Making Change: The Simplest Practical Gold Standard System

Making Change: The Simplest Practical Gold Standard System
July 28, 2011

(This item originally appeared in on July 28, 2011.)

Before you get into the complex, it is good to start with the simple. What would be the simplest possible gold standard system for practical use today?

“Just use gold coins!” comes the immediate reply. Ummmm … nope. The smallest practical gold coin is about a tenth of an ounce. That would be worth $160 today. Look at how many $100 bills you use in day-to-day transactions. Not many, right? This is not because you are not allowed to use $100 bills. You can go to any bank and get as many as you want. But nobody uses them, because they are inconvenient.

Even if you did use such a coin, what would you use for smaller denominations? Grains of gold dust?

Historically, this problem was overcome with the use of silver coins. The silver to gold ratio was reliably stable for decades at a stretch, even though it did tend to drift over longer periods. You could use a coin down to about 0.07 oz., the U.S. silver dime. For most of the 19th century, silver had a value of about 16 to 1 compared to gold. So, an ounce of silver would be worth about $100 today, with a 16 to 1 ratio. A dime would be worth 0.07x$100 or $7. Even this is still a rather large figure, which is why nickel and copper coins were then used.

Using metal coins was never as simple as people would like to believe today. The coins would naturally wear down, or could be purposefully clipped. Often, they traded below their face value due to this lightening. How would you like it if every coin had a different value? The Chinese put holes in their coins so they could be sorted according to their wear and grouped on strings. A string of a hundred coins that were somewhat worn might be worth 95 cash.

These problems were resolved through the use of paper money. No longer was it necessary to use silver coins, whose value drifted slightly compared to gold. No longer did you have coins with uneven wear and clipping. Each paper bill was worth exactly the same as the others. Each was redeemable for gold coins on demand.

With the widespread adoption of paper bills convertible with gold, silver fell out of monetary usage. Beginning at this point, in the 1870s, silver’s value compared to gold began to vary wildly. It was no longer so closely linked that it could be used as a small-denomination gold proxy.

Thus, I would say that the simplest practical system today is one that uses paper bills. The bills’ value is linked to gold. It would probably be worthwhile to make them redeemable in gold.

I don’t think a 100% reserve system, where each banknote has a corresponding reserve holding of gold bullion, would work for a major currency like the dollar, euro or yen. There just isn’t enough gold in the world. However, it can work for a small country, whose gold reserve needs are irrelevant in relation to the total world gold supply.

Let’s say you had a small country, like Belize. Belize’s central bank has a monetary base of about 575 million Belize dollars, worth about $287 million (U.S.), or 179,000 ounces of gold. The present market exchange rate is about 3,200 Belize dollars per ounce of gold.

The central bank holds a similar quantity of foreign assets. To convert to a 100% bullion reserve gold standard system, the central bank would sell the foreign assets (foreign government bonds) and buy gold bullion. Net cost: zero.

Now, the central bank would have 575 million Belize dollars in circulation and 179,000 ounces of gold in reserve. There are a lot of options, but for now we will assume that we will peg the Belize dollar to gold at the present rate, around B$3,200/oz. The central bank is willing to make a two-way market in Belize dollars and gold at 3,200/oz. (in practice, it might be worthwhile to have a small bid/ask spread of perhaps 2%).

In other words, the central bank would be in the business of “making change.” Just as you can go to any U.S. bank and get a hundred pennies for a dollar, or a $20 bill for 20 $1 bills, the central bank will make change for you. If you give them an ounce of gold, they will give you 3,200 Belize dollars. If you give them 3,200 Belize dollars, they will give you an ounce of gold. You could even call the 1 oz. coin a “B$3,200 coin” if you wanted to.

Let’s say you bring an ounce of gold to the central bank, and ask for 3,200 Belize dollars in return. Why would you do that? Because B$3,200 in paper bills might be a lot more useful than a gold coin. You could buy coffee with it. You go to the central bank, which “makes change.” The central bank’s balance sheet expands by one ounce of gold on the asset side, and increases by B$3,200 on the liabilities side. The currency in circulation expands by B$3,200. This is a wholly automatic process, caused by people going to the central bank to “make change.” There is no “discretionary monetary policy.”

Let’s say that you have a big pile of paper banknotes, more than you need. You go to the central bank with 3,200 Belize dollars, and ask for a 1 oz. gold coin in return. Why would you do this? For the same reason you take a piggy bank of pennies to the bank and get a $20 bill in return. Don’t need so many pennies. The central bank “makes change.” The central bank’s assets decline by 1 oz. of gold and the liabilities decline by 3,200 Belize dollars. The B$3,200 received goes into inventory, and the currency in circulation declines by B$3,200.

In the extreme case, let’s say that people wanted to take all the Belize dollars in existence and trade them with the central bank for gold. The very last 3,200 Belize dollars would come in, and the central bank would deliver the very last ounce of gold out of reserves. Both the assets and liabilities of the central bank would be zero, and the system would quietly disappear.

We can see that there is no limit to how much the central bank’s balance sheet can expand as it “makes change.” For example, the gold-linked Belize dollar might become popular in neighboring Mexico. Lots of Mexicans might start to think: “Hey, let’s dump these crappy pesos and U.S. dollars and get some of those gold-linked Belize dollars.”

They would buy gold with their pesos and U.S. dollars, and take it to the Belize central bank to “make change.” The central bank’s balance sheet would grow by huge amounts, perhaps by ten or twenty times, as a flood of Mexicans arrived to trade their gold bullion for Belize dollars. The Belize dollar would become an international currency.

We started with 179,000 ounces of gold in the vault, and 179,000 X 3,200 or 575 million of Belize dollars in circulation. After the currency becomes popular in Mexico, we might have a balance sheet with 2,375,000 ounces of gold for assets, and 2,375,000 X 3,200 or 7.6 billion of Belize dollars in liabilities.

We see here that a gold standard system does not arbitrarily limit the amount of currency in circulation. When a currency becomes popular, the currency in circulation can expand by many multiples, but its value will remain linked to gold. If it became unpopular, the currency in circulation could shrink all the way to zero, but it would remain linked to gold.

The currency in circulation has no relation at all to gold mining, or the amount of gold in the world, or imports or exports of gold, or interest rates, or the balance of trade. It is wholly a residual product of the bank’s convertibility policy.

For some reason, people think this stuff is complicated. It’s not. It can be as easy as “making change.”