The gold standard, explained

You either love it or hate it

In our previous article, we mentioned how Franklin D. Roosevelt signed Executive Order 6102, which forbade the hoarding of gold coins, gold bullion, and gold certificates in the US. The reason he passed this law was because back in 1933, the US was still on the gold standard. This raises the obvious question: what is the gold standard? 

Simply put, it’s a monetary system where the value of a country’s currency is directly linked to gold. With the gold standard, there is a fixed price for gold which is then used to determine the value of the currency. For example, if the price of gold is $500 per ounce, then the value of each dollar would be 1/500th of an ounce of gold. 

Why would anyone want this? 

Proponents of the gold standard argue that the money supply needs to be controlled, in this case by the quantity of gold. Since gold is a finite natural material and must be mined and processed, it tends to be produced at levels consistent with the demand for gold. Under a gold standard, creating more currency requires obtaining more gold, which raises gold’s market price and stimulates increased mining.

Thus more gold is then used to back more money until a point when currency levels are adequate, the price of gold levels out, and mining is scaled back accordingly. In other words, the system regulates itself in terms of preventing needless inflation. Under a fiat currency system, where the value of currency is allowed to fluctuate against other currencies on the foreign-exchange market, there are no such checks and balances. 

This lack of oversight can have some severe consequences. For example, consider that between the years 1900 and 1970, there have been only 4 (yes, 4) economic crises, but since 1970, there have been 23 financial crises. Or what about the fact that the largest bank failures in the US took place after 1971. Interestingly, that is also the same year the US completely got rid of the gold standard, with President Richard Nixon suspending the convertibility of the US dollar into gold in international transactions. What a massive coincidence, right? 

Probably not. The Federal Reserve (America’s central bank) can now print fiat money and artificially lower interest rates with little to no end. Looking at the 2008 financial crisis, many economists point to the Fed lowering interest rates from 6.5% to 1% during the early 2000s in order to soften the effects of the dot-com bubble and the 9/11 attacks, as a major cause of the crash. 

A gold standard, keeping the money supply in check, could drastically reduce the risk of economic crises and recessions. 

So if the gold standard is so great, why did we get rid of it? 

To understand the conditions that lead to the abolishment of the gold standard, we have to go back to WW1. During this time, international debt increased and government financial institutions deteriorated. As such, people were becoming increasingly skeptical of the gold standard (despite it’s golden years from 1871 to 1914) and felt that something more flexible was needed especially during wartime. 

The gold standard, by its nature, tightly restricted government spending during wartime - because governments simply couldn’t print money, their funds for the military were very limited. WW1 was expensive, and that’s when most countries abandoned the gold standard. 

After WW1 many Western economies were recovering from their loss when the Great Depression hit them. It was only a matter of time before both the US and UK governments (both of which still used the gold standard at the time) felt monetary systems needed to act in accordance with what's needed to rectify economic downturns, not the value of gold. Eventually, President Franklin D. Roosevelt signed Executive Order 6102 and then several decades later, President Nixon killed off the last remnants of the gold standard. 

But these decisions arguably have been for the better. For example, because the supply of money under a gold standard would be dependent on how much gold is produced, sudden inflation would occur in the wake of large gold discoveries and deflation would occur during periods of gold scarcity, which doesn’t sound ideal if you’re looking for a stable economy. This is precisely what happened during the California Gold Rush of 1848, when the United States suffered a monetary shock as large quantities of gold created inflation. 

Another problem is that because the gold standard limits the central bank’s ability to inject money, this can prevent them from taking the necessary monetary actions to help the economy during recessions. In our article on inflation, we explain how and why the central bank lowers interest rates during recessions, as it’s often crucial for economic recovery. 

This is what happened in response to the 2008 financial crisis; the Federal Reserve expanded the US money supply, which was then used to put the unemployed to work through public spending. The 2009 Obama stimulus, for instance, prevented the loss of an estimated three million jobs. With a gold standard, these stimulus actions could not have taken place. 

Despite seeming to be a single issue, the gold standard touches upon the main debate in monetary policy; one side blaming reckless management of the money supply on several seemingly unrelated economic troubles - things like stagnated incomes or decreased savings rates. While on the other hand, proponents of a more flexible monetary policy argue that the abolishment of the gold standard prevented the world from going through another Great Depression in recent years.

At this point, it’s unlikely that the US or any country for that matter is going to bring back the gold standard. However, that doesn’t mean that  the debate surrounding it is going away anytime soon.