45 Years after the Gold Standard: What Did It Bring Us?

August 23 2016

Last week it was exactly 45 years ago that president Nixon took the United States off the gold standard. At the time the Federal Reserve lost lots of gold after the Fed itself eased monetary conditions to help finance the Vietnam war. Ever since we live under a fiat money regime, or a PhD standard as Jim Grant calls it because the value of our money (its purchasing power) no longer depends on gold, but on the whims and fancies of a handful of academics. What did this PhD-standard bring us?

The Evolution of Our Banking System: The Increasing Centralization of Gold Reserves

Money emerged once, as Austrian economist Carl Menger demonstrated, because people out of self-interest tend to the best medium of exchange. Direct exchange was the norm. In order to obtain eggs as shoemaker, shoemakers had to trade shoes for clothes and clothes for eggs. Our biggest problem in direct trade was the need for a double coincidence of needs. We were forced to trade multiple times to get whatever we wanted. Direct trade goes hand in hand with an unimaginable number of practical problems.

For this reason people tried to get hold of that thing that was easiest to “trade” or “market.”

In the western world the two precious metals gold and silver soon became the most favorite media of exchange. These metals gained additional value on top the value they already had as metals used for different purposes than as medium of exchange. They thank this additional value to the demand for them as medium of exchange.

Gold Standard = Gold Standard?

Societies evolved from direct trade to indirect trade. Money was born. And gold was money. That gold was in the hands of the people, of the consumers. Gold was exchanged physically.

However, exchanging physical gold can be cumbersome and inconvenient: gold is easily robbed and taking physical gold with you is rather uncomfortable. Moreover, small fraction payments were sometimes complicated.

In this chapter of history the 100% reserve bank came into existence.

This bank simply stores the gold of the people and gives its depositors claims on the gold, or promises to pay gold, either as a balance or paper bank notes representing a certain amount of gold in the vault. This way, people could just trade the promises to pay gold instead of the gold itself. A 100% reserve bank can settle transactions between bank clients without even touching or physically moving a bar of gold but simply by changing the allocation of the gold.

In certain sense GoldRepublic is such a “100% reserve deposit bank.”

Where Are the Gold Reserves

 Relatively soon these gold reserves were pledged at central clearing houses. These clearing houses settle transactions between banks. When the banking system functions properly, banks that expand credit lose gold reserves while more conservative banks gain gold reserves.

Many central banks still fulfill this role as clearing house.

Gold reserves were no longer stored at common banks, but at a central bank. Commercial banks subsequently held promises to pay gold on their balance sheet with the central bank as counterparty, either as bank deposits at the central bank or paper notes.

This was not the end of the evolution of the gold standard. A central bank of central banks arose: the Federal Reserve. No longer did central banks store gold as reserves, but the Fed. The other central banks simply held Federal Reserve notes (dollars) or deposits, which functioned as promises to pay gold.

Until the other central banks lost trust in the ability of the Federal Reserve to turn dollars into gold. President Nixon saw exactly 45 years ago no other way out than separating the dollar and gold.

But to talk about “the gold standard” as a completely homogeneous, never changing phenomenon, no. Essentially we had four gold standards. Gold reserves went from consumers, to bank, to central banks, to the Federal Reserve.

The Advantages of a Gold Standard

Whether a gold standard is of value is often doubted. Yet however positive or negative one might be about a peg between gold and money, the key advantage of a gold standard is as clear as water: a peg between gold and money forces governments and central banks to act with prudence.

Central banks are bound to a given amount of gold (which grows slightly every year) and government debt cannot be bought by central banks in great amounts. Budget deficits cannot be financed by means of the government monopoly on money which a central bank enjoys.

A gold standard functions as a break on government spending and inflation.

The Results after 1971: What Is the Score?

We will look at two different data to compare the pre- and post-gold standard periods:

  • Budget deficits (or budget surpluses, however rare they might be)
  • Inflation

Budget Deficits

If we take a look at the data and our theory is correct, then we should expect to observe higher budget deficits after 1971 in comparison to before 1971. These are the data for the United States:

Source: St Louis Fed

In the period from 1951 to 1971 budget deficits as a percentage of GDP where on average 0.6% in the U.S. In contrast, from 1972 to 2015 budget deficits as a percentage of GDP averaged 3%. This suggests that the gold standard indeed functioned as a break on high budget deficits because central banks simply could not finance (“monetize”) public debt without losing gold reserves.

The conclusion is that since abandoning the gold standard we experience structurally higher budget deficits.

On a side note, these data are strongly correlated to the data that we have at our disposal in Europe. We can generalize these findings to European countries, such as Germany and the Netherlands.

Inflation

Inflation is the next statistic we will take a look at. In this case we will use data from the United States as well. What happened with inflation – defined as a rise in the consumer price index – after the last link between the dollar and gold was severed?

Source: St Louis Fed

The period of high inflation and economic stagnation – popularly referred to as "stagflation" – might distort the picture. After president Nixon left the gold standard the Western world experienced a decade of high inflation. Prices sometimes rose by over 10% a year. In defense of the gold standard: with help of countries such as China which integrated themselves in the global economy since the change of the millennium, the world experienced an unprecedented increase in productivity. The fact that prices rose 2% while productivity increased by, let’s say, 10%, might distort the picture on the other side of the medal.

Yet the pre- and post-gold standard averages might tell us sufficiently.

The consumer price index after 1971 reveals a significant increase. Inflation amounted to a 2.2% average between 1951 and 1971. Since 1971 this average rose to 4.1%, almost a doubling compared to the period before the Nixon shock.

In summary: the track record of our current monetary standard (of free-floating currencies) is considerably worse than that of our most recent gold standard.

Gold Protects against Fiscal and Monetary Abuse

Gold protects against fiscal and monetary abuse of governments and central banks. The prove is that budget deficits and inflation are structurally higher after abandoning the gold standard in 1971.

We are entering the forty-sixth year of the post-gold standard era and as we could have expected the results are not very pretty.

But despite the fact that today you cannot pay with gold in the supermarket, you can still hold gold as a store of value. In this sense buying gold would be a very wise thing to do, especially taking into account the performance of fiat money. 

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