Are we going back to gold standard? Not quite so fast

Recently there have been increasing number of pundits calling for bringing the dollar back to gold standard. If you have read the Wall Street Journal and Financial Times in the past few weeks, you would have seen on the opinion pages many anti-Keynesian economists arguing for the virtues of gold standard and a real free market monetary system. Many of them point out the current financial crisis is precisely caused by credit bubble created by an inflationary fiat monetary system. To cure the global financial malaise, they contend that we need a sound money, the value of which is not based on the illusive credit-worthiness of the government, but on the tangible worth of certain precious metal such as gold.

How does gold standard work? It is very simple. Under the gold standard, the value of the dollar will be determined by its exchange rate with gold. Usually government should be the only entity that issues (meaning prints) paper bills at a predetermined exchange rate with gold (which is dictated by the market). For example, gold is now trading at around $800/troy ounce. You can bring one troy ounce of gold to the government, it will print out $800 fresh paper dollar bills for you (maybe minus a small fee, which is called seignorage), and keep the gold in its vault. The government cannot print more paper money than the worth of gold it receives. Individuals can exchange paper money for real gold if they choose to. Under a true gold standard monetary system, the amount of paper money in circulation should be exactly the same as the amount of gold in government reserve (gold stored in its vault).

The advantage of gold standard is that the government has to eventually balance its budget. The government cannot simple print money to spend. It has to borrow money from the private sector at an interest rate that is determined by the free market, not by the Federal Reserve. If the government borrows too much, the market will demand a high interest cost for its borrowing, which deters the government from running up its budget deficit.

Another benefit of gold standard is the elimination of fluctuation in currency exchange rates which should greatly facilitates global trades. When currencies are all pegged to gold, the exchange rate between currencies will be fixed. Nations will not have to be concerned above currency manipulation by their trading partners. Corporations will not have to buy expensive currency hedges when doing business in foreign countries. Wall Street currency traders will lose their jobs (that is a good thing for the economy, less friction cost).

In order for the gold standard to work, the Federal Reserve has to be abolished. Under the gold standard, money supply is completely determined by the market, rendering the Federal Reserve irrelevant. In fact, any Federal Reserve intervention in money supply will undoubtedly break the link between value of the money and value of gold. That is why even before President Nixon completely decoupled US dollar from gold in 1971, gold had been already traded way above the official dollar/gold exchange value.

But gold standard is not without its potential perils. One of the gravest risks of gold standard is that it is highly susceptible to speculation. Speculators who amass huge amount of gold can manipulate the price of gold and wreck havoc on the financial market. By hoarding gold, they can potentially deplete bank reserves and create a run-on-bank. Even sovereign reserve can be depleted by speculators' manipulation (recall the 1997 Asian financial debacle that was largely caused by western financial speculators). That is why in order for gold standard to work, we have to have absolutely strong market oversight and appropriate rules and regulations in place to prevent speculators like Rothchild and George Soros from creating instability in the financial market.

Personally, I do not believe we will ever go back to gold standard. First, no politician will be able to muster the kind of support needed to pass a law to abolish the Federal Reserve. Second, governments around the world are addicted to the easy money afforded by the fiat monetary system. Third, people who support gold standard loath government regulation. I believe stringent government regulations are absolutely critical for gold standard to function properly. Without implementing proper rules and regulations, gold standard will be subjected to constant market manipulation and eventually lose popular support.