Gold vs. Fiat
By: Michael Kopelman and Luay Kanaan.
“I just want to make it clear to everybody that our policy has been and will always be…that a strong dollar is in our interest as a country, and we will never embrace a strategy of trying to weaken our currency to gain economic advantage at the expense of our trading partners” (U.S. Treasury Secretary Timothy F. Geithneron) On august 15th 1971 Richard Nixon cut the ties between gold and the US dollar. It has been 41 years since the United States has moved from the gold standard, to fiat money. In essence this means that the banking standard moved from something far more tangible(the price of gold) to something far less tangible (trust in a countries currency among investors). As is everything in economics, there remains debate today whether or not the switch to fiat money was truly the best idea for the United States economy in the short run as well as the long run.
One of the advantages to using the gold standard is evaluation. A constant universal commodity such as gold allows a country to look at current and past numbers and evaluate them. With gold being a common denominator throughout you can get a far greater understanding of how your economic standing of today compares to that of previous years. This comparison is not nearly as easy under a fiat money system.
Another advantage for the gold standard is that it is more stable than fiat money, this is because fiat money is based on trust in a government and not a set standard(ie gold). In its most basic element, a lack of confidence caused Greece’s financial crisis. Investors feared Greece’s ability to pay back its debt leading to a full out crisis where greece now stands.
Due to the instability of the financial system in recent years, embedded risk has been increased through currency wars, the debasement of the dollar, and leverage in the too-big-to-fail banks. The failure of banks such as Lehman Brothers in 2008 and other corporations has been due to fiat money. If an underlying security is priced in dollars and the dollar is collapsing, then the value of that security is collapsing too, forcing traders to sell everything! Markets in the dollar and dollar-based securities collapse while markets in commodities and non-U.S. stocks begin to spike. A solution to these problems however can be realized through the adoption of a gold standard.
One of the disadvantages of the gold system is the creation of larger amounts of money. While the gold standard would allow for the creation of credit through the exchange of money for a receipt which indicates a fixed quantity of gold, it would not allow for the creation of money beyond the amount of gold on deposit. Since gold is a scarce resource it could seriously limit the growth of an economy.
Another disadvantage of the gold standard can be thought of in light of the Great Depression. The gold standard limited the flexibility of the central bank’s monetary policy by limiting their ability to expand the money supply, and thus, the U.S. was unable to lower interest rates. Higher interest rates intensified the deflationary pressure on the dollar and reduced overall investment in banks. Therefore, a limited supply of gold reserves in central bank vaults would lead to a deliberate tightening of monetary policy, higher labor costs, and weaker securities.
A flexible gold standard should be adopted to reduce uncertainty about inflation, interest rates and exchange rates. Once investors have greater certainty and price stability, they can then take greater risk on new investments. Inflation, interest rates and exchange rates act as barriers standing in the way of innovation. The U.S. economy has seen asset bubbles, booms and busts, and crashes in the forty one years since it left gold. Gold produces the greatest price stability in asset values and therefore reduces the volatility for entrepreneurs, who are the real source of wealth creation.
Categories: Money
Discussion
Franziska Meinherz October 3rd, 2012 at 16:35
Alyssa DiZoglio October 8th, 2012 at 14:16
I agree that while gold standard currencies may provide more stability, because as stated in the article, if the dollar is collapsing there is no longer any underlying security in a gold standard. However I do think that readopting the gold standard would only hinder economic growth at this point because as also stated in the article, with a gold standard there is less power granted to monetary policy. It would limit our country’s ability to control monetary policy through changes in the money supply or changes in the interest rate which I do not feel would be an advantageous decision for our country.
I agree that a mixture of gold and foreign currency seems to the the most appealing and most useful for our economy because it allows the stability of gold, combined with the ability to react to financial changes around the world.
Gold equivalents certainly have the effect to stabilise prices, but the problem is that this isn’t always advantageous. Instead of just covering a currency with gold, you could also think of a more diverse way to cover the money. A mixture of gold and foreign currency is usually much more useful to react to financial impacts coming from the rest of the world. By holding large amounts of foreign currencies, the National Bank can directly react to the market and ensure that the exporting and importing industries don’t have to take the full impact of external shocks.
Gold is very inflexible, but by buying and selling the currencies of the trading partner nations, the National Bank can directly take influence on this specific exchange rate, which is usually far more efficient. The fact that a currency is partly covered by another rather trustworthy currency also gives more confidence to investors.