Originally posted February 11, 2008 at http://blogs.themarkettraders.com/gold-standard-still-gold-standard-among-monetary-systems.

The Fiat Generation

When the mainstream press wasn't discrediting Ron Paul with conspiracy theorizing, they were calling his monetary policy "esoteric". And to the present generation, it is esoteric. Young professionals and pundits have lived their entire lives under a system of floating fiat currencies. The gold standard might as well be a barbarous relic since it is barely understood.

In my conversations with otherwise intelligent individuals, it takes a herculean intellectual effort to shift their frame of reference from fiat to gold. These bright people lack the conceptual tools necessary to regard gold as money. They say things like, "what's the difference if the government sets the value of gold or the value of paper dollars?" They can't see the difference between defining a weight and manipulating the money supply because they can only see the gold standard in terms of a fiat monetary system.

Can We Talk About Gold?

Discouraging this may be, but all of us born before 1971 need not despair. If Ron Paul's candidacy accomplished anything, it brought the phrase "gold standard" back into the realm of relevant discussion. If you want to keep this conversation going, let me recommend the CATO Institute's latest briefing paper on the subject.

Lawrence White does a fine job addressing key objections to the gold standard. If you don't have time to read the seven pages in this report, let me quickly summarize them for you. (btw, I don't completely agree with all of White's responses, but I'm not feeling very argumentative today.)

Objection: A gold standard leaves the quantity of money to be determined by accidental forces

Response: The gold standard is not a panacea against anything that can happen in the market, but it is much better at stabilizing prices by comparison with fiat money. According to a study conducted by economists at the Federal Reserve Bank of Minneapolis, "the average inflation rate for the fiat standard observations is 9.17 percent per year; the average inflation rate for the commodity standard observations is 1.75 percent per year." Even the largest supply shock in the US in 1848 did not result in the kind of inflation we've had under fiat.

Objection: A gold standard would be a source of harmful deflation

Response: One must distinguish between benign inflation caused by a relative increase in the output of goods from a harmful deflation caused by a contraction in the money supply. The gold standard is a source of benign deflation. Fiat money, on the other hand, can be a source of harmful deflation when it tries to correct its inflationary excesses.

Objection: The gold standard was responsible for the U.S. banking panics of the late 19th century and for the monetary contraction of 1929-33 and, thereby, for the Great Depression

Response: The panics were due to completely avoidable legal restrictions (namely the ban on branch banking and compulsory bond collateral requirements that make the supply of banknotes inelastic) that weakened the U.S. banking system.

Objection: The benefit of a gold standard (restraining inflation) is attainable at less cost by properly controlling the supply of fiat money

Response: It is true that a commodity money standard entails a resource cost. So does the production of bicycle locks from metal rather than paper. The resource cost of a gold standard has often been exaggerated by estimates that assume 100 percent gold backing for all forms of money.

Objection: A gold standard is no restraint at all, because government can devalue or suspend gold redemption whenever it wants

Response: A similar claim could be made about any (other) restraint in the Constitution. And yet constitutional rules are useful.

Objection: A gold standard, like any fixed exchange-rate system, is vulnerable to speculative attacks

Response: What opens the door to speculative attacks is a weak commitment to the existing parity...with decentralized private money issue, there is no institution capable of devaluing, so there is no danger of speculative attacks on the parity.

Objection: Fiat money is necessary so that a lender of last resort can meet the liquidity needs of the banking system

Response: History shows that a lender of last resort would hardly be needed, given a stable monetary regime and a sound banking system. In the rare cases such a lender might be needed, bank clearinghouses could play the role.

Objection: Switching to a gold standard would involve massive transition costs

Response: The transition cost involved in reestablishing a gold definition for the dollar would be small. Unlike with Europe's transition to the euro, price tags and bank accounts would not need to be re-denominated because the name dollar would be retained. At the right reentry rate, dollar prices would not need to jump.

Objection: We must have gone off the gold standard in the first place for good reasons

Response: In 1933, President Franklin D. Roosevelt devalued from $20.67 to $35 per troy ounce of gold as a means to re-inflate the dollar price level. But the (harmful) money stock shrinkage and price deflation of 1929-33 hadn't been due to a loss of gold. It had been due to a collapse of weak U.S. banks.

In 1971, Nixon shut the gold window because the Federal Reserve had expanded the stock of dollars too much to maintain the $35 per ounce parity. Nixon's action could have been avoided had the Fed not expanded the stock of dollars so much in the 1960s.

Objection: The gold standard is an example of price-fixing by government

Response: The gold standard doesn't fix a price between dollars and gold any more than the traditional British measurement system fixes a price between pints and quarts. The fixed relationship is a matter of definition. A gold standard defines the dollar (or whatever the name of the monetary unit) as a specified mass of gold. Dollars are not separate goods from gold.

Objection: A gold standard would allow Putin to buy the United States

Response: The current fiat system is enriching Putin more than a gold standard would.

Objection: There isn't enough gold

Response: There is necessarily enough gold to support enough dollars to support today's dollar price level (or whatever price level is desired), at the right gold definition of the dollar.

Objection: The United States can't recreate the classical international gold standard by itself

Response: White recognizes this is an obstacle. So do I. A unilateral shift to the gold standard would not bring with it all the benefits of the classical international gold standard. And by their nature, governments seek control of the money supply. It is unlikely that the governments of the world are going to relinquish their newly acquired monetary power without a fight.

On the bright side, history is against fiat. If a power can be abused it will be abused. Fiat has been and is being abused and it will eventually fail. It will fail in the U.S. and abroad. And when it does, all the citizens of democracies worldwide need to do is ask for their money back.