The Big Debate

The big debate raging amongst economists at the moment is whether we should go back to the gold standard.

Perhaps the first logical question to ask ourselves is why tie a currency to gold? Why not rice or bananas, diamonds, silver or wheat, or maybe even a basket of commodities?

Gold has a number of unique properties, its difficult to forge, it is malleable, it can be easily stored,

it is not perishable and it’s not easily destroyed. It is also more physically difficult to loot. A blue diamond 122.5 carrot, valued at 20 million US dollar could fit in your pocket. You just can't put 20 million dollars of gold in your pocket and leg it. Scarcity is another important factor. Gold has a finite supply, the world's mining regions are already known.

So that’s why gold was used previously to tie currencies.

The alternative of not being tied to gold is what we have now, currencies not tied to anything other than faith and trust. Known as fiat, meaning an arbitrary authorative decree or sanction, there is no standard backing the currency. Under a gold standard gold is fixed to an amount of dollars. For example, one ounce of gold might be equal to say 100 US dollars. That then becomes fixed and declared and the US dollar is then directly linked to gold. The holder of 1000 USD in cash can then exchange the paper money for 10 ounces of gold. Note on the UK sterling paper notes, the words state, “I promise to pay the bearer on demand the sum of ….”(five,ten/twenty/fifty) whatever the value of the paper note in gold or sterling silver. But try going to your local bank branch with a fifty pound note and ask the bank manager if you could have the equivalent in gold and he will look at you as if you have lost the plot and probably call security.

Again, sweet words that bear no reality to the truth. It seems we have been spun along for some time.

What does the old lady on Threadneedle Street, the Bank of England have to say about the matter? The words, "I promise to pay the bearer on demand the sum of five [ten/twenty/fifty] pounds" date from long ago when our notes represented deposits of gold. At that time, a member of the public could exchange one of our banknotes for gold to the same value. For example, a £5 note could be exchanged for five gold coins, called sovereigns. But the value of the pound has not been linked to gold for many years, so the meaning of the promise to pay has changed. Exchange into gold is no longer possible and Bank of England notes can only be exchanged for other Bank of England notes of the same face value. Public trust in the pound is now maintained by the operation of monetary policy, the objective of which is price stability.”

In other words, UK sterling, like the world's major currencies is a fiat currency. The currency has value because the public places their trust in the Bank of England, central bank, to support economic growth, inflation and financial stability, which it does by controlling the money supply (monetary policy). So without a central bank, a fiat currency would become unstable, it would have no value and the system would collapse. When a currency has no intrinsic value you need an institution to manage the money supply.

Then why not go back to a gold standard, maybe we could do without a central bank?

Recently, former FED chairman Alan Green Span was asked that very question; Do we need a gold standard? “Well the question is a very interesting one,” said Greenspan. “We have at this particular stage a fiat money which is essentially money printed by a government and it’s usually the central bank which is authorized to do so. Some mechanism has got to be in place that restricts the amount of money which is produced, either a gold standard or currency board or something of that nature because unless you do that, all of history suggests that inflation will take hold with very deleterious effects on economic activity….There are numbers of us, myself included, who strongly believe that we did very well in the 1870-1914 period with an international gold standard.”

But did the gold standard really create price stability and prevent economic shocks? Former FED chairman Ben Bernanke doesn't believe so.

Over the short run the gold standard failed to create price stability, notes Bernanke. Indeed, during the late 19 century when there were lots of gold discoveries it created a big increase in the money supply and inflation in the US was rampant. Moreover, the gold standard didn't prevent the financial crisis and the Great Depression that ensued in the 30s.

In fact, some economists argue that the gold standard may have actually contributed to the depression. It certainly did contribute to spreading the monetary shocks from one country to another because they were all connected.

When the international money system was based on gold the rules of game were as follows; the amount of US gold controlled the amount of money issued by the FED, which in turn controlled the amount of money issued by commercial banks, thereby influencing consumption and investment in the economy. The result was a monetary structure tied to the amount of gold in US vaults, But in 1930, FED didn't play by the rules and stood idly by as banks failed. When the banks failed, the money supply fell. Britain could export less to the US but continued to import by paying the difference with gold. With every bar shipped out the money supply decreased and the depression in the UK worsened. So vast amounts of gold flowed into the US but was then locked up. The result was that the UK remained in trouble until it broke-free from linking money to gold.

So dissatisfaction with the gold standard is why the link was broken and perhaps we are unlikely to see it come back.