If they dare to come out in the open field and defend the gold standard as a good thing, we shall fight them to the uttermost, having behind us the producing masses of the nation and the world. Having behind us the commercial interests and the laboring interests and all the toiling masses, we shall answer their demands 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.
–William Jennings Bryan on July 9, 1896, at the Democratic National Convention in Chicago

I know, this speech by Jennings was about the debate for bimetalism (gold and silver) versus a gold-only backing of currency in order to inflate the currency to aid cash poor farmers…I still love this speech as a piece of oratory and encourage Blogmocrats to take a look at it.

The point of this post is to bring up and simplify an argument that occurs every time the economy goes south: the Gold Standard as backing for currency instead of a Central Bank (the Fed). The Gold Standard is when every dollar in circulation is backed by gold held in reserve, dollars can be cashed in at any time for the face value in gold. In a Central Bank model the Fed controls the size of the money supply through the setting of interest rates through open market operations (bond market), and through the setting of banking reserve requirements.

When a currency is backed by gold, as the dollar was in from 1880 to 1914, the golden age of the Gold Standard, we saw excellent growth and relatively freer trade between countries. The money supply during that period only grew when new gold was put in reserve and therefore, price levels remained very level, inflation was .01% per year because of fixed government prices for gold, exchange rates were mostly fixed as well. Interest rates were driven by reserve gold, if a country had reduced gold holdings due to a balance of payment problem, the reserve (interest) rate would go up, slowing down the expenditures in that country and attracting short term gold investment, thereby raising the level of reserve gold.

So, what are the problems with this Gold Standard? Domestically, this means that there is very little discretionary control of the money supply because of a set amount of mined gold in reserve holdings both at home and abroad. In English this means that that period was far more volatile in unemployment and domestic economic shocks, ups and downs in the economy. There is no expansion/contraction of the monetary supply that smooths out the boom/bust cycles, the only way to expand the monetary supply is to discover and mine more, new gold. The total amount of gold ever mined is about $4.5 trillion @ $1,000 an ounce. That does not even cover the amount of ONLY $US in circulation as M2 which is approximately $8.5 trillion, circulating and deposit. A return to a Gold Standard puts a very large hole in the US and world economy. If the government tries to play with the price of gold to raise or lower the money supply, the trading partners and speculators will pounce, rendering that policy almost suicidal.

The problem with a Gold Standard internationally is that as soon as one of your major trading partners decides to go off the standard or to cheat, or you get teamed up on in a speculative attack, you have very little control on the options to save your economy. In the 1930’s, the US had to raise interest rates in the middle of a depression because if it did not, the currency would have come under speculative attack from the outside causing massive monetary crisis. Gold Standard also is incapable of handling modern velocities and speculation of international finance.

The Central Bank system is flawed as well, we know that. The government is spending too much…printing too much money. Too much debt is held by foreign powers (this is another debate in itself). Fractional banking works on confidence in the $US alone. But, it allows the economy to grow beyond the physical holdings of gold, frees up monetary policy so that it can smooth the boom/bust cycle, and provides for a lower rate of unemployment over time.

I can hear the howls and hisses from the Gold Standard proponents: “the Fed is unconstitutional! Down with fiat currency! Bernanke is a twit, (well, OK on that one)! Fractional Banking is evil!” . That’s fine, but that is not a defense of the Gold Standard, it is a Paulian critique of the Fed. My answer to these arguments are this: show me how to fix these two problems with the Gold Standard: how will you repay the people who loose savings and investments because there is not enough gold ever mined to even cover ONLY the $US M2 (money in circulation and holdings)? And, Why are you willing to give up discretionary monetary policy and hand it over to other countries or wealthy speculators who may declare economic war on you? And, are you prepared for the viscous boom/bust cycles that occur under a Gold Standard? Yes, we have given up some freedoms to have a Central Bank, the myth is that we would have more freedom under a Gold Standard.