Ever Since the 1971 Nixon’s departure from the Bretton Woods System, we live in a Fiat Currency World.

This Gives Governments Total Control of the Currency as they can devalue it as much as they wish.

Many, among them Steve Forbes, Ron Paul and Peter Schiff are calling for ‘The Return of the Gold Standard’.

This basically means the US dollar will be tied by a Fixed Conversion Rate to Gold, which the Federal Bank will use to sell and buy Gold in exchange for Dollars.

With the Gold Standard, The Government can’t really devalue the currency — Say the Fed wants to apply some Quantitative Easing like it has been doing since 2008 — All money printing would have to be backed by the ability to Pay it in Gold — Because you can always exchange your Dollars for ‘Actual’ Gold.

It is advocated as a Policy that will make the Monetary system more sound and less political and easy to manipulate. People that are opposing this view usually want the Fed to have the Ultimate Power to play with the currency, Set artificial goals and rig the economic playground. You don’t want to be on their side, right ?

Why is the Gold Standard a Bad idea — A Simple Argument

Gold and the US dollar are two different commodities. They’re not the same thing.

While quite a Trivial Observation, this has meaningful applications. The Price of one commodity measured with a different one is never fixed and always changes by Market Sentiment. People know that the US dollar is backed by the US Government and the US Economic situation, and just by looking at history they may know there is a chance the US will break away from the Gold Standard or change the Conversion Rate between USD And Gold Out of the Blue. This means that under the Gold Standard there are Two Prices to Gold Measured in US dollars -

The Policy-Enduced Price — This is the Price the Fed Determines and sticks-to which allows the Conversion.

The Market Price — What People would actually Pay for Gold in US dollars

Because of the Fed’s policy, the Market price will never be seen Directly, only in the behavior of Economic Agents -

If the Market Price is higher than the Fed’s price, people will rush to buy Gold. They will not trade it among themselves in the higher price — this makes no sense as they can always go to the Fed and buy it in the lower price. This happens when the Market Confidence in the Dollar is low.

If the Market Price is lower than the Fed’s price, people will be willing to sell Gold to the Fed. This happens when the Market Confidence in the Dollar is high.

What happens if Due to some Financial Crisis, People lose their confidence in the Dollar ?

Then the Gold Standard Implodes. Rigid Structures tend to break badly and the Gold standard is a very Rigid structure.

Instead of Slowly losing ground on its exchange rate versus Gold, the Dollar will be kept to the same Exchange Rate by the Fed’s policy, until it breaks — The Fed will no longer be able to support the Gold Standard, maybe because it doesn’t have enough Gold Reserves, and will have to change the Exchange rate or detach from the Gold Standard Completely. This is a very bad outcome that is highly disruptive and destabilizing. So, we should try to avoid it — and in an uncertain world the Best idea is to not even initiate the Gold Standard.

Gold — And Silver, and nowadays also Crypto-Currencies are Great market solutions to Currency. Government Issued Currencies are a form of Government Monopoly Regulated Solution for Currency. Mixing them is Bad Alchemy — It doesn’t turn the Government Monopoly Currency into the Free Market Solution it’s attached to.

In this sense, the current system is even better than the Gold Standard — it allows the Free Market to determine the Exchange Rate between Gold and the US dollar. The Bad thing about it is the Fed is not committed to anything and can play with the Currency as it pleases.

Just a Thought

If One Doesn’t have Trust in the Government and the Government’s policy, One should avoid its currency all together ! Today no regulations prohibit exchanging gold — as was the Situation up until the 70s — so ventures like GoldMoney which Peter Schiff advocates is a Good market solution. Crypto-Currencies, with all their shortcomings are also a solution one can choose. But Paper money is so easy to use, right ? You put it in your Wallet and go anywhere, no need for Network Connectivity and such. I Would really like to see a Crypto-Currency solution to Offline Money, but so far Researching it and Thinking about it I did not come up with anything. Avoiding Double Spending is a tough nut to crack. I will present a Thought Experiment on the Subject in a later Blog Post though.

If People still want to advocate for a Sound Monetary Policy — what about the Following one -

The Fed will set some Goal Price for the US dollars in Gold at the Beginning of each monetary year. It will then buy gold when the Gold Price is beneath it and sell when it’s above. This will provide some attachment between US dollars and Gold, it will be more flexible and less breakable, and it could account for changes in Gold Production that shouldn’t really affect the Government Monetary Policy — One of Gold’s few disadvantages — the unpredictable changes in its Supply.