Every few years someone suggests we return to a gold standard.
It’s an election year, so discussions about money, the Fed, deficits, debt, and the gold standard are bound to come up. For millennia gold served as medium of exchange, unit of account, and store of value. As the densest material in the world, it’s fairly easy to determine its purity. Politicians often suggest tying the currency to something—in order to restrain the government’s ability to print money at will. But economists almost uniformly reject the idea of a gold standard. Why?
In its early years, the US was on a bimetallic standard. Banks issued their own notes that were convertible to gold or silver on demand. The government set the standard by which gold and silver could be exchanged for one another. During the Civil War, the government suspended convertibility and issued fiat money. In 1873, we resumed convertibility, but only into gold. Countries around the world had adopted a gold standard, and this uniformity facilitated global trade.
McKinley runs for President on the gold standard. Source: Wikipedia
But the fixed standard created problems. During boom times banks would issue far more notes and deposits than they had gold in reserve. When the economy slowed and people demanded their money back, banks failed, credit contracted, and the economy fell into a recession. The US had at least four bank panics and one depression between 1872 and the creation of the Federal Reserve in 1914.
The main problem, economically, wasn’t boom/bust nature of the gold standard, though. It was the fact that an increasing percentage real resources were devoted to a creating a monetary unit. During the California Gold Rush and the Klondike Gold Rush, farms and factories around the country were vacant, as men caught “Yukon Fever” and went off to grub in mills and mines. The same problem would plague Bitcoin if it ever became a widespread mode of exchange.
Price of gold in real and nominal terms. Source: Wikipedia
In the long run, economies grow faster than gold can be extracted from the earth. Prices will tend to fall, and the value of money rises. When the value of money goes up, the price of goods and services is falling. This is deflation, and it leads to hoarding—people receive a real return just for holding money. There is little incentive to put money to work—and at risk—in the economy. Productivity and living standards inevitably fall. This is one reason the US closed the gold window in 1971.
Most importantly, the gold standard is the solution to the wrong problem. Folks are rightly concerned about the temptation for government to abuse fiat money—printing more than the economy needs in order to finance excessive spending. That kind of behavior has inevitably led to hyperinflation, from post-Revolutionary France in the 1790s to Zimbabwe in 2009. But the problem today isn’t inflation, it’s deflation. We don’t have too many dollars chasing too few good. We have too much stuff chasing too little money.
In the end, the gold standard served a purpose as the world became more interconnected through global trade and capital flows. Now that the global economy is already tightly interlinked, it would be a mistake to tie the world’s largest economy to a limited supply of money. And if the Fed has discretion to change the monetary exchange rate for gold–as it did in the ‘70s–that effectively puts the economy on a Fed standard—exactly where we are right now.
Douglas R. Tengdin, CFA
Chief Investment Officer