In the debate over the future direction of the U.S. economy, federal spending and inflation have once again entered the crosshairs of congressional Republicans intent on further removing the government’s influence on the economy. According to a report from The Financial Times, a proposal for a return to the use of a gold standard is in the works for debut at the party convention in Tampa, FL. Ideally, Republicans would use a gold standard to limit the ability of the Federal Reserve to increase the money supply beyond a finite ceiling and in turn, force greater fiscal discipline from the federal government. However, the use of gold standard goes too far in limiting the scope of the Federal Reserve and would harm the general economy by suddenly contracting the money supply.
So What’s A Gold Standard Exactly?
A gold standard is used to link a fixed weight (usually in ounces) of gold to a specific demonination of paper currency. Under this system, consumers could go to banks and, at their choosing, exchange their paper money for an exact measure of gold. Since the total gold reserve in any national treasury would be some finite quantity, then the total amount of currency a central bank could print and issue into circulation is also a precise amount. For a more visual explanation of how a gold standard works, CNBC’s Steve Liesman does a good job here.
Have We Ever Used A Gold Standard?
Yes. From 1834 until 1933, the United States used some form of either gold or silver standard (see Bimetallism) to value and effectively collateralize the dollar. Prior to the Federal Reserve Act of 1913, the U.S. Treasury managed the printing of paper currency that could be exchanged for the gold in its reserves, but after 1913, the Federal Reserve System was established as America’s central bank and took over the resposibility of managing the money supply.
Why Did We Stop Using It?
The U.S. has the Great Depression to thank for that. When the Depression hit in the 1930s, banks experienced serious shortfalls in capital as panicked investors retreated from the securities excahnges and consumers flooded banks attempting to exchange their paper currency for gold, fearing a devaluation of the dollars in circulation. The increase in conversion of currency to gold reduced the overall reserve held by U.S. Federal Reserve Banks hamstringing the central bank who couldn’t increase the money supply enough to prevent capitalize commercial banks against bankruptcy. In 1934, the Gold Reserve Act was passed, prohibiting the private ownership of gold and requiring that all privately held gold reserves be sold to the U.S Treasury including the reserves held by Federal Reserve Banks.
Why Shouldn’t We Go Back?
First, a gold standard goes too far in restricting the ability of the Federal Resere system to lower interest rates and increase the money supply when the financial system needs additional liquidity. Remember, during the housing crisis American financial institutions had serious liquidity concerns after they had borrowed excessively to invest in speculative asset-backed securities. It was the Federal Reserve who increased the money supply to inject capital into U.S. financials to keep them from failing (see TARP and ARRA). Without this, it is likely that the U.S. economy would have witnessed a far greater number of bankruptcies in the financial system which would have deepened the recession, potentially into depression.
Second, the U.S. economy is far too large to warrant the use of a gold standard. In GDP terms the U.S. economy is worth about $2.7 trillion, but the estimated value of all the gold ever mined (in metric tons) is around $6 trillion. So there’s literally not enough gold available for the U.S. Treasury to back the currency currently in circulation since the U.S. doesn’t actually own all the gold ever mined.
Third, if a gold standard were implemented, the Federal Reserve would have to contract the money supply in accordance with the exachange value set for U.S. gold reserves. Remember, with a gold standard, the Federal Reserve can only print and issue currency until the value of bills in circulation equals the corresponding total weight of U.S. gold reserves. After two successive bailouts of the financial system, and two rounds of quantitative easing from the Federal Reserve, it stands to reason that the current amount of money in circulation would exceed the weight of gold that U.S Treasury has in reserve. Therefore, the money supply would contract accordingly, raising the low interest rates U.S financials are using to keep credit flowing through the economy. A sudden contraction in the money supply, combined with an equally sudden increase in interest rates would spark another panic in the financial sector effectively silencing the already slow recovery.
Government spending isn’t really the problem. The Federal Reserve is forced to expand its balance sheet to keep cash flow in the economy stable because financial institutions are not lending! The purpose behind QE and the bailout bills was to capitalize banks enough to lend at lower interest rates, which would help fuel economic growth. But if the financials continue to essentially hoard the cash instead of putting it into the economy, the Federal Reserve will have to continue pumping cheap cash into the economy. The Gold Standard is a ludicrous idea and just another reason not to trust the guidance of the economy to Republican politicans.