The price of gold has gone over $1,400 an ounce recently. In addition to the raft of stories and questions about investing in gold, I get questions about whether we should return to the gold standard. Blogger confession – I’m going to use the opportunity to organize my own thoughts on the issue.
The quick answer comes from John Maynard Keynes (written in 1924) “In truth, the gold standard is already a barbarous relic.” I lack Keynes’ vivid parsimony, so it will take many more words for me to explain why I agree with him.
First, a general definition. When we talk about monetary policy and the gold standard we mean that a country promises to keep a stable relationship between gold and the country’s currency. This often has two consequences. First, the country needs to hold/own enough gold in proportion to the money in circulation. This proportion need not be 100%. During the period between World War I and the Great Depression economically healthy countries had enough gold to represent about 40% of the currency in circulation. Whatever the proportion, a country on the gold standard is obliged to ease or constrain credit to keep the value of currency in circulation in line with gold reserves. No gold – no economic growth.
The second consequence is that the government often needs to promise to redeem its currency for gold, at a price within an established range. This promise reinforces the government’s commitment to a stable currency value.
Many (most?) industrial governments sought to stay on the gold standard during the first half of the 20th century. The three major exceptions were during the two world wars and during the Great Depression. The wartime pressures on government spending usually required the creation of more money and easier credit. and governments had to set aside the promises inherent in the gold standard. The Depression had similar and additional pressures. Towards the end of WWII the Allies met and agreed on a stable international currency system, focused on the U.S. dollar, with the U.S. government also committing to maintaining a stable relationship, in terms of value, between the dollar and gold. This agreement lasted from 1944 until 1973. Since 1973 the U.S. currency, and most other first world currencies have floated in value and are not linked to gold.
One interesting conclusion reached by researchers, including Ben Bernanke when he was an academic, was that nations that stayed on the gold standard longer in the early part of the Depression had slower recoveries. Those nations that abandoned the constraints of the gold standard recovered more quickly.
Gold bugs are people who advocate for a return to the gold standard. Actually, originally (and more correctly) the term referred to investors who were bullish on gold. They prefer that money creation by the central bank (Federal Reserve in the case of the United States) be limited to the amount of gold reserves held by the country. They also prefer the implicit global currency exchange stability that could occur if our trading partners were also on the gold standard. Sticking with gold would constrain economic growth – limited by the discovery and availability of this precious metal.
Their faith in the gold standard is misplaced. There are numerous times when central bankers, with the support of their governments, have abandoned the standard under stressful conditions. The strength of a limited standard is based on everyone believing that the standard will prevail permanently. Unfortunately, political history doesn’t give us any confidence that we could stick to a standard indefinitely, and the markets and businesses will be quick to spot any weakening in resolve. Once that happens, a spiral of inflation expectations, accompanied by reduced investments, will cripple economies.
To grossly over-simplify Keynes’ objections to the gold standard – he wanted governments to have flexibility to react to adverse economic conditions, easing or tightening credit, influencing the value of their currency, and building or reducing debt. He argued that temporary fixes were necessary, and that remedial action after the crisis was also necessary. Strict adherence to a gold standard removes the flexibility he wanted.
There are dangers in letting a central bank print/create money with abandon; this invites dangerous inflation. It is crucial that central bankers have a plan in place to reduce the money supply when the economic crisis is over, and to do it in a way that allows the economy to anticipate and adjust. Adopting a gold standard doesn’t automatically make central bankers and politicians wise. It is a flimsy framework and no replacement for thoughtful monetary policy.