Could a return to hard money save the dollar?

By Robert P. Murphy

Conservatives and libertarians often lament President Franklin Roosevelt’s decision in 1933 to confiscate Americans’ monetary gold, a move that killed the classical gold standard. In 1971, Richard Nixon abolished even the diluted gold exchange standard of Bretton Woods and totally severed the dollar’s tie to the precious metal. The world economy has since rested on a foundation of fiat paper money.

What, if anything, have we lost as a result? And could we return to the golden age even if we wanted to?

The supreme virtue of the gold standard was that it restrained the power of the government to debase the currency. Before FDR’s 1933 order, the U.S. was obligated to redeem paper dollars for physical gold. In other words, the dollar was pegged to gold at a fixed rate.

In practice, this put a serious constraint on those who controlled the U.S. printing presses. Other things being equal, if the government—or the Federal Reserve, after 1913—printed more currency, the prices of goods and services quoted in dollars went up. On the other hand, with a fixed number of dollars in existence, there would be a tendency for the prices of goods and services to fall gently in a healthy economy that produced more output over time. As a loose rule of thumb, on a strict gold standard the Fed could only print more dollars as miners brought more physical gold to the surface.

The gold standard offered automatic feedback to restrain excessive inflation of the money supply. If Fed officials started running the printing presses too heavily—flooding the world with new dollars—this would put upward pressure on the market price of gold. If, say, gold began trading at $21.67 per ounce in the open market, and the officially pegged price of gold was $20.67, speculators would short the dollar. They would redeem dollars for gold, then they would sell that gold on the world market, and reap profits of $1 per ounce.

With speculators “attacking” the dollar in this fashion, government gold reserves would soon be depleted, as the Fed effectively had to buy back the excess dollars from speculators. In order to reassure investors that the dollar was still as good as gold, the Fed would be compelled to stop printing money and wait for the dollar to strengthen against the metal before attempting any more inflationary policies.

The gold standard was not perfect. It allowed the Fed to foster a massive asset bubble in the late 1920s, which ushered in the Great Depression as Herbert Hoover foolishly implemented a New Deal-lite to combat the financial crash. Even so, the gold standard prevented runaway inflation of the kind that destroyed interwar Germany and, in our times, Zimbabwe. By providing a solid anchor for the paper currency, the gold standard gave investors, firms, and households confidence in the long-run purchasing power of their monetary unit.

Ludwig von Mises went so far as to liken the gold standard to a bill of rights or constitution. In his view, it prevented the government from diluting the value of the currency to achieve its spending objectives.

Practically speaking, it would be straightforward to put the U.S. back on a gold standard. Fed Chairman Bernanke can do whatever he wants so long as he argues that it will “help the economy.” This includes not only making public proclamations of “quantitative easing,” but also giving behind-the-scenes bailouts worth several trillion dollars to private institutions, including foreign banks.

It would be quite simple for Bernanke to announce at a news conference something like the following:

Starting on January 2, 2012, the Federal Reserve will stop targeting interest rates. Instead, we will use our open market operations to keep the price of gold within a narrow range centered on $2,000 per ounce. To convince investors that we will have the ability to maintain the new peg, starting immediately the Fed will begin selling off its mortgage-backed securities and using the proceeds to accumulate gold. Furthermore, we will allow outside auditors to inspect our holdings of gold every 6 months, so the world will have no doubt that we can maintain our commitment to a stable dollar-price of gold.

After the announcement, Bernanke and his colleagues would figure out whether they had chosen a realistic exchange rate. If the gold price went up to, say, $2,400 per ounce, the Fed would have to remove dollars from the economy, by selling off assets, such as the Fed’s enormous holdings of U.S. government debt—and then, crucially, not buying anything else with the proceeds. This tightening of monetary policy is exactly what the Fed currently does when it wants to hike interest rates. The difference would be that the Fed’s target variable wouldn’t be the federal funds interest rate, but rather the price of gold.

On the other hand, Bernanke might observe that his announcement provided a flood of relief to investors who thought that successive rounds of “quantitative easing” would destroy the dollar. They might sharply reduce their gold holdings and rush back to more conventional assets. This would lead to a fall in the price of gold. In that case, Bernanke could begin writing checks on thin air—just as he currently does—to accumulate more physical gold. He would stop when the price had been pushed back up to the target of $2,000.

The chances of Bernanke following this path are nil. But even if he were willing to do so, should he?

Critics often argue that in a financial panic people rush to gold as the safest of assets. With a floating dollar-price of gold, this shows up as skyrocketing prices for goods. But what if the dollar-price of gold had been fixed? Then the worldwide rush into gold would require massive price deflation for everything else, as measured in dollars. Wouldn’t that have been disastrous?

There are three responses to this. First, part of the reason for skyrocketing gold prices has been investor fears that Bernanke will cripple the dollar with his inflationary schemes. If people were convinced that the currency would always be “as good as gold,” there would have been no reason to dump dollar-denominated assets in favor of gold.

Second, Austrian Business Cycle theory indicates that the reason for our financial panic was the credit expansion undertaken by Greenspan, which fueled the housing bubble. Although booms and busts are still possible under a gold standard, they are kept under tighter control.

Third, a market economy can handle falling prices just fine. The depression of 1920-1921 saw a much sharper fall in prices than any one-year stretch of the Great Depression. The difference was that in the early 1930s Herbert Hoover didn’t allow wages to fall, thus making labor artificially expensive. By the same token, the U.S. economy would have recovered from the collapsing stock market and real estate bubbles long ago had the government and Fed stood back and let nature run its course.

The true danger to economies is a printing press run rampant, not the gold standard.

Robert P. Murphy is an economist with the Institute for Energy Research.