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GOLD STANDARD: YES OR NO?

Well, before answering this question, let me start by confessing something. This question has been on my mind for a while now; and to be honest, for me, there has never been a second of doubt with regards to the answer to this. Thus, there was no need for a debate or an article about the question. But, considering the number of papers and commentaries from economists, businesses, politicians and civil society organisations, calling for or rejecting the idea of a return to a Gold Standard system, I felt the need to write something.

Should we start with some fundamentals? Okay.

The Gold Standard is a monetary system in which the standard economic unit of account is a fixed weight of gold. Under this system, paper notes are convertible into pre-set fixed quantities of gold; any issuance/creation of money is counterbalanced and guaranteed by gold reserves. Parity between two different currencies is therefore set through gold and the exchange rates are stable if not fixed between them.

This definition leads immediately to some questions:

First of all, who would decide on the weight of gold that would be allocated to currencies? Would the weight depend upon the current monetary strength of each country’s economy? What would determine the monetary strength or simply the strength of an economy? Would it be its ability to repay debts, its growth rate or the trust placed in its currency by international investors? Would the current quantity of a currency including treasury bonds (issued to pay debts) count towards determining the strength of an economy? Would all currencies be convertible into gold? If no, which currencies would be convertible and based on what criteria? If under the Gold Exchange Standard started in1922, only the U.S. Dollar and the British Pound were convertible into gold and other currencies were pegged to them, could this be the case today with new currencies such as the Euro and emerging economies such as China?

If there are so many questions raised with a potential Gold Standard system, why are some “famous” people calling for its return?

I must acknowledge that there are some advantages with such a system taking place. For instance, the Gold Standard would limit the power of governments in issuing fiat currency through central banks without counterpart in the real economy (quantitative easing, anyone?). The ultimate effect of financing debt through bond issues is to destabilise other economies who buy debt without gold collateral.

The Gold Standard also tends to reduce uncertainty in international trade by providing a fixed pattern of international exchange rates. Indeed, under a Gold Standard, disturbances in price levels in one country would be partly or wholly offset by an automatic balance-of-payment adjustment mechanism called the “price specie flow mechanism.”

Let’s take the example of a country with a negative balance of trade. Gold would flow out of that country in the amount that the value of imports exceeds the value of exports. This would mean reduction in the money supply in that country since the creation of money would be indexed to the quantity of gold held by the central bank. This fall in money supply would in turn, generate the drop in prices of products in that country. The lower prices would cause exports to increase and imports to decrease, which will improve the balance of trade. Inversely in countries with positive balance of trade.

Having said that, the idea of going back to the Gold Standard does sound really rustic to me owing to the high speed and complexity of today’s monetary and financial transactions around the world. Under such a system based on pre-determined, fixed exchange rates between currencies, there would be a need to review these fixed parities between gold and currencies every time that there would be a significant fluctuation on commodity, stock, financial or monetary markets. Furthermore, if a country decided unilaterally to devalue its currency, it would produce sharper changes on a global scale than the smooth declines seen in fiat currencies since the exchange rates are fixed. How? As its currency would become cheaper to obtain with less gold, economic agents would rather acquire it and later exchange it at the same exchange rate for a more powerful currency.

Also, in such a system where coins, paper notes, electronic funds and any other form of money are automatically convertible into pre-set fixed quantities of gold, what would happen if a country like China calls in all their debts including treasury bonds owed by western countries to be repaid immediately in gold?  With the vast quantity of dollars worldwide laying claims to the U.S. Treasury, an overnight transition to gold convertibility would certainly create a major discontinuity for the U.S. financial system.

People might respond that there is no need for the whole block of current dollar obligations to become an immediate claim. Well, no comment!!!

What about the bilateral debt owed by developing countries to developed nations? Would this be claimed in gold?

Finally, the idea of a Gold Standard could be suicidal for emerging economies. You would probably ask why?

Let’s have a look.

Indisputably, emerging or developing economies need to spend in order to finance their growth and their development. Most economists would also agree that when a country creates a budget deficit designed for public investment (infrastructure, education, basic research or public health), such a deficit is bearable, beneficial and even necessary in the case of emerging economies. Therefore, restricting these economies to spend in proportion to the quantity of gold produced would be anything but understandable. Indeed, budget deficit can help emerging nations to stimulate their economies by creating a market for business output, creating income and encouraging increases in consumer spending, which creates further increases in the demand for business output. As a consequence, the real GDP of the country raises and the unemployment rate decreases, leading to more tax income for the government.

The restrictions of gold convertibility could therefore profoundly jeopardise the development of some emerging economies.

I can hear some Gold Standard advocate voices responding that, they are not referring to the previous or old “Gold Standard”. Instead, they are referring to a new “fractional reserve system”, under which the gold reserve will indirectly affect the amount of currency circulated in countries and around the world.
Well, during economic crises like the current one, the “fractional reserve system” could meet the currency supply in countries such as U.S.A and E.U., and would not hinder the development of their economy. However, for emerging economies, the lack of gold reserve would not meet the monetary supply of rapid economic development.
But above all, being under a more traditional Gold Standard or a so called new modern one, developing countries, particularly those without enough gold, would have to purchase gold with their foreign exchange reserves. In that way, U.S. and Euro-zone could decide to withdraw dollars and Euros in order to protect their leading positions in international financial system.

To conclude this paper, and for those who have not yet noticed it, to the question on “Gold Standard: yes or no?” my answer is without doubt no. However, I must admit that the current global financial system, which predominately relies on the U.S. Dollar as a reserve currency by which major transactions such as the price of gold itself are measured, must change. Especially as U.S.A do not issue their currency with proper real economic counterpart.

But instead of going back to a strict Gold Standard system, the idea of having a more diversified reserve currency system based on market baskets of currencies or commodities including gold would be more sensible.

Related Article:

Towards a new global reserve currency…the end of the U.S. dollar?

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January 2, 2010 Posted by | Articles In English, Economics, International Economics | , , , , , , , | 10 Comments