Sunday, January 25, 2009

A Return To A Gold Standard Currency

Why did countries embrace the gold standard?With all of the currency financial instability there is a lot of talk about international financial reform, and one idea proposed by some is a return to the gold standard. But that begs the question of what the gold standard is. It is a monetary system in which paper notes are backed by gold, that is to say, the notes simply represent the gold that you own and can be converted into fixed quantities of gold freely.

This system stands in contrast to fiat currency, which is a currency with no guaranteed value in gold. A fiat currency has no intrinsic value, but the government declares it to be legal tender, meaning that it must be accepted as a means of exchange.

One of the main benefits of the gold standard is that it protects citizens from
hyperinflation and the debasing of the currency through excessive government spending. With a fiat currency, a government can print as much new money as it likes to pay for spending. This leads to a gradual decline in the value of the currency and
the citizens' savings. In 1966 Alan Greenspan said:

under the gold standard, a free banking system stands as the protector of an economy's stability and balanced growth… The abandonment of the gold standard made it possible for the welfare statists to use the banking system as a means to an unlimited expansion of credit… In the absence of the gold standard, there is no way to protect savings from confiscation through inflation.

John Maynard Keynes supported a gold-backed currency.John Maynard Keynes similarily stated that

By a continuous process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some.

The problem with gold standard systems is that a country's gold reserves are limited, and in times of crisis when countries need a critical supply of money, gold can run out. A fiat currency on the other hand can be produced when needed, and even though this decreases the relative value of the currency, it provides the country with a supply of needed money. Examples of times when such supplies are needed are wars and times of severe economic depressions.

A brief history of the gold standard.

The United States had some form of gold standard (in which silver was also a standard currency) in the 1800s, with a full federal gold standard being adopted in 1900 with the Gold Standard Act. This came to an end in 1933, when President Roosevelt made the private possession of gold illegal, forcibly buying all privately owned gold at a price of $20 an ounce, and then revaluating gold at $35 an ounce. This was done as a source of reserve funds during the Great Depression.

During the Second World War, a need for a system that allowed for access to emergency money supplies while still insuring the integrity of currencies and international economic stability resulting in the creation of the Bretton Woods in 1944. This system essentially pegged all currencies of signatory states to the
US dollar, which was convertible into gold at a fixed rate. In order to keep currencies within 1% of their fixed exchange rates, countries agreed to buy or sell US dollars to whatever extent was necessary.

When did the gold standard end? And Why?

A return to the 1971 gold standard?The collapse of gold standard came in 1971 when President Nixon cancelled the Bretton Woods agreement, cutting the link between the US dollar and gold. This was done because the United States no longer had enough gold to buy back all the US dollars held by foreign countries, and with the Vietnam War raging on, the United States was running a trade deficit for the first time in the Twentieth Century. The cancellation of the agreement eliminated fixed gold market prices at $35 per ounce, and eliminated fixed exchange rates amongst the world's currencies, which are now mostly "floating" (having variable exchange rates determined by market factors).

All major currencies now consist of fiat money, whose value are determined by market forces and the control of the government and central banks. Some people such as Ron Paul are calling for a return to some form of gold standard currency as a way of curbing government spending and maintaining the integrity of our currency and savings.


Danny Merkel said...

It's rare to find such a well written article on a blog these days. Best of luck with your blog.

nitroglycol said...

Nice article. Unlike most things out there, you do a good job at pointing out the pros and cons of a gold standard and fiat currency.

Based on my admittedly non-expert understanding of things, what I'd like to see is something similar to Bretton Woods, but without the US dollar as intermediary; each currency, including the US dollar, would be directly tied to gold. The Achilles heel of Bretton Woods was that once the US decided they didn't like it, the rest of the world was off the standard whether they liked it or not. Under my proposal, any country (including the US) that wished to leave the system would be on its own.