Should we return to the gold standard?

Is it time to take the control of our currency out of the hands of the Government and Bank of England?

Should our coins and notes be backed by gold?

For hundreds of years currencies were based on a single pound, dollar or franc being worth a set amount of gold or silver*.

But with banks in trouble and governments in the West burdened with literally trillions of debt (like the UK, whose debt burdened jumped to £1 trillion last month), are currencies that we know and love actually worth anything anymore?

At the same time as we see some European economies teeter towards bankruptcy then the luster of currency values of yore, like the gold standard, can appear very attractive. So why not return to it? It’s a cause many are starting to rally to, but they’re wrong and this is why.

The call of gold

Newt Gingrich
and Ron Paul are on the campaign trail to try and win the Republican nomination for the US Presidential, both of whom are proponents of “hard” money. Their reasons to switch from fiat money (what we have now) to a currency backed by “something” like a precious metal, is to “take government out of the business of controlling the money supply” according to Gingrich.

That is a dig at the Federal Reserve (who some Republicans either want to disband or arrest, depending on who you talk to) which has printed dollars and expanded the money supply through its programme  of quantitative easing and also boosted the size of its balance sheet by  a whopping $2 trillion dollars in the last four years.

Gingrich and Co. argue that the US is losing its credibility on two fronts: Firstly an enlarged money supply can lead to more inflation down the road and, secondly, the Fed could be accused of printing money to pay off the US’s enormous $15 trillion debt, thus denting the US’s reputation especially in eyes of its many foreign creditors.

Although it might be a stretch to believe that Newt will get all the way to the White House – although stranger things have happened – so what would a return to the gold standard be like?

How things would change

Firstly, we’d have to stop thinking of a currency in terms of a value against another currency. Right now the dollar may be trading at $1.30 to the euro. The value is based on the market’s weighing up the political and economic risk of the two countries and coming up with a “fair” value. Instead, if the world went back to the gold standard we would need to think of the euro and dollar in terms of the yellow metal not with each other.

But what about the actual value? A currency’s worth on the gold standard comes down to the amount of gold reserves its government has. (That’s bad news for the UK after the bulk of UK reserves were sold off by Gordon Brown back in 2000). So let’s take the US – the world’s largest holder of gold

It has 8,656 tonnes – or there about – of gold stored away at Fort Knox in Kentucky and a few other places. So its currency would be worth more than a country with far fewer reserves, like the UK for instance. Germany has the second largest reserves; however they are less than half of US holdings at 3,700 tonnes. However, France, Italy and the Netherlands all rank in the top 10 biggest for gold reserves, and combined the EU nations have bigger reserves than even the US.

So the dollar and the euro would be the most powerful currencies worldwide, with no one else even close, but the UK doesn’t even feature in the top 15 holders of gold reserves, so the pound could theoretically be worth less than the Russian rouble and Chinese renminbi.

Herein lies the problem with the gold standard. Some of the world’s biggest export powerhouses like China, Taiwan and other emerging markets have been buying up hoards of gold in recent years. A return to the gold standard would cripple their economies because the value of their currency would rise.

In contrast, a country like the UK that is a major consumer, would suffer as imports would become more expensive thus threatening the British economy with inflation.

A tool of the rich

And this isn’t the only problem. Gingrich needs to be careful if he is calling for a return to the gold standard. In the 1896 and 1900 Presidential elections, Democratic candidate William Jennings Bryon called the gold standard the tool of the rich, as the US suffered three depressions as a “result” of the gold standard according to Bryan.

Thus Gingrich’s whole-hearted support of a return to hard money could lead to some harsh rebukes from his Democratic rivals.

Going back to Newt’s main argument in favour of the gold standard, controlling your money supply is a double edged sword. The current system allows you to do it too much, which can lead to hyper-inflation and debt monetisation à la Argentina, but the gold standard doesn’t allow you to do it enough.

Rather than use interest rates to relieve an economic slump, things aren’t that simple. You can only adjust the supply of currency in the economy based on the amount of gold you have.

But with gold a fairly scarce resource and production of the precious metal expensive and fairly limited, boosting your money supply when economic conditions deteriorate isn’t going to be that easy. Which is why the gold standard is blamed for causing economic hardship: It doesn’t allow the money supply to efficiently adjust to the economic conditions at hand.

Keeping constant exchange rates

Some argue that having a gold standard actually helps world trade as it reduces some of the exchange rate volatility that plagues the fiat system. Add that to the anti-hyper-inflation argument and Gingrich could win some people over to his camp.

Believe it or not, but throughout history the “value” of money has changed many times. Globally we currently have a system of fiat money, which means that the value of our coins and bank notes are commanded by the authority or fiat of the government.

However, in the past currencies have been backed by gold and even silver. The British ditched the gold standard in favour of fiat to fund its efforts in the Napoleonic wars in the 19th Century. In World War One out went the gold standard only to be brought back in again in peace time.

Since we’ve just been through the Lehman crisis and are quite possibly still in the eye of the storm of the eurozone sovereign debt crisis, then history would suggest that now is not a prescient time to return to “hard” money.

*We talk about “pounds sterling” because 240 sterling silver pennies originally weighed one pound. Sterling silver was introduced in 1158 by Henry II because it was harder and less prone to wear than the pure, or “fine”, silver that had been used before and remained the basis for the British pound until 1816.