Guide to the Gold Standard

We’ve been hearing alot of talk in the US about a return to the Gold Standard, especially by Ron Paul – here it is, straight up: BAD IDEA. Does he even know how the Gold Standard works?

This is the simplest possible explanation i can write of how it works and why it’s a bad idea:

1) The Gold Standard makes deflation a dangerous possibility

The structure of any pegged monetary mechanism, of which the gold standard is one, is such that prices and income are connected.

A government, let’s say the US, fixes a price of dollars relative to gold, and promises convertiblity between the two. In other words, people can at any time trade their paper dollars for a pre-determined and fixed amount of gold.

Because the price of the dollar is fixed to gold, it can’t be devalued without defaulting on commitments to gold convertibility. This is not a good thing. It shifts the adjustment mechanism from currency depreciation (relatively bearable) to deflation (big problem). This is because people will not buy uncompetitive products – you can reduce the price for them in two ways: devalue your currency relative to theirs, or do nothing and wait for market clearing to push prices down, effectively reducing asset values and causing deflation.

In turn deflation freezes up the whole economy: consumers withold consumption (as prices are dropping they try to wait for a better bargain), investors also delay investment. Meanwhile banks holding nominal liabilities (people who took out a loan for a fixed amount of $US) find that the borrowers can’t pay back their loans, which have risen in real terms. People start to default, banks have to sell the collateral (like houses) that they confiscate from borrowers in order to raise the funds to continue operating. As many people default at the same time, there is more supply than demand for typical collateral – fuelling more deflation which in turn causes more defaults and bankruptcies. this is known as a deflationary is a well known phenomenon, and the gold standard contributed, through this mechanism, to generalised economic collapse in the US and Europe in 1931-33.

This is why Bernanke is so adamantly opposed to even the possibility of deflation. Inflation is a much more desirable outcome than deflation, especially when the world is so highly leveraged. But i digress.

2) The Gold Standard is massively vulnerable to speculation

As the US trades with the rest of the world, Balance of Payments surpluses allow it to accumulate gold reserves, conversely Balance of Payment deficits (which the US runs) forces the US to sell gold to maintain the exchange rate.

As gold leakages continue due to America’s long running trade deficit, the amount of gold held by the central bank (which it holds in order to enable conversion) dwindles. Once it reaches  certain point, holder of $US start to wonder how the central bank (The Fed) will be able to uphold it’s commitment to back up fiat (paper) currency with real gold. They start getting worried and convert their paper dollars into gold, accelerating the decline in ‘free’ gold reserves. This causes panic and everyone tries to get out at the same time – causing a run on the dollar. When this happens the government can either suspend convertibility till calm is restored (which freezes up the entire economy due to massive uncertainty), or it can revalue dollars to gold – effectively reneging on their commitments and screwing up the financial system.

Oh and Ron – how do you expect to get out of a 100% debt:GDP ratio without collapsing the economy if you can’t monetize the debt or inflate your way out of it?

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