Gold Standard Basics

A student recently emailed me about the gold standard, and why it is not feasible anymore. Here is my response.

There are two major problems with using gold to back an economy. First, the gold standard limits growth capacity of an economy. Secondly, the gold standard limits the ability of a central bank to respond to economic disturbances.

Let us first consider how the gold standard limits the growth capacity of an economy. The gold standard was a policy of fixing the supply of money in an economy to the value of gold it possessed. The supply of money means how much money an economy has circulating. In economic terms, matching the supply of money to the amount of gold an economy possesses is called “pegging.” For example, if an economy possesses one billion dollars worth of gold, then that economy should only have one billion dollars worth of money circulating (for a good explanation, see here).

Generally speaking, proponents of a gold standard (e.g., Ted Cruz in the last presidential campaign cycle) approve of the gold standard for two reasons: because they believe it promises the most price stability; and because it limits the ability of central banks (who are usually unaccountable to the democratic will of citizens ) to cause what they perceive as harm to the economy with things like deficits, debt, and inflation, etc..To be clear, price stability means that prices do not fluctuate too much. Price stability is preferable because people like to be able to predict how much something is going to cost in the future, within a limited range of variability. For example, for budgeting purposes, it is preferable that the price of milk remain somewhat predictable for households. So too is it true for businesses owners: it is preferable that the cost of the raw materials they use in the production of their goods remain somewhat predictable. If they were not predictable, neither households nor businesses could budget appropriately, causing many businesses to go out of business when things turn bad, and many households to go bankrupt. Because economies must peg their supply of money to the value of the gold they possess under a gold standard, businesses could not adjust prices according to the supply and demand of that good they are selling. So, hypothetically, if an economy has its entire supply of money circulating, and there is an increase in the demand for a good they are selling, a seller could not raise prices of its goods too much. For all of the money is already in circulation. Hence consumers would not have access to new money to cover the increased costs via things like credit cards, loans, etc. , and, therefore, prices would generally remain stable.

This logic, however, is what limits growth as well. The gold standard expects businesses and economies to trade-off expansion (and the profits that go with it) for price stability. Normally, a business experiencing high demand for the goods it produces will increase both the price and supply of the good (law of supply). How could they do this? Well, one way would be for the business owner to expand production with the profits or savings they have accrued. However, for most businesses, such profits and savings are not enough to expand to a degree that makes such expansion worth it. In economics, this is considered a problem of scale. So how might a business expand its production enough to remain profitable for the owner, and add to the growth of the larger economy? They would seek new money for expansion through attracting capital (for example, selling shares that provide the buyer a claim on future profits – we call them stocks), or by obtaining a loan, which provides a bank with a claim on the expected future profits that its loan made possible. If we apply the same hypothetical conditions I used above, however, then new money is not available. Hence expansion cannot proceed, which denies the business owner of profits, denies banks and shareholders of sources of revenue that they could further invest in other opportunities, denies unemployed workers new job opportunities since no new jobs are created (and free-market economies need all people buying things), and denies current workers raises since wages cannot be increased as easily as they might have otherwise been. When this happens for millions of businesses and workers simultaneously, it harms the health of the larger economy. This is how the gold standard limits growth, harming us all.

But if there is a potential trade-off to be made with price stability, isn’t it worth it? Unfortunately, history proves that price stability does not accompany the gold standard. Instead of price stability during the years when the gold standard was the norm, we see significant price volatility. In contrast, prices were much more stable once economies rid itself of the gold standard (for a good and easy-to-understand explanation of this can be found here – pay attention to the graphs!)

Why is this so? Part of the answer lies in the gold standard itself. Logically, keeping prices stable by pegging money supply to gold works. But, it works only if we assume there are no supply shocks to the amount of gold. For example, if there is a sudden decrease in the amount of gold we have, the money in circulation would be worth less, making it hard to buy the same goods at their old/current prices. If prices drop too fast, businesses have to further adjust by firing workers and decreasing production (since no one is buying their goods). This leads to problems associated with a surplus of goods not being sold (they become less valuable), and an increased inability to pay debts they incurred from their production costs. This is how depressions start (including our depression in the 1920s). This could also happen were there a sudden discovery of gold: on the belief that the increase in the supply of money will lead to increases in purchases, prices soar. However, the profit motive gets in the way of such price inflation being a good thing. That is because the wages of workers generally do not increase at the same time as prices do, or at the same rate as profits increase (in economics, this is called the problem of “sticky” wages – employers do not want to increase the pay for workers and will avoid doing so while they can sell their goods at higher prices, leading to higher profits). What you then have is a temporary rise in the money supply, which leads to a drastic rise in prices, which benefits only those with enough money already to shoulder the burden of high prices (very successful businesses with stocks of capital, wealthy individuals, etc.), which leads soon thereafter to a steep recession, then depression, etc. This is not good for an economy.

These reasons lead us to the second reason why the gold standard has been determined illegitimate: it constricts the ability of a central bank to respond to economic shocks. If an economy pegs its money supply to the value of gold it possesses, and a shock occurs, it cannot respond by providing to the economy more money unless it discovers new gold. When the gold standard was the norm, economies would transfer gold to countries they owed money to because of trade deficits. What’s more, if they needed to print more money, they could buy more gold from another country willing to sell it to them at a fixed exchange rate. However, in times of crisis, no economy wants to get rid of its gold. So no economy sells gold, leading to disastrous consequences. If a crisis hits, and an economy needs more money in its supply, it cannot print anything unless it has the gold to back it up. If the gold is not there, then there is no way to respond, and the economy must proceed on whatever course it must, including depression. Conversely, in today’s economies, because we are not beholden to a gold standard, economies can print or restrict the money supply as it sees fit, according to what is best for the economy. Though this makes many fiscal conservatives mad – DEFICITS! – contemporary economic thinking since post-depression economists (notably Keynes) proves that such deficits are the far better trade-off.

I should note that there is even more to the story of why the gold standard is not feasible. Particularly, the story of exchange rates, and trade surpluses and deficits that I briefly mentioned above. There is also a more significant story about the gold standard and its role in creating and sustaining the Depression. The last link above is a good place to start, but there are many others that a simple google search will provide.

For these reasons, however, the gold standard has been abandoned. The gold standard made our economies too volatile, restricting stability, growth, and GNP (we use GDP today). Since leaving the gold standard, economies have been much more stable (see here, and the second article I link above). Tellingly, a poll of economists at a conference at the University of Chicago in 2012 asked if returning the U.S. to the gold standard would be better for price stability and employment for average Americans. All – that’s right, ALL! – said no. 

No gold here, and we are all the better for it.

JH

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