Advantages and Disadvantages of a Gold Standard

Advantages

  •  Long-term price stability has been described as the great virtue of the gold standard.  The gold standard limits the power of governments to inflate prices through excessive issuance of paper currency.  Under the gold standard, high levels of inflation are rare, and hyperinflation is nearly impossible as the money supply can only grow at the rate that the gold supply increases.  Economy-wide price increases caused by ever-increasing amounts of currency chasing a constant supply of goods are rare, as gold supply for monetary use is limited by the available gold that can be minted into coin.  High levels of inflation under a gold standard are usually seen only when warfare destroys a large part of the economy, reducing the production of goods, or when a major new source of gold becomes available.  In the U.S. one of those periods of warfare was the Civil War, which destroyed the economy of the South, while the California Gold Rush made large amounts of gold available for minting.
  • The stability of the gold standard fosters economic prosperity.
  • The gold standard provides fixed international exchange rates between those countries that have adopted it, and thus reduces uncertainty in international trade.  Historically, imbalances between price levels in different countries would be partly or wholly offset by an automatic balance-of-payment adjustment mechanism called the “price specie flow mechanism.”  Gold used to pay for imports reduces the money supply of importing nations, causing deflation and a reduction in the general price level for goods and services, making them more competitive, while the importation of gold by net exporters serves to increase the money supply, causes inflation and an increase in the general price level, making them less competitive.
  • The gold standard acts as a check on government deficit spending as it limits the amount of debt that can be issued. It also prevents governments from inflating away the real value of their already existing debt through currency devaluation.  A central bank cannot be an unlimited buyer of last resort of government debt. A central bank could not create unlimited quantities of money at will, as there is a limited supply of gold.
  • A gold standard cannot be used for, what economists call, financial repression.  Newly printed money can be used to purchase goods and services, and to discharge debts, at no cost to the printer. This acts as a mechanism to transfer the wealth of society to those that can print money, from everyone else. Financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation, and it can be considered a form of taxation.  In 1966 Alan Greenspan wrote “Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists’ antagonism toward the gold standard.”  Financial repression negatively affects economic growth.
  • The gold standard benefits savers by preventing their savings from being devalued or destroyed through inflation, and by rewarding them with higher real (inflation adjusted) interest rates. In the US and United Kingdom, from 1945 to 1980 negative real interest rates have cost lenders an estimated 3-4% of GDP per year on average.
  • The gold standard tends to limit credit booms and the resulting boom bust cycle because of the inelastic supply of money. There is no central bank to print ever increasing amounts of money which act as fuel for the boom, and overextended banks fail sooner as there is no central bank to bail them out, causing credit to contract and ending any booms that do occur.

 

Disadvantages

 

  • The total amount of gold that has ever been mined has been estimated at around 142,000 metric tons and arguments have been made that this amount is too small to serve as a monetary base. The value of this amount of gold is over 6 trillion dollars while the monetary base of the US, with a roughly 20% share of the world economy, stands at $2.7 trillion at the end of 2011.  Even in the unlikely prospect that all mined gold could be turned into coin, a return to the gold standard would result in a significant increase in the current value of gold.
  • The unequal distribution of gold as a natural resource makes the gold standard much more advantageous in terms of cost and international economic empowerment for those countries that produce gold.  In 2010 the largest producers of gold, in order, are China, followed by Australia, the US, South Africa and Russia.  The country with the largest reserves is Australia.
  • Although the gold standard has brought long-run price stability, it has also historically been associated with high short-run price volatility.  It has been argued by, among others, Anna Schwartz that this kind of instability in short-term price levels can lead to financial instability as lenders and borrowers become uncertain about the value of debt.
  • Deflation punishes debtors.  Real debt burdens therefore rise, causing borrowers to cut spending to service their debts or to default. Lenders become wealthier, but may choose to save some of their additional wealth rather than spending it all.  The overall amount of expenditure is therefore likely to fall.
  • Mainstream economists believe that economic recessions can be largely mitigated by increasing money supply during economic downturns.  Following a gold standard would mean that the amount of money would be determined by the supply of gold, and hence monetary policy could no longer be used to stabilize the economy in times of economic recession.  Such reason is often employed to partially blame the gold standard for the Great Depression, citing that the Federal Reserve couldn’t expand credit enough to offset the deflationary forces at work in the market.
  • Monetary policy would essentially be determined by the rate of gold production.  Fluctuations in the amount of gold that is mined could cause inflation if there is an increase or deflation if there is a decrease.  Some hold the view that this contributed to the severity and length of the Great Depression as the gold standard forced the central banks to keep monetary policy too tight, creating deflation.
  • James Hamilton contended that the gold standard may be susceptible to speculative attacks when a government’s financial position appears weak, although others contend that this very threat discourages governments’ engaging in risky policy.  For example, some believe that the United States was forced to contract the money supply and raise interest rates in September 1931 to defend the dollar after speculators forced Great Britain off the gold standard.
  • If a country wanted to devalue its currency, a gold standard would generally produce sharper changes than the smooth declines seen in fiat currencies, depending on the method of devaluation.
  • Most economists favor a low, positive rate of inflation. Partly this reflects fear of deflationary shocks, but primarily because they believe that central banks still have some role to play in dampening fluctuations in output and unemployment. Central banks can more safely play that role when a positive rate of inflation gives them room to tighten money growth without inducing price declines.
  • It is difficult to manipulate a gold standard to tailor to an economy’s demand for money, providing practical constraints against the measures that central banks might otherwise use to respond to economic crises.  The demand for money always equals the supply of money. Creation of new money reduces interest rates and thereby increases demand for new lower cost debt, raising the demand for money.

1 Comment

  1. Well I know that in the late 19th century (possibly the grseteat economic period in American History), we had the gold standard. The main reason why the gold standard is better than purely fiat paper currency is that it cannot be subject to the whims of whoever has monopoly power over the printing press. The government can’t use alchemy to inflate gold and devalue the savings of many Americans to finance wars, that’s why a period of war (such as the civil war) often involves a departure from the gold standard. The gold standard won’t quickly end the debt, but it will control inflation and heavily restrict government spending since the government will no longer be able to borrow money from the Fed’s printing press. Also consider banking, if we had a gold standard and a person’s deposit had to be backed up 100% by gold, there wouldn’t any worry about a run on the bank like what happened during the great depression. People would know that they could withdraw all of their money and whenever the bank loaned someone’s money, it would get that person’s permission, and the person would know that X number of dollar in their account was being loaned out and would not expect to be able to withdraw it.The problem is the interest allied against this, namely the banks as well as people who want to get bank loans quickly to finance their projects. Fractional reserve banking can generate real short term wealth, but it is nonetheless fraudulent. Also, governments wouldn’t be able to print the money they need so they prefer to have a fiat system. They and the people who get the new money first would benefit because the market hasn’t yet caught on to the increased money supply, but by the time it trickles down to the average citizen, inflation would’ve sent in and the new money would do nothing to improve their buying power.