Going Back to the Gold Standard

Over a year ago, I wrote a blog post on the specie gold standard 'method' of money supply management. At that time, I was certain that this would be the last blog entry I would make on this subject (I don't like blogging about gold). However, recent occurrences in the Eurozone (and the US) have forced me to reflect again on this topic:

In this post, I will conduct a thought experiment on the implications of returning to the specie gold standard of money supply management.

Let us postulate that the world returns to the specie gold standard of money supply management, and that the system possesses the following features:

• All forms of money in circulation in each country, i.e.; M0, MB, M1, M2, M3, MZM, represent actual gold in the vaults of each respective country's Central Bank.
• Whenever Nation X imports goods/services from Nation Y, gold that is comensurate with the value of the traded goods/services, is shipped from the vaults of Nation X's central bank to the vaults of Nation Y's central bank. Thus, this implies that imports deplete a country's gold reserves and its money supply, and; that exports grow a country's gold reserves and its money supply.

What would happen in such a system?

1) The Fractional Reserve System would create less money

Currently, banks around the world (except those in Islamic countries) employ the fractional reserve system to create money.

What is it? This is best illustrated by way of an example. Let's say that a bank receives $1,000 in clients' deposits. In this country for every $1 transaction that occurs in cash, 7.33 times the number of cheques are accepted. The bankers are unsure about the frequency of withdrawals, so they decide to leave the depositors' money untouched.

People trust the banking system and each other, and cheques are as good as cash. Hence, instead of lending the depositors' funds to borrowers, the bank can simply issue cheque books, that correspond to the amounts that each borrower seeks. And, the borrowers could write cheques up to their respective requested loan amounts.

Being rational people, with MBAs from IMD, INSEAD and Harvard Business school, the bankers decide to gain operational leverage from the community's trust by lending 7.33 times their cash base; i.e. the bank lends $7,333.33. Thus, each dollar of depositors' funds creates $7.33 dollars worth of loans in this scenario!

Contrastingly, If the specie gold standard, with the above mentioned features, was introduced, $1 worth of depositors' funds would create $1 worth of loans. Succinctly, credit, the lifeblood of the modern economy, would immediately dry-up, and this would trigger either a recession or a depression in most jurisdictions.

Simply put, the gold standard would reduce: economic growth, living standards, job creation and societal stability. Further, the gold standard would reduce the likelihood and severity of credit-induced crises, like the subprime mortgage crisis of 2007-2009. So, its disadvantages do come with an important advantage.

2) Barter Transactions would rise exponentially

To satiate human beings' unlimited needs and wants, commerce has to occur. And, money is the lubricating force of the world's engines of commerce.

The main problem with using gold as a unit of account, through the employment of the specie gold standard, is its scarcity. There is not enough gold in the world to support the volume of transactions that occur in the modern economy every day. Stated otherwise, if the specie gold standard was reintroduced, the scarcity of gold would be a checking mechanism that would curtail people's ability to satisfy their needs and wants through commerce.

It is reasonable to assert that people would circumvent the above mentioned problems by batering the goods they produce for the goods they need.

In short, the gold standard would morph the world economy into the Burning Man festival! I'm not to sure whether this is a bad thing or a good thing.

3) The rise of beggar thy neighbour protectionism

As was mentioned eslewhere, imports would drain countries' gold reserves. And, this would, in turn, cut money supply and curtail economic growth. Clearly, this is undesirable for most governments, and thus, they would institute tarrif and non tarrif barriers to imports, while vigorously promoting exports, in a bid to maximize gold reserves.

Simply put, this would trigger beggar-thy-neighbour protectionism. And, this could start a depression as acute as The Great Depression.

Still want to return to 'The Gold Standard'?