By Freund, William C.
The World and I , Vol. 12, No. 3
Federal Reserve Board Chairman Alan Greenspan shook up global markets when, in his December speech to the American Enterprise Institute, he referred to the possibility of "irrational exuberance" in the stock market. But buried in that speech was another noteworthy observation: a not so subtle criticism of the old gold standard.
In the 1920s, that standard, he said, was "the dominant constraint on the issuance of paper currency and the expansion of bank deposits. Accordingly, the Federal Reserve was to play a minor role in affecting the purchasing power of the currency for many years to come."
Despite our experience with the gold standard, some opinion-makers still long nostalgically for a return to it. Among them are Jack Kemp and other monetarists as well as the influential Wall Street Journal. Greenspan had it right when he said that basing money on gold paralyzed the Federal Reserve's ability to stabilize prices and production.
"The world changed markedly with the advent of the Great Depression of the 1930s and the evisceration of the gold standard," he observed.
Most people don't understand the issue and may think it's just one of those debates carried on by economists. They could not be more wrong.
THE GOLD BUG
Economists disagree on many things. But when it comes to the gold standard, I would expect over 90 percent of them would wish it a continued good rest in peace.
A reading of history shows that the gold standard was a real disaster for the world. It was not a mere accident that the United States and the other industrial countries jettisoned the gold standard in 1933, in the midst of the Great Depression.
Under the strict gold standard, the supply of dollars is determined by gold. It's very simple. Gold must have a fixed dollar value, say $35 per ounce, which means that if the supply of gold increases by one ounce, then the money supply can grow by $35. It's a wonderful way to prevent inflation from ever taking hold, because the government cannot goose the money supply at will. The supply of gold available each year for monetary reserves (and jewelry) is, of course, limited largely by the amount of gold mined. The distinct advantage of gold in limiting inflation is why monetarists favor a return to the gold standard.
The gold standard can prevent runaway inflation. As Kemp said during the recent presidential campaign, "The new president should instruct the Treasury secretary to stabilize the dollar value of the nation's gold reserves, say within a $30 band, as a critical first step toward restoring sound money to America." That prescription would end the threat of severe inflation. But there is no free lunch. There is a cost to a gold standard, and nations have found its price too high.
Imagine that our country is in the grip of a serious economic downturn, which, as we know, can occur for a variety of reasons. If the money supply cannot be expanded, the country may be destined to suffer through a long period of depression and stagnation. That's why every country quit gold in the 1930s.
Governments everywhere became determined to do something about unemployment and to gain control over their domestic economies. The gold standard would have condemned them to a policy of standing there and doing nothing. Undoubtedly, we would have come out of the Depression at some point, but countries were unwilling to leave it to the vagaries of the gold supply.
The important point to grasp is that under the gold standard, if there are important new discoveries of gold, the money supply will expand and economic activity can advance. Similarly, a dearth of discoveries spells a stagnating money supply. There is no room for stabilizing the economy through interventionist policies.
A small downturn could develop into a Great Depression, as it did in the 1930s. Small wonder that governments throughout the world ditched that policy without ever looking back. …