Let's start from a premise that we have pure capitalism, which means, there is no government involvement in the economy.  Government laws, controls, and regulations are totally designed to protect individual rights and property rights; to prevent force and fraud;  to establish a court system where disputes can be resolved and crimes prosecuted; and to establish standards and rules of the road in order to conduct transactions consistent with these goals.  This means we would be living in a nation of totally free markets, and assuming individuals chose gold as their medium of exchange as they have most of the time over the last 2500 years,  the supply and value of money would be determined by the market, not government as it is today under a fiat standard.  

Under a gold standard,  the money supply is determined by the amount of gold produced. Credit is determined by the amount of deposits banks receive for savings.  Banks lend out what is deposited, on a short term to long term basis. Since there is a risk that depositors may want to withdraw their savings at any time, they must keep sufficient reserves on hand to cover any withdrawals on demand.  The market over decades of the gold standard determined that a prudent reserve ratio was 4 to 1.  Thus leverage was always contained and so was credit expansion. The amount of paper claims to gold was always limited.  The amount of the money and credit supply was the amount of gold in circulation times four.

A fiat standard, as envisioned by the late Milton Friedman, would have the government, rather than the market, determine the quantity of money and credit.  Friedman would set the money supply at 3 to 5% where he believed price stability would be ensured.  Notice that under both systems the goals are price stability, limited credit expansion, and optimum economic growth.

The fact is, we have had financial panics under both the gold standard, such as in 1907, and the government controlled fiat standard of today.  But, under the gold standard the value of the dollar remained stable nationally and internationally for a hundred years with few exceptions.  Since 1913, when the Federal Reserve took over the control of the money supply, the dollar has fallen to about three cents of its previous value, and is depreciating further as we speak.  If preserving the value of money is the standard by which to judge a monetary system, the fiat standard has been a dismal failure, where the gold standardhas succeeded.

During the reign of the gold standard, money supply did what Professor Friedman wanted the fiat standard to do:  it increased at a low and stable rate.  Under the fiat standard the money supply has exploded at times as it has today.  The big difference is that gold increases were dependent on finding and mining gold where under a fiat standard the quantity of money is determined by men, arbitrarily, by whim and decree.  Friedman's solution to this problem is simple:  Replace the Federal Reserve Open Market Committee with a computer.  Make the money supply increase automatically and consistently.  By suggesting this Friedman was conceding that the best a fiat standard could do was to mimic a gold standard.

Leverage existed under the gold standard but was restrained by the fact that at the first sign of any banking problem, depositors would begin to lose confidence. This would result in an immediate run on the bank in question as depositors turned in their paper claims to gold and withdrew the gold itself.  The fact of convertibility kept leverage low.

However, even with low leverage, speculation and panics can occur.  In 1907 we had a financial run on banks that almost brought the entire financial system of America tumbling down.  J.P. Morgan rallied a handful of millionaires and eventually saved the system by restoring confidence on Wall Street as well as on main street.  It was then that a call for a stronger bank of last resort was urged and six years later the Federal Reserve was created.

The idea of a strong national bank is not new.  It was vigorously debated by Alexander Hamilton and Thomas Jefferson, and Hamilton ended up winning that argument.  The idea is not a bad one.  In it's purest form it argues that a bank with huge reserves on hand should at all times stand ready to back up any institution that threatens to bring down the financial system.  In 1907 it was a handful of extremely rich investors that served this function.  In the 1980's it was the FDIC which collects fees from banks to back up the strong banks by helping them absorb the bad banks.  And in 2007 and 2008 it was the Treasury and Federal Reserve that played that role with the backing of the US taxpayer.

Where the money of the bank of last resort comes from becomes a crucial point.  US bonds are backed by the "full faith and credit of the US government".  That's us folks!  We the taxpayer are the backers of bonds.  Should we be the backers of a bank of last resort?  My own view is that the idea of a bank of last resort is a good one but it should be funded by those most likely to cause structural damage to the economic and monetary system.  The dues paid into the FDIC by all banks have worked well as an insurance policy and back stop for banks that go bad.  Many banks within that system have failed, but without structural damage to the system as a whole, and depositors have remained relatively unburdened by their internal problems.  

The regulations and government agencies that were put in place after 1907 and into the 30's were all designed to prevent what has happened today.  Some worked well such as the FDIC insurance program.  Some were and are totally worthless.  The attempt to update the regulatory architecture of the financial system is being written, and to some extent, implemented now.  Many of the proposals will become law over the years.  I am for regulatory reform.  I think we need reform given the massive fraud that was allowed to occur during the last several years.  But as sure as I am that we need regulatory reform, I also am absolutely sure that regulatory reform will not prevent a future panic and crisis, such as the one we've just had, from happening in the future.

But just because you can't rid society of criminals doesn't mean we should have bad or useless laws on the books.  And the regulatory laws and agencies we have today definitely need inspection.  One of the areas that needs a hard look is the use of leverage.

Most people agree that some kind of rules need to be established when it comes to leverage.  For example we have had margin requirements on stocks since the crash of '29 and they have worked pretty well.  Under the gold standard the 4:1 leverage rule of banks did not prevent runs, but the downside risk was much less than it would have been at 100:1 leverage.  You can't get hurt much falling out of a one story apartment, but you can get killed falling out of a skyscraper.  A move back toward gold standard leverage ratios would be a move in the right direction.  And it appears to me this is the direction we are moving in.  Higher capital requirements, which is the other side of the leverage coin, are being discussed in all nations around the world.

Another reform being proposed is to set up a separate regulatory body to relieve the Fed of that responsibility.  I think that makes sense.  It is the government’s job to police fraud and prosecute the violation of rules and regulations, not the Fed’s.  The Fed should simply set monetary policy and operate as a bank of last resort.  It should, in my opinion, set the money supply at a low and stable level and allow theFed funds rate and all interest rates to seek their own level.  As bank of last resort it should naturally monitor any abuses of the system that threaten systemic damage and assist the government in monitoring risk.  But theFed cannot, nor should it try to be a policeman.  The problem arises when and if a new regulatory body is established that does not perform its duties or over regulates.  This "cure" could be as bad as the disease.

It is interesting that over the years the fiat standard and the gold standard have been slowly converging.  A move in the above proposed direction would move both systems even closer. Just as Milton Friedman's vision of a fiat standard shared many of the same goals of the gold standard the two systems can, have been, and are, converging to some degree.

Consider the following:

Over the years the fiat standard has become more gold-oriented.  The first major move was the re-legalization of gold in 1975.  For the first time since 1933, individuals were allowed to own gold.  Gold ownership is a necessary condition of a gold standard.  It offers individuals a choice of wealth preservation.  They can choose to save in paper dollars or ounces of gold.  It was the first step in the defense against the debasement of the currency.  This moved us closer to a gold standard within the context of a fiat standard.

In the 70's, inflation was hidden.  Few understood the relationship of an increase in money supply and rising prices.  But Milton Friedman, established and "sold" that relationship to the economic community as well as the public at large.  His clear and simple explanations took the "dismal science" and made it intelligible to the man on the street.  The result of this new understanding of the cause of inflation led to a further accumulation of gold by individuals and governments alike.

Today, inflation is no longer an esoteric phenomenon.  It is understood by most Americans.  As a result, the Fed’s option to inflate has decreased.  During the 70's we experienced progressive inflation as the Fed progressively increased the money supply for a decade.  The result was an inflation rate that progressively climbed from 2% to 12% by 1980.  Paul Volker ended that era.  One of the pillars of Reaganomics was a strong dollar and a sound monetary policy.  From that time to this the inflation rate has progressively declined from 12% to an average of about 3% to almost zero today.  We have even at times experienced a little deflation.

Today's calls for the reduction in the Fed’s independence, greater transparency, and even the elimination of the federal reserve itself by some, would never have happened in the 1970's.  The alarm among economists of a soaring money supply to the tune of over a trillion dollars and the calls by Wall St. to delineate a Fed "exit strategy" stands as a check on  Fed actions.  Further, the existence of hundreds of TV and radio commentators together with newsletter writers and bloggers warning of possible future inflation reduces the power of the Fed.  If it were not for the economic and monetary emergency we faced I seriously doubt any such huge increase in money supply would ever be tolerated. Today there are a million prying eyes on theFed and the money supply, where in the 70's there were not.

In addition, there is a keen awareness of the importance that credit expansion and leverage played in creating the panic of 2007 and 2008.  Controls on credit expansion are now being considered by both Congress and the US treasury, as well as the Federal Reserve.  This ideological move toward reducing the money supply as well as reducing credit, debt creation, and leverage, is a move toward the kind of monetary system a gold standard would provide.

I am not suggesting that we are returning to the gold standard.  But I am suggesting we are moving toward it. Gold has been mobilized.  It is moving into the hands of investors and savers all over the world.  It is being rediscovered by central banks as a currency of last resort.  Gold reserves are being increased by surplus nations.  And paper currency is being sold for gold all over the world.  Gold as a reserve asset among governments, and a preferred asset among individuals, investors, and institutions, is once again in vogue.

And every day that the value of the dollar drops on international markets, there are fresh calls for the need for a stable reserve currency.  The dollar continues to become less desirable and gold more desirable to satisfy that function.  This, I submit, is a reduction in the confidence of the fiat standard and an increase in the interest gold can play in the monetary systems throughout the world.  As we speak, individuals in every corner of the world are trading paper for gold.  And this trend, in my opinion, is not a fad.  I give you the huge increase in Gold ETF's in the last five years as just one example.

Next, consider the level of education among newsletter writers and media commentators.  It is greater today than at any time in my lifetime.  There is very little that is not understood today about money and economics.  There are strong disagreements to be sure.  And there is an intellectual battle taking place daily.  But the ideas are out there.  They are being debated.

The degree to which we move toward a gold standard will depend a lot on how this debate plays out and how the Fed performs over the next few years.  It will be one thing if it pulls off a fairly smooth transition from a near-meltdown to a return to monetary stability without creating any major inflation.  It will be quite another thing if it does not.

The Fed definitely has its work cut out for them.  If the Fed pulls off a smooth transition from its emergency lending strategy of a trillion dollars of new money without causing inflation or any major disruptions, the fiat standard will emerge as a stronger more credible system than ever before.  But it may only be able to do so by moving toward the principles of a gold standard.  If we reduce leverage, increase capital requirements, increase gold within the central banks as reserves and within public hands as savings, commit to low and stable rates of money growth, and establish a floating funds rate that is market originated, we will end up with a stronger and more predictable monetary system than we've had since the 19th century.

The movement today to deal with systemic risk is an attempt to approximate conditions of a free market and a gold standard without allowing them to completely exist. For each market action that is not allowed to happen government must invent a rule or regulation to compensate for it.  For example in the absence of the 4:1 reserve ratio adopted by banks in the 19th century we are talking about government imposing greater capital requirements on banks in the 21st century.  In a perverse way we are being forced by reality to move closer to free market and gold standard principles of conduct without calling it that.

To summarize:  The mega trend is the following:

1) Gold is returning to portfolios and government coffers as speculative risk assets are being reduced.  Central banks are buying gold for the first time in decades instead of selling.  We are moving slowly toward a de facto gold standard.

2) The Fed’s – and the public’s – understanding of what causes inflation have served to reduce the increase of money supply over the last three decades.  We no longer have a hidden inflation.  We have an open inflation, and as such, the insidious nature of theft by inflation is much more obvious.  Everyone is on the lookout for inflation, as evidenced by the countless commercials for gold.

3) The mindset of Congress is to redouble their efforts to enforce laws against fraud, deceit, and excess leverage,a necessity for a sound monetary system.

4) The intellectual movement worldwide toward free market capitalism is flourishing, as witnessed by the free market tendencies of China , Russia, and Eastern Europe.

5)  The money supply as defined by M1, the only "M" that the Fed directly controls, grew at 7 to 8% rates in the late 70's.  M1 was brought down substantially since then and was held at zero in 2005, 2006, 2007, and most of 2008.  This indicates the degree to which the monetary philosophy has changed over the years.  It is true that the Fed recently exploded their balance sheet, but that was an emergency move in an attempt to replace the money lost through de-leveraging in financial institutions.  It has been the exception in monetary policy, not the rule.  And it could not be accomplished without it being open to the public and the promise of an "exit policy" to assure the public and the markets that inflation was not the goal.  It was initiated as an emergency measure, not a change in policy.

6) The price index defined by the CPI fell from 12% to very low levels over the last 30 years.  You may want to question the efficacy of the CPI, but you can not question the direction.  In fact from time to time we actually had a little deflation.

If, indeed, we move toward greater stability of the money supply, open and market originated interest rates, and greater enforcement of laws against fraud, deceit, and leverage, we will have improved our monetary system and created a more stable system of honest money.  Not a bad move.  And a move in the right direction I might add.

Paul Nathan