The Myths About a Return to the Gold Standard

“…it is not necessary that paper money should be payable in specie to secure its value; it is only necessary that its quantity should be regulated according to the value of the metal which is declared to be the standard. If the standard were gold of a given weight and fineness, paper might be increased with every fall in the value of the gold, or, which is the same thing in its effects, with every rise in the price of goods.” – David Ricardo, Principles of Political Economy and Taxation

The financial crisis of the past year has predictably generated all manner of suggestions about how to fix the problems before us. And while most solutions have missed the point along the lines of treating a cancer patient with a pacemaker, there’s a small but growing call for a return to the monetary stability wrought by a gold standard.

The cries for gold are surely exciting given the basic truth that had the dollar been stable this decade, there’s simply no way we’d be in the financial mess we’re in today. When money values gyrate, mistakes with regard to investment and trade are magnified and economic corrections always reveal themselves. A dollar defined in gold terms would not erase all economic mistakes, but it’s a certainty that they would be reduced exponentially.

Unsurprisingly, calls for a return to monetary stability have generated not insignificant chatter about the problems inherent with a gold standard. Some have said gold is too unstable, some say a return would drive gold’s price up to nosebleed levels due to a lack of supply, and some actually suggest that floating currencies have actually enhanced worldwide trade.

On the stability front, it’s been argued that the unstable value of the dollar price of gold since 1971 points to an unstable measure not suitable for fostering currency stability. What the detractors miss is that when the gold price moves, this isn’t a signal that gold’s value is volatile; instead it’s a sign that the paper currency in which it is priced is changing in value. Simplified, when the gold price rises that’s a sign that the dollar is weakening; when gold falls that’s a signal that the dollar has strengthened.

Why is gold so stable? The answer is very basic and has to do with the fact that just about every ounce of gold ever mined is still with us today. Unlike commodities such as oil, copper and wheat which are constantly consumed, gold’s almost total non-involvement in the economy explains its value as a money measure. Since there’s so much gold stock in the world, annual flows into the marketplace either due to discovery or central bank sales cannot credibly change its long-term price.

It’s also said that our leaving gold actually fostered increased cross-border trade. No less than the highly insightful senior currency strategist for Brown Brothers Harriman, Marc Chandler, argued in a recent client piece that floating currencies “helped create the conditions for the rapid and dramatic expansion of trade, capital flows and globalization.”

Importantly, there are strong differences of opinion when it comes to floating currencies and trade. Indeed, floating currencies enable the very protectionist impulses that are less likely to reveal themselves when money values are stable. As Stanford economist Ronald McKinnon noted in his 1996 book, Rules of the Game, “In the 1950s and 1960s, when par values for exchange rates were more or less fixed under a common monetary standard the industrial countries experienced an unprecedented increase in the growth rate of GNP and an expansion of world trade.” But with the advent of floating exchange rates in 1973, McKinnon observed that we experienced “an upsurge of ‘new’ protectionist policies-including quotas, VERs, market-sharing schemes, anti-dumping, and countervailing duties.”

The above shouldn’t surprise us owing to one of the chief reasons we left gold to begin with: a desire to undercut Japanese imports with a weaker dollar. Floating currencies led to regular currency manipulations by monetary authorities in countries around the world, but most notably right here in the U.S. Laboring under the naïve assumption that currency devaluations would enhance the economic outlook of countries served, monetary authorities foisted inflation on their respective countries given the belief that this would stimulate exports. That the vaunted gains in exports never reveal themselves didn’t then, nor does it now, seem to trouble our monetary stewards.

In reality, floating currencies are anti-trade for creating winners and losers (thanks to currency gyrations), and anti-globalization for uncertain exchange rates making the smooth transfer of capital across borders more uncertain. Simplified, exchange rate risk, particularly of the devaluationist kind, makes cross-border investment less, as opposed to more likely. McKinnon and Japanese economist Kenichi Ohno wrote in Dollar and Yen that over the last two centuries “periods of vigorous expansion of free trade have coincided with fixed exchange rates." Contrary to assumptions made today, fixed currency values would be a boon for trade and globalization.

Lastly, some argue that a return to a gold standard would be incredibly expensive. Gillian Tett of the Financial Times is of this view, and she cites a recent UBS study which suggests that with U.S. reserves of gold so small relative to the size of its monetary base, “a price above $6,000 an ounce would be needed to reintroduce a gold standard.” Tett goes on to say that if the standard were introduced in China and Japan, the gold price “would be more than $9,000.” The problem with Tett’s reasoning is that it does not describe the kind of gold standard that most of its adherents desire.

First, however, the notion of price needs to be addressed. Perhaps unsurprisingly, similar, but reverse logic was applied before the U.S. left the gold standard in 1971. It was assumed then that the demonetization of gold would lead to a collapse in terms of its price. No less than gold-standard advocate and Nobel Laureate Robert Mundell observed in his 1968 classic, Man and Economics, that if the “United States and the other monetary authorities abandoned all dealings in gold for the indefinite future, it would be quite easy to predict a fall in the price of gold relative to the dollar” due to its “role as international money having been jettisoned.”

But as Mundell later predicted with the collapse of Bretton Woods, once the dollar lost its gold definition, the price of gold skyrocketed alongside the dollar’s plunge. Schumpeter once described the gold standard as the “naughty child that keeps on telling unpleasant truths”, but even without the standard, the gold price was still set in the markets, and its rise exposed impressively bad management of the dollar by U.S. monetary authorities.

Looking at the price of gold if we return to a standard, there’s nothing suggesting that the price of it would rise. That’s the case because as Ricardo, J.S. Mill and others noted, there’s nothing saying a country on the gold standard must have physical gold backing all the currency issued. In fact, under a Ricardian gold standard, monetary authorities would realistically have no gold at all.

Indeed, they wouldn’t need it. If the dollar’s price were credibly fixed for the long-term, the U.S. Treasury wouldn’t need a lot of gold on hand precisely because there would be no desire to exchange interest-bearing dollars for a commodity possessing very little in the way of real-world purpose. Instead, Treasury would merely make the dollar convertible into gold if desired, but if monetary authorities were to simply add dollars to the system if gold were to fall, and extinguish dollars if gold were to rise above its set price, exchanges for gold would be infrequent at best.

About gold, Ricardo observed that “there is probably no commodity subject to fewer variations.” Gold’s inherent stability explains why for most of history the world has been on a gold standard; the nearly 40 years since the collapse of Bretton Woods surely an exception to the historical currency rule.

A gold standard won’t itself make us more prosperous, but for fostering the kind of currency stability necessary for wealth-enhancing production and trade, a return to a stable dollar value would unleash a huge amount of economic activity and trade the world over. In that sense, increased prosperity would be a certain result of a return to a dollar defined in gold for removing economically retardant variables to productivity and investment that we face at present. That economic crises caused by monetary mistakes would decline would be yet another good that would result from this most positive and costless of economic changes.