How to Operate a Gold Standard

How to Operate a Gold Standard

August 26, 2007


Both gold standard advocates and detractors alike share one feature — the majority of them have no idea how to operate a gold standard. Of course they think they do. So what else is new.

All currencies are managed via adjustment of the total supply of base money. Base money consists of paper bills and coins (typically about 90%), and bank reserves (10%). The Fed adjusts base money every day, through its various open market operations. The only difference between the Fed’s present system and a gold standard, or any other system — currency peg, currency basket, commodity basket, CPI target, monetarist aggregate target, etc. — is when and how much to adjust base money. The present system is a short-term interbank interest rate target. When the market interest rate for interbank credit is above the Fed’s target, the Fed increases base money supply. When the market interest rate is below the target, the Fed reduces base money supply.

Simple, right? A gold standard works much the same way, but the target is different. When the currency’s value is above the gold parity target, base money supply is increased, thus depressing the value of the currency. When the currency value is below the gold parity target, base money supply is reduced, supporting the value of the currency.

This is how the Fed works, but any institution (for example a private bank) that is managing a paper currency would use a similar system, and did in the 19th century when commercial banks were regularly engaged in currency issuance.

Needless to say, you can’t target both interest rates and gold parity. However, under a gold standard, interest rates typically fall to very low and stable levels, so there is no need to fuss with them.

Even in a situation where the currency was wholly metallic, currency supply would adjust to demand via natural means. Where more metal coins were demanded, as a tool for use in trade, metal would naturally flow to those areas to be minted into coins. The result would be that California would have a lot more gold coins (supply of money) within its borders than Wyoming, because of the different sizes of the economy (and consequently demand for money). The value of money, of course, would be the same in either place.

We all know that the Federal Reserve (or any currency issuer, such as a private bank) is able to “print money” in any amount, if it wants to. What many people are not aware of is that the Federal Reserve is also able to “unprint money” or reduce the supply of base money, also in any amount. The Fed “prints money” by buying something, typically a government bond, and giving “new money” (in practice bank reserves) in return. The Fed “unprints money” by selling something, typically a government bond, and making the money it receives from the sale disappear. Since the Fed stockpiles bonds on a 1:1 basis to the total amount of base money, the Fed is capable of “unprinting” every dollar out there.

So we see that, even in a case where there is a great reduction in demand for dollars (as may be taking place now as the dollar is replaced by the euro and other local currencies for use worldwide), this does not pose a problem if the manager of the currency (central bank) “unprints” money correspondingly such that it maintains is value. In a gold standard, the currency would remain pegged to gold.

That’s pretty much it. See how simple this is?

Only ten or so years ago, you could take a hundred gold standard advocates, and a hundred gold standard detractors (mainstream economists), and put them in a room, and I doubt you could find five people that could accurately describe the process outlined above. That is improving considerably these days, as people become more sophisticated. But it illustrates what the state of knowledge has been on these issues for many decades.

The gold standard advocates remembered all the ageless principles regarding the superiority of gold-linked currency. Also, they well understood the disaster that occurred when the world left gold in 1971. However, many never quite understood what led to the departure from gold in 1971 — namely Arthur Burns’ increase in base money supply beginning in 1970, in an effort to bring the economy out of recession and goose the economy enough that his patron Richard Nixon would be re-elected in 1972. In other words, the problem was mismanagement of base money supply, in a manner contrary to the operation of a gold standard. There were a few who argued that the problem was large deficits related to Vietnam. (No relation.) And, there were a few who observed that the amount of dollars outstanding (base money) was in excess of the remaining gold holdings of the US government, and therefore everyone was doomed. (I believe Jacques Rueff was a fan of this theory, but I could be wrong about that.) As I’ve said many times, a currency manager does not need to hold any gold at all to peg a currency’s value to gold. It merely needs to adjust the supply of base money appropriately. Also, putting a whole bunch of gold in a box doesn’t do anything for a paper currency either, if it is not being managed properly. “Backing” of paper money is largely a fictional concept. If, for example, the dollar is worth 1/40th oz. of gold (i.e., $40/oz.), but I am willing to sell gold at $35/oz., then I will simply sell all the gold I have. Big surprise. Just selling gold has no lasting effect — the important thing is to properly manage the supply of currency through the adjustment of base money. In this case, the thing to do is to reduce the supply of base money such that the value of the dollar rises to $35/oz. If anything, selling bullion in the hope that this will affect the currency’s value is a good sign that the managers of the currency are incompetent. When people figure that out, they sell the currency. Wouldn’t you? Thus, at the end of the exercise, the dollar would be worth $45/oz., and you would be out of gold. (This is roughly what was going on in the late 1960s, until the US put a stop to gold outflows by introducing the Special Drawing Rights in 1968.)

I’ll say it again: all the gold in the world won’t help if the managers don’t know how the manage the currency. If the managers manage the currency properly, via base money supply adjustment, no gold at all is necessary.

There is a subset among the gold standard advocates that tends towards these “gold backing” theories. They want a 100% reserve backing of paper bills, i.e., base money. Even this, however, does not really accomplish anything. If you stuck a huge amount of gold in a vault, that does not mean that the supply of currency (base money) is being properly managed. The currency can still fall apart. Even redeemability (selling gold at $35/oz. for example) doesn’t solve the problem. The vault holding of gold would simply be sold off at below-market prices. What could work is if, whenever a dollar is redeemed for gold, that dollar disappears permanently. In other words, base money supply is reduced. Actually, this is exactly the process I outline above, where the central bank sells a bond and makes the money received disappear. The only difference is that they would sell gold instead of a bond. Actually, you can sell anything — gold, domestic bonds, foreign bonds, etc. — and the result is largely the same, namely a reduction in base money. This kind of “warehouse chit for gold” could work for a small economy, like that of New Zealand or Singapore. However, it wouldn’t work for the eurozone, because there simply isn’t that much gold out there. And even if there was, would you want the government to keep it all in a vault? That practically guarantees that, someday, they’ll say “we’ll just keep this gold, thank you, and why don’t you all get stuffed?”

These sorts of gold standard advocates can see that, if there is $1 billion out there, and there’s only 100 oz. of gold in the vault, then if people want to redeem their dollars for gold at $100/oz., a lot of people would get left out. Which is true. But that sort of widespread “dumping of dollars” implies a loss of dollar value. If the currency is being properly managed, then the Fed (or other manager) would busily “unprint” dollars by selling bonds, so that the value of the dollar wouldn’t fall. And if the value of the dollar was stable (i.e., pegged to gold), and the managers of the currency have proven to be competent, then why dump dollars? Which brings us again to the basic principle, which is that a gold bullion hoard is no substitute for competency in the practice of currency management.

If you know how to play the game, you don’t need gold. If you don’t know how to play the game, you’re going to end up in a whole heap of trouble one way or another.

Some gold standard advocates like to talk about the “Classical Gold Standard”, by which they usually mean the processes in operation during the 1870-1914 period. In those days, currency managers, whether quasi-governmental (Bank of England) or more private (in the US), never held much gold reserves. They didn’t have to, because they understood the supply adjustment processes described earlier. This “100% reserve holding” type system is extremely antiquarian, and appears to have gone extinct in the 17th century.

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New Hampshire Taxpayers, July 7 ~ 1st 65.3%
North Carolina, Gaston GOP, August 13, ~ 1st 36.6%
New Hampshire, Stafford, NH, August 18 ~ 1st 72.7%
Alabama, August 18 ~ 1st 81.2%
Washington State, August 21 ~ 1st 28.1%

He placed second in five more:

Utah GOP, June 12, 2nd 5.4% conference, June 16 ~ 2nd 16.7%
Georgia, Cobb Co. GOP, July 4 ~ 2nd 17%
South Carolina, Georgetown Co., July 28 ~ 2nd 18%
West Lafayette, Indiana, August 18 ~ 2nd 11.7%

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Illinois Straw Poll Shenanigans
Ron Paul Supporters Not Allowed at Texas Straw Poll
Ron Paul Iowa Exit Poll Shows Win
Evidence Suggests Ron Paul Was Cheated
ABC Caught Censoring Ron Paul Support to Favor Mitt Romney
Romney Jokes About Cheating in Poll
Malfunctioning Diebold Voting Machines Run By Romney Team Member At Iowa Poll
Fox News Censors Straw Poll Results
Vote Machine Malfunction in Iowa Straw Poll Raises Hackles
Iowa Straw Poll Results Delayed
Ron Paul Signs Removed by Police At Ames Straw Poll
Ames Iowa Tribune Runs Poll — Paul with 81%