The Top 5 Myths of a Gold Standard

Money LendersIf you can get your friend to stop laughing, and actually give you an answer as to why it would be a bad idea to return to a classic gold standard, you will invariably get one of the following responses. As we will see, some of these are either just plain wrong, or they are at best misunderstood.

1. Nobody wants heavy gold coins weighing down their pockets

This response is usually accompanied by some quip about going back to medieval times, with gold ducats carried around in purple drawstring pouches. But this just shows a lack of understanding of the essence of a gold standard. Yes, under a gold standard, you could transact in actual gold coins, which is what happened earlier in history. But people eventually figured out they could use paper currency that represented claims on the gold actually stored at banks and in vaults. The only stipulation for a gold standard is the ability to convert or redeem your money into gold, if so desired.

Therefore, you can still have currency and even units like ‘dollars’ as long as they represent a fixed amount of gold. This is what is meant by ‘gold-backing’. The option to convert to gold keeps banks and governments honest, but as long as citizens are unconcerned that banks or governments would ever default on this pact, then they will happily use the dollars and leave the gold in the vaults. In fact, our monetary system wouldn’t look much different; you would still have your checking and savings accounts, debit cards and credit cards, all denominated in dollars. The only difference is the additional option to convert those dollars to gold at any time.

2. Gold is a barbarous relic

Economist John Maynard Keynes and even talented investors like Warren Buffet and Charlie Munger have described gold in these terms. It has been suggested that if aliens saw humans digging up gold from the ground – refining it and shaping it into coins and bars, only to bury it back in the ground in vaults and guard it – they would think we are crazy. Perhaps this is not an unreasonable remark, considering the wasted resources on all of this energy, equipment and labor.

But if fiat money is superior and gold really doesn’t matter anymore, then we should see people selling and abandoning their gold. If gold is no longer used today as money, then the only people who should care about it are the few that need it for industrial uses and jewelry. This should make the price of gold go down in real terms. Yet the exact opposite has happened! People continue to value it, acquire it and hoard it. Even central banks have held onto their gold and increased their stockpiles, despite claiming it doesn’t have a practical use in our modern economy. The real price of gold has therefore increased, which in turn drives even more energy, resources and labor into the market to mine it.

3. The gold standard caused bank panics and harmful deflation

It is true that more bank panics and deflationary periods did occur under the gold standard; but this is merely causation and not correlation. Other countries like Canada were also under a gold standard, but they did not experience bank panics. The difference between the two countries lies in their differing banking laws and regulations. Unlike Canada, the United States had regulations that prevented banks from adopting practices that would have made their banks more diversified and less fragile. Sharp and severe deflation can be painful, especially for heavily indebted borrowers. But this is almost always preceded by an unsustainable boom in credit, so the bust and deflation is in fact the cure to return the system back to normal.

4. Under a gold standard, we couldn’t use monetary and fiscal policy to help us get out of recessions

It is indeed true that under a classic gold standard, there could be no monetary policy. In other words, there would be no way for the Federal Reserve to print money to try to jump-start spending or employment. This is exactly the point of a gold standard, and it is an advantage not a disadvantage! Monetary policy, or printing money, cannot create wealth or sustain/increase jobs.

The size and spending of the government would also be limited to how much the rest of the world would be willing to lend them, because there would be no Federal Reserve to print up money and buy the government’s debt: again, an advantage!

5. The price of gold fluctuates wildly, so going back to a gold standard would make prices too unpredictable

This is a misunderstanding as well as a falsity. Under an explicit gold standard, a dollar is worth a certain amount of gold and vice-versa. In 1834 for example, the U.S. set the rate as 1 troy ounce of gold being equal to $20.67. Therefore, the two were the same and could not fluctuate! The ‘price’ of gold in terms of dollars would never change. Take a look at this chart and see if you can locate the point where FDR devalued the exchange rate, and also the point where we went completely off the gold standard.

However, there are others that try to claim that the ‘value’ of gold fluctuates too much. By this they mean the value of gold in dollars as adjusted by inflation. Another way of saying this is that under the gold standard, the exchange rate may be fixed, but an ounce of gold could still fluctuate in terms of what it could buy. But looking at changes in consumer prices, we can see that although there was very little inflation under the gold standard, there were huge amounts of inflation after we abandoned it. A consumer basket of goods selling for $100 in 1790 cost slightly more in 1913 at $108 (just an 8% increase over 123 years!), while that same basket cost approximately $2,422 in 2008!

Now to be fair, in earlier times price changes had higher standard deviations over the short-term, meaning they did ‘fluctuate’ a little more wildly as compared to today. But would you rather have some short-term fluctuation with the advantage of knowing that prices will be the same years from now, or less fluctuations but not know how high prices will be in the future? The latter makes investments and long-term contract planning difficult. It also stands to reason that today’s global and diversified economy could smooth out those fluctuations much better than in the past.

In conclusion, although some of the top disadvantages attributed to the gold standard seem legitimate, on further inspection it turns out they are deeply misguided or simply not true. Indeed, the transition back to a gold standard could be tricky in some sense. But once back on it, there would be loads of advantages including stable prices, little to no inflation, no monetary policy to perpetuate boom and bust cycles, and a natural restraint on the size and spending of government.

Arguably, it is in fact fiat money that is the barbarous relic in modern society, not gold!

Chris Kuiper, CFA is currently a student and researcher at George Mason University, pursuing a Master’s of Economics. His previous experience includes asset management, investing and banking.