Understanding the Gold Standard
I first starting thinking seriously about the gold standard back in 1980, when inflation spiked up over 10% (completely destroying my very first budget) and the value of the dollar seemed to be collapsing. (See also: Surviving a Financial Panic — Lessons from the Past)
During the early 1980s, I read quite a few "hard money" books. Each of them included refutations of the arguments against a gold standard — refutations of arguments I hadn't yet been exposed to, so my experience was a little backwards — but I learned why a gold standard was good and got the gold bug chapter and verse on why the arguments against the gold standard were all bogus.
(The term "gold bug" was originally a pejorative term for those who thought that only gold was "real money," and was quickly expanded to include anyone who thought gold was a great investment. Over time, though, the hard money advocates embraced the term and started calling themselves gold bugs.)
You will not be surprised to learn that it turns out to be more complicated than either the gold bugs or their detractors would have you believe.
Historical Gold Standards
Since ancient times, gold coins have circulated as money. That was always problematic, and gold was only rarely the main sort of money. Actual gold coins would be used by rich people and for certain kinds of transactions — in particular, to pay taxes and to trade internationally.
For ordinary transactions, though, gold tended to be too valuable. The monthly pay for a Roman legionnaire was one gold aureus (a coin about the size of a nickel, weighing a bit less than a quarter of a troy ounce). It was a lot of money — a similar size coin right now would cost you about $400. (Back in those days it was similarly valuable, although relative prices have changed so much it's pretty hard to compare. The historical record shows 8 aurei buying 23 acres of woodland in Kent.) That's a lot of wealth to carry around in a short stack of small coins.
Paper money was invented (gradually, with various intermediate forms) to solve some of the problems with gold coins.
In the heyday of the gold standard, banknotes were issued by banks against gold held in their vaults and circulated in parallel with gold coins. If you had a banknote, you could go to the bank that issued it, present the note, and receive gold coin in exchange. Contrariwise, you could deposit your coins at the bank and receive banknotes in exchange.
There were lots of reasons to go with banknotes. For one thing, you could have a $1 (or smaller) note — smaller than any practical gold coin. You could also pack very large sums into a reasonably small case — a bundle worth $50,000 could fit in your coat pocket. That amount in gold coin would weigh a couple hundred pounds.
That sort of gold standard worked pretty well over a fairly long period. It doesn't prevent inflation (you'd have inflation any time the gold supply was growing faster than the economy), but it limited inflation. Importantly, it kept inflation from being a political tool.
An Inconsistent Standard
The downside of banknotes was that you were relying on the bank to be sound. Sometimes banks are, but the temptation to issue more banknotes than they have gold on hand is irresistible.
Still, the real problem with a gold standard isn't unsound banks. That would be easy enough fix — a regulator could track the issue of banknotes and audit the gold supplies in the vault. The real problem is that there isn't one, true gold price.
The price of gold is set by the market — and the market is strongly influenced by psychology. During good times, the price of gold is modest. (For example, during the 1990s — after the previous decade's inflation had been squelched and before the dotcom boom popped — the gold price hovered around $300 a troy ounce.) During bad times, the price of gold spikes up toward infinity.
Since we're not on the gold standard, those price changes show up as changes in the price of gold. If you're on a gold standard, they don't show up that way. But that doesn't mean that they don't happen. It just means that the price change shows up as change in the value of the currency.
Over the last decade, the price of gold has spiked up more than 460% (an annual rate well above 19%). That's a lot higher than the inflation rate over the same period. (The CPI is only up 27% over the same period, an annual rate of less than 2.5%.)
Imagine that the value of your money had spiked up by that much! Of course, it'd be great if you had a lot of money. (I expect this is why gold bugs don't tend to worry about this scenario — in fact, with a bunch of gold in their portfolios, they're positively yearning for it.) But what if you didn't? What if you were a businessman who had to sign long-term contracts with customers and vendors? When the value of the money jumps around like that, you're totally screwed. Worse yet, what if you're in debt? If the value of the money spikes up, the cost of making your loan payments spikes up as well. Could you pay your mortgage if it took you a week to earn what you'd earned in a hour a few years ago?
The gold bugs counter that we wouldn't see scenarios like that. The spike in the price of gold is due to a collapse in confidence in paper money. If the money were as good as gold, confidence wouldn't collapse and values would be relatively stable.
There's some truth to that, but we know it's not completely true. During the gold standard in the 1800s and early 1900s, prices were pretty stable — but only on average, only over the long term. But short-term price swings produced just the sort of effect I'm describing.
It could happen due to ordinary market forces. The supply of gold would fluctuate as new mines opened and old mines closed. The demand for gold would fluctuate as well — in particular, as exciting new overseas markets heated up, gold would flow to those countries to invest in the hot new thing. The result was a flow of gold out of established markets, producing just the sort of jump in the value of gold that I'm describing. Of course, it didn't show up as a price spike, but rather as deflation.
So, it wasn't just a theoretical problem. It actually happened, over and over again.
All these things — wars, financial disruptions of all kinds, inflation or deflation due to changes in the gold supply or changes in the demand for gold various places around the world — made the gold standard problematic. The worst was a particular kind of financial crisis called a panic.
The Problem of Panics
Panics happened when people began to doubt the soundness of their banks or their money and decided that they'd better turn in their paper and get actual gold coins instead. Because there was rarely as much gold in the vaults as there was paper in circulation, the result was a crisis.
During the days of the gold standard, panics were perfectly ordinary — there'd be one every ten years or so. (We had something pretty close to a panic in 2007–2008, our first in something like 70 years. I wrote about it at the time in a post called Credit Squeeze (Formerly Known as a Panic).)
Having sound banks that don't issue paper beyond the gold in their vault would reduce the severity of a panic, but that turns out to be a poor solution. There are reasons why banks issue more paper than they have gold, and it's not just because it's like printing money. Rather, it's because during good times, the amount of money that the economy can put to good use is larger than the value of the gold stock. The only way to have that much money in the economy would be to set the value of gold to be much higher — rather like setting the price of gold to levels that are only typical during a panic. That sounds great to a gold bug (who probably has a bunch of gold), but it doesn't work, because that's not the price of gold. The price of gold — the real, market price — is almost always much less than that.
You can set a different price. You could, for example, set the price of a new gold dollar by dividing the US government's gold reserves (about 261 million troy ounces) into the total supply of currency in circulation (about 10,000 billion dollars) and suggest that a new gold dollar should be valued at $4,000 a troy ounce. Except that's not what gold is worth.
You could set the current market price (about $1,600 a troy ounce), but even that is the price level based on the current near-panic conditions about the value of the dollar.
If people weren't worried about the future of the dollar, the global economy, the deficit, the debt ceiling, the European debt crisis, etc., I suspect the price of gold would be pretty close to the $300 a troy ounce that we saw through most of the 1990s.
(You'd think that gold bugs of the libertarian sort would understand that prices are set by the market, rather than by government fiat. But for all they rag on fiat currency — that is, money that only has value because the government says it does — they seem utterly oblivious to the notion that denominating gold in dollars is another fiat decision.)
And that's the problem with a gold standard. There isn't one true price for gold. The right price — the market price — surges and collapses with the psychology of the market. You can let your whole economy get dragged around by that — most of the world did for centuries — but don't imagine that they did so without difficulty. They had panics, they had inflation, they had deflation, and they had all manner of crises when gold flows caused by booms in far off parts of the world threatened to crush local economies.
The End of the Gold Standard
When things got particularly bad — usually either a war or some sort of financial crisis — banks or governments would suspend convertibility into gold. If both the country and the currency survived, convertibility would eventually be restored. If just the country survived, a new convertible currency would be introduced (the old currency by then being nothing but waste paper).
In the depths of the Great Depression, the U.S. took a slightly different path. In 1933, instead of suspending convertibility, the government banned the private ownership of gold, requiring citizens to turn in their gold in exchange for banknotes at the then current gold price of $20.67 per troy ounce. Shortly thereafter the value of the dollar was changed to a new parity of $35 per troy ounce. Convertibility was preserved (although only for foreigners), but at the new parity gold flowed into (rather than out of) the United States.
Gold ownership by U.S. citizens wasn't legalized until 1974.
In the run-up to World War II, the last few countries that had tried to stay on the gold standard had to suspend convertibility. Since then, essentially no currency has been convertible into gold — they're all fiat currencies. (For a few decades after the war, the U.S. dollar was technically convertible — but only for foreign central banks).
It turns out a good fiat currency can avoid most of the problems of a gold standard. Our fiat currency hasn't always been good, but it's been doing sorta okay for a long while now.