What Happened to the Gold Standard?
by Tom Donelson on December 27, 2011 at 8:41 AM
Over the past year, the Gold Standard has now come into vogue as a campaign issue. While most economists dismiss the gold standard as a crazy idea or anachronism, no one has yet to come up with an answer to the question: "If the dollar standard is collapsing, what do we replace it with?" These are not insignificant questions since the world has been on a dollar standard since the end of World War II, with the dollar being linked to gold until 1971, and the rest of the world was linked to dollar. We have a whole generation of politicians and economists who have never worked with or dealt with a gold standard or any aspect of gold linked to a currency. Lawrence White noted, “The gold standard is not a flawless monetary system. Neither is the fiat money alternative. In light of historical evidence about the comparative magnitude of these flaws, however, the gold standard is a policy option that deserves serious consideration…A gold standard does not guarantee perfect steadiness in the growth of the money supply, but historical comparison shows that it has provided more moderate and steadier money growth in practice than the present-day alternative, politically empowering a central banking committee to determine growth in the stock of fiat money. From the perspective of limiting money growth appropriately, the gold standard is far from a crazy idea.”
For many advocates of the Gold Standard, the advantage has been that monetary policy is determined by forces of supply and demand and their biggest objection to our present fiat system is that the Federal Reserve market committee determines the worth of a currency. This leaves us with the question, Which system protects the purchasing power of the currency? As White stated, the gold standard is not perfect, but it does have its advantages, if control of monetary policy and stabilization of currency is the goal. The Federal Reserve of Minneapolis economists Arthur Rolnick and Warren Weber surveyed countries over decades and found that monetary growth and inflation were higher under fiat currencies versus the commodities standard of gold and silver.
Many critics have accused the gold standard of creating a period of deflation, and certainly in the last twenty years of the 19th century, the United States experienced a prolonged deflationary cycle. The economy soared as total real per capita grew at 46% and the real GDP doubled despite the deflationary cycle. So why did the deflation during this period show no real detrimental effect? The reason was due to the fact that output of goods grew faster than gold stock as great technological improvement improved productivity. It could be argued that a Central bank operating a fiat currency could offset productivity deflation by the expansion of monetary quantity, driving prices upwards. The question is should the Fed automatically expand monetary quantity to prevent deflation since productivity-created deflation did not dampen investment in the late 19th century, nor did it penalize debtors since nominal interest rates correct downward to offset the repayment in dollars of higher purchasing power.
The United States deflationary cycle between 1929-33 showed the result of destructive deflation and critics of the gold standard often blame the Feds' adherence to the gold standard, but it begs the question, why did the Feds miss the deflationary signal? While the United States was vulnerable to bank panics in the past, the Federal Reserve did not prevent the banking meltdown, which it could have done by supplying replacement reserves. Canada was also on the gold standard in the same period, and yet, there was not any massive banking panics. So what did Canadians do to prevent a massive banking meltdown, whereas the United States banking system collapsed?
Alan Greenspan endorsed the idea of controlling the fiat money supply by imitating the behavior of the gold standard. At a congressional hearing in 2001, Greenspan noted, “Mr. Chairman, so long as you have fiat currency, which is a statutory issue, a central bank properly functioning will endeavor to, in many cases, replicate what a gold standard would itself generate.” In 2003, Greenspan added that inflation of the 1970’s was due to the lack of a gold standard restraining central bankers. He told a congressional panel, “The general wisdom during the period subsequent to the 1930s was that as we moved to an essentially fiat money standard, that there was no anchor to the general price level. And indeed, what we subsequently observed is, as you point out, a very marked increase in general price levels, indeed, around the world as we removed ourselves from commodity standards, and specifically gold. I had always thought that the fiat money system was chronically and inevitably an inflation vehicle, and indeed, said so repeatedly. I have been quite surprised, and I must say pleased, by the fact that central bankers have been able to effectively simulate many of the characteristics of the gold standard by constraining the degree of finance in a manner which effectively has brought down general price levels.”
Today inflation is not approaching the double digit inflation of the 70’s, but the recent expansion of monetary policy could lead to further inflation. The other problem with a gold standard is that any government could simply go off the gold standard, but a government could also print excessive amount of money. The deflation at the beginning of the Great Depression could have been managed by better monetary policy, and there are those who argued that it was not the Gold Standard that caused the Great Depression, but the Fed's mishandling of the monetary policy that aided it along Herbert Hoover's interventionist policy of increased spending, increased taxes and higher tariffs. Nixon ended the Bretton Wood arrangement by closing the gold window when the Fed expanded dollar supplies in the late 60’s, thus ending the dollar's link to gold.
Today, the fate of the dollars is in the hand of Federal Reserve. Proper management of a fiat currency works if the Federal Reserve mimics a gold standard, but proper control of fiat currency belongs with political leaders with wisdom. Presently, the United States is led by a President whose policies is leading America off the cliff with spending trillions without any growth oriented policy to spur growth nor is Congress showing any restraint. With present Federal monetary policy, are we trying to prevent a deflationary spiral with real estate prices continuing to drop or a new wave of inflation with oil prices and food prices rising? We have no clue, which should be scary to voters.
We are at a crossroads with the dollar standard imploding, and there are no other currencies to replace it. The Euro is threatened with collapse, the Chinese banking system is hardly mature, and they are already guilty of manipulating their currency. There are no true alternatives to replacing the dollar standard unless with a basket of currencies, but can anyone have confidence in an international banking system based on the whims of central bankers who are presently not managing their currencies very well.
Is this the time for reestablishing a Gold Standard and if so, how do we make the transition? There are many questions left to answer, but when a government ceases to control its budget or its currency, disaster is the result. Could a dollar link to dollar be the solution?