What would happen if we returned to the gold standard?

Commentary about business and finance.
Nov. 9 2010 6:48 PM

Gold Rush

What would happen if we returned to the gold standard?

Gold bars.
Returning to a gold standard wouldn't be such an easy fix

World Bank President Robert Zoellick set economists atwitter Monday with a column arguing that the G20 should "consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values." (He also recommended a bunch of other things that no one paid attention to because they didn't include the word "gold.") The Wall Street Journal praised Zoellick for "offering a better policy path: More careful monetary policy in the U.S., and more U.S. leadership abroad with a goal of greater monetary cooperation and less volatile exchange rates." Berkeley economist Brad DeLong, meanwhile, declared Zoellick in the running for "Stupidest Man Alive."

No one claims that a return to the gold standard is imminent. "It's about as likely as Barack Obama suggesting he should step down and John McCain should be president," says J.D. Foster, an economist at the Heritage Foundation. "We're in the realm of extreme fantasy." "It's a joke," says Barry Bosworth of the Brookings Institution. "It doesn't have anything to do with the modern economy."

But let's entertain the possibility: Say the United States decided to peg the dollar to the price of gold. What would happen?

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First, the government would have to decide what the price of gold is. That's a lot harder than it sounds. In theory, there's an ideal rate at which to peg currency against gold. We just don't know what it is. Gold is notoriously volatile—its price has doubled over the last two years. If the Federal Reserve were to simply fix the dollar to the price of gold on a given day, and demand for gold changed drastically, it would wreak havoc on the economy. If the Fed pegs the rate too low, for example, people would want to trade their dollars for gold, forcing the Fed to raise interest rates in order to make dollars more attractive. * Even if the Fed were to pick the rate correctly, it would still have to make adjustments based on the economies of the United States' trading partners. If the dollar is growing in value, but another country's currency is decreasing in value, yet both currencies are pegged to gold, something has to give—either one of the currencies has to inflate or deflate, or the exchange rate has to be adjusted.

Once the Fed set the price of gold, it would then have to keep the currency fixed, leaving the economy subject to the vicissitudes of the gold index. If the price of gold goes up, the United States would have to raise interest rates, which could lead to tighter credit. Which might be OK, except that gold is a primary indicator of economic uncertainty: When the economy is bad, the price of gold goes up. So the Fed would be tightening credit just when people need it most. The result: a deflationary spiral that drives the economy even deeper into recession.

Another problem: Any country with investments in the United States could demand its gold at any moment. That's what happened in 1971. For years, the price of gold had been fixed at $35 an ounce. Finally, the British ambassador asked that $3 billion of the United Kingdom's investments be converted into gold. The United States soon went off the gold standard.

History offers plenty of cautionary tales. In the 1800s, gold was the standard. "The 19th century was one of recurrent financial panics and tremendous downturns," says James Hamilton, a professor of economics at University of California-San Diego. The creation of the Federal Reserve in 1913 didn't stop fiscal crises, of course, but it did a lot to reduce their damage. Other fixed rates have produced disasters, too. Greece's economic woes were exacerbated by the euro, which Foster calls "the ultimate fixed exchange rate." Argentina's attempt to peg its economy to the dollar produced a deflationary spiral.

If a gold standard is so problematic, why do so many people—including Ron Paul and various libertarian economists—want to peg the dollar to it? Part of the reason is distrust of the Federal Reserve. The gold standard takes the power to manipulate currency out of the Fed's hands, which economic libertarians consider a good thing. Another reason is that gyrating exchange rates make international trade difficult, since prices are always changing—better to have every economy pegged to the same index.

But economists say you can't force currency to be stable—at least not for long. Economic uncertainty is a fact of life, says Foster. Advocates of the gold standard want to "legislate certainty," he says. "It's like you have a town of declining morals, so you legislate churches. It's not going to work."

Correction, Nov. 10, 2010: This article originally stated incorrectly that the Fed would have to raise interest rates if it fixed the price of gold too high. (Return to the corrected sentence.)

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