What Would a Return to the Gold Standard Mean for You?

I thought the Gold Standard was abandoned by the US way back in 1971, you are probably thinking. Be that as it may, the time for its return may be long overdue. The decline of the Dollar over the last decade indicates that investors are rapidly losing confidence in the currency. At the very least, the twin deficits (referring to trade and government spending) have caused global investors to reconsider what they think the Dollar is worth. By no coincidence, the price of Gold, which typically moves inversely to the Dollar, has exploded, recently touching a 25-year high. Related securities, like gold ETFs and futures, have followed suit.

In this article, the pros and cons, as well as the likelihood and feasibility, of returning to the gold standard will be set aside. Suffice it to say, the process of re-instituting the gold standard would be complex and difficult, and perhaps economically painful. In addition, while it is a deeply partisan issue, it is not currently under consideration by either major political party. However, the continued deterioration of global capital markets in the wake of the credit crisis, as well as the continued decline in the USD, could put the idea back on the table. Already, it is a cornerstone of Presidential candidate Ron Paul’s economic policy platform, and has been endorsed by such venerable economists as Alan Greenspan. Nevertheless, the focus below will be limited to the implications of a gold standard, in the event that it is implemented.

I should point out that there are many different forms that a gold standard could assume. Unfortunately, the precise mechanics of said gold standard also fall outside the scope of our discussion. For the sake of simplicity, the analysis will be based on a gold standard in which all paper currency is theoretically backed by gold.

  1. Macroeconomic Stability: One of the chief arguments for a return to the gold standard is its theoretical link to price stability. Skeptics are probably wondering why price stability should be an economic priority, since inflation has remained low for over a decade now. Advocates of the gold standard would retort that this decade was largely an aberration in modern economic history, and the low rate of inflation was largely a product of globalization, rather than sound monetary policy. In the end, goes the old adage, "you can’t fool the markets." Inflation is surging, and not just in the US. Well the factors underlying this bout of inflation are nuanced, it can be closely connected to an erosion of confidence surrounding the Dollar, which have driven natural resource exporters and food producers to raise their prices in Dollar terms, merely so that they remain constant in local currency terms. Since inflation is ultimately a product of changes in the supply/demand of money, a return to the gold standard should alleviate inflation by limiting the government’s ability to print money. Governments would only be able to print money in proportion to their gold reserves. Thus, prices for certain goods and services would fluctuate only in accordance with supply and demand, rather than in response to monetary policy. "Under a gold standard, price changes due to such shifts in the quantity of money would be relatively minor and easy to anticipate, and the purchasing power per unit of gold would be more stable than under an unpredictable paper currency standard." It should be noted however, that a Central Bank must choose between managing either the currency (prices) or the economy. Think of the predicaments facing countries that currently peg their currencies to the Dollar, namely China. Such countries are often forced to keep interest rates unnaturally low, in order to prevent upward pressure on their currencies. The inevitable result of this kind of policy is inflation. Similarly, it has been argued that the gold standard contributed to the Great Depression, as Central Banks were constrained in their ability to expand the money supply in order to raise demand and employment.
  2. Change in the Structure of Government: Those who favor the gold standard for political reasons often argue that such would force governments to balance their budgets. Under the current fiat money system, in contrast, a government can essentially spend as much as it wishes, knowing that it can simply borrow its shortfall. In this way, governments are able to avoid raising taxes directly. Congressman Ron Paul observes wryly: "Printing money to pay the bills was a lot more popular than taxing or restraining unnecessary spending." Instead, citizens are taxed indirectly, in the form of inflation. Under a gold standard, governments could not print money to cover a budgetary shortfall. Furthermore, since an across-the board tax increase in such a situation would amount to political suicide, it would probably be cajoled into cutting spending. This view is corroborated by former Federal Reserve Chairman Alan Greenspan: "With unlimited dollar conversion into gold, the ability to issue dollar claims would be severely limited. Obviously if you cannot finance federal deficits, you cannot create them." The structure of the government would also change. First, the $300 Billion+ of interest that the Federal government pays on its national debt would be reduced and eventually eliminated, creating opportunities to shift spending in other areas. Second, spending on defense and military would shrink. To quote Congressman Paul again, "Since printing paper money is nothing short of counterfeiting, the issuer of the international currency must always be the country with the military might to guarantee control over the system." In other words, the US is forced to pursue an aggressive foreign policy in order to protect the Dollar. In turn, the strong Dollar further enables the military by underwriting its expenses. Says Paul, "Ironically, dollar superiority depends on our strong military, and our strong military depends on the dollar." Thus, a return to the gold standard would undermine some of the raison d’etre of the military, not to mention make it more difficult for it to finance large scale operations.
  3. Increase in Gold Prices: It has been estimated that "only" 142,000 tons of gold have been mined in the history of the world. Based on prevailing prices, this translates into approximately $4 Trillion, not nearly enough to cover all paper currency in circulation. Thus, a return to the gold standard would necessitate a drastic increase in the price of gold. Does this mean that you should invest your savings in GLD? Probably not, since it’s unclear exactly how a conversion of paper currency to gold would take place.
  4. Relative Impact: If only a handful of nations adopted a uniform gold standard, it could prove comparatively difficult to maintain. Under a gold standard "Countries seeing downward market pressure on the values of their currencies are forced to contract their economies and raise unemployment." By analogy, think of the futility of Cuba’s quest to preserve some semblance of communism in a world where nearly every nation is unabashedly capitalist. If the US adopted a gold standard in isolation, for example, the US Dollar could become overvalued as a result of perennially low inflation, which would make it difficult for it to compete in the global economy.
  5. Shift in Balance of Power: This is essentially an extension of "He who has the gold makes the rules," whereby return to the gold standard could affect relations between gold producers and gold importers. Countries like South Africa and Australia would suddenly find themselves awash in cash, and would then become entrenched in the power struggles. Such countries could also effectively control global inflation levels by moderating the production and hence, supply, of gold. Again, it would depend on the precise mechanics of the gold standard, but prices could theoretically be influenced by geopolitics more than on economic fundamentals, much like oil is today. Speaking of which, the price of oil would probably decline upon the return of the gold standard. Currently, most of the world’s oil contracts are settled in US Dollars; accordingly, part of the fluctuation in the price of oil can be explained by fluctuations in the Dollar. The inherent stability implied by the gold standard, in contrast, would mitigate these adjustments, and the price of oil would presumably fluctuate in accordance with supply and demand.
  6. Increased Equity: This implication is largely political/philosophical, rather than economic. As described above, inflation represents an indirect tax on the citizenry. Moreover, since legislators don’t need require the explicit approval of their constituents when deficit spending, the tax is automatic and impossible to avoid. Under a gold standard, all levels of government would be able to spend only that which they own in gold, a method which is inherently more democratic than the current system. In addition, the fractional reserve banking system (that is made possible by fiat money) enables lenders (banks) to lend out a multiple of savings. Under a gold standard, such lenders would be able to lend the nominal amount of savings, thereby protecting savers from the inflation that results from an expansion of the money supply.
  7. No Financial Bubbles: Asset price bubbles represent one of the most pernicious (and recurring) byproducts of the fiat money system. "The new economy belong[s] to finance, insurance, and real estate—FIRE. FIRE is a credit-financed, asset-price-inflation machine organized around one tenet: that the value of one’s assets, which used to fluctuate in response to the business cycle and the financial markets, now goes in only one direction, up, with no more than occasional short-term reversals." In the last 10 years alone- to say nothing of the previous 100 years- the US witnessed two major asset bubbles, the first in technology, the second in real estate. Both bubbles were directly made possible by fractional reserve banking, as lenders are encouraged to conjure money out of nothing. Many of these borrowers are actually investors, producing nothing of substantive value, but rather purchasing "proxies" for value. In the case of the dot-com and real estate bubbles, the proxies refer to technology stocks and subprime mortgage debt, respectively. At the peak of the dot-com bubble, it was estimated that over $12 Trillion of completely fictitious value had been "created." As the real estate bubble is still deflating, it could be years before economists can accurately calculate the size of the bubble at its peak. Unless the monetary system- not to mention the financial culture- that produced these bubbles is reformed, it is inevitable that investors will rush to inflate a new one in the not-too-distant future. Perhaps in healthcare technology or alternative energy…
  8. Change in Economic Structure: According to Congressman Paul, "The artificial demand for our dollar, along with our military might, places us in the unique position to rule the world without productive work or savings, and without limits on consumer spending or deficits. The problem is, it can’t last." In other words, the perceived infallibility of the Dollar, combined with globalization, has enabled the United States to consume nearly $800 Billion more than it produces- every year! Over the last decade, factory work and increasingly, white collar-work, has been "outsourced" to countries with large pools of cheap labor. It is not necessarily the case that these countries’ supply chains and manufacturing processes are more advanced than those in the US. In fact, more often than not, the opposite is true. Rather, extreme confidence in the US Dollar makes it possible to pay overseas workers a small fraction of what comparable American workers require, due to exchange rates. As Congressman Paul further points out, "It is an unbelievable benefit to us to import valuable goods and export depreciating dollars. The exporting countries have become addicted to our purchases for their economic growth." Unfortunately, cracks are beginning to appear in this arrangement. It goes without saying that a return to the gold standard would force the US to balance its current account and reduce the gap between domestic production and consumption.
  9. No More Central Banks: This aspect of the gold standard is the most dependent on the precise type of gold standard that is adopted. In most cases, Central Banks (The Federal Reserve Bank, in practice) would face a drastically reduced role. They could no longer print money at will to assist governments that engage in deficit-spending. In addition, they could no longer indirectly print money by using monetary policy to expand the money supply. Interest rates would be determined by the markets, and would be a measure of risk, rather than manipulated by Central Banks in order to control the speed at which new money is created.
  10. Multiple Currencies: The elimination of Central Banks and the return to the gold standard would end the government’s de facto monopoly on the issuance of money. One economist notes: "Under a 100 percent gold standard…the various countries would have a common monetary system, just as the various states of the United States now have a common monetary system." Accordingly, investors and consumers would theoretically be free to mix and match currencies when engaging in commerce. Especially, if the gold standard was adopted universally, currencies would no longer compete with each other in terms of their ability to "store value." Rather, their function would be to serve as "mediums of exchange" and consumers could feel confident knowing that all currency is ultimately backed by gold, regardless of which specific "brand" of paper money in which they were dealing.

There seems to be a question of causation inherent in the return to the gold standard. Would it be precipitated by a recognition that the current system of deficit spending and "Dollar diplomacy" is probably unsustainable, or rather would it be adopted for political reasons, and then ultimately lead to a change in culture that produced the current system? In any event, the theoretical implications of such a return are manifest: increased governmental accountability, macroeconomic stability, and political freedom.