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What if we dumped the Fed and returned to the gold standard?

REUTERS/Mike Segar

Countries adopted the gold standard so that they could more easily trade with Britain, which was the leading economic power from the late 1700s to World War I.

Last week I sketched the evolution of  the U.S. banking through 1913 to understand some of Ron Paul’s economic ideas. This is important to Minnesota voters because Kurt Bills, the GOP nominee for U.S. Senate, and other candidates are Paul supporters.

Understanding U.S. banking before the Fed is the first step in understanding Paul’s economic views.  Next, “To understand exactly why the Fed must go, one must realize that a commodity used as money is needed for a society to be free. It’s as much an argument for gold as it is against a central bank,” Paul writes in his book “End the Fed.”  Paul believes that the Federal Reserve should be abolished and a strict gold standard put in its place.

What would this mean? To answer that question, let’s take a look at the gold standard in theory and practice.

Commodity money

To an economist, money is any asset that can be used in making purchases. Historically, societies have used sheaves of wheat, bundles of tobacco, seashells and all kinds of physical objects as money. These are known as commodity money since the money itself (wheat, tobacco) has intrinsic value. 

Copper, silver and gold were the leading forms of commodity money in 17th century Europe. Great Britain moved to a gold standard in 1717, and over the course of the next 200 years most countries followed Britain’s lead. This was not because gold was clearly superior to copper or silver standards. Rather, countries adopted the gold standard so that they could more easily trade with Britain, which was the leading economic power from the late 1700s to World War I.

In theory, a gold standard has three components:

  • each country fixes the value of their currency in terms of gold;
  • gold can be owned by anyone;
  • gold can be traded freely across international borders.

So, for example, in 1791 Alexander Hamilton proposed (and Congress agreed) that the value of the dollar be set to 24.75 grains of gold. At the same time, the British pound-sterling was worth 112.75 grains of gold. American citizens and British subjects owned gold and could sell it both within each country and to one another.

This meant that there was a fixed exchange rate between the dollar and the pound, in this case $4.56 per pound. More generally, a gold standard creates fixed exchange rates between all pairs of countries.

The system maintains these exchange rates through gold flows. If the price of gold in one country gets out of line with the price in another, gold will move from the country where it is less valuable to the country in which it is more valuable the original exchange rate will be reestablished.

Notice that, in theory, this system is self-equilibrating. This is one of the most attractive features to Paul and his followers: theoretically, there is no need for governments to do anything except set the price of gold. Banks and individuals all over the world hold gold as money and gold flows do the rest.

How gold standard really worked

This is not how the gold standard actually worked before World War I. The big reason was that gold flows meant changes in the money supply and either inflation (in the case of gold inflows) or deflation (gold outflows), neither or which was desirable from the point of view of policymakers.  (I explained the relationship between changes in the money supply and inflation in my March 29 column.) 

For instance, if the Bank of England perceived a discrepancy in the price of gold between New York and London, they would either raise interest rates (to make it more attractive to keep gold in Britain) or decrease them (to keep gold from arriving.) Central banks in countries such Britain, Germany and France all used interest-rate adjustments as a way of minimizing gold flows and keeping price movements in check.

The United States was an exception to this pattern for the simple reason that it did not have a central bank until 1913. American monetary policy was thus dictated by two factors: British interest rates and the amount of gold Americans held. 

This meant that American banking was the most unstable in the industrialized world until the creation of the Fed. Changes in British interest rates and changes in the amount of gold in the United States caused financial panics, and banks had to suspend gold payments when depositors rushed to withdraw their money. The financial system would seize up resulting in a recession or in some cases a deep depression.

These panics were, among other reasons, a driving force behind the Populist movement in Minnesota and throughout the Midwest, and led to calls for coinage of silver as an alternative to gold and the printing of paper money. It also led to calls for breaking up the large banks in New York and other financial centers, and contributed to the unique structure of the Federal Reserve (12 district banks in 1913 rather than a single central bank).

Implications for banking and trade

There are three implications in following Paul’s advice.

First, the Federal Reserve would be abolished and a price for the dollar set in terms of gold by the U.S. Treasury.

Second, banks and individuals in the United States would hold gold directly and use it as money or hold it indirectly via bank-issued certificates entitling the bearer to gold on demand. The gold could take any form from government-issued gold coins (from any government, not just the United States) to gold bars.

Third, the exchange rate between the dollar and other currencies would be determined by the price of gold in dollars and the price of gold in the other currencies. Since, no country in the world currently values its money directly in terms of gold, other countries would either have to adopt official gold prices or allow international gold markets to determine the price. 

All of this would require radical changes in U.S. banking and international finance. To start, domestic banks would need to hold gold so that their depositors could make deposits and withdrawals. Similarly, international financial institutions and central banks would need to replace their dollar holdings with gold or other currencies.

The benefits of these changes and the other changes required under a gold standard are hard to fathom.

Would inflation be lower?  It’s hard to imagine given that the Fed has kept inflation around 2-4 percent for the past 30 years. Would business cycles be less likely? I doubt it, given that expansions and contractions were at least as pronounced before the Fed was created and perhaps even worse.

The gold standard is not the cure for our difficulties. Instead of tinkering with the monetary system, we need to deal with fundamental issues such as the size and role of government generally and the relationship between the financial system and government in particular.

Using gold, silver, copper, seashells, or anything else instead of paper won’t help us face these problems.

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Comments (24)

The problem with the gold standard...

... is it preys on peoples' ignorance. It sounds scary when you say, "the gubmint can just PRINT MONEY!". The thing about gold, though, is it's entirely arbitrary. You may as well have a banana standard. If you study economics and look at the progression of the concept of "money" over history, it becomes fairly obvious that a gold standard was a logical point to progress to and from. That era is over. I'd be shocked if many Paul's supporters have put enough effort int to really understand the implications of this - it just makes him "different" than the (admittedly flawed) Democrat and Republican perspectives, but they never stop to ask, is this different in a good way?

Banana Standard

I agree that re-attaching our currency to the gold market is as arbitrary as attaching it to virtually any commodity market, but I think there is a distinction between why it isn't the banana market but needs to be a rare metal market and I think that the reason for this is important to understanding the ideological foundations of libertarian economic policy.

Obviously the problem with "the banana standard" is that that would mean the money supply grows on trees. That's the opposite of what the Paulites want. They need a commodity of which a fixed amount exists in the world so that the money supply can only be added to either through great pains or through sheer luck.

What this means, though, is that money becomes way easier to horde. The libertarian argument basically breaks down to being that scarcity is a good thing, and that without strictly enforced scarcity (I think of Fort Knox), the economy grinds to a halt. I would argue the opposite -- that we are so focused on enforcing scarcity in general, that resources that have inherent utility are squandered on destructive, fruitless, and pointless enterprises, rather than being consumed by those who have the skill and the ability to use them in beneficial way.

Anyone who claims that the

Anyone who claims that the Gold Standard would eliminate most of the problems in the economy needs to explain away the wrenching boom and bust cycle of the late 19th century. But somehow, they always insist that things were actually better then. Presumably either they are simply ignorant, or assume that their listeners are.

I think most Americans would prefer the pizza standard.

That forces the banks to maintain a "healthy" (?) standard to suit almost everyone's tastes.

The headline presents a false

The headline presents a false choice. How about we just nationalize the fed? Why should a semi-private entity controlled by the bankers get to control the money supply, and create debt, when if the federal government printed the money we could just print it with no debt (albeit maybe with some inflation, although so much paper money has been destroyed since 2007 it might not make a difference).

The author needs a history lesson

Our two greatest recessions/depressions happened with the Fed. In fact the busts haven't stopped, they've just gotten longer and deeper. Finally, there is a lot of work done by free market economists to demonstrate that the fed actually caused the Great Depression (see Rothbard's America's Great Depression) and our current Recession (which even the likes of Krugman admit is a Depression).

During the 19th century, there were quite a few busts. Mostly caused by failed bank policies. One only need to compare to Canada's banking system, which was far more stable and didn't have a central bank until decades after the fed.

Free market economists want to return to a better Gold Standard of the 19th century, not 19th century technology.

As for "Money", some commentors really need to study what money is. Money has specific requirements (look it up on wikipedia) and Banana's and paper do not meet those requirements. Gold does.

The notion that a few bankers can determine the price of money, is the pretense of knowledge.

Ron Paul actually doesn't want to abolish the Fed overnight. This would cause some economic woes. Instead, Ron Paul advocates the Hayek, concurrent currency theory: Legalize gold and silver as legal tender and let the market decide if they want to use it, or paper. In theory, the market will determine the best currency and lesser currencies (ie, federal reserve notes) will be unable to compete. Thus the fed will go out of business because it serves no function.

Last of all, the constitution still says gold and silver are the American currency.

Wikipedia is by far not a

Wikipedia is by far not a standard of truth. Anyone can add or subtract anything they want. The free market only pertains to the rich who set all standards including who gets to eat banana's. So don't get to attached to Wikipedia and the theory of gold as some constitutional currency.

I take it

the government tells you which breakfast cereal to eat.

Gold and the Constitution

The Constitution does not say that gold and silver are "the" American currency. Individual states are prohibited from making anything other than gold or silver a tender in payment of debts (art. I sec. 10), but there is no such limitation on the federal government. Congress has the power to coin and regulate the value of money.

Tax protestors often seize on your gold and silver "constitutional money" argument, but to no avail. Courts are declaring that argument frivolous, and not worthy of discussion.

Incidentally . . .

. . . on the subject of long and deep depressions, you might want to look up the Depression of 1836-1842, or the "Long Depression" of 1877-1879 (or 1901, according to some historians).

There's a problem with the

There's a problem with the argument about the 2 greatest recessions/depressions happening with the fed. One (the big one) also happened with the gold standard, and many have written fairly convincing arguments that it was the inability to stimulate the economy by the central bank (because of the limitation of the gold standard) that led to the drawn out great depression. Others have already talked about the prior booms/busts that happened in the pre-fed era, and the odd notion that somehow a commodity should be immune to price swings. Lets face it: sometimes collective wisdom works. And most economists think this is a terrible idea.

Gold standard in our current state would be a disaster

The admittedly riskiest part of a gold standard today is our massive trade deficit. With so many more dollars going out than actual goods, America would stand to lose a lot of gold. However, this deflation would help facilitate a restructure in the economy and the trade deficit may become a trade surplus... like it was during the 19th century.


This is what I don't get about it. Ron Paul also endorses the subjective theory of value as his preferred approach to economic value -- i.e. that prices determine the value of a commodity and it possesses no intrinsic value. However, his argument for the gold standard relies precisely on the principle that there IS an objective value to gold. Isn't this a contradiction? He wants to base our currency on the market, but wasn't the problem with the mortgage crisis precisely that debt became TOO much of a commodity (hence it could be bundled, traded, etc.)?

Also confused at their rationale

I'm similarly confused. Letting money adjust its value naturally to reflect an economy's worth seems like a free-market booster's dream. Setting it to one commodity by act of government seems to be exactly opposed to their ideals. And what happens when, I dunno, Zambia happens to stumble upon some giant cavern of gold? Is their economy suddenly worth more than ours even though their output is miniscule by comparison?

Free market economists..

Don't do evidence based research. Friedman often described his Chicago school acolytes as apostles of new economic order, and disdained the demand for evidence. What's funny is their insistence that they're doing science. You trust these writers conclusions at your own peril.

Be careful critizing Friedman here

People can blame this recession on de-regulation, which was certainly partly to blame. The government had it's role as well with a huge moral hazard which allowed the banks to take the risks they did, and individual people to take the risks they did. This corporate-government relationship which allows corporations to distance themselves from risk was a specific criticism of Friedman. If we wouldn't have been trying to make housing "cheap", we wouldn't have had the bubble in the first place. Furthermore, the only reason the Federal Reserve managed to prevent a depression immediately was because of Friedman's critique of their response to the Great Depression. While Paul's libertarians won't admit it, the feds actions in 2008 were out of Friedman's playbook, and that is what helped stave off a huge deflationary collapse. If you need proof of that here it is in Bernake's own words “I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again”

First, gold is as arbitrary

First, gold is as arbitrary as a form of money as any other possible item.

Second, the value of financial transactions that currently use paper dollars as denomination far exceeds the supply of gold at current pricing. Maintaining that rate of transaction requires an enormous revaluation of gold upwards. This immediately puts a lie to the "fixed value" of gold, rewards speculators and chokes financial transactions to match the gold on hand at the current value.

Will there then be a free market in gold, bid up and down minute by minute? How could any transaction be completed when a tick or two of pricing changes the favorability of a transaction in minutes? In the net, huge amounts of gold would be tied up in hedging against that risk and economic inefficiency would rise. If that isn't desirable, wouldn't the artificial setting of a gold price by any agency be as big or bigger plum for financial/political manipulation as any other monetary system?

South Africa

Please tell me how a shift to Ron Paul's strict gold standard would not result in South Africa and Russia mining huge quantities of gold and buying us.
If gold has intrinsic value and is acceptable as legal tender I see nothing to prevent this.

South Africa...

All depends on whether or not the Chinese are willing to sell.

Ignorance of Standards is Astounding

Reading the article and then the comments here has irritated me sufficiently to register and created this post. Very few here seem to understand the nature of standards. A world without a standard definition of monetary units is like:

A world without a standard unit of time where one person's second is allowed to be different than anothers. A world without a standard unit of length where one person's unit of meter is allowed to be different than anothers. A world without a standard unit of mass (weight) where one person's unit of kilogram or pound is allowed to be different than anothers. A world without a standard unit of force where one person's unit of Newton is allowed to be different than anothers.

How many of you really believe mathematics is able to function with varying definitions of the units the math is meant to describe? It isn't. Math is only as good as far as the units it is represented are defined. That's why the units of "jobs" and "workers" make fore extremely poor math. One worker cannot fill any one job. The limitless number of variation between jobs and workers make mathematics that use those units very fuzzy.

The point to a gold, silver, copper, wheat, diamond, or whatever standard unit of currency is so that everyone's math in trade functions correctly. Currency is something of an abstract concept that lubricates the trade of real goods and services. Money should never be thought of anything other than a facilitator of trade. A gold backed dollar can't be manipulated to serve some publicly unseen purpose. A dollar would represent what it represents ALL the time. A standard dollar allows anyone to understand the risk in their financial condition at the present as well as in the future. Without this understanding everyone is scared of inflation and deflation of currency.

Fractional reserve banking allows for adjustments to the supply and demand of available dollars to buffer the economy. This puts all risk on the hands of the banks (which are privately owned). Should a bank not reserve sufficient capital (gold, land, houses, wheat, etc) to match the demand of people desiring to redeem their bank notes for capital, the bank collapses. Our government bails out banks that CHOOSE to run at crazily risky ratio. In conjunction with the banks running the risks, those who use fractional reserve banks run a risk themselves. Force all bankers to be personally liable for the funds they manage and not remove liability via corporate law and the crazy risks being run these days by them wouldn't exist.

The armchair economists here have no idea about science and the standardization of units. It would totally blow chunks if I ordered a part of Florida that didn't use the correct units of measurement to fit my machine in California. Thank goodness some people are intelligent to understand standards and how they facilitate functioning society.

As an FYI. The standard unit of length is the Meter, as defined by a finite number of wavelengths of a specific isotope of the Krypton atom. It is VERY well defined and allows for all the sweet mechanical inventions we have. The standard unit of time is the Second. Defined by a finite number of periods of radiation form a specific isotope of Cesium. These STANDARDS allow mathematics to work extremely well with them. Imagine if money were so precisely defined.

Gold standard is "barbarous relic"

The economist John Maynard Keynes, not exactly an armchair economist, called gold a barbarous relic though in the Bretton Woods Agreement which he helped negotiate for the UK, gold became the "constitutional monarch" that created price stability in trade from 1946-1971. I don't think there's any disagreement in the comments that a) you need to have a standard of value and b) money and, in turn, prices , need to be kept stable. The question is whether a gold standard would accomplish that result. I get it that Ron Paul and his supporters are absolutely convinced that the gold standard would be a panacea for a lot of the country's economic problems and, moreover, would achieve their goal of having government intervene in any economic affairs. But the gold standard has a lot of history and has been found just as wanting in achieving price or monetary stability as any other standard. There is a case for monetary and banking and financial reform, but the gold standard, "barbarous relic" as it is, can be eliminated in consideration of any needed reform.

"Standard" is something that

"Standard" is something that is fixed, or unchanging.

What is fixed about the price of gold?

If the price of gold is fixed, it immediately limits financial transactions.

If the price of gold is not fixed, many financial transactions become perilous, and the necessary hedging enormously increases economic inefficiencies and stifles longer term investment decisions.

And the politics of "fixing" a gold price will bring much mischief.

errors and ignored facts

Mr. Johnston ignores that the Constitution requires that "No State shall... make any Thing but gold and silver Coin a Tender in Payment of Debts." Note that silver is included; nothing about bananas. Until 1974, most coins were 70% silver and dollars were redeemable at any local bank for silver coins. Perhaps the reason this was put into the Constitution was so the government could not so easily inflate away the value of the people's hard earned money and go on spending sprees without their permission to wage wars or buy votes. Nixon ended the gold standard to be able to pay for the Vietnam War with the printing press just as we are doing now in the Mid-East. In 2010, a watered down audit of the Fed revealed that the Fed had handed out $16T including a couple of trillion to foreign banks. A few days ago, there was a report that over $4T of Fed money was handed out to banks associated with Federal Reserve officers. The value of any fiat currency, such as our Federal reserve Notes, eventually goes to zero. At least if money is backed by something real, the silver or gold will have a value outside this country.

Mr. Johnson also erred when he wrote that the US "did not have a central bank until 1913." This is our third. Presidents Jefferson and Jackson ended the first two. He ignores that the Great Depression and Carter's inflation occurred with the Fed. Only Congress is responsible for monetary policy according to the Constitution. ("To coin money, regulate the value thereof, and of foreign coin, and fix the standard of weights and measures") not the private bank owned Fed or technically, not the US Treasury. Banks would not be required to hold gold for their depositors as Mr. Johnston claims if the dollars were backed by gold. When was the last time banks were required to hold gold though President Nixon? Nonsense.

The US thrived before President Wilson gave the Rockefellers of his day the national bank they so wanted. I suspect what Mr. Johnston is saying is go vote for Klobuchar because she is a friend of the Federal Reserve and the wars and deficit spending the fed makes possible. Open Secrets report that Sen. Klobuchar raked in $322k from security and investment firms and another $167k from commercial banks between 2007-2012.

Errors and Ignored Facts?

Perhaps you're forgetting that the federal government is not a "State." The Constution prohibits states from printing their own money.

And maybe you're ignoring the fact that there were may recessions and depressions before President Wilson's day, some very severe and long-lasting. Recessions and depressions are a natural part of the business cycle and cannot be avoided, but with a proactive government that uses monetary policy appropriately, they can be (and typically have been) minimized.