Gold standard: Could it return in the US?
For many years, calling for "a return to the gold standard" in the United States put you in the company of economic eccentrics and the libertarian, Congressman Ron Paul. But this week, the Republican Party agreed to set up a commission to look into fixing the gold value of the dollar. Why?
The usual reason given for a return to some kind of gold standard is that gold leads to sound money. It links the supply of money to the supply of gold and since gold reserves increase only slowly, the growth in the supply of money is limited, thus helping to choke off causes of inflation.
The problem is that in practice, things do not always work out like that - from 1919 to the 1930s, US prices were anything but stable.
Kenneth Rogoff, an economics professor at Harvard University, agrees that a gold standard would not necessarily be more stable than the current monetary system.
"The price of gold fluctuates a lot and therefore the price of your currency would fluctuate a lot," he says.
Rogoff points to the fluctuations of the dollar in the 19th and early 20th centuries when the dollar was tied to silver and gold.
"You find yourself tied to the availability of the particular metal."
The US had another go at linking the dollar to gold after World War II.
Going for gold
- 19th Century: US dollar linked to silver and gold
- 1900: Gold Standard Act sets dollar at 1.5 grams of pure gold
- 1917-18: Export of gold suspended
- 1929: Wall Street Crash
- 1931: UK abandons gold standard
- 1934: Gold Reserve Act outlaws most private possession of gold and US dollar devalues over 40% from $20.67 to $35 dollars to the Troy Ounce
- 1944: Bretton Woods Agreement sets up new global finance rules. Dollar established as world reserve currency linked to gold at $35 an ounce - the gold exchange standard
- 1968-1971: Gold standard in crisis. US gold reserves as percentage of dollars in circulation fall
- 1971: US President Richard Nixon abandons gold exchange standard
- 1981: President Ronald Reagan sets up a Gold Commission to look at reintroduction of gold standard, but it rejects the idea
From 1945-1971, the period of the "gold exchange standard", the US fixed the dollar to gold at $35 an ounce. Growth rates were higher and rises in wealth were more equitably shared across society than in the years that followed.
Unemployment has been higher, growth lower, and wealth more unevenly distributed since the US dollar came off gold in 1971. This could have been coincidence, however. Many would argue that the dollar's link to gold contributed little to post-war prosperity.
Furthermore, the US and other advanced economies were on the gold standard together. So if the gold drained from one part of the system, it pooled in another part, with the concomitant expansion of the money supply, demand and the potential to pull in goods from the part that had been depressed . Theoretically it was a self-sustaining system.
So how could the US implement a new gold exchange standard today?
"For a gold standard to work, people have to believe that you will never go back to fiat money," says Rogoff. Fiat money is the way the modern money supply works. Dollars, euros and pounds are created by central banks without reference to any underlying asset such as gold or silver.
"If people doubt your resolve, if you are not completely credible, they will want to get your gold," he says.
The current price of gold is about $1,665 an ounce. Theoretically, the US government could promise to redeem dollars for gold at that price. Alternatively, the US could in effect devalue the dollar against gold by fixing the price lower, at say $2,000 an ounce.
The initial problem would be the maintenance of credibility. At the end of the 1960s, foreign central banks no longer believed US assurances that the gold standard would be maintained and started demanding US gold - in other words, redeeming dollars - in ever greater quantities.
Total gold holdings, top 10
The value of gold may fluctuate but countries are still keen on having the stuff:
- USA: 8,133 metric tonnes
- Germany: 3,401 tonnes
- IMF: 2,814 tonnes
- Italy: 2,451.8 tonnes
- France: 2,435.4 tonnes
- China: 1,054.1 tonnes
- Switzerland: 1,040.1 tonnes
- Russia: 824.8 tonnes
- Japan: 765.2 tonnes
- Netherlands: 612.5 tonnes
Source: World Gold Council
Such demands would start after any return to gold. For Anil Kashyap of the University of Chicago Booth School of Business, any suggestion of a return to gold is "incredibly crazy". If the US returned to gold unilaterally "all you would hear is a giant sucking sound as Fort Knox was drained" - with no corresponding benefits.
Holders of dollars - such as foreign central banks - would want to test the US government's resolve and the demand for gold could mount, especially as there is no reason to think that other major economies would also want to return to gold. There would also be speculative attacks on the dollar just as there is with other fixed exchange rates - eg the Black Wednesday sterling crisis of 1992.
Charles Wyplosz, professor of international economics at the graduate institute of international and development studies in Geneva, says that if the US government substantially devalued the dollar "it could buy a few years" but eventually the system would break.
To maintain a gold exchange standard, the US could either hope that the demand would cease before US gold reserves were badly depleted or it could successively reduce the amount of gold needed to back the dollar. Or the dollar could start to devalue against gold. "None of this could go on for long," says Wyplosz.
As for the effect on the US economy, "it would depend on the rate at which the dollar was pegged to gold" says Rogoff.
"It could either be inflationary or deflationary depending on the initial rate." If the rate was low, in other words if it would take more dollars to buy an ounce of gold than it does today, the effect would be to increase the money supply and it would therefore be inflationary.
If the system managed to get up and running its effect would be to prevent the government from expanding and contracting the money supply in relation to the state of the economy. Forget quantitative easing.
The US has the largest gold reserves in the world but if the gold exchange standard was implemented, the US would need to ensure that it was more attractive to hold dollars than gold. This could be done by raising interest rates. But the latter would risk dragging the US in to recession. However, if like Congressman Paul you are concerned about the amount the US government is spending and borrowing, downward pressure on the country's debt would be welcome.
Meanwhile, the US has run a large balance of payments deficit for years and the mountain of US public debt grows ever higher. Both of these problems would continually put pressure on any fixed link to gold. Foreign governments would look at American debt and worry about the country's ability and willingness to maintain the dollar's link to gold.
The last gold exchange standard blew up in 1971 in part because of the Vietnam war - but US debt today, both in real terms and as a percentage of GDP, is in a much worse state than 1971. The US is a big economy and the government could raise revenues to reduce its debt, it could reduce spending on the military, but so far both things have proved difficult politically.
Given how opposed most economists are to a return to gold, what is behind the desire to explore the issue?
"There has been no significant inflation in the advanced economies for the last 25 years, so the need for gold to defeat inflation seems unnecessary," says Wyplosz.
Rather he sees nostalgia as the real reason for going for gold. "People long for a simpler age. But the world of the 1950s and 60s was nothing like the world we live in today. The US was the dominant economy and there were no financial markets to speak of."
Paul has been making the case for gold since 1981. "Paper money is a moral hazard," he has said in the past. He objects to a system in which the US Federal Reserve allows asset bubbles to inflate and in which the US government bails out failing banks and businesses.
Paul believes the present system encourages risky investments and discourages saving. These views and his plain speaking will ensure he has supporters for years to come.