response to all this, a monetary authority could periodically
reduce the amount of gold defined as the dollar, but this is no
different from the floating, fiat money that the gold bugs so
bitterly criticize.
So the gold bugs would have to resolve historical
and theoretical challenges of King-Midas proportions before they could
ever reinstate the gold standard. But if a workable gold standard
requires a tremendous amount of design, effort, regulation and
safeguards, we might as well use fiat money, which is already
simple and enjoys a successful track record.
Related Essay: Austrian School of Economics
Return to Overview
Endnotes:
1. The method of paying trade deficits during the Gilded Age
worked something like this. Suppose Britain bought more products
from the U.S. than vice-versa. Britain therefore owed the U.S.
money; it had a trade deficit. Obviously, the British needed to
pay the Americans in their own currency, dollars. So the British
demand for dollars rose, and this drove up the price of the dollar
on the foreign exchange market. The British could have simply
paid the higher price, but they also had a second option by international
agreement. They could convert their British pounds into gold,
ship it to America, and then sell the gold for dollars at the
higher American price. This saved them money only when the deficit
became large enough to justify the cost of a trans-Atlantic shipment
of gold. This cost threshold was known as the "gold point,"
and it ensured that the actual exchange rate did not fluctuate
too far from the official exchange rate. In short, this system
meant that Britain paid its deficit quickly and directly in gold.