The Argument for Gold

A few weeks ago, while Fed Chair Jerome Powell was addressing members of congress, he was asked about his opinion on returning the US to a gold standard. I found his response interesting.  He didn’t exactly answer the question, but he said that on a gold standard the Fed’s main objective of price stability and maximum employment would have to come to an end. Instead, its major role would be to maintain the dollar value of gold. In the past there have been many calls to return to a gold standard, but these calls usually fall on deaf ears. The topic is rather esoteric and the country’s history with the gold standard is muddled at best. But a brief history lesson, as always, can shed light on a confusing topic.

A gold standard can take many forms but, in essence, it is an economic system where gold is used, either directly or indirectly, as money. Currency is “backed” by or represents a claim to gold. During the first century or so our country operated on a bimetallic standard; both gold and silver were legal tender. The Gold Standard Act of 1900 declared the gold dollar the standard unit of account and all forms of money issued by the government were to be maintained at parity with it. For the first time, a gold reserve for government-issued paper notes was formally established. Government issued paper money, silver certificates and silver dollars continued to be legal tender, and were redeemable in gold. Free market forces at the time, such as the discovery of gold in California, had already firmly established a gold standard in the US. The Gold Standard Act of 1900 was basically the government’s way of trumpeting to the rest of the world that it was a worthy trade partner.

US monetary policy during the turn of the 20th century was as close to a pure gold standard as we have ever seen domestically. But those days would not last long. The Great Depression ushered in a time of unprecedented economic hardship and the federal government, under the leadership of FDR, took drastic measures to remedy the situation. The Gold Reserve Act of 1934 nationalized all significant quantities of gold requiring American citizens to turn in gold coins and bullion valued over $100. In return, holders of the precious metal would receive $20.67 per ounce which was the official price of gold set by the federal government at that time. Afterwards, the nominal price was increased to $35 per ounce effectively increasing the money supply in the country in a hopes of sparking inflation (deflation was a serious problem in the economy during the depression). The United States now found itself on a quasi-gold standard: the US continued to define the dollar in terms of gold but transactions were limited to official settlements with other sovereign nations.

By 1970 the US had reached the legal limit on outstanding currency it could issue based on the gold stock that was held in reserve. This produced two significant economic effects: 1) the country began to experience severe and prolonged inflation, and 2) the price of gold on the open market skyrocketed. The rapid increase in government spending during the 1960’s and 1970’s led to larger than usual federal deficits and an alarming increase in the national debt. Maintaining a gold standard at any level became impossible. So, in October 1976, the government made official what was already true in reality: the definition of the dollar in terms of gold was removed from statute. The monetary system officially became one of pure fiat money.

In order to maintain a gold standard, the US would need to constrain its money supply and reduce deficits, something it just seems incapable of doing at this point in history. There is one other phenomenon that took place in the 20th century that made a gold standard difficult to preserve. Supplies of gold no longer defined a wealth of a country, supplies of oil did. Oil became essential to running an economy and military in the 20th century. A country with all the gold in the world couldn’t buy a drop of oil from its enemy. So how valuable was the gold? Gold in and of itself is pretty useless compared to oil. In the future, perhaps it will be some other asset or resource that defines a country’s wealth. So, while a gold standard in theory is a great idea, in practice it’s just not realistic.