The Gold Standard and Inflation

Includes: GLD, IAU
by: Stephen Yu, CFA

In his 1923 book Tract on Monetary Reform, economist John Maynard Keynes urged the United States and Great Britain to abandon the gold standard, calling it a “barbarous relic.” In the decades that followed the book’s publication, countries around the globe heeded Keynes’ advice and relegated the gold standard to the dust bin. But lately, as the financial crisis deepens, and as the size of government bailout packages grows ever larger, the public becomes alarmed by the potential for future inflation and the call for a return to gold standard grows louder by the day. The belief is that the gold standard can prevent runaway inflation. Perhaps it is time to revisit history to examine if there is validity to this belief.

In terms of the gold standard, the United States experienced 3 distinct phases between 1834 and the present. These phases are as follows:

  • Phase 1, 1834 to 1932: In 1834, the United States fixed the price of gold to $20.67 per ounce. U.S. dollars and gold were interchangeable according to the fixed price. The U.S. was on the gold standard then.
  • Phase 2, 1933 to 1970: In 1933, President Franklin D. Roosevelt outlawed private ownership of gold by U.S. citizens and devalued the dollar (by almost 40%) by raising the price of gold to $35 an ounce. From that time on, only foreigners could demand the U.S. government to exchange gold for dollars. U.S. citizens could not do so. In effect, the U.S. went half way off the gold standard then.
  • Phase 3, 1971 to Present: In 1971, President Richard Nixon declared that U.S. dollars could no longer be converted into gold, whether by foreigners or by U.S. citizens. From that point on, gold price, vis-à-vis, the U.S. dollar, fluctuated in the market, and the U.S. was completely off the gold standard.

To test if there was any relationship between the gold standard and inflation, we reviewed the Consumer Price Index (All Urban Consumers, CPI-U) between 1914, the first year in which data is available, and 2008. Our findings are summarized in the table below.

As the table shows, as the government moved off the gold standard in two steps, inflation increased. So, as far as U.S. history in the past century tells, gold standard did seem to bring about low inflation. This result, however, came at a price. Under the gold standard, although prices were stable in the long-run, they were very volatile in the short-run, as the high standard deviation during the period of 1914 to 1932 shows.

Disclosure: long GLD