August 7, 2017    10 minute read

Here’s How a Return to the Gold Standard Could Cure the Ills of Modern Finance

Lessons from History    August 7, 2017    10 minute read

Here’s How a Return to the Gold Standard Could Cure the Ills of Modern Finance

The gold standard is a system where the nation’s money supply is determined by the supply of gold that is mined. Over time we have had different types of gold standard economies and countries have even suspended the gold standard during wars (e.g.: WWI). Until WWI the world had the international gold standard.

The price of gold was set at $20.67/oz. After the breakdown of the gold standard in the 1930s, the Bretton Woods Agreement from 1945 to 1971 was not exactly a gold standard. Individuals were not allowed to own gold and thus banks couldn’t offer gold checking accounts. Only governments held gold and they could make the US$ convertible to gold. Gold was set at $35/oz. However, Nixon ended the Bretton Woods agreement in 1971.

  • Engineering of Credit Bubbles

To understand the origin of the business cycle, we need to understand the Austrian Business Cycle Theory.

Austrian Business Cycle Theory

Interest rates are determined by people’s desire to save or consume. The market interest rate would be based on people’s time preferences. A lower time preference would indicate that people have more desire to save as opposed to consuming now. This increases the supply of loanable funds and hence lower market interest rate. This, in turn, allows other people to borrow more money for capital investment. This results in more investment on long-term projects and hence allows the supply of more goods in the future. As there is more saving, it means there will be more consumption in the future and hence the capital investment is justified.

  1. However, when the central bank increases the supply of money and increases the amount of available in the loan market, it reduces interest rates. This would make it seem that there is an increase in ‘delayed consumption’ and hence more funds for investment.
  2. Businessmen are misled into thinking that there is a large amount of savings that will be spent in the future.
  3. Therefore capital investment and investments into ‘’longer processes of production’’ (higher order goods) all increase. Hence the capital structure is lengthened.
  4. Businesses take the newly acquired funds and bid up the prices of capital and hence shift large amounts of investment from consumer goods to capital goods.
  5. This marks the boom period of the business cycle. The large investments made in capital goods stimulate more employment in these industries. This is known as ‘malinvestment’.
  6. These long-term projects are erroneous as the demand was never there and hence the investments are abandoned. Asset prices begin to fall and labour that was employed in these capital goods industries are now unemployed. The bust period now begins.
  7. It is capital goods industries that suffer the most in the economy.
  8. Asset prices fall, consumer confidence falls, more labour becomes unemployed and economic growth slows and more business and households enter bankruptcy.
  9. The bust also includes the liquidation of the malinvestments and hence a reallocation of capital in the correct proportions (according to consumer preferences). This is the readjustment process. The greater the misallocation, the more violent the readjustment process. This marks a recession.

The key takeaway was that central banks expanded the money supply. Under a 100% gold standard without any increase in the supply of gold, the money supply cannot change. Hence to expand credit and capital investment, saving in the economy must increase. As a result, a 100% gold standard economy would force economic growth to be achieved through saving and capital investment as opposed to consumption, which may only stimulate the economy in the short run. This increase in productive capacity means that growth can occur without hurting future growth and hence makes credit bubbles much less severe.

In fact recessions like 1929 was caused by the Federal Reserve. While the world was still on the gold standard in the 1920s, unfortunately, the total money supply grew faster than the supply of gold. This is shown by the fact that the total money supply increased from $44.7bn to $71.8bn between 1921 and 1929 (Rothbard, America’s Great Depression) despite an only 15% increase in the total gold reserves. One reason is that the absence of a full, 100% reserve gold standard allowed a more than proportional increase in the total money supply.

Wages and Growth: Higher Under Classical Gold Standard

When the world was on the gold standard, the fastest rate of economic growth happened between 1870 and 1914, when the gold standard was suspended in Europe because of WWI. Not only that, but blue collared workers then saw vast increases in their purchasing power. Had we stayed on the classical gold standard, wages would be higher and the middle class would continue to grow.

For example in 1915, Henry Ford paid his workers $5 per day. At that time the price of gold was set at $20.67/oz. This means that in terms of gold (which was a legitimate form of payment and was easily redeemable into paper money) a blue collared factory worker was paid 0.242 oz. of gold per day. Assuming a 5-day work week and 40 weeks of work in a year, Ford workers could be paid 48 oz. of gold per year. Today the price of gold is $1200/oz; this means the Ford workers were paid $57,600/year in today’s money. This is significantly higher than what manufacturing jobs pay today.

Similarly, in 1965, the minimum wage was $1.25/hr (5 silver dimes) and under the Bretton Woods Agreement, silver was $1.25 per ounce. Today silver is $15/oz and hence workers would have had a purchasing power of $15/hour in today’s money.

Inflation

This implies that it is government control over a nation’s monetary system, which has allowed the middle class’s income to be eroded by inflation. While the CPI may show us that central banks have kept inflation under control, once we use precious metals as a measurement, the cost of goods and services have gone up much higher than what current inflation would suggest.

As a result, it is the poor and middle class who get hit the hardest by this inflation and the wealthy the least. This explains why many socialists make the claim that the wealthy are profiting off the poor and middle class and why many countries have become increasingly unequal since 1971. As a result, a return to laissez-faire capitalism is the solution- ending the government monopoly of money and replacing the monetary system with a 100% gold standard.

In fact, at no point in American or European history has there been a full 100% backing of the money supply by gold. As a result, the ability for the currency to devalued is even less and greater increases in purchasing power under a 100% gold standard system. Under a gold standard, real incomes go up by simply being able to buy more goods and services with a particular amount of gold. Hence if someone were paid 1 oz of gold in 1870 and again in 1914, the purchasing power of that person would have increased.

In fact, during the 1880s, US real GDP per capita grew by 3.8% per year, labour productivity increased 23% and consumer prices fell by 4% in the decade, hence supporting the assertion that it is ensuring a stable value of the nation’s money that ensures that jobs pay well enough. Today many blue collared workers struggle to make ends meet. We have now been able to identify that it is their money, which is worthless as opposed to greedy capitalists. If anything capitalism would partially solve the plight of the poor.

De-Facto Gold Standard

While the overall economic performance between 1971-2017 in the developed world hasn’t been as good as pre-1971, the 1980s and 1990s were a time of very rapid economic growth. It was the 1970s and the 2000s that had far less economic growth. The 1970s saw stagflation and the 2000s saw growth below 3%/year, then the 2008 crash and a very slow recovery since. Between 1981 and 1999 (Reagan, Bush Sr. and Clinton administrations), 40 million net new jobs were created, the stock market increased 15 fold and economic growth averaged almost 4% per year.

The reason could be traced to the price of gold during each decade. During the 1970s we see that the price of gold fluctuated between $35/oz and $800/oz. Similarly, during the 2000s, the price of gold fluctuates between $400/oz in 2000 to $1,800/oz in 2011. This is in stark contrast to the 1980s and 1990s. Between 1981 and 1996 the price of gold fluctuated little between $391/oz and $367/oz respectively.

The data shows that even when the world was off the gold standard but gold prices were stable the economic prosperity seen during the gold standard was somewhat replicated in the 1980s and 1990s. The reason is that guaranteeing a stable currency creates more certainty, which in turn creates more investment. This is certainly true of the 1980s and 1990s, which saw a technological revolution as well as increases in real median household income. Imagine how much growth could be achieved if the world returned to the classical gold standard before WWI whilst also maintaining a 100% reserve gold standard.

Boosts International Trade

One of the main barriers to countries trading with each other is not only the fluctuation of currency on the FOREX markets but also the current valuations of a particular currency may be inaccurate. For example, many politicians worry that the Chinese Yuan is undervalued. Converting to the gold standard was correct these imperfections by certain countries experiencing an outflow of gold or vice versa.

Once we have a 100% gold standard, it will also be possible for every country to disband its currency so that gold is used as money anywhere in the world. Gold would be acceptable in China as it would in the UK. As a result, there’d be no foreign exchange risk. This would create much more certainty for investors and as a result, countries could experience more FDI.

Also, it would be much easier to trade goods and services with other countries now that there is no currency risk. This would make trade easier. Benefits of more trade include increased competitiveness and productivity and destruction of monopolies, as they now have to compete worldwide. Most importantly more trade could lead to cheaper products for consumers and hence higher real incomes.

The Transition

It is impossible to suddenly transition into the classical gold standard system like before WWI. As a result, we would have to take baby steps in the transition to a 100% gold standard economy. The government could start off by simply allowing private banks, citizens and businesses to accept gold as a legitimate form of payment. The government would not set the price of gold like in the international gold standard system ($20.67 per ounce), but instead, people would decide the true value of gold based on whether they prefer gold to the Federal Reserve note.

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