Talk of a return to the gold standard is in the news. And with it, there’s no short of misinformation and hyperbole.
Arguments about a hard link between gold and America’s currency always wind up being contentious — and frequently see both sides getting wrapped up in their own circular logic. It also doesn’t help that gold is iconic and universal in its representation of wealth; it also is physical and can be touched, unlike so much in the world of finance. Thus, debates tend to be philosophical as much as economic in nature.
So at risk of further angering folks on every side of the issue, I’d like to try to speak logically about the gold standard and why it’s a bad idea. I’ll start by trying to outline the case for a gold standard and against the current dollar as I understand it in seven key points:
- “Real” Money: Gold is real and has real worth, unlike fiat money such as the dollar that holds no intrinsic value. There is no guarantee your dollars won’t be worth nothing tomorrow.
- Economic Stability: The value of gold cannot be manipulated by bureaucrats for political ends. At best, Federal Reserve moves have had unintended negative consequences by messing with the dollar — and at worst, central bankers have willfully enriched some and caused hardship for others.
- Price Stability: A side function of an unstable dollar is the large swing in consumer prices, particularly commodities like oil that are tied to the greenback’s value. Since gold prohibits this kind of manipulation, prices would be more stable.
- Bank Risk Tamed: Banks still would exist, to be sure. But the practice of “fractional reserve” banking would cease to be so dangerous since currency deposits would be convertible to physical gold on demand — thus increasing the need for banks to keep substantial assets on hand.
- Deficits Tamed: As with bank leverage, a fiat currency like a dollar allows for (and some contend encourages) bigger government deficits since there’s no need to back up the debt with anything real. Gold stops this.
- No Link to Dummies in D.C.: Similarly, the dollar also is tied to the fate of our government. As we saw in Europe, political instability can cause the value of money to drop precipitously. But gold is always gold — regardless of how poorly run Congress is.
- Not a Barter System: A gold standard doesn’t mean only trading physical gold coins. E-commerce will exist — as will paper currency, so long as dollars could be converted to the commensurate amount of gold on demand.
I believe that’s the case for gold, as succinctly as I can make it. But now allow me to tackle these points one by one to show the flaws in their logic — and why the gold standard is at best an equally bad idea, and at worst damaging to the economic stability of the U.S.:
On ‘Real’ Money — Gold Can Lose Value, Too
True, gold will always be worth something. Paper money can become worthless based on poor policies — as we most recently saw in the case of Zimbabwe, where hyperinflation caused the nation to abandon its currency.
But while an ounce of gold is worth “more” than many things — like, say, a pound of beef or a yard of fabric — exactly how much more is up for debate. Gold prices are notoriously volatile, and are not immune to declines. Take a look at this chart from InflationData.com, showing the inflation-adjusted price of gold and how it has whipsawed:
Just as the value of a dollar fluctuates, the value of gold fluctuates, too — sometimes to the downside. It’s not fair to say that gold only continues to hold or even grow its value over time, because while nominal prices have gone up, they’ve also gone up for coffee and corn in the past few decades. Adjusting for inflation, we are still below the 1980s peak of the precious metal. Gold clearly can lose value.
It admittedly has been a good run for gold since 2000, and I won’t deny that. But let’s talk economics and not returns vs. the S&P 500 — because that only proves the case that gold is subject to investment “speculators” and thus big swings in price.
Now, detractors point out that the volatility coincides perfectly with Nixon’s 1971 move to end the practice of redeeming dollars for physical gold. Fair — but the fact that gold values were cut in half from the beginning of World War II to the mid-1950s proves this kind of volatility predates that policy.
On Economic Stability — ‘Inflexibility’ a Better Word
It’s a fair point that the Federal Reserve is imperfect and has sometimes caused more harm than good in its efforts to manage the U.S. economy. But it is impossible to argue that the Fed is wholly evil and has never done anything right.
In fact, the inciting incident for the third incarnation of America’s central banking system was the Banker’s Panic of 1907. Under a gold standard and without the Federal Reserve, stocks flopped 50% and a lack of liquidity caused a run on banks. It took folks like J.P. Morgan acting like a central banker to shore up the financial system.
It’s also worth noting that, thanks to an elastic currency, a federal reserve system has largely succeeded in eliminating deflation — an ugly downward spiral of wages and prices — since the Great Depression, despite the relatively common occurrence of deflation before the Fed and after the Civil War.
So while very different in nature, the bottom line is that neither “soft money” with the Fed or “hard money” via a gold standard wholly prevent economic crashes — and both have benefits in different situations. Neither is perfect.
Of course, an unavoidable fact is that gold has no human hand behind it. That drives many to prefer the rigid option of gold to prevent damage caused by corruption or stupidity. And considering all parties should admit that the Fed and Alan Greenspan’s easy-money policies are at least partially to blame for the 2008 meltdown, the point hits close to home.
But now we have strayed into the philosophical, about whether you trust policymakers to do what’s “best.” And that’s far too weighty a discussion to have here, involving bigger questions about the size and scope of American government.
Let’s just say that on a crisis-prevention basis, gold also has its flaws, and leave it there. Leaving the free market to its own devices free of monetary policy doesn’t always result in boom times.
On Price Stability — It’s Impossible
The criticism that the Federal Reserve and its monetary policy are “causing inflation” is perhaps the most populist selling point for the gold standard since this hits people directly in their wallet. As goldbugs like to say, an item that cost $1 in 1913 would now cost you $22.55. Clearly we have to do something, they say.
But inflation existed in America even without a central bank, so those claims are oversimplifications. Particularly during the Civil War, inflation was a huge problem in America. Equally troublesome was that after sharp periods of inflation, there were periods of sharp deflation — and while not as obvious, it must be acknowledged that steadily dropping prices can be just as damaging to an economy as steadily rising prices. Just ask Japan about its “lost decade” caused by deflation — or better yet, those who warned of the risks of deflation immediately after the financial crisis.
Also, it must be noted that broader demographic trends will persist for many goods that simply have to cost more over time. The bottom line is that supply and demand still drive the bottom line on many things. Take oil output and world crude demand, and that has much more to do with oil prices than central bank policies. The spike in crude after Isaac is a short-term example of this trend at work, and long-term, the peak oil crowd is quick to remind us that energy prices have nowhere to go but up.
In short, the idea of price stability is just naïve. Inflation is painful and real for many families, but there is no magic bullet — certainly not a golden one — to stop this trend for many goods.
On Bank Risk — Gold Not the Only Way
This probably is the best point in favor of the gold standard, in my view. The financial crisis was precipitated by the lack of real money on the books at banks to back up their risky gambles. If banks had to have the real gold on hand instead of simply asking the Fed for more dollars, they would have to behave better.
I cannot argue with this point at all, and wholeheartedly agree the banks need larger caches of real assets.
Unfortunately, I think that goal can be achieved by having those bedrock assets be denominated in dollars and through central bank regulation. Gold-standard advocates claim that defeats the purpose because dollars are fake fiat currency, can become worthless and thus the reserves aren’t real … but now we are having a circular argument.
Let’s just say that I agree with the idea of taming risk, but that the gold standard isn’t the sole mean to do this.
On Deficits — It’s Impractical
Here’s an uncomfortable point: While I do think the government should be living within its means, the rigidity of a gold standard where dollar reserves around the world can be exchanged for hard gold is impractical. In fact, part of the reason the dollar was decoupled from gold in 1971 was because of simple supply concerns. Here’s an excerpt from Peter Schiff’s money management firm Euro Pacific Capital:
“In 1971, adherence to the gold standard meant the Nixon administration faced a politically difficult decision. Big increases in government spending associated with the Great Society programs, the war on poverty, the Vietnam War, and the Space Race, resulted in large deficits (by 1971 standards of course). This led the government to print lots of money, thereby hitting Americans with large doses of inflation. As a result, general prices had by then tripled from the levels seen in 1932. But the price of gold had been held at 35 dollars per ounce. This led America’s foreign creditors to exchange their paper dollars for gold (It was illegal for American citizens to do likewise). This created a drain on our gold reserves, and if something were not done, it was likely that the U.S. would lose all of its reserves.”
You can argue that Vietnam and the NASA missions — or even the social programs — never should have been enacted to begin with. But how we unwind back to that level of debt or build up adequate reserves based on global gold supplies is impossible to manage in the near future.
This is not a cop-out, but a fact. The logistics and practical challenges of a gold-standard change based on the scale of the U.S. economy and current federal spending — to say nothing of the $829 billion of U.S. currency in circulation, the majority of which sits outside America — have to be acknowledged. Otherwise we are simply not living in reality.
On Congress — Is THIS the Best We Can Do?
Look, I’m pissed off about Congress like everyone else. But even if the value of our currency would remain intact regardless of the stupidity in Washington, how does that help make our country a better place to live?
Debt and monetary policy are but one concern voters should have. It is imperative that we staff Congress with men and women who understand not just the importance of fiscal responsibility, but of building a better nation at the same time. This involves difficult choices about the burden of taxes, how we should invest that revenue and what areas matter to us most in regards to the quality of our lives as Americans.
Even if we could impose some kind of rigid spending requirements, the bottom line is that legislators still would be as corrupt as ever and funnel money to special interests if the voting public does not hold them accountable.
It’s tempting to impose some kind of fail-safe on Congress so our leaders will do their job in regards to spending and keep deficits under control. But deficits are symptomatic of a failure of leadership among our elected officials, and it’s about time voters fix the main problem by putting some adults in charge.
In short: Even if you “fix” deficits, you haven’t fixed the corrupt spending and pandering that goes on in Congress. I would argue that one without the other doesn’t matter much.
On Not Bartering — It Has to Be Bartering to Work
The idea of gold coins as the only acceptable currency is just not happening in an age when people buy products from China with their PayPal account. Global commerce would simply become too inefficient.
That’s why most gold-standard advocates are practical in their desire for currency that is simply based on gold, not gold itself. The main difference is that the currency could be redeemed for gold whenever the currency holder chooses.
Also, many advocates are pushing a “denationalization of money” that involves private coinage and currency competing with government-issued money. The idea would be that as long as you can get $1 worth of gold for a $1 note, it doesn’t matter whether Uncle Sam or private citizen Sam Smith is making the trade.
But this topples the very argument that gold is the only way to go because it is proven and solid in a world of intangible value. How can you be sure that Sam Smith actually has the gold to back his currency? How can you be sure that the gold you get is real gold and not full of impurities when you get it? How can you be sure that in a time of crisis, when people race to convert their notes to physical gold, that anyone — government worker or private banker — will be willing to turn over that gold even if they have it?
In short, the idea of a gold-based paper currency is just as “fragile” as a fiat currency created by the Fed. And since physical gold for everything is a practical impossibility, I don’t see how the gold standard can hold onto any of its arguments about the “real” value of this option when it is just a piece of paper as well.
Agree or Disagree? Speak Out Below, Please!
This article admittedly is way too long, but I felt the need to be exhaustive after a previous column attracted some criticism for not making any sense. The trouble with writing daily on InvestorPlace.com is I sometimes naively assume that everyone is familiar with my past writing and is reading all of the outside articles I am.
To that end, I would appreciate any comments or criticism on these points as a way to make this article as complete as possible. I tried to faithfully represent the gold standard advocates as best I could without warping their position, so I welcome any feedback on these or other points.
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at email@example.com or follow him on Twitter via @JeffReevesIP.