The Real
Issues: Economics
A Return to the Gold Standard?!?
By Charles Kirchofer, Nov. 12th, 2008
Home Economics
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I have recently noticed a disturbing trend. You may have thought it
ended when Ron Paul lost the Republican nomination, but those who would
like to return to the gold standard are still out there. In these times
of financial crisis, it may even be possible that they manage to get
their plan implemented. This is very unlikely however, because luckily
most governments take economic action based on sounder arguments than
those the proponents of the gold standard have to offer. But what is
the gold standard, why did we move away from it, and why would it be
such a bad idea to go back to it?
The gold standard used to be the, well, standard for monetary policy.
Governments agreed to exchange their currencies at a set rate per ounce
of gold. This standard thereby guided the interest rates central banks
set: with a specific value in gold in mind, central bankers set
monetary policy to maintain that value. For example, if a government
has a currency called blings, it might agree to exchange an ounce of
gold for 10 blings. That way, everyone knows exactly how much a Bling
is worth.
The problem with this system is twofold. For one, It is inflexible. For
two, it does not take into account the fact that gold can rise and fall
in relative value just as any other commodity can due to changes in
supply and demand. There is also a third problem: setting a gold
standard means standardized exchange rates. This is essentially a world
currency. A world currency is also a bad idea due to its inflexibility
and the fact that not every economy in the world will need the same
things at the same time. Let's look at our country with blings again.
Let's say the country is an oil producer. Let's say oil starts off at
10 blings per barrel (equivalent to $10 per barrel). Due to rising
demand and declining supply (sound familiar?), the oil price shoots up
to 50 blings per barrel (= $50 per barrel because the gold standard
assures fixed interest rates). This means a lot of money is flowing
into the oil producer's economy via the oil sales, and a lot of
investors are pouring money in there as well. A government would
normally raise interest rates in that situation to prevent the
inflation that would come from such an inflow of cash. This would raise
the value of the currency, however, which is not permitted on a
gold-standard system. If the currency becomes more precious, then the
price of gold in that currency would drop. At the same time, the United
States, suffering an economic slowdown partly due to high oil prices,
would like to cut interest rates. With a gold standard, the two
countries could not diverge on monetary policy, even though their
situations are completely different. The result? High inflation in
Bling-land, or a heavy recession in the United States, or quite
possibly both.
In fact, the gold standard is partly to blame for the Great Depression,
which is why claiming the gold standard as a remedy for the current
economic crisis is absurd. In 1929, the demand for gold began rising as
some investors began getting nervous. They were essentially betting
that if anything happened, the Federal Reserve would cut interest rates
and abandon the gold standard, making gold much more valuable. As the
financial crisis hit, more and more began buying gold. This meant the
Fed had to raise interest rates to stabilize the value of the dollar
compared to gold, rather than cutting them drastically as it should
have to stave off a depression. The result: the value of the dollar
remained stable compared to gold, but since gold had become
considerably more valubale, the dollar gained in value compared with just about every other good. The result: deflation.
Deflation means less and less money is available, meaning people demand
less and less money for the same goods. This is the opposite of
inflation. "So things got cheaper? That sounds good!" It is not, the
effect is devastating. The incenstive to save during deflation is very
high, since your money becomes more valuable in relation to the goods
it can buy with every passing minute. That means people buy as little
as possible, and shops and industry suffer. In addition, if you had
taken out a loan, the value of the loan would steadily have increased,
making it nearly impossible to pay it back (this lead to an increase in
default rates). The shops and industries going under meant higher
unemployment and much smaller paychecks for those lucky enough to have
jobs. This is why deflation is scary. Every economy that abandoned the gold standard began recovering again within a year. This is why we departed from the gold standard.
One of the gold standard proponents' arguments is that because many
countries currently peg their currencies to the dollar, the whole world
was forced to follow the Fed's moves in cutting interest rates,
exacerbating the debt crisis. This is indeed a problem, but the
solution is nearly the opposite of what proponents of the gold standard
propose! The solution would be to let those currencies float. A gold
standard would only serve to further link them to the dollar. In
addition, any agreement on fixed exchange rates would require
governments to (obviously) agree on them. At the moment, many
governments utilize currency manipulation to keep their currencies low
(exporters like China, Japan, Norway, Russia, and Saudi Arabia). Many
U.S. government officials would be happy to see them stop doing that,
since this pushes the dollar abnormally high (largely responsible for
the U.S. trade and current account deficits). In addition, some
countries (like Norway) must engage in currency intervention, otherwise
their currencies would become so highly valued due to their natural
resource exportation that all of their other exports would dwindle, as
they would be far too expensive denoted in other currencies. The gold
standard would allow those economies to peg their currencies to the
gold, but it would not allow the governments the flexibility to react
to changing conditions.
Part of the solution to the current financial problems in the world would be to let currencies float more,
not less, or at least to peg the currencies to a basket of others, not
just to the dollar. This would give countries a more sensible and
accurate target than either the dollar or gold. Returning to the gold
standard would unnecessarily choke world economic growth, and would not
even be able to prevent another world financial/economic crisis, as the
case of the Great Depression clearly shows. Its advantages then? Very
few. The potential damage? Extreme.
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