Having money linked to a Gold Standard is an idea that almost every economist opposes. It is described as the economic equivalent of creationism and a major cause of the Great Depression. It is ignored by policymakers and no country has one anymore. Yet there is some support for it on the internet. It is one of Ron Paul’s main ideas in his campaign for the Presidency and is supported to some extent by Paul Ryan. The Republican platform promises a commission to consider reintroducing it. So what is a Gold Standard and why is it so bad?
At the moment the central bank can print as much money as it wants without limit. However in a gold standard the central bank can only print as much money as gold it has. For example if the government has one billion dollars in gold, then it can only print one billion dollars. Or the country might not have any paper notes but instead just use coins. From the late 1800s until the 1930s all the developed countries were on a gold standard. Its proponents argue that a gold standard avoids inflation and instead has stable prices. It is claimed it avoids the central bank destroying the economy through hyperinflation. The gold standard is described as a model for fiscal responsibility that prevents trade deficits and budget deficits.
This chart is a good example of the argument for a gold standard. It says the dollar has lost 94% of its value over the last 76 years. It gives the impression that this is a terrible thing without saying why. It primarily suffers from the money illusion. It says inflation erodes a consumers purchasing power, therefore the 129% inflation since 1980 means we’re all poorer. Of course this fails to state the obvious point that wages have risen by a similar amount so we’re no worse off. Another example of this is that it notes that in 1980, 80 cents could buy a loaf of bread but today it can only buy three slices. The implication is that if we could go back to 1980 prices we’d all be richer, failing to realise that our wages were lower so are purchasing power was the same.
The thing about the gold standard is that most of its advocates base their arguments on morality rather than economics. Ron Paul criticises the “debasement” of the dollar which he claims amounts to “theft”. Gold is seen as something real and solid, whereas paper is seen as almost fake or only an illusion. Nostalgic references are made to how much a dollar used to be able to buy. Gold is intrinsically valuable whereas paper is not. Paper money is controlled by the government which many would oppose on principle. Paper money is associated with hyperinflation and chaos (Ron Paul has been predicting imminent hyperinflation for the last 30 years). Gold is “responsible” and the opposite of wasteful government.
However in a survey of economists, zero supported a gold standard. There are many reasons for this. The main advantage or problem (depending on your point of view) of the gold standard is that is severely constrains the actions of the government. It cannot use monetary policy to influence the economy. A common response to recession is to print money which a gold standard prevents a government from doing. This means it must use fiscal measures, but a gold standard limits these as well. This means a government cannot do much to combat a recession no matter how severe it is. Instead it must stand idly by and let the recession take its course. While some hardcore free marketers would agree with this, most economists recognise that if the government doesn’t intervene the recession gets worse.
Interest rates are normally set according to the state of the economy. If the economy is booming and inflation is rising, then interest rates will be raised to stop the economy overheating. If the economy is stagnant and unemployment is high, then interest rates will be lowered to give the economy a boost. Under a gold standard, interest rates would be set according to the supply of gold. This is unrelated to the state of the economy which can cause serious problems. So if gold reserves are low then interest rates will be risen even if the economy is in a recession.
This is what happened during the Great Depression. The depression was made worse by countries inability to use monetary policy to intervene. Instead they were forced to raise interest rates to maintain their gold reserves which made the depression worse. As a result nearly every developed country abandoned the gold standard. In fact the sooner they did, the sooner they recovered from the Depression. In contrast when in 1987 the stock market crashed, many feared a second Great Depression. However this time the Federal Reserve responded strongly and used monetary powers to boost the economy. Its lowering of interest rates and printing of money is widely credited with ensuring no recession resulted from the largest stock market crash since 1929.
Countries lose flexibility and independence under a gold standard. If county R’s interest rates are 5% but country N’s is 7%, then gold will flow out of country R (causing a decrease in the money supply and a recession) and into country N (causing an increase in the money supply and a boom). To avoid this countries have to have the same interest rate. However the example of the Euro shows the problem with this. Interest rates were kept low to help Germany and France but lead to a bubble in Ireland, Spain and Greece. A gold standard is a one size fits all policy. It also means governments have to keep interest rates higher than they should which will damage the economy and keep unemployment higher than it should be.
The gold standard significantly benefits countries with gold mines, mainly South Africa and Russia. It also means that if gold was discovered one day, the country would automatically get a boost to its money supply leading to an inflationary boom regardless of the state of the economy. There is also the reverse problem, namely that the world is running out of gold so deflation is inevitable. There is also serious questions over whether there is enough gold in the world to support the American economy. The price of gold is not stable and has risen roughly tenfold since 1971, whereas consumer prices have risen roughly fourfold. Even within the last year, gold prices have risen by 40% whereas wages are constant. If we were under a gold standard, wages would have to be cut by 40% within a year.
A gold standard necessarily leads to deflation (falling prices) as the money supply is either fixed or increasing by tiny amounts. Now you’re probably thinking isn’t falling prices a good thing? Doesn’t it mean we’ll get things cheaper? Yes but, it also damages the economy. If I told you that you could buy something for $10 today or $9 next week, chances are you’ll wait until next week to buy it. But what if I told you that you could wait another week and it’ll be $8 and so on. What will end up happening is that you will keep waiting for the price to hit bottom before you spend anything. But your spending is the shops’ income and if you don’t spend anything it will go bankrupt. This is the problem with constant deflation, it encourages people to hold off their spending. This drives sales down so businesses cut prices to try to get sales up but all this does is encourage people to wait even more. Shops eventually go out of business which leaves people with less money which reduces sales even more, continuing the cycle. This vicious circle is known as a deflation spiral resulting in unemployment. A prime example of this is the Irish housing market, prices are falling so everyone is waiting to buy, so prices fall more.
The other problem with deflation is that it makes loans harder to pay back. Let’s say your expenses are $10, your wages are $10 and you owe a loan of $50. Now add some deflation so your expenses and wages both fall to $5. However you still owe $50 so in actual fact your debt burden has doubled. This is the problem with deflation, it benefits creditors at the expense of debtors. If the debt is too high and people cannot pay back their loans, they will default. If enough people default, the bank will collapse. This is why there were so many financial crises during the gold standard.
Most economists believe that a small amount of inflation is actually good for the economy. Most central banks aim for 2% inflation but some economists believe a higher rate is beneficial. Inflation is the grease that oils the system and helps things move more smoothly. It makes adjustments easier and helps the payment of debt.
The gold standard era was not a stable era. If anything it was more unstable than the current era. There were regular financial panics and recessions in the years 1857, 1873, 1884, 1893, 1896, 1907, 1921, 1930-3. The gold standard leads to a more, not less, unstable economy.
The gold standard makes it near impossible to fight a major war. Most countries temporarily suspended the gold standard for the duration of the First World War. Instead they ran huge deficits and printed enormous amounts of money to fund their war effort. Now I personally think it’s a good thing that less war would be fought, though it is a fact that America would not have been able to fight World War Two if it was still on the gold standard. The wars in Korea, Vietnam and Iraq would also be ruled out (I’ll let you decide if this is a good thing). So if you’re a conservative reading this, if you have a gold standard you can’t invade Iran unless you are willing to massively increase taxes.
A gold standard would mean a country could run neither a trade deficit (good news for America) nor a trade surplus (bad news for Ireland). If a country imports more than it exports, it would use its gold reserves to pay for this. This would reduce the money supply and cause deflation. This would make the imports more expensive and its exports relatively cheaper and restore the balance. Likewise if it exported more than it imported, it would receive extra gold, increasing the money supply and leading to inflation.
The gold standard could not even fulfil its main promise, that of stable prices. A look at the last 13 years of the gold standard shows that inflation was more volatile than it is now. There was wild swings throughout the 20s and 30s. This is because the money supply was based upon the supply of gold, if there was a gold discovery, then inflation would shoot up. There is also the fact that the price of gold is not that stable. It is prone to sharp rises and declines, making it hard to argue that it would stabilize the economy.
The gold standard belongs to another era and it is testament to how backward looking the Republican party is that it supports it. There are good reasons why no economist supports it. The gold standard lead to financial instability and recession. It deprives government of the ability to fight recessions, instead leaving the economy stuck in recession. It would separate the money supply from the fundamentals of the economy. It would lead to higher unemployment, lower growth and a debt-deflation spiral. To quote William Jennings Bryan “We will answer their demand for a gold standard by saying to them: You shall not press down upon the brow of labor this crown of thorns, you shall not crucify mankind upon a cross of gold.”