Discussions and debates on the merits of various forms of monetary policy–usually relatively technical–have invaded even the mainstream news media of late. One idea often advocated is a return to the “gold standard”, a form of monetary policy in place (although not continuously) sometime after the invention of paper currency until about the 1930′s depending on what country you happened to live in at the time.
While the advocacy in favor of or against a gold standard is often intense (especially in certain circles in the United States and the United Kingdom) specifics on the mechanics and policy implications of implementing such a system are often lacking.
A Quick Review of Floating Currency Management
Free floating currencies such as the US Dollar or the UK Pound Sterling have no intrinsic value. Instead their value resides in the prices set between buyers and sellers in the marketplace as to what goods or services are believed to be equivalent to a given amount of currency. The currencies are merely a medium to sustain a complex barter of goods and services between producers and consumers. Two major things affect whether a given good or service requires more currency to purchase in the future (inflation) or less currency to purchase in the future (deflation):  the trade balance (and investment balance) between the given country and other countries (overall trade deficit or surplus); and  the overall amount of currency created or destroyed by the actions of the nation’s central bank or similar institution.
Nations manage their supply of money and the investment balance through one or more of these tools:  bank reserve requirements;  interest rates; and  actually printing or destroying money.
The US, UK, and most other nations currently manage their money supplies in accordance with what is called Monetary Policy as originally outlined by Milton Friedman and practiced by American Federal Reserve Chair Paul Volcker, although since modified for practicability.
The Mandates of the U.S. Federal Reserve
By law, the US Federal Reserve system (similar to central banks of other national governments) must use the monetary policy tools at its disposal (mainly setting interest rates combined with printing more money) to minimize inflation (without deflation) and maximize employment. Much of the dislike of the US Federal Reserve system is based in the fact that these two mandated objectives can often be at odds in the short term meaning that the subjective choice of which priority to elevate above the other will always seem to be politically motivated by one group or another.
How Does the Gold Standard Change Things?
The gold standard is a mandate to maintain a nearly constant currency valuation for a given weight of gold, for example, freezing the price of gold indefinitely into the future at $1530.17 per ounce. Although many expect that the gold standard would entail a promise to redeem a given amount of gold at that price, this aspect is not necessary and has not been a historically consistent component of gold standard currency systems. The gold standard does not involve using actual gold as money.
Instead, rather than being consumed with other concerns about economic performance or trade balances, in a gold standard regime, the central bank (or currency board or similar authority) uses the tools available (setting interest rates, buying and selling the currency against gold and against other currencies) to maintain an almost constant price for a given amount of gold. For example, if the demand for gold were to rise around the world due to one circumstance or another such as economic uncertainty, the currency authority would have to contract the supply of money (raising interest rates or exchanging gold for currency) to maintain the gold standard. Or, if the demand for gold were falling, the currency authority would have to expand the money supply to maintain the gold price (lowering interest rates or exchanging currency for gold).
Long term changes in the demand for gold versus the currency would be managed through interest rate changes, while short term changes would be managed through gold-currency exchanges or currency exchanges between nations. Trade deficits or surpluses would also have an effect here with their own policy tools, but in general, I have not included them here in this article.
Because of these needs–even with a gold standard–to actively management money supply in response to changes in gold demand, the redemption of gold for currency would not likely be a part of any modern gold standard. This is because with a redemption policy, the actual physical gold reserves of a country on one end and the available gold supply for purchase in the market on the other end would set hard limits on the possible money supply changes necessary to maintain the currency’s value against gold. For example, if a nation had to sell gold for currency to maintain the gold standard valuation and satisfy all redemption requests, it could only do so until all gold reserves were gone at which point the redemption would have to be suspended (as often happened historically during “runs” on gold). As any one nation does not control global gold demand, it is unlikely that any would want to have their hands tied on maintaining the gold standard only for a certain range of possible future conditions were they to implement it.
What are the Ramifications of the Gold Standard?
Whether to one’s chagrin or elation, a gold standard does not remove the need for a federal reserve or a central bank. Instead, it changes the mandate by which such an institution operates. It also does not necessarily remove any of the typical central bank tools for managing the money supply (e.g. interest rates, bank reserve requirements, and currency sales/purchases), it simply changes their objective.
The overall impact on the economy (in the current globalized situation, which is quite different from the pre-1930s economy) is difficult to predict with any kind of certainty. Money supply management under a gold standard would be very different from what most nations exercise today.
Today, times of slow growth in economic output or contractions in economic output (recessions) generally result in central banks applying low interest rates and increasing the supply of money as an incentive for capital holders to invest in economically productive purposes and dis-incentivizing saving. The intention of this policy is to make equipment purchases and business loans more attractive versus saving money, thus hopefully leading to increased employment and greater economic output in the future.
Under a gold standard, times of slow growth or contractions in economic output, if global and not localized in nature, would likely lead to an increase in demand for gold as is typically the case. As gold becomes more valuable in terms of other floating currencies, the central bank tied to the gold standard would have to contract its money supply in order to maintain a constant gold price, or equivalently would have to increase demand for the currency by increasing interest rates or by buying up the circulating currency. Many economists believe that this would dis-incentivize business investment, encourage keeping more capital in the bank, and thus prolong the economic recession; while gold standard advocates believe that overall increased stability in the monetary system overall will reduce excesses of the market like investment bubbles that cause their own problems.
Long Term Deflation
This may sound scarier than it is, but given the anticipation in the long term of a growing population combined with a growing economy, and a very slightly increasing gold supply, overall prices including prices for labor (wages) would be expected to fall over time in a gold standard currency regime. That means that while you make $40,000 this year in income, in 20 years time, you may make only $30,000 in income, even though your actual standard of living would be higher.
This already, in fact, happens with much of the electronics market: cell phones and computers next year will be both more capable and lower cost. However, the implications of training generations of people who expect inflation to not be discontent with deflation might be more than any political system could handle.
On the other hand (as the favorite saying of economists goes…), a gold standard currency regime could be designed with a pre-programmed inflationary rate, so that rather than maintaining a constant price for an ounce of gold, instead the price of gold would be managed to increase at 2% (or whatever value) per year.
How Beneficial (or Harmful) Would the Gold Standard Be?
This question is very difficult to answer mainly due to the fact that the devil is in the details of implementation combined with the historical uniqueness of an established western economy converting from a free floating currency to the gold standard (the nearest example being Germany in the 1920s). If many had attempted it previously, we could have more confidence in its effects, but an economy such as that of the United States implementing such a policy would be a first time occurrence. Even while some technical benefits may exist, economic performance is determined as much by subjective population responses, which can be unpredictable.
Some believe that the countercyclical nature of money supply management when one nation is on the gold standard and others are not, would exacerbate the extremes of the business cycle making booms and busts both more frequent and severe. With high interest rates when the economy is bad and low interest rates when the economy is booming. Whether the worst case consequences would happen in fact, is little more than a guess on either side at this point, but it would be wise for any nation implementing a gold standard to include risk control provisions to mitigate this kind of situation.
Smaller nations that have been ravaged by the ineptitude of dictators seeking to avoid difficult choices and having been led instead to hyperinflation would probably be better served by a gold standard (even though the gold standard still requires competent money supply management as described above). However, many of these nations might also be served by fixing their currency to one or more of their bigger trading partners. In any event, frequent transitions to and away from a gold standard would not be advisable, so even those with a history of poor money management should not proceed down such a path without considerable debate.