Gold Standard Fallacies

Gold Standard Fallacies

August 19, 2007


People’s understanding of gold standard systems is not very good — and that applies to advocates as well as detractors. This week we’ll make a list of what a gold standard is not.

In short, a gold standard is a system which connects the value of money with the value of gold. The simplest way to do this is to make coins out of gold, which trade at their full commodity value. But that is a very archaic approach, and not well suited to today’s world. A basic problem over the last few centuries has been the fact that economies’ need for base money (essentially paper bills) has grown faster than the world supply of gold, which has increased by about 2% per annum. Even that 2% growth rate has fallen off in the past few years. Base money demand has tended to increase along with gross domestic product, and even if we adjust for inflation that figure tends to work out to 3%-4% per annum.

A few people have made some funny arguments that the world’s gold supply would suffice to serve as money, but their arguments tend to boil down to an idea that the economy should be shrunk to fit the gold supply. Typically this takes the form of some post-disaster scenario where gold becomes very valuable in relation to goods and services and labor, which is another way of saying that people are very poor. “We can have a gold standard as long as everyone stays poor.” OK, that’s exactly what people want to hear.

Beginning in the 19th century, there has been a steady process of “economizing on gold,” which has taken the form of the use of paper money linked to gold, rather than a 100% metallic currency of full-weight coins. We can create paper money in any amount, and as long as its value is linked to gold, it functions as well as gold bullion coins — better, actually, since paper money doesn’t “wear down” and isn’t at risk of clipping like bullion coins are. Some people take offence at that “as long as it’s value is linked to gold” phrase, as that condition has never been permanent. You have to trust the government. In practice, you have to trust the government anyway. Even if all commerce was done in bullion coins, the government could make bullion coins illegal and force everyone to use paper money. This is exactly what happened in 1933, and if it could happen in the US it could happen anywhere.

So, we see that if we link the value of paper money to gold, via a system of supply adjustment, then paper money’s value will be as stable as gold’s value. This makes a very good money, which is why people have used gold-based monetary systems for thousands of years with consistently good results.

That’s it. The purpose of a gold standard is to produce a currency of stable value.


1) A gold standard does not inhibit government deficit financing. On the contrary, a gold standard makes it easier for a government to issue debt! Under an established gold standard, yields on government debt are typically in the neighborhood of 3.0% — not just for a week, but for decades at a stretch. With such low financing costs, governments can issue lots of debt, if they want to. It is true that a gold standard prevents printing-press financing of government deficits. However, only the shoddiest government indulge in that, and if such a government was on a gold standard, it would soon leave it.

2) A gold standard does not create “balanced trade.” You’ll find this one in most college textbooks. It’s totally false. A gold standard in fact facilitates international capital flows, which today go by the confusing name of a “current account imbalance.” A “current account imbalance” basically means that, on net, people in Germany, for example, are offering goods and services and receiving financial assets, typically debt assets, in return. Why would they take these debt assets? One problem with receiving debt assets in trade for goods and services is that you have business and counterparty risk. If you receive goods and services in trade for your goods and services (“balanced trade”), then you have no further relationship with your trading partner. However, if you take bonds instead, then you have a relationship that lasts until the maturity of the bond. Naturally, you want these relationships to be as trustworthy and reliable as possible. When your bonds are denominated in a gold-linked currency, your debt relationship becomes more trustworthy and reliable. Thus, the “export” of bonds (which is really the net import of capital, i.e. goods and services) is facilitated by a gold standard. This would mean potentially a larger “current account imbalance.”

3) Under a gold standard, the amount of gold held by monetary authorities is largely irrelevant, as long as the currency is being properly managed. Let’s say a central bank has issued $100m of gold-linked notes, and has a reserve of $10m of gold. At $100/oz., that would be 100,000 ounces of gold. A gold standard is a value peg. The number of banknotes issued derives from the operation of the peg. In other words, the issuer has issued $100m of notes because that is the supply that balanced demand at a value of $100/oz. If the supply was too much, then the value of the banknotes would drop below $100/oz. to perhaps $110/oz. If the supply was too little, then the value of banknotes would rise perhaps to $90/oz. Since the issuer is properly managing the currency, it adjusts supply so that it hits its target of $100/oz., and it just so happens that this results in a supply of $100m. If the central bank deems it worthy to increase its reserve to 200,000 ounces of gold, it would not then go out and increase the number of banknotes to $200m. No No No. It would have $100m of banknotes and 200,000 oz. of gold. And if the issuer then reduced its gold holdings to 100,000 oz. or 20,000 oz. or zero, the supply of currency, and their gold value, would not change. It would remain $100m. Alongside this, we can see that moving gold from place to place is also largely irrelevant, since that does not change gold’s value. Also, we can see that it is not necessary for the currency-managing entity to hold any gold at all, as long as it properly manages the supply of currency such that the currency’s value is solidly linked to gold.

4) A gold standard does not inhibit “fractional reserve banking” or any other financial process. You can do everything with gold-linked money that you can do with a fiat-currency money — including all sorts of stupid things. All of today’s financial processes would work in much the same way, with a gold standard, as they do today. Linking a currency to gold stabilizes its value. That’s all it does. But that’s important!

5) A gold standard does not cause panics, crashes, etc. A gold standard creates stable money. I know of no negative economic event that was caused by stable money. Certainly there are all sorts of bad things that can happen to economies, even when their money is stable. To that we can add innumerable horrible things that can happen when one departs from stable money. For some reason, when a government leaves the gold standard, has a disaster, and then returns to the gold standard, this is sometimes regarded as a problem “under the gold standard.” Whatever. Sometimes, when one country leaves gold and devalues, that has consequences (especially trade consequences) for countries that remain on a gold standard. I would call this a problem caused by leaving the gold standard. Has there ever been a situation where gold itself has been so unstable in value — in turn leading to instability in value of currencies linked to gold — that it caused some major economic event? I can find no such example, although others have made that argument. I’ve looked at them, and I don’t find them very convincing.

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Interesting graph here of the value of US equities (a sort of long-term index) in gold oz.

Gold Standard Fallacies

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I reread The Case For Gold, by Ron Paul and Lewis Lehrman in 1982. This represented their arguments before the 1981 Congressional Gold Commission. When I read it before, about seven years ago, my impression is that it was heavily colored by “pure gold standard” ideology, and thus not a very practical solution. Today, I don’t see anything particularly outlandish about it, and indeed it seems a fine piece of work. This is not to say I agree with the “pure gold standard” types, just that the book is much more even-handed than I remember. Ron and Lewis did a wonderful job back in the day, against considerable intellectual opposition. The historical segments of the book, which make up most of it, are especially worthwhile.