The long-run goal of monetary policy is simple: Supply the economy with the right amount of money to promote healthy economic growth and a stable price level. Determining that amount is impossible for the Federal Reserve. Nevertheless, since 1971, when we said good-bye to the last semblance of a gold standard, we have delegated that responsibility to the Fed and the world’s central bankers. This 40-year experiment has failed. Real economic growth is faltering, and the world’s leading powers are waging a currency war in which success, perversely, is measured by the level of currency weakness rather than strength. What has happened to the idea of a sound dollar?
Because our monetary problems were decades in the making, we forget that over a very long interval (1834 to 1971), interrupted only by war, the US economy enjoyed tremendous economic growth and price stability, thanks largely to a convertible dollar (a dollar defined as a weight unit of gold). Numerous misperceptions about the gold standard keep this fact from today’s debate on monetary reform. Ask the average Washington insider, and he will tell you that the gold standard causes deflation and restricts economic growth. One need look no further than the historical record to understand that these criticisms are false.
Price stability, not deflation, was the hallmark of a dollar convertible to gold both in the 1800s and the pre-1971 20th century (see Charts 1 & 2). The US price level (CPI) was the same in 1914 as it was in 1834. The absence of inflation for almost a century did not come at the expense of economic growth. On the contrary! US real Gross Domestic Product (GDP) grew approximately 4% per year for that entire interval, the greatest period of growth in US history. Even during the period 1914 to 1971, as the gold standard was progressively diluted by the gold exchange standard, the residual link between the dollar and gold restrained the CPI, and promoted robust economic growth. After Nixon suspended convertibility of the dollar to gold in 1971, the CPI began its steep, modern-day ascent and the US economy, while continuing to grow, never regained the growth level and price stability seen from 1834 to 1971.
Chart 1: Inflation & GDP Growth 1834-1914 Source: NBCM
At the heart of the gold standard’s remarkable history of producing stable prices is the natural alignment of the long-run rate of growth of the above ground gold stock with global population and per capita GDP (see Chart 3). Over long periods, the three variables have grown in direct proportion to each other (0.6%-0.7% per year from 1810 to 1914; 1.4%-1.7% per year from 1914 to 2010). This symmetry is the primary reason why people have used gold as the natural monetary standard throughout history. There is an understanding, based on empirical fact and centuries of production history, that gold will not be overproduced or underproduced relative to population and per capita GDP. It follows, therefore, that when the dollar can be redeemed for a specified weight unit of gold, confidence in the dollar as a reliable measure of wealth increases. Price stability ensues.
Chart 3: 1810-2010 Growth of the Above Ground Gold Stock, World Population & GDP per Capita Source: NBCM
At the October 5th Heritage “Conference for a Stable Dollar,” James Grant noted an important irony of the Gold Standard – when the dollar is defined as a weight unit of gold, individuals rarely exchange their paper money for gold. It is only in the absence of a gold standard that they desire gold, a store of value amidst fluctuating paper currencies. Said another way, when the dollar is “as good as gold,” people choose the convenience of the convertible paper dollar.
It is also true, however, that the desire and the freedom to hold gold by all market participants, not just the central banks, is a critical underpinning of the stability provided by the gold standard. Under the true gold standard (1834 to 1914), in the case where the central bank produces an excess of money relative to the economy’s demand for money, market participants will exchange their dollars for gold, and will continue to do so until the central and commercial banks reduce the supply of money such that price stability is restored. It is this spontaneous and automatic market mechanism, rather than the ratio of central bank gold reserves to the money supply, that keeps the price level in check. The gold standard is the solution to today’s monetary problems of currency chaos and financial market instability. While it is not perfect, no other system can match its long record of success in providing stable prices and superior economic growth. We have the map. Let’s use it.