Issue: 96
Sent: 05-02-2008 11:08:02
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Time to Return to the Gold Standard?
A common refrain that I hear is that our currency should return once again to the gold standard.
Before we discuss the pros and cons of this approach, it's essential to understand what the three important things are that we want money to do:
1. Stable domestic price level
2. Maintain a stable relationship against other currencies
3. Freely convertible into goods including other money
In 1971 the Bretton Woods system collapsed and since then the price of money has been set by central banks. In democracies these central banks report through to politicians. Potent arguments can be made that this is not a very efficient system and politicians will apply pressure to ensure their own ends are met. But it has to be said that at least the "will" of the electorate is being served by these politicians.
Proponents of the gold standard call this "fiat money" and might also argue that central banks also solve their problems by "printing money". However the central bank model does enables domestic price stability as well as free convertibility. It certainly doesn't provide a stable relationship against other currencies if currencies float freely in a marketplace as do most currencies.
The gold standard provides a stable relationship with other currencies and is freely convertible into goods. It does not provide stable domestic prices even when the conversion rate between dollars and gold is fixed simply because gold is a commodity. It goes without saying that all commodities in an open market have highly volatile prices. Therefore money fixed to it would be highly volatile in price. Why is a stable relationship with other currencies more important that a stable domestic price level?
In the 1890s, McKinley won the US Presidential election with a policy to remain on the gold standard. At about the same time large gold fields were discovered in South Africa and Australia. This gave the world a period of high inflation because more gold meant more money could be printed. In effect the supply of money (or perhaps I should say the rate money can be printed?) under the gold standard is determined by miners and successful mining speculators and not central banks.
It is impossible for any "money system" to provide all three objectives. It is only possible to provide two of the three.
Bretton Woods gave us stable domestic prices and a stable relationship with other currencies but also gave us high levels of government regulation. For example during the 1950s and 1960s inflation was low but in the US it was highly illegal for citizens to own monetary gold.
When working out what money we want to use we need to decide what we want it to do. If we want free convertibility of money we either have to use the gold standard or the central bank system.
Whatever preference we have it is worth pointing out that in reality the gold standard is gone forever because it can never be restored. The reason for this is that the gold standard would only survive if it were to be believed that it can never be replaced. But we all know that is not true (because we have been on the gold standard and gone off it). If we were on the gold standard now and slipped into recession or worse depression then the effects could be lessened by going off the gold standard as happened during the Great Depression. If this occurred it would make our "gold" money worthless. Some of us might try to preempt this by converting this money into bullion. The government would likely anticipate this and would have to seek to dump gold at the first sign of bad news. How many of us would seek to act even faster than the government? The government in turn would have to try to preempt those trying to preempt it. As you can see the gold standards days are gone.
Yes it is true that fiat money has an inflationary bias. But it is also true that since the 1980s overall central banks have been doing a better and better job at setting the price of money. And it must be said that these banks have been doing this in extremely difficult circumstances. David Uren's column in the Australian on Monday said that "there is a considerable lag before monetary policy affects the economy. Reserve Bank modelling suggests that a 1 per cent rise in rates will cut economic growth by 1.3 percentage points and inflation by 0.4 per cent after a period of nine months. However, there is little science in this estimate, and modelling by other central banks suggests the lag before monetary policy has its greatest effect could be two years."
No monetary system can be perfect. However if you want to argue for the gold standard, please do so. But also please make sure you've thought through all the issues.
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