I’ve discussed this before, however, it carries more weight when described by a man of Einstein’s stature. The one primary flaw in the gold standard was very similar to what we are seeing in Europe today. Because nations were required to have specific amounts of gold there was generally an imbalance in the global economy due to trade imbalances. Trade surplus nations were hoarders of gold while trade deficit nations were generally in shortage. If you were unable to mine or obtain the gold through other measures your trade deficit put you at a persistent and inherent risk of recession without a reasonable ability to defend your citizenry from depression.
Einstein described the inherent weakness in this monetary system:
The gold standard has, in my opinion, the serious disadvantage that a shortage in the supply of gold automatically leads to a contraction of credit and also of the amount of currency in circulation, to which contraction prices and wages cannot adjust themselves sufficiently quickly.
In essence, trade deficit nations (as we see in Europe today) were forced to overcome their trade deficit by counteracting it with high budget deficits. The sectoral balances must net to zero so a nation which attempts to run high trade deficits cannot also run budget surpluses without experiencing economic contraction. As we’ve seen in the sectoral balances approach, this is an accounting identity and not opinion. So, there is an inherent flaw in a monetary system which lacks the flexibility to respond to these imbalances.
This is apparent in Europe today where trade deficit nations have been largely coerced into profligacy with no real ability to defend themselves from the inevitable recession. Not surprisingly, Germany, the trade surplus nation in the region is booming. In a floating exchange rate system with monetary sovereignty the periphery nations would simply devalue their currencies and natural market forces would help to remedy the trade imbalances. Germany’s currency would rise which would make German manufactured goods less attractive, the periphery nations would experience currency devaluation and higher trade.
Over time their economies would stabilize and recover. This, of course, was not an option under the gold standard and is not an option in modern day Europe. Hence, the persistent weakness across the region’s periphery nations.
The gold standard is not a viable monetary system. The reasons why it failed are simple to understand once one sees the natural flaws that the sectoral balances approach exposes.