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

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