The 10-Minute Gold Standard System
January 31, 2013
(This item originally appeared in Forbes.com on January 31, 2013.)
Sometimes people ask me: “How do we transition to a gold standard system?” People think it’s really difficult.
Actually, it can be very easy. The easiest, simplest, fully-operational form of a gold standard system could be implemented in ten minutes. It doesn’t cost anything, and doesn’t require any gold bullion.
I don’t think it is the best system. But, it is fast and easy, and fully operational.
The better classical economists have always known that gold bullion itself is not really necessary for a gold standard system. Gold is the “standard,” in other words, the “standard of value.” It is just something you compare against.
David Ricardo wrote in 1817:
“It is on this principle that paper money circulates: the whole charge for paper money may be considered as seignorage. Though it has no intrinsic value, yet, by limiting its quantity, its value in exchange is as great as an equal denomination of [gold] coin, or of bullion in that coin. …
It will be seen that it is not necessary that the paper money should be payable in specie to secure its value; it is only necessary that its quantity should be regulated according to the value of the metal which is declared to be the standard.”
In other words, when the value of the currency is too high compared to the standard, you increase the supply. When the value of the currency is too low compared to the standard, you decrease the supply. It really is that simple.
Here’s John Stuart Mill, on the same topic in 1848:
“If, therefore, the issue of inconvertible paper were subjected to strict rules, one rule being that whenever bullion rose above the Mint price, the issues should he contracted until the market price of bullion and the Mint price were again in accordance, such a currency would not be subject to any of the evils usually deemed inherent in an inconvertible paper.”
The Federal Reserve has the responsibility today of increasing or decreasing the base money supply. Only the Federal Reserve can do this.
The Federal Reserve already increases and decreases the base money supply on a daily basis. However, this is not done according to a gold standard system operating framework. Rather, it is done according to an interest rate target framework, or today a “quantitative easing” framework.
To implement a gold standard system — in ten minutes — you simply have the Federal Reserve stop managing the base money supply according to an interest rate/quantitative easing framework, and start managing it according to a gold standard framework. All this means is that the base money supply is adjusted at different times, and in different quantities.
To increase the base money supply, the Federal Reserve typically buys something, usually a bond of some sort. This is paid for by newly-created base money. Thus, the total amount of base money in existence increases.
To decrease the base money supply, the Federal Reserve typically sells something. The money received in payment disappears, which shrinks the base money supply.
Unfortunately, although this method is certainly quick and easy, it is also prone to eventual corruption and failure. This is not because the basic methods don’t work – they do – but rather because it is all too easy for the managers of the system to deviate from what they are supposed to be doing.
Immediately after confirming that such a system is indeed possible, John Stuart Mill then describes its inherent problems. This is an extended passage, but he puts it as succinctly and clearly as anybody can:
“But also such a system of currency would have no advantages sufficient to recommend it to adoption. An inconvertible currency, regulated by the price of bullion, would conform exactly, in all its variations, to a convertible one; and the only advantage gained, would be that of exemption from the necessity of keeping any reserve of the precious metals; which is not a very important consideration, especially as a government, so long as its good faith is not suspected, needs not keep so large a reserve as private issuers, being not so liable to great and sudden demands, since there never can be any real doubt of its solvency.
“Against this small advantage is to be set, in the first place, the possibility of fraudulent tampering with the price of bullion for the sake of acting on the currency; in the manner of the fictitious sales of corn, to influence the averages, so much and so justly complained of while the corn laws were in force. But a still stronger consideration is the importance of adhering to a simple principle, intelligible to the most untaught capacity. Everybody can understand convertibility; every one sees that what can be at any moment exchanged for five pounds, is worth five pounds.
“Regulation by the price of bullion is a more complex idea, and does not recommend itself through the same familiar associations. There would be nothing like the same confidence, by the public generally, in an inconvertible currency so regulated, as in a convertible one: and the most instructed person might reasonably doubt whether such a rule would be as likely to be inflexibly adhered to. The grounds of the rule not being so well understood by the public, opinion would probably not enforce it with as much rigidity, and, in any circumstances of difficulty, would be likely to turn against it; while to the government itself a suspension of convertibility would appear a much stronger and more extreme measure, than a relaxation of what might possibly be considered a somewhat artificial rule.
“There is therefore a great preponderance of reasons in favour of a convertible, in preference to even the best regulated inconvertible currency. The temptation to over-issue, in certain financial emergencies, is so strong, that nothing is admissible which can tend, in however slight a degree, to weaken the barriers that restrain it.”
Mastery of these concepts means understanding all the options. Ricardo understood them. Mill understood them. We need more people today with the kind of mastery that people had in the mid-nineteenth century. The gold standard system of the time – the most perfect monetary system ever created – was a reflection of their mastery.