Gold Standard Abandonment: Economic Mistake or Necessity?

[00:00:00]on august 15 1971 president richard nixon announced that the united states would be terminating the convertibility of american dollars into gold turning the world's reserve medium of exchange into something backed by nothing but belief over the next five years the price of gold which up until that point had been the baseline store of value more than tripled in price thought of another way by this same standard the american dollar lost more than two-thirds of its value this decision preceded two decades of record-high inflation in the us where prices are increasing by double digit percentages year on year or while the value of the american dollar slumped in international markets today we are once again staring down the barrel of record high inflation so it seems only sensible to ask ourselves was dropping the gold standard a mistake many prominent economists and financiers point to this moment as the beginning of the end for america's economic superiority while many more argue that it was a necessary step that released the currency and by extension the global economy from an unnecessary burden following the global financial crisis of 2008 there were renewed calls by certain policymakers to take a look at the possible return of a gold standard in america and once again as the world struggles through another period of economic uncertainty the idea does seem worth exploring this is also a great excuse to understand the history of what got us onto and off of the gold standard and take a look at some genuine pros and cons that champions from either side of this very contentious debate tend to omit from their arguments so what was the gold standard and why was it abandoned what was the advantage of the gold standard and what were the drawbacks and finally is returning to the gold standard something that could fix the economic issues that we are facing today the gold standard as it existed up until 1971 was first introduced in 1944 towards the end of world war ii with the introduction of the bretton woods system the bretton woods agreement was a system of monetary management that was established to make financial relations between the united states and its new allies easier it worked by having all countries in the system make their currencies exchangeable for a set amount of us dollars and the us dollar itself would be exchangeable for a set amount of gold this indirectly made the currencies of all of the participating nations gold backed in their own right without requiring them to keep massive gold reserves themselves however american dollars themselves could not be directly converted to gold domestically this convertibility was only available to foreign participants not regular everyday americans this system worked all right and it certainly enabled a level of global trade that was inconceivable up to that point but of course there were problems currencies sort of act like shock absorbers for international trade if left to do their own thing they will naturally increase and decrease in value as the economies that they represent go through periods of boom and busts if an economy goes through a really rough patch its currency will lose value in foreign exchange markets this devalued currency will make the economy's exports artificially more competitive globally which will help domestic industries if an economy is doing really well it means that its currency will increase in value giving it the opportunity to invest into foreign economies which should in theory help them do well too if a currency is fixed then this self-correcting force can't do its thing and economies can quickly spiral out of control the us under the bretton woods system was unique in that its currency was pegged both to gold but also to a whole bunch of other currencies as well if the us was doing well then in a floating model its currency should have increased in value but in a peg system it did not and other countries were able to take advantage of this by stockpiling american dollars for less than they were truly worth now this was a small price to pay for securing the us dollar as the global reserve something that paid dividends far and away beyond the small cost of currency outflows but what was less palatable was when this situation was reversed high levels of borrowing to fund the vietnam war along with a number of other domestic issues meant that the u.s economy was not particularly healthy towards the end of the 60s normally this would mean that the us dollar would fall in value which as long as that fall isn't too severe wouldn't be a huge problem as we saw earlier it could actually help american exports which could cushion the blow of the economic turmoil but with pegged rates this didn't happen the other bretton woods countries saw that the american dollar was overvalued relative to what it should be obviously they wouldn't want to trade their own currencies for us dollars while it was overvalued but they had another option they could trade their relatively overvalued american reserves for physical gold most participating countries especially the french started trading more and more of their american dollars in for gold which caused two big issues the first was that it reduced america's economic influence if people were holding gold instead of american dollars then they lost the advantages that came along with having control over the world's default medium of exchange the bigger issue though was that america simply didn't have enough gold to honor all of these transfers endlessly and that's because there are two basic types of gold standard the first is what you probably think of when you think of a gold standard and that's a system where there is enough gold sitting in a vault somewhere to redeem every single last dollar floating around an economy even if everyone decides to redeem all of their money all at once this is often called a full reserve standard or a speech standard and these systems have existed throughout history but only in very rudimentary economies most modern gold standards have been fractional reserve systems where as the name would suggest only a fraction of the gold necessary to honor all the outstanding dollars are kept in vaults the theory behind such a system is that so long as people know that they can exchange their dollars for gold they probably won't ever choose to because gold is heavy and cumbersome and hard to store effectively a fractional reserve gold standard is susceptible to the same kinds of risks as a fractional reserve banking system and that is if participants start to fear that there isn't enough gold to go around they will rush to withdraw it all at once which will ensure that there isn't enough gold to go around now france wasn't exchanging enough us dollars for this to be an issue at least in the short term but if ever this exchangeability was brought into question the system could fall apart very quickly in a devastating way so the preemptive decision was taken to suspend the convertibility of the dollar into gold this temporary suspension was later turned into an elimination of the gold standard entirely so was this a mistake what good does the gold standard do it's disingenuous to say that the gold standard is simply an outdated relic because it can do a lot of good if used correctly in certain circumstances perhaps its greatest use is how simple it can make foreign trade gold is about the most fungible thing in the world it's elemental a gram of gold is equal in value to every other gram of gold in the world it can be melted recast and melted again and it will still be a gram of gold for this reason if two nations that are both on a fixed gold standard want to trade with one another they can do so without fear of either of their currencies being worth more or less during the process of their business in theory this is still possible with peg currencies that are backed by nothing but there is still the inherent risk that despite the government's best efforts their currency will still tank in foreign exchange markets now just because trade is easier doesn't necessarily mean it's better and remember on a large scale currency fluctuations actually help global trade but on an individual level not having to deal with them is a welcome relief another big advantage of the gold standard is that it prevents most types of financial repression financial repression not to be confused with economic depressions are situations where savers earn interest below the rate of inflation there are two ways to end up in this situation high inflation or low interest sounds familiar doesn't it the problem with severe financial repressions is that they can act as a wealth transfer from those that have saved money to those that have borrowed it if you have your life savings in a bank account earning 3 interest you are going to be very unhappy if the value of the dollar halves over the next 5 years your neighbor on the other hand who just took out a huge loan to buy their house would be very happy because the real value of their mortgage would have halved over the same time of course anybody who watches this channel regularly will know that a less severe version of this inflation scenario isn't necessarily a bad thing in fact the fed and most other reserve banks around the world actually target a moderate rate of inflation precisely because it encourages people to go out and consume rather than hoarding their money away but too much inflation is obviously a bad thing a gold standard also prevents governments and central banks from using financial repression for their own devious ends the mortgage holder that just happened to benefit from high inflation and low interest rates was a lucky participant but governments themselves can also take on debt and they are the ones with their hands on the levers to make financial repression happen it can be very tempting for governments to inflate away their own debt to put themselves in a better financial position this in effect is an invisible tax on people responsible enough to save money which supporters of the gold standard argue should not be possible and with money backed by real physical gold it isn't this is all great but of course the biggest benefit of the gold standard is price stability with a currency backed even fractionally by gold it makes it much harder for reckless money printing to increase purchasing power enough to materially impact prices now this is sort of true but only in the really long term and only with all other things being equal assuming all other things being equal is a great way to construct economic models but it's a terrible way to run an economy to show you what i mean take the federal reserve as it exists today its central goal is price stability you know the thing that the gold standard is supposed to do automatically it does this primarily by raising and lowering interest rates and in extreme circumstances by buying or selling assets in the open market in a fiat currency system like the one that we use now there are no real limitations to how it moves these rates it can do whatever it feels is best for maintaining price stability does it always get it right uh well no but it is better than the alternative in a gold standard system the central bank has its hands tied by how much gold it has if the economy produces lots of gold and exports lots of stuff it will have a bigger supply of gold back currency to play with so it can reduce interest rates if the economy's gold mines run dry and it imports more than exports then the central bank will be forced to raise interest rates and restrict the money supply this can all happen completely independently of how the rest of the economy is doing gold reserves might be very valuable but compared to all of the other industries in an economy combined it's practically insignificant this means that interest rates are not being set to stabilize prices instead they have been set to manage the amount of gold the bank has matthew o'brien perhaps highlighted this best in an article that simply featured two charts measuring inflation in america the first from the gold standard period around the great depression and the second from the period of quantitative easing following the great recession in 2008. working around the gold standard was one of the biggest reasons that the great depression got as bad as it did the central bank had to ensure that there wasn't a run on gold which came at the expense of maintaining prices and stimulating the economy by contrast the fed was able to focus on those two things in the aftermath of the global financial crisis and while things weren't great by any means it wasn't nearly as bad as in the 1930s but what about the record high inflation of the 1970s and 80s following the end of the bretton woods gold standard how do economists explain that one well a lot of this was a hangover from inflation that really should have occurred sooner but was held back in an attempt to maintain the gold standard in the currency pegs of the 1970s it was also fueled heavily by low interest rates and ongoing and incredibly expensive war and above all else skyrocketing oil prices which not only hit american consumers at the gas pump but also made everyday essentials more expensive to transport and produce correlation doesn't always equal causation and almost every prominent economist agrees that leaving the gold standard was not to blame for the high inflation experienced in the 70s and the 80s so if the gold standard can't ensure price stability and in many cases actively makes it worse where else does gold go wrong a true adoption of a gold standard would only really be possible for a few countries because gold is unequally distributed around the world china america australia ghana and russia produce most of the world's gold everyone else would need to get gold off a nation that is lucky enough to have it they could do this through pillaging which is obviously not ideal or they could do this through mechantless trade which means countries try to export as much as possible while importing as little as possible so that they have net gold inflows that they can stockpile to keep their economy running this might be slightly preferable to war profiteering but it would still be a remarkably large shock to countries like the us who are currently dealing with their largest trade deficits ever there is also the issue of the value that is assigned to gold if the usa wanted to implement a fully gold back system which is what most of the gold standard hardliners argue for then the price of gold would need to increase significantly there is just not enough gold to back all the dollars out there at anything approaching current market rates and if the us did introduce a fully gold back system where the price was off market value then cunning arbitrages could just trade in their dollars for gold take that gold to another country sell it for euros or whatever and then trade those euros for more doors than what they started with it wouldn't take very long for this system to break down a more practical solution is the fractional reserve gold standard where a bank only needs to keep a fraction of the gold on hand to exchange for dollars but even in this system the value of gold would need to increase significantly and what was the point you just traded in needing to trust fiat currency with needing to trust the fed to avoid bank runs gold has another problem as it relates to economic growth generally as an economy grows the money supply should grow with it the idea being that a larger economy can produce more goods and services so there should be more money to purchase those goods and services we actually explored this in depth in our video and recessions last week so i don't want to repeat too much here but if the money supply is not allowed to grow in line with economic growth you are left with one of two outcomes the first is deflation which is bad for a number of reasons again go and watch our video from last week to find out why but another thing a restricted money supply can do is straight up restrict economic growth if the money supply is restricted to what a central bank has sitting in a vault then there may not be enough liquidity floating around to facilitate genuine expansion we tend to think of the post-war period as the golden age of america's economy a time when america just so happened to be on the gold standard if we look at the data though in the 20 years between 1951 and 1971 america's economy roughly tripled in size from a gdp of 336 billion to just over 1.1 trillion in the 20 years between 1971 and 1991 it grew from just over 1.1 trillion to 6.1 trillion roughly a six-fold increase this is despite the fact that the 70s and 80s were more trying economically and america had lost its unique advantage of being the only industrialized country that had not been bombed to smithereens in the second world war were there other factors contributing to this growth yes of course but a lot of them things like unrestricted free trade free wielding monetary policy and yeah even inflation that encourage people to avoid sitting on their money and instead getting out and using it to contribute to the economy would not have been possible on the gold standard finally there is the biggest problem with the gold standard which is that it doesn't really achieve what people think it achieves people perhaps understandably like the idea that their money is backed by something as opposed to our money today which is backed by the belief that it has value but what gives gold its value yes okay it has some very narrow industrial applications and yes it's pretty but let's be real most of the value comes from people's belief it has value without that belief it's just a soft off-colored dense metal running an economy on a gold standard is like riding a bike with training wheels yes it can protect you against doing things that are outrageously dumb but you are never going to see someone doing the tour de france with training wheels on just like you aren't going to see a modern advanced global economy conducting business backed by gold gold just like training wheels also can't protect us from everything and neither of these safety measures are good alternatives to being able to steer the bike or the economy properly and if you can do this properly then these safety measures aren't going to do much besides get in the way and slow you down