What was the Gold Standard and What Does Being off of it Mean to the U.S. Economy?

As the bank crisis unfolded, and our economic woes began to become more obvious, prices for gold and silver spiked drastically, as they usually do during times of economic turmoil. This ignited the debate over gold as currency and gold-based international trade, which let me point out, is essentially two different debates; one of which is of serious consequence right now, the other not so much. Let me explain.

Gold as currency

First, let's talk about gold as a currency. The price of gold against the dollar, as well as the fear of a collapsing dollar have led people to believe that gold will once again become a currency of exchange. That is extremely unlikely. First, it is gold's limited supply and unstable production that allowed people's fears to drive up the price by hoarding gold that was available.

During times of dramatic uncertainty, human nature has a tendency to seek comfort in the familiar or perceived axioms. There is an idea that gold will always be valuable and therefore remain a medium of exchange, even in an apocalyptic type scenario. In an investing sense, when people are scared, they buy gold (and smart investors buy gold, anticipating the rising price that follows). This increased demand predictably drives up the price of gold, which cannot instantly be mined and produced, meaning that people can make a profit on it, but only in relation to the faltering currency.

It always perplexes me that people who are long on gold because they believe in the coming failure of the dollar measure their success by its price in something they consider all but worthless. The only profit they can recognize is selling it back in exchange for a non-gold currency. So, if you are ”investing“ in gold, it should be to profit (in dollars) from people's perceptions in terms of a total collapse. But if you are buying gold because you believe that you are accumulating what will become the only viable currency, then the price in dollars isn't really relevant to value.

Now let's talk about why gold is unlikely to ever be used as a hard currency again. It is in limited supply and subject to drastic fluctuations. It is not a very durable form of currency once in circulation. It is extremely easy to counterfeit when compared to modern paper money, and it can still be devalued, simply by diluting the minting of coins in order to expand the money supply, the same way the Roman Empire did for hundreds of years.

Also, gold does not have the intrinsic value that we sometimes confer it. Mankind can complete every and any task where gold might be used with a substitute – usually a plentiful substitute and often a cheaper and more durable one at that. Water has value. Man cannot live without it. Unlike water, if you deny a man gold, his need for it does not increase unless someone ascribes a value to it and says that he needs it to buy necessities such as water or food.

But now, you're right back to the dollar – something that can be debased, counterfeited, fluctuates in supply and can be manipulated by whomever has the power to coin it and deem it legal tender. Also, in terms of banking, as long as you're still using fractional reserve practices (a must in modern leveraged economies like those of the entire world today) you're still lending money into the system. If you put gold in my bank, I can still lend much more than you've deposited.

If not, you're talking about a 100 percent reserve system, in which all money in circulation is redeemable for it's fixed value in gold, largely impossible with the limited amount of gold and tremendous amount of economic activity in the world today. Even if gold was set at many, many times the current price to achieve this, there would not be sufficient velocity of money in the economic system and credit markets as we know them (and rely upon) would lock up, while massive deflation could occur as too little money chased too many goods, especially at the capacity for production of modern economies.

I don't believe we will ever see mankind trading with gold as his currency again. Even in an apocalyptic scenario, he'd likely be bartering with canned goods, bottled water and good old fashioned flesh in the absence of a monetary system.


Gold and International Trade

Now, when we talk about international reserves and the balance of trade between nations, this is where things get interesting. In 1944, the 44 Allied Countries signed a pact in Bretton Woods, NH where they agreed to tie all of the member currencies to the dollar in order to maintain an exchange rate. As part of the agreement, the IMF was created the next year to bridge temporary gaps in balances between member countries.

Prior to World War I, the world trade had been on an actual gold standard since 1875, at the end of the Napoleonic Wars (hint: you'll see a trend with war and currency). All world currencies were at a fixed exchange, set to a fixed amount of gold. This acted as a built-in guard against many macro-economic problems, because gold leaving or entering an economy had an immediate impact. Too much gold coming in expanded credit, causing economic growth and eventual inflation as more dollars chased fewer goods. The higher prices made the goods less competitive with foreign goods, attracting imports and trade imbalance, which in turn led to more gold leaving the economy, which tightened credit supplies and cooled the economy while reigning in inflation.

If the economy cooled too much and prices of goods dropped as they chased less money in the economy, then the cheaper exports would become more competitive and gold would flow in, expanding the money supply and hence credit again... and on and on in relative balance. It was also difficult to run government deficits because with limited money supply (and therefore credit) excessive government borrowing drove up interest rates, which hurt the economy since businesses could not borrow and invest at profit in order to achieve growth.

After World War I, many countries abandoned the gold standard as the war had left most of them (the U.S. a notable exception) in deep recession. At that time, many nations began trying to increase economic activity by employing policies that would shift demand away from imports like tariffs, quotas and most dangerously – currency devaluation. These games provoked similar responses from the other countries that can start a quick spiral to the bottom, as it did in that instance.

After WWII, there was tremendous anxiety about international trade and a strong desire to avoid many of the factors that were believed to have led to the Great Depression. A competent substitute to the traditional gold standard, the Bretton Woods system put back into place the balancing relationships of foreign trade that staved inflation, sparked growth and discouraged deficits. All currencies were pegged to the dollar as an international reserve. A dollar was set at a fixed price to gold ($35 USD per ounce) and a U.S. dollar could be exchanged for gold at that amount (though it didn't have to be converted). Therefore, the value of the dollar was backed by the U.S. gold supply.

This system was designed to incorporate government intervention in the money supply. It relied upon the Keynesian belief that the government had an obligation to its citizens to take steps to keep unemployment low, whereas unabated capitalism saw certain levels of high-unemployment as a positive factor because it kept down the price of labor. At the time (and probably aided by the devastation of a world-wide depression and war), the governments of the world felt that balanced trade and open markets would provide the greatest degree of free-market stability, which had become the priority once more.

Rather than creating a true world bank, capable of creating money, the U.S. had a preference for a pool of currencies (and gold) that could be on hand to provide bridge loans to satisfy trade deficits, so that countries would not again be tempted to debase their currencies in order to pay debts. It was no secret that the United States was positioned to benefit most greatly as holder of the world's reserve currency and the chief economic power in light of Great Britain's economic devastation from the war. As such, this time became the greatest period of economic growth and parity that we'd ever experienced as a country.

But there were challenges and unseen design flaws, many of which had not previously existed or been major factors prior to the massive expansion in international trade that technology had made possible. First, gold is also a commodity and there is a gold market outside of the international trade system. Because it is in limited supply and the U.S. had amassed such large reserves, the available amount shrunk and the private market price went higher than the pegged currency value of $35. Now countries were motivated to convert all dollars into gold and then resell them on the private market, when they often would have held onto dollars otherwise.

Also, the rise of international banking conglomerates enabled massive non-government transfers of currencies for investment and speculation. Runs on gold and currencies like the British Pound further complicated matters. As U.S. financial dominance shrunk, other countries also began to resent the dollar's role as the reserve. Many steps were taken in an effort to regain stability, including pooling gold from the private market when prices got high, then using a floating rate of exchange, tightening rules on foreign investment and lifting import quotas.

But at the same time, the U.S. was also spending heavily on the war in Viet Nam, petrodollars were pouring out of the U.S. as oil prices spiked at historical levels, and the U.S. began running massive trade deficits for the first time that century. As assets poured out and gold coverage shrunk, the Bretton Woods gold standard became untenable. In 1971, President Nixon closed the gold window and suspended all conversion of U.S. dollars to gold. At that point, the dollar, as the world's reserve currency, became a fiat currency, with nothing backing it other than the nation's faith and credit.

By 1973, the Bretton Woods era had totally ended, shifting the world to a mercantile system of paper money in which currencies were floated at an ever-changing exchange rate. As printer of the world's reserve currency, the United States could now run massive deficits simply by issuing debt instruments (bonds). This drastically increased the role of the Fed and began an era of money supply manipulation in which debt issuance was manipulated to achieve desired (though not often desirable) and often politically motivated results. This was achievable because the natural ebb and flow driven by trade surplus/deficits and their corresponding capital outflows/inflows were (at least temporarily) avoided.

The U.S. trade deficits grew exponentially and more money was printed and debt issued to satisfy the imbalance. Even more money was printed  to keep interest artificially low and the money supply loose, while otherwise impossible to finance wars (the arch nemesis of a gold standard) were simply put on the same credit card. Without these brakes on the train and with added deregulation making goosing the system that much easier on a non-government level, we saw a credit bubble, a housing bubble, an equities bubble and finally economic collapse – predicted for almost a decade prior by opponents of the mercantile system.
 
It is therefore no surprise that people are talking about bold steps to redefine international trade. Going back to a gold standard probably won't work for the same reasons that it ultimately fell apart at the end of the 1960's, but it is clear that a debt-instrument, purely fiat money system where this much finagling of currencies can occur will not work, perhaps chiefly because it is never a politically good time to ask people to take some corrective economic pain when there's a short-term voodoo fix at your disposal. Arguments for mercantilism assume that proper adjustments will be made regardless of whether it's an election year. Politicians didn't used to have that option and I think it's clear we need to discover a viable system in which something other than people who must win expensive elections control our economic destiny. I don't pretend to have the answer, but it frightens me that smarter people than myself aren't having more serious conversations about it.