Fears surrounding the plunging dollar have sent some scurrying to history books for a remedy. Some, such as one-time presidential hopeful Ron Paul, have strongly questioned the merits of a fiat currency and insist upon a return to the gold standard. Before proceeding, please permit some definitions first and clarification second. essential to understanding the debate over currency. First, fiat money is backed by an implicit guarantee of the issuer. This contrasts to commodity money which represents a fixed value of a commodity per unit of exchange. Second, the United States eliminated the gold standard in 1933. It did not die in 1973 when the Bretton Woods agreement on fixed exchange rates collapsed.
So why did the US and Britain shift from commodity money to fiat money? Britain needed to fund a war. Faced with malaise, the American federal government opted to stimulate the economy through New Deal spending programs. Neither nation could have funded the ambitious scope and scale of those projects without access to credit and raising debt. Financial markets have matured and become virtually perfectly competitive, and returning to commodity money would diminish the advances markets have made since the dissolution of the Bretton Woods accord. Returning to the gold standard comes with other problems.
Starting with the outside in, what would it mean to American trading partners? Whatever fixed value the government may give the dollar would upset one of its chief trading partners. Universal satisfaction and agreement in the WTO, let alone the EU or China, is as likely as getting a room of random people to agree on pizza toppings. Moreover, valuation would reflect current economic conditions. How would it affect existing debt? What would be the knock-on effects on emerging market nations or the global exchange rate mechanism? Such a move would isolate America when it can least afford to do so.
Next, what about the role the central bank would play in maintaining price stability and applying monetary policy? How free would the FOMC be to set interest rates to respond to price signals? Could a Federal Reserve beholden to the gold standard coordinate security sales and short term lending with the ECB, BOJ, or Bank of England in the event of credit constraints?
Furthermore, the rate of technological advancement of production techniques as well as goods and serviced traded has accelerated more than the ability to fill treasury coffers with shiny stuff. In the absence of sufficient shiny stuff, debt service and necessary discretionary spending on defense, infrastructure, and law enforcement - the essential services of government - would become increasingly burdensome.
How come the status quid pro has so much cachet? Perceived and actual malfeasance by financiers has prompted this reaction. A commodity currency, return to the gold standard in particular, would forestall repeats of recent events such as the subprime fiasco, the concomitant central bank bailouts, and the moral hazard precedent. What advantage does gold have in the 21st century that it lacked in the 20th?
In the good old days of gold, the preferred method of economic stimulus was war. If we lacked a commodity, and a weaker country had it, then we used to expropriate it by politics through other means. Though globalisation signals cut-throat, cost competition to some, the WTO, customs unions, and trade forums show that cooperation produces greater returns for all. Moreover, gold did not provide the stabilizing anchor during the industrial age. In the information age, a currency backed by gold will be held back by gold.
While all fiat currencies have failed throughout American history, commodity currency does not guarantee a strong currency. Price instability and inflation were the lag effects of the Hume gold transfer mechanism. As exports grew, the flows of gold into a country increased, the economy expanded, and strengthened the currency. Hence, its citizens could consume more imports. However, when the currency became so strong that the export market shunned the newly high prices, the economy would slide into recession. How is this an advantage?
Beyond circumstantial evidence and the fact that fiat currency has failed in the past, little substantiates that a gold standard to the dollar would provide a palliative to the imbalances of speculative bubbles, reckless borrowing and spending, and the ills of the current credit market. Moreover, without having sorted the extent of the present credit crisis, a return to the gold standard would be dangerous. Even if the US returned to the gold standard, how long could it manage it while maintaining a negative trade balance and a high propensity to import?
For all the purported stability, gold standard advocates seem to forget the currency runs, economic panics, and the social cleavages between debtors and creditors. The crucial question is what does a weak currency represent? High imports, high consumption, high public and consumer debt. If atavistic Americans cling to dollar strength and supremacy, then consumers, firms, and government must learn what anyone trying to get fit already knows: lay off the sweets, especially the Kool-Aid.
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