Gold Backed Currency System

If the monetary authority holds sufficient gold to convert all circulating money, then this is known as a 100% reserve gold standard, or a full gold standard. Some believe there is no other form of gold standard, since on any “partial” gold standard the value of circulating representative paper in a free economy will always reflect the faith that the market has in that note being redeemable for gold. Others, such as some modern advocates of supply-side economics contest that so long as gold is the accepted unit of account then it is a true gold standard. In an internal gold-standard system, gold coins circulate as legal tender or paper money is freely convertible into gold at a fixed price.

In an international gold-standard system, which may exist in the absence of any internal gold standard, gold or a currency that is convertible into gold at a fixed price is used as a means of making international payments. Under such a system, when exchange rates rise above or fall below the fixed mint rate by more than the cost of shipping gold from one country to another, large inflows or outflows occur until the rates return to the official level. International gold standards often limit which entities have the right to redeem currency for gold. Under the Bretton Woods system, these were called “SDRs” for Special Drawing Rights.

Gold Backed Currency System

Effects of Gold Backed Currency

The commitment to maintain gold convertibility tightly restrains credit creation. Credit creation by banking entities under a gold standard threatens the convertibility of the notes they have issued, and consequently leads to undesirable gold outflows from that bank. The result of a failure of confidence produces a run on the specie basis, which is generally responded to by the bankers suspending specie payments. Hence, notes circulating in any “partial” gold standard will either be redeemed for their face value of gold (which would be higher than its actual value) – this constitutes a bank “run”; or the market value of such notes will be viewed as less than a gold coin representing the same amount.

In the international gold standard imbalances in international trade were rectified by requiring nations to pay accounts in gold. A country in deficit would have to pay its debts in gold thus depleting gold reserves and would therefore have to reduce its money supply. This would cause prices to deflate, reducing economic activity and, consequently, demand would fall. The resulting fall in demand would reduce imports; thus theoretically the deficit would be rectified when the nation was again importing less than it exported. This lead to a constant pressure to close economies in the face of currency drains in what critics called “beggar thy neighbor” policies. Such zero-sum gold standard systems showed periodic imbalances which had to be corrected by rapid falls in output.

The gold standard, in theory, limits the power of governments to cause price inflation by excessive issue of paper currency, although there is evidence that before World War I monetary authorities did not expand or contract the supply of money when the country incurred a gold outflow. It is also supposed to create certainty in international trade by providing a fixed pattern of exchange rates. The gold standard in fact is deflationary, as the rate of growth of economies generally outpaces the growth in gold reserves. This, after the inflationary silver standards of the 1700s was regarded as a welcome relief, and an inducement to trade. However by the late 19th century, agitation against the gold standard drove political movements in most industrialized nations for some form of silver, or even paper based, currency.

Advocates of a Renewed Gold Standard

The internal gold standard is supported by anti-government economists, including extreme monetarists, objectivists, followers of the Austrian School of Economics and even many proponents of libertarianism. Much of the support for a gold standard is related to a distrust of central banks and governments, as a gold standard removes the ability of a government to manage the value of money, even though, historically, the establishment of a gold standard was part of establishing a national banking system, and generally a central bank. The international gold standard still has advocates who wish to return to a Bretton Woods-style system, in order to reduce the volatility of currencies, but the unworkable nature of Bretton Woods, due to its government-ordained exchange ratio, has allowed the followers of Austrian economists Ludwig von Mises, Friedrich Hayek and Murray Rothbard to foster the idea of a total emancipation of the gold price from a state-decreed rate of exchange and an end to government monopoly on the issuance of gold currency.

Many nations back their currencies in part with gold reserves, using these not to redeem notes, but as a store of value to sell in case their currency is attacked or rapidly devalues. Gold advocates claim that this extra step would no longer be necessary since the currency itself would have its own intrinsic store of value. A Gold Standard then is generally promoted by those who regard a stable store of value as the most important element to business confidence.

It is generally opposed by the vast majority of governments and economists, because the gold standard has frequently been shown to provide insufficient flexibility in the supply of money and in fiscal policy, because the supply of newly mined gold is finite and must be carefully husbanded and accounted for.

A single country may also not be able to isolate its economy from depression or inflation in the rest of the world. In addition, the process of adjustment for a country with a payments deficit can be long and painful whenever an increase in unemployment or decline in the rate of economic expansion occurs.

One of the foremost opponents of the gold standard was John Maynard Keynes who scorned basing the money supply on “dead metal”. Keynesians argue that the gold standard creates deflation which intensifies recessions as people are unwilling to spend money as prices fall, thus creating a downward spiral of economic activity. They also argue that the gold standard also removes the ability of governments to fight recessions by increasing the money supply to boost economic growth. Much of this thought has been reversed when stagflation hit the United States in the early ’70s in contradiction to Keynes’ General Theory of Employment Interest and Money.

Gold standard proponents point to the era of industrialization and globalization of the 19th century as the proof of the viability and supremacy of the gold standard, and point to Britain’s rise to being an imperial power, conquering nearly one quarter of the world’s population and forming a trading empire which would eventually become the Commonwealth of Nations as imperial provinces gained independence.

Gold standard advocates have a strong following among commodity traders and hedge funds with a bearish orientation. The expectation of a global fiscal meltdown and the return to a hard gold standard has been central to many hedge financial theories. More moderate gold bugs point to gold as a hedge against commodity inflation, and a representation of resource extraction, in their view gold is a play against monetary policy follies of central banks, and a means of hedging against currency fluctuations, since gold can be sold in any currency, on a highly liquid world market, in nearly any country in the world. For this reason they believe that eventually there will be a return to a gold standard, since this is the only “stable” unit of value. That monetary gold would soar to $5,000 an ounce, over 10 times its current value, may well have something to do with some of the advocacy of a renewed gold standard, holders of gold would stand to make an enormous profit.

Few economists today advocate a return to the gold standard. Notable exceptions are some proponents of Supply-side economics and some proponents of Austrian Economics. However, many prominent economists, while they do not advocate a return to gold, are sympathetic with hard currency basis, and argue against fiat money. This school of thought includes US central banker Alan Greenspan and macro-economist Robert Barros. The current monetary system relies on the US Dollar as an “anchor currency” which major transactions, such as the price of gold itself, are measured in. Currency instabilities, inconvertibility and credit access restriction are a few reasons why the current system has been criticized, with a host of alternatives suggested, including energy based currencies, market baskets of currencies or commodities. Gold is merely one of these alternatives.

The reason these visions are not practically pursued is based on the same reasons that the gold standard fell apart in the first place: a fixed rate of exchange decreed by governments have no organic relationship between the supply and demand of gold and the supply and demand of goods.

Thus gold standards have a tendency to fall apart as soon as it becomes advantageous for governments to overlook them. By itself, the gold standard does not prevent nations from switching to a fiat currency when there is a war or other exigency, even though paradoxically gold gains in value through such circumstances as people use it to preserve value since fiat currency is typically introduced to cause inflation.

The practical matter that gold is not currently distributed according to economic strength is  also a factor: Japan, while one of the world’s largest economies, depending on which measure, it has gold reserves far less than could support that economy. Finally, the quantity of gold available for reserves, even if all of it were confiscated and used as the unit of account, would put the value of gold upwards of 5,000 dollars an ounce on a purchasing parity basis. If the current holders of gold imagine that this is the price that they will be paid for giving up their gold, they are quite likely to be disappointed. For these practical reasons — inefficiency, misallocation, instability, and insufficiency of supply — the gold standard is likely to be more honored in literature than practiced in fact.

Gold as a Reserve Today

During the 1990s Russia liquidated much of the former USSR’s gold reserves, while several other nations accumulated gold in preparation for the Economic and Monetary Union. The Swiss Franc left a full gold convertible backing. However, gold reserves are held in significant quantity by many nations as a means of defending their currency, and hedging against the US Dollar, which forms the bulk of liquid currency reserves. Weakness in the dollar tends to be offset by strengthen of gold prices. Gold remains a principal financial asset of almost all central banks along side foreign currencies and government bonds. It is also held by central banks as a way of hedging against loans to their own governments as an “internal reserve”.

In addition to other precious metals, it has several competitors as store of value: the US dollar itself and real estate. As with all stores of value, the basic confidence in property rights determines the selection of which one is chosen, as all of these have been confiscated or heavily taxed by governments. In the view of gold investors, none of these has the stability that gold had, thus there are occasionally calls to restore the gold standard. Occasionally politicians emerge who call for a restoration of the gold standard, particularly from the libertarian right and the anti-government left. Mainstream conservative economists such as Barros and Greenspan have admitted a preference for some tangibly backed monetary standard, and have stated that a gold standard is among the possible range of choices. Some privately issued modern notes (such as e-gold) are backed by gold bullion, and gold. Both coins and bullion are widely traded in deeply liquid markets, and therefore still serve as a private store of wealth.

In 1999, to protect the value of gold as a reserve, European Central Bankers signed the “Washington Agreement”, which stated they would not allow gold leasing for speculative purposes, nor would they “enter the market as sellers” except for sales that had already been agreed upon. A selling band was set. This was intended to prevent further deterioration in the price of gold.

Credit: Global Financial Markets and Instruments-PU