Wednesday, August 17, 2011

Reviving the gold standard is of dubious value

Vijay K. Mathur

Published in Standard-Examiner, Ogden, Utah, August 8, 2011.  

Many who are unhappy with the decline in the value of the dollar against foreign currencies, and especially against Yuan (Chinese currency), and with the Federal Reserve Bank's monetary policy would like to bring back gold in the international monetary system. The brief history of the gold standard and its variant will show that bringing gold into international monetary arrangements is impractical and misguided. There are two types of arrangements that have prevailed in the past: the gold standard and the gold exchange standard.

Under the gold standard, all countries fixed the price of gold in terms of their currencies and made them convertible into gold at a fixed price. This system led to fixed exchange rates between currencies, as long as all countries kept the price of gold in terms of their currencies fixed. The need to finance World War I and reconstruction afterwards prompted countries involved, except the U.S., to abandon convertibility of their currencies into gold and dollars at fixed rates.

Professors Paul Krugman and Maurice Obstfeld argue that implementing the gold standard will put constraints on the use of monetary policy to fight unemployment and creates more volatility in prices of commodities. In addition, gold reserves will not meet demands of expanding economies and international trade unless more gold is discovered; gold standard also would give more economic power to gold rich countries like South Africa and Russia to influence macroeconomic policies of other countries.

Attempts were made to resuscitate the gold standard after WWI, but it collapsed again in the midst of the great depression of the 1930s. After World War II, the international monetary system was on life-support, and uncertainty about flexible exchange rates to regulate it led to the gold exchange standard with fixed exchange rates under the Bretton Woods Agreement.

The agreement also called for the establishment of the International Monetary Fund to monitor the system and provide short-term credit. All non-dollar currencies were convertible into dollars at fixed exchange rates (except under certain special conditions) and only dollar was convertible into gold for $35 per ounce.

Hence, the dollar became the key currency for international reserves. At that time, the U.S. had more gold reserves than its liabilities abroad. And other countries, especially European countries and Japan, with war-shattered economies, had large trade deficits and faced dollar shortages. Reconstruction of Europe and Japan required US economic aid. That led to the accumulation of dollar reserves in countries' central banks to conduct international transactions.

The gold exchange standard provided some flexibility in fiscal and monetary policies of countries, as long as the U.S. was willing to provide dollar reserves and convertibility of dollars into gold. But it did make other countries' monetary policy dependent upon the monetary policies of the U.S. Because all countries' central banks fixed prices of their currencies in terms of dollars, market forces with the assistance of central banks kept exchange rates between currencies fixed.

This system required that all central banks have sufficient dollar reserves to keep their currency prices fixed in terms of dollars. For example, if the British pound declined in terms of dollars due to the UK's large trade account deficit, then U.K. central bank had to intervene in the foreign exchange market to buy enough pounds and supply enough dollars to increase the dollar price of pounds at the predetermined fixed rate level. Just the reverse intervention was required if the pound appreciated against the dollar. The fixed price of gold and the quantity of US gold stocks constrained U.S. monetary policy to fight recessions.

The limited U.S. supply of gold was not keeping pace with dollar liabilities due to the growth of world trade and large capital movements. Around 1964, U.S. dollar liabilities were larger than its gold stock, and hence it could not meet all its commitments to convert dollars into gold. Therefore, the confidence in dollar started to decline. The option to increase the price of gold above $35 per ounce would have caused inflation and decreased the value of dollar reserves of other countries' central banks. Thus, the Bretton Woods System was showing strains.

In 1971, the U.S. announced that it would no longer convert dollars into gold at $35 dollars per ounce, and under the Smithsonian Agreement the price of gold increased at first to $38 and then to $42 per ounce. Finally the gold standard was replaced with a dollar standard with no convertibility of the dollar into gold. Fixed exchange rates were replaced with a managed float exchange rate system. Under this system all governments maintained their currencies' exchange rates within certain bounds.

This brief checkered history does not inspire confidence in the gold standard or the gold exchange standard. There is not enough gold to keep up with the growth of world trade and capital movements. Nostalgia with the shiny metal that is good for filling teeth, making jewelry and in other industrial uses, will not solve our or other countries' economic problems. The U.S. trade deficit will not disappear and the dollar will not recover its former value unless we become more competitive in the world market. That requires building up our manufacturing base, complemented by investment in human capital, renewable energy and new technologies.

Mathur is former chair of the economics department and professor of economics, Cleveland State University, Cleveland, Ohio. His articles also appear at He also writes original blogs for the Standard-Examiner at

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