First let's define what a gold standard is. A gold standard requires that the monetary unit of a nation be defined by a specific weight in gold. This cannot be arbitrary, it must be based on market conditions to be lasting. Also, gold must be available and convertible on demand in exchange against any notes or claims issued against it.

 

A gold standard presupposes that government maintains a balanced budget and does not intervene to artificially increase or decrease the money supply or the price of money – interest rates. The quantity and value of money is market originated rather than government dictated. The only task of government under a gold standard is to keep the currency unit at par with gold, but allow the value of that unit to fluctuate with market conditions against all other goods and services.

 

Obviously the need for a Federal Reserve Board would then become unnecessary. While I believe replacing the FRB is a worthy goal, it’s important to understand that it would take years to make an orderly transition from central bank operations to free markets and market originated money.

 

The money supply would be determined by the national production of gold and the inflows and outflows of gold among nations. To establish an international gold standard, the currencies of other nations should be pegged to one another, and free trade allowed to flourish. Not all nations need participate to have a viable working international gold standard. As long as two or more major nations establish the value of their currencies vis-à-vis one another, other nations could peg theirs to that trading block or not. But the main precondition necessary for a gold standard to operate successfully is the free flow of goods, services, and capital between participating nations.

 

Under a gold standard a nation's price level moves up as money comes into the country due to increased exports. The price level moves down as money flows out of the country due to increased imports. This means a modest inflation and deflation must be allowed and a tendency toward equilibrium is always at play. During the 19th century (under the gold standard) the price index with few exceptions moved only 2% either side of zero.

 

To recap: all parties must allow free trade in goods, services, and capital, and allow the money supply, prices, and interest rates to be set by the market—not governments. Those are the rules of a gold standard.

 

But there is no rule about having to replicate a gold standard in any exact way so long as it is consistent with free markets. In fact any metal, or combination of metals, can be used as the standard. The money supply would still be largely made up of demand deposits and other money substitutes so the actual gold in circulation would vary according to supply and demand and be small relative to the total stock of money claims. All paper money would be claims to specie and convertible on demand (unless otherwise specified, such as for time deposits).

 

Who are the likely candidates to partner with in an effort toward establishing an international gold standard? China is one of our main trading partners, but China is a mercantilist nation, and as such cannot be trusted to abide by a free trade treaty. A more likely trading arrangement would be to turn to our two leading trading partners, Canada and Mexico. We have a good trading relationship with both and if they would abide by the rules of a gold standard there would be little problem in establishing one. If other nations wanted to peg their currency to our dollar, as China does today, they could do so. But we would not pay them in gold unless they agreed to abide by free trade practices.

 

The fact is the world has changed greatly since the last time we had a genuine gold standard. Technology has made things possible today that were impossible in the 19th century. ATM’s, debit cards, bill pay and a continuous move toward monetary diversity is part of our everyday economic landscape.

 

The threats are different too. How the nation, banking system, and government would respond to various threats and how that would affect money flows is unknown. For example, today we face physical terrorist attacks and cyber attacks that could bring stock and bond trading and even banking to a halt. Add to this list “black box” and flash crash events that could lead to market panics, oil shocks that could disrupt world trade, or an outright attack on our energy grid; there are many unknowns to consider when it comes to reinstituting a gold standard in a technological age.

 

Perhaps under a gold standard the Fed would evolve into a new type of bank of last resort that tried to anticipate and identify such threats to the system. We just don't know. What we do know is that this is all academic because to try to fix the price of gold in the current morass of undisciplined fiscal policy and multiple structural threats would be madness. We would just go off gold again, and the gold standard and capitalism would be blamed for the mess left behind.

 

Before we could ever establish a gold standard we would have a lot of work to do. We’d need to balance our budget, establish free trade zones, and de-leverage our financial system to much lower levels. We would need time to recapitalize our banks to gold standard ratios. This will not be completed any time soon. We must earn our way toward a gold standard, not impose one. The gold standard demands a return to free market capitalism where the role of the government as a player in the economy is substantially reduced if not completely eliminated.

 

There are those advocating returning to a kind of Bretton Wood’s system of international gold convertibility at a fixed price. One reason we went off such a system is that it was a fiction. France was running huge trade surpluses and demanded to convert their surpluses into American gold at 35 dollars an ounce. Since the fixed price was fictional and not operational we reneged and went off the Bretton Woods gold/dollar exchange system. If we were using the same system today, wouldn’t China make the same demand?

 

To get around this threat, many advocate using gold simply as a unit of account, arguing that it does not need to be the actual medium of exchange. But that is not a true classical gold standard like the one that fostered price stability for a century. A gold standard without gold as money is not a gold standard. And Bretton Woods as an international trade system never approximated a gold standard; it only impersonated one and was unsustainable.

 

A true gold standard arises from the principles of freedom and sound fiscal policies. It is the effect of such policies, not the cause of them. A gold standard cannot be grafted onto an economy. The best we can do is to work toward the ideal of a gold standard, until political discipline, economic discipline, and free markets are reestablished. As I said in my book, The New Gold Standard, “If a gold standard is to return, it will return on the wings of capitalism and not before.”

-PN



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