What Is the Gold Standard?

What Is the Gold Standard explained by professional Forex trading experts the “ForexSQ” FX trading team.

What Is the Gold Standard?

Definition: The gold standard is when a country ties the value of its money to the amount of gold it possesses. Anyone holding that country’s paper money could present it to the government and receive an agreed upon amount of gold from the country’s gold reserve. That amount of gold is called “par value.” The United States ended the gold standard in 1971.

Advantages

The benefit of a gold standard is that a fixed asset backs the money’s value.

It provides a self-regulating and stabilizing effect on the economy. The government can only print as much money as its country has in gold. That discourages inflation, which is too much money chasing too few goods. It also discourages government budget deficits and debt, which can’t exceed the supply of gold.

A gold standard rewards the more productive nations. For example, they receive gold when they export. With more gold in their reserves, they can print more money. That boosts investment in their profitable export businesses.

The gold standard spurred exploration. It’s why Spain and other European countries discovered the New World in the 1500s. They needed to get more gold to increase their prosperity. It also prompted the Gold Rush in California and Alaska during the 1800s.

Disadvantages

One problem with a gold standard is that the size and health of a country’s economy are dependent upon its supply of gold.

The economy is not reliant on the resourcefulness of its people and businesses. Countries without any gold are at a competitive disadvantage.

The United States never had that problem. It’s the world’s second-largest gold mining country after South Africa. Most U.S. gold mining occurs on federally owned lands in twelve western states.

Nevada is the primary source. Australia, Canada and many developing countries also are major gold producers. (Source: National Mining Association.)

The gold standard makes countries obsessed with keeping their gold. They ignore the more important task of improving the business climate. During the Great Depression, the Federal Reserve raised interest rates. It wanted to make dollars more valuable and prevent people from demanding gold. But it should have been lowering rates to stimulate the economy. (Source: “The Great Depression,” Econlib.)

Government actions to protect their gold reserves caused significant fluctuations in the economy. In fact, between 1890 and 1905, the U.S. economy suffered five major recessions for this reason. (Source: “Remarks by Governor Edward M. Gramlich, 24th Annual Conference of the Eastern Economic Association,” Federal Reserve, February 27, 1998.)

Can America Return to a Gold Standard?

How would a return to the gold standard would affect the U.S. economy? First, it would constrict the government’s ability to manage the economy. The Fed would no longer be able to reduce the money supply by raising interest rates in times of inflation. Nor could it increase the money supply by lowering rates in times of recession.

In fact, this is why many advocate a return to the gold standard. It would enforce fiscal discipline, balance the budget and limit government intervention. For an analysis of methods of returning to the gold standard, see The Cato Institute’s The Gold Standard: An Analysis of Some Recent Proposals.

A fixed money supply, dependent on gold reserves, would limit economic growth. Many businesses would not get funded for lack of capital. Furthermore, the United States could not unilaterally convert to a gold standard if the rest of the world didn’t. If it did, everyone in the world could demand that the United States redeem their dollars with gold. American reserves would be quickly depleted. Defense of the U.S. supply of gold helped cause the Great Depression. For more, see FDR and the New Deal.

The United States no longer has enough gold at current rates to pay off its debt owed to foreign investors. Even when gold hit its peak price of $1,895 an ounce in September 2011, there wasn’t enough gold for the United States to pay off its debt. At that time, China, Japan and other countries owned $4.7 trillion in U.S. Treasury debt. That was ten times more than the $445 billion in gold reserves at Fort Knox. (Sources: “Major Foreign Holdings of U.S. Debt,” Department of the U.S. Treasury. “Audit Report,” Office of Inspector General, September 2010.)

Today, the U.S. economy is an important partner in an integrated global economy. Central banks work together throughout the world to manage monetary policy. It’s too late for the United States to adopt an isolationist economic stance.