The Problem With the Return to the Gold Standard

by: Wall St. Cheat Sheet

By David Friedman

James Grant, of Grant’s Interest Rate Observer, argues for a return to the gold standard:

The classical gold standard, the one that was in place from 1880 to 1914, is what the world needs now. In its utility, economy and elegance, there has never been a monetary system like it.

It was simplicity itself. National currencies were backed by gold. If you didn’t like the currency you could exchange it for shiny coins (money was “sound” if it rang when dropped on a counter). Borders were open and money was footloose. It went where it was treated well. In gold-standard countries, government budgets were mainly balanced. Central banks had the single public function of exchanging gold for paper or paper for gold. The public decided which it wanted.

“You can’t go back,” today’s central bankers are wont to protest, before adding, “And you shouldn’t, anyway.” They seem to forget that we are forever going back (and forth, too), because nothing about money is really new. “Quantitative easing,” a k a money-printing, is as old as the hills. Draftsmen of the United States Constitution, well recalling the overproduction of the Continental paper dollar, defined money as “coin.” “To coin money” and “regulate the value thereof” was a Congressional power they joined in the same constitutional phrase with that of fixing “the standard of weights and measures.” For most of the next 200 years, the dollar was, in fact, defined as a weight of metal. The pure paper era did not begin until 1971.

First, some background. The United States dollar, and indeed the corresponding currencies of all other countries in the world, is what is called fiat currency: it is backed by the faith and credit of the government which issues it, and so it has no intrinsic value. Its value is derived from the soundness of the promise to which it is linked. Gold, on the other hand, as a fungible commodity, does have an intrinsic value. Its value, like that of diamonds or palladium or platinum or silver, derive from its scarcity. Silver, which is less scarce than these other five commodities, is obviously cheaper. Silicon, which is one of the most common minerals in the Earth, is even cheaper. So, there is a direct correlation between scarcity and value: the scarcer a commodity, the more valuable it becomes.

Paper currency has no intrinsic value because the pulp and cotton which it is made of are essentially worthless: you can’t melt down paper currency into a lumpen form and then use it for another purpose. You can only shred it, burn it, use it to acquire goods or services, or accumulate it.

These are all fair points.

But does it really make sense for the US to go back to a gold standard? Grant argues that its virtue is its simplicity:

If only they gave it some thought, though, the economists — nothing if not smart — would fairly jump at the chance for counter duty. For a convertible currency is a sophisticated, self-contained information system. By choosing to hold it, or instead the gold that stands behind it, the people tell the central bank if it has issued too much money or too little. It’s democracy in money, rather than mandarin rule.

Instead of managing this simple system, the Fed employs hundreds of PhD’s who:

conduct research at the frontiers of economic science. “The Two-Period Rational Inattention Model: Accelerations and Analyses” is the title of one of the treatises the monetary scholars have recently produced. “Continuous Time Extraction of a Nonstationary Signal with Illustrations in Continuous Low-pass and Band-pass Filtering” is another. You can’t blame the learned authors for preferring the life they lead to the careers they would have under a true-blue gold standard. Rather than writing monographs for each other, they would be standing behind a counter exchanging paper for gold and vice versa.

(Note that the NYT provides bad links to the papers mentioned above; I can’t find the papers on-line.)

The main problem that I see with a return to the gold standard is that the total value of US dollars in circulation vastly exceeds that of all the gold ever mined. Therefore, if the dollar were to be linked to gold, and ignoring any other currency whose issuer wants to link their currency to gold, the price of gold would increase dramatically, much more so than it has to date. This would pose significant problems for the industrial use of gold, of which there are many processes.

Let’s put some numbers on these claims:

  • Gold is presently selling for about $1,400 per oz.
  • The total amount of gold ever produced is estimated at roughly 142,000 metric tons (see page 12 at the link - pdf file), or 142,000,000 kilograms.
  • There is about $8,766,000,000,000 in United States dollars as of October, 2010, floating around the world (eight point seven trillion)
  • There are about 35 ounces in 1 kilogram.
  • Accordingly, one kilogram of gold costs about $1,400 * 35 = $49,000.
  • This implies a total market value of all gold ever produced of $49,000 * 142,000,000 kilograms = $6,985,000,000,000 (six point nine trillion dollars), or 80% of the money supply

Remember that all of these numbers ignore other countries’ money supplies. If other large, industrial countries were also to go back to the gold standard, the price of gold would be bid up even higher. Grant does not propose what would happen in this instance.

Now, there’s a very important point here, which complicates my analysis. My assumption is that the gold standard would tie that $8,766,000,000,000 to gold. But what is that figure comprised of? Well, it turns out that the US Federal Reserve measures the money supply in two ways: M1 and M2. M1 is the value of all the currency (in paper and coin form) and checking accounts and M2 includes that plus all highly liquid sources of money. That $8,766,000,000,000 figure is the M2 money supply. We could well have a gold standard which ties gold only to the currency presently in circulation. That would change the analysis somewhat. But what it won’t resolve is the question of what happens if a number of large, industrial nations decide to revert back to the gold standard.

In any event, that is just one of the many problems with the gold standard, none of which Grant addresses in his editorial. Wikipedia has a pretty good discussion of other criticisms of the gold standard, here.