Gold Standard. Part 2 … Ron Paul has entered the match!

Ron Paul recently announced that he will be entering the race to become the Republican candidate for President of the United States.  One of his well known views is that the U.S. should return to the gold standard.  So in honour of Mr. Paul’s announcement I have decided to continue my discussion on the gold standard. The first post did not really deal with gold itself so much as establishing what money is and how fiat currency is differs from the gold standard.

The first major problem with gold is its supply.  With a fiat currency a central bank can use monetary policy to increase or decrease the supply of money of an economy. With gold you are limited by how much of it you can extract from the ground.  When an economy starts to slow down a central bank will add money to the system in order to keep things moving.  Gold does not allow for this. If things start to slow down in an economy people will tend to hoard money, especially at the low inflation levels that are associated with the gold standard.  With the decreases in spending the economy gets worse.  Some argue that this is a good thing, that economies should correct themselves from time to time to remain efficient. 

If we look instead to an international scale we see that as the world’s economy grows there needs to be more money to go around.  Since gold is in such limited supply we would run into shortages that would drive the price of gold up. This would benefit some countries and harm other in a way completely outside of their control. Also, since the amount of currency issued is related to the value of the gold in a fixed proportion this would actually cause inflation.  A very low level of inflation is the main feature that proponents of the gold standard mention.  So a problem arises because while it is true that inflation levels are low under a gold standard most of the time, so is stability.  The ability of an economy to absorb shocks is diminished.  Let’s looks at an example.

Fake Canada trades with the Fake U.S. and both are on the gold standard.  Each have issued an amount of domestic currency equal to their gold reserves.  In this fictional example let’s say that Canada is running a trade deficit with the U.S. meaning that they are importing more than they are exporting. The difference must be paid in gold. So Canada sends gold to the U.S. and must reduce the amount of domestic currency in circulation. This forces prices to drop, and interest rates and unemployment to rise.  Gold bugs (people in favour of the gold standard) argue that this is how it should be, that the correction is a good thing and is required.   So it really depends on your personal beliefs here, but I am guessing that the people that lose their jobs or have increased mortgage payments to help with this correction would not argue that the gold standard was the better option.

Another issue with the gold standard is of course is the gold is now used for many things other than money.  Gold is purchased as an input material in industry and so fluctuations in demand for say, computers could affect the price of gold. This would cause the value of currency to change as well.  We certainly do not want the industrial demand for gold to influence our currency.

Finally if we are talking about the real U.S economy we have to understand that the amount of currency in circulation is enormous.  If they were to change to the gold standard there would be massive deflation. When deflation hits people stop spending all together because they believe that prices will continue to drop and hold onto their money waiting for the lower prices. This is of course disastrous for the economy as everyone is holding money and not spending.

So this was a scattershot look at the gold standard.  I will likely address this issue again sometime but for now at least we have taken a very broad overview of why it is unlikely the gold standard will ever return.