What Is a Gold Standard?

Release Date
May 2, 2013

Topic

The Fed & Monetary Policy
Description

The United States abandoned the gold standard completely in 1974. Professor Lawrence H. White discusses what the gold standard was, why it was abandoned, and whether abandoning it was a good idea. The gold standard meant that currency could be redeemed by banks for gold. The dollar had a set value that it retained. If you went to the bank in the gold-standard era before World War I, for example, you could trade $20.67 at the counter for an ounce of gold. Because the currency was guaranteed in gold, paper money based on gold had a set value. Now that we do not have a gold standard, paper money does not have a set value and the purchasing power of a dollar can fluctuate pretty dramatically. This is called fiat currency.
The gold standard really constrained the federal government, Prof. White says. The obligation to redeem dollars for gold limited money printing at times when the federal government thought printing money might be a good idea. As a result of ending the gold standard, the U.S. Federal Reserve can print as much money as it decides to print. This can be problematic, however, and many countries without a value standard have seen high inflation because of it.
Under our current standard the supply of money is up to the decision of the Federal Open Market Committee. “The fate of the dollar rests with a handful of political appointees,” Prof. White says. Is this a good idea? Is fiat currency a better choice than gold-backed currency? This begs a practical question: Which system better limits inflation? Historically, gold (and silver) standards have dramatically outperformed fiat standards around the world in providing stable, low-inflation currency.

Source Data
Professor White compiled his data on the comparative inflation rates under gold and under fiat using this website.
He calculated the annualized growth rates in the CPI between periods of change in monetary policy:
– 1792-1862 (on the gold coin standard; 70 yrs): 0.07%
– 1862-1879 (off the gold standard; 17 yrs.): -0.05%
– 1879-1933 (on the gold coin standard; 54 yrs.): 0.54%
– 1933-1971 (on the gold-exchange standard; 38 yrs.): 3.04%
– 1971-2011 (off the gold standard; 40 yrs.): 4.38%
He found that the average annual inflation rate in Gold Standard years is 0.27%. Average inflation rate off the Gold Standard is 3.06%.
Learn More
Lawrence H. White, “Is the Gold Standard Still the Gold Standard Among Monetary Systems?” [policy paper]:  Professor White addresses some leading criticisms of the gold standard relating to the costs of gold, the costs of transition, the dangers of speculation, and the need for a lender of last resort
“Gold Standard”[encyclopedia entry]: The Concise Encyclopedia of Economics provides a thorough and accessible understanding of the gold standard
Milton Friedman on the Gold Standard (video): Renowned economist Milton Friedman connects abandonment of the gold standard with the Great Depression and inflation
What Is a Gold Standard? (video):  MoneyWeek’s Tim Bennett explains in simple terms how a gold standard works, why the last one was abandoned and asks whether we should return to one today
Paper Bugs, or Stupid Arguments Against Gold [article]: George Selgin fiercely rebuts a NY Times Columnist who argues against the gold standard
A New Golden Age? [article]: Reason magazine interviews a gold moderate who argues that fiat money should be pegged to a gold standard
The Gold Bug Variations [article]: Paul Krugman argues against the gold standard and those who support it in this Slate article
 
Discussion Questions
1. Why do you suppose that governments have typically monopolized the business of minting gold and silver coins? 
2.  Does the economy need a central bank in order to be on a gold standard?
3. In ranking the classical gold standard against fiat money standards, what else would you consider important in addition to which has lower inflation rates?

What Is a Gold Standard?

Why did the United States leave the gold standard? Basically, because the gold standard constrained the federal government.
I get a lot of questions from students about the gold standard. For example, what is it? And why don’t we have one anymore? I will start by explaining what it is. Under a gold standard, the monetary unit is defined as a certain amount of gold, like 1/20 of an ounce, or 10 grams. In the era of the international gold standard, before World War I, the U.S. dollar was defined as a little less than 1/20 of an ounce of gold. To be precise, one ounce of gold equaled $20.67.
A silver standard follows the same idea. The British monetary unit, the pound sterling, originally meant exactly that: one pound of sterling silver. A gold standard can operate with or without government involvement in the minting of gold coins, the issuing of gold-backed paper currency, and the provision of gold-backed checking accounts. Historically, private mints and commercial banks were reliable providers of gold-denominated moneys.
Thanks to the banks, a gold standard doesn’t mean that people have to carry around bags of gold coins. Anyone who finds paper currency and checking accounts more convenient can use those. But it does mean that if a person wants to redeem a bank’s $20 bill or cash its $20 check, the bank is obliged to give him a $20 gold coin. The obligation to redeem for gold guarantees the gold value of all kinds of bank-issued money. And the purchasing power of gold was historically very stable. By contrast, under today’s unbacked—or fiat—dollar standard, there is no value guarantee. If you take a $20 Federal Reserve note to a bank, all you can get for it is other Federal Reserve notes. The experience with fiat moneys in various countries has ranged from mild inflation to terrible inflation.
Why did the United States leave the gold standard? Basically, because the gold standard constrained the federal government. The obligation to redeem in gold limited money printing at times when the federal government, rightly or wrongly, thought more money printing would be a good idea. The United States went off the gold standard in two major steps. First, in the 1930s, under President Franklin Roosevelt, the federal government broke its promise to redeem Federal Reserve notes in coin for U.S. citizens.
Private ownership and use of gold coins were actually outlawed. Individuals and banks were ordered to turn in their gold coins and bullion to the Federal Reserve. In the late 1960s and early 1970s the Fed printed dollars rapidly. The falling purchasing power of the dollar triggered redemptions by foreign central banks, and the U.S. government began running out of gold. Rather than stop printing dollars, Nixon ended their redeemability in 1971. The money printing then accelerated, culminating in double-digit inflation around 1980. By contrast, inflation under the classical gold standard was never in double digits and averaged only 0 to 1 percent per year over the long term.
A common objection to a gold or silver standard is that there can be random shocks to the supply or demand curves for metal and that these will make the purchasing power of metallic money unstable. But historically this was not much of a problem. For example, after the major supply shock of the California gold rush of 1849, as the gold dispersed over the entire world, the resulting inflation was less than 1.5 percent per year for about eight years. Thereafter the price level leveled off and later gradually declined as the world output of goods grew faster than the stock of gold. Under our current fiat standard, the supply of money is up to the decisions of the Federal Open Market Committee. There is no self-correcting market tendency to prevent the creation of too much money under that system. The fate of the dollar rests with a handful of political appointees.
The practical question is under which system are the quantity and purchasing power of money more stable. In other words, which system better limits inflation? The answer to that question is clear from the historical record. Gold and silver standards have dramatically outperformed fiat standards around the world in providing stable, low-inflation currency.