David Glasner. National Review. Volume 37. 5 April 1985.

The reference by last year’s republican platform to a gold standard as a useful tool for restoring price stability was seized upon by editorialists, pundits, democrats, and dissident republicans as an example of the zaniness of the right-wing crowd that renominated Ronald Reagan in Dallas. What a difference a century makes. In 1896, a group of populist, fundamentalist religious zealots took over the Democratic Party, pledging, to the horror of the enlightened, to take the country off gold. Now, in 1985, a new group of populist, fundamentalist religious zealots is taking over the Republican Party, pledging, to the horror of the enlightened, to put the country back on gold.

The gold standards, once the very symbol of monetary and fiscal probity and the pillar of an international economic order, is now viewed as a kind of wild, radical experiment embraced by a band of reckless ideologues. It would be a mistake, however, to assume that the disapproval of their betters will be enough to keep the crazies from restoring the gold standard. Such disapproval didn’t prevent enactment of the Kemp-Roth bill, and it won’t scare off the gold-bugs. It may be time, therefore, to begin thinking seriously about how a gold standard would operate if it were adopted.

In fact, that will not be easy, because a gold standard differs so radically from our current monetary institutions that there aren’t many people around—including its staunchest supporters, its most ardent opponents, or most professional economists—who really understand how a gold standard would function. Even during the nineteenth century there were sharp disagreements among experts as to exactly how the gold standard worked. Nor is it clear that those with the better understanding of how it did work had the most influence on policy.

One of the principal reasons for the confusion about the gold standard is the notion that the quantity of money determines the price level. If there is too much money, for example, increased spending is supposed to drive up prices until the higher prices absorb the excess cash. While essentially valid for an inconvertible paper currency, this relationship doesn’t hold at all for a convertible money. Under a gold standard, money is convertible into gold at a fixed rate—$21.86 an ounce when we were on a real gold standard from 1879 to 1914—so the value of money is identical to the value of the equivalent amount of gold. The amount of money—bank deposits and currency—in existence is the amount the public wishes to hold given its needs for transactions balances, its total wealth, and the return on deposits and on alternative assets. As long as confidence in the maintenance of convertibility is not impaired, the quantity of money, like the quantity of any other good, is determined in the marketplace and has no impact on inflation or deflation—which can result only from changes in the value of gold. Excess money isn’t spent, it is simply cashed in for gold or, more likely, returned to the banking system in exchange for alternative financial assets.

In an age of monetarism, a view suggests that the quantity of money is unimportant for policy purposes is bound to seem somewhat strange. That is why many suppose that the function of the gold standard is to limit the quantity of money that can be issued by the government or the banking system. This notion stems from the mistaken belief that what the gold standard does is ensure that the amount of currency and deposits issued cannot exceed some multiple of the amount of gold reserves. However, all the gold standard does is enforce convertibility of money into gold at a stipulated rate; it has nothing to do with legal reserve requirements. Such requirements may or may not be desirable, but they are neither necessary nor sufficient for a gold standard to operate.

It is also asserted that under a gold standard all balance-of-payments deficits would have to be settled by gold shipments. This sounds particularly scary because of the huge balance-of-payments deficit the United States is now running. If gold outflows required a contraction of the money supply, and if a contraction of the money supply meant a declining price level, this would be very scary, indeed. But under a gold standard the money supply does not have to fluctuate with the gold stock, nor, to repeat, does the price level depend on the money supply.

Moreover, nothing requires that balance-of-payments deficits be settled in gold. Whether they are depends on whether the surplus country prefers taking payment in gold or acquiring interest-bearing securities from the deficit country.

Since our balance-of-payments deficit has arisen because foreigners want to acquire interest-bearing assets denominated in dollars, it is foolish to think they would be trying to convert these assets into gold if we were on a gold standard. Just the opposite is taking place now, since the price of gold has been falling steadily and the exchange value of the dollar rising. If anything, we should, under a gold standard, be acquiring more gold as the rest of the world converted gold into dollars. Only if confidence in convertibility were impaired, so that the future value of dollar-denominated assets was in doubt, would a U.S. balance-of-payments deficit imply an outflow of gold.

Since a huge pyramid of credit is erected on a very narrow base of gold, maintaining confidence in convertibility is the crucial problem under a gold standard. In the nineteenth century, there were occasional panics when confidence in convertibility was shaken—for example, because the banks were mistrusted, or when it was feared that William Jennings Bryan would be elected and take the country off gold. As people sought to cash in their claims to gold, the resulting demand drove up its value. Under a gold standard, when the value of gold rises, the money price of everything else goes down, since money is equivalent to a fixed weight of gold. The consequence is deflation and depression.

This sequence of panic, deflation, and depression, often repeated in the nineteenth century, still colors the view of many economists and historians about the gold standard. But it should be recognized that the data about economic performance in the nineteenth century that would be needed for a meaningful comparison of the severity of economic fluctuations in the nineteenth and twentieth centuries are just not very reliable. We can’t be sure that fluctuations under the gold standard were worse than those we experience now. Furthermore, with larger, more efficient banks and with deposit insurance, the likelihood of a return to the sort of panics and crises that occurred in the nineteenth century has been diminished.

Our present monetary system has eliminated some of the risk of panics by making currency rather than gold the base of the credit pyramid. In case of panic, the quantity of currency, unlike that of gold, can be expanded to meet the public’s demand, so that the credit pyramid is not as precarious as it was under a gold standard. But with no constraint that guarantees, as convertibility did, the future purchasing power of money, our current monetary system has created a different kind of risk—the risk of high and fluctuating inflation that undermines productive saving and investment and impedes economic growth. If we don’t want to undergo the risks associated with a gold standard, we should consider other reforms that would restore the confidence in the long-term stability of the price level that the gold standard used to provide.

The first requirement would be to amend the legislation under which the Fed now operates (the Federal Reserve Act, the Employment Act of 1946, and the Humphery-Hawkins Act) to impose an unambiguous obligation on the Fed to maintain a stable price level. As things stand now, the Fed has so many legislatively mandated and internally adopted objectives from which to choose that it can justify virtually any policy it carries out in terms of at least one of them. Even if the Fed under Paul Volcker seems committed to keeping inflation low, who knows how long Mr. Volcker will be around to pursue that policy? And who knows what policy his successor will pursue? It is just this uncertainty over what the Fed’s ojbectives and policies will be in the future that undermines the confidence of the public in stable prices. A gold standard would be one way of eliminating the public’s uncertainty, but a clearly stated legislative mandate obligating the Fed to set policy so as to maintain a particular price index (such as the producers’ price index) within a prescribed range just might do so too without subjecting us to the short-term instabilities associated with the gold standard.