Gold, Paper, or Is There Something Better?

Buy gold! That is a major message in times like these. That used to be our standard. It has gained in value while curries, stocks and bonds have lost large percentages in the last few years. It becomes very confusing, especially if you stop to think about the people who are making these claims. Of course for the most part it is paid advertisements with paid pitchmen. Isn’t it amazing that they always show up in economic times like we are experiencing today? Why not read Bill Woolsey’s article below to learn his different perspective on this commodity.

By Bill Woolsey

By Bill Woolsey, Special Economic Correspondent of The Free Enterprise Foundation

The “great moderation” that began in the mid-1980s, of low inflation and mild recessions, suggested that the Federal Reserve had finally learned to effectively manage paper money. Unfortunately, the deep recession that started at the end of 2008 suggests a need to return to the drawing board.

The Founding Fathers advocated a gold or silver standard. Fundamentally, a gold standard means that the unit of account, the dollar, is defined as a specific amount of gold. The dollar price of gold, then, is fixed by definition. Like all goods and services, the relative price of gold depends on supply and demand. How can gold become relatively cheaper or more expensive when the dollar price of gold is fixed? The prices of all other goods and services must change. An increase in the supply of gold, or a decrease in the demand, requires higher prices for other goods and services. The result is a temporary inflation that ends once a higher price level is established. An increase in the demand for gold, or an increase in the supply, requires lower prices for other goods and services, including wages. The result is an episode of deflation until a lower price level is reached.

The historical record of the gold standard is mixed. Gold discoveries and mining activities caused a growing supply of gold, while growing wealth resulted in an increasing demand for gold. Although this created substantial instability on a year to year basis, with periods of deflation offsetting periods of inflation, the relative price of gold remained quite stable on average,

The most serious problem with the gold standard is the market process that forces everyone to adjust prices and wages. Today, a shortage in the gold market is fleeting. Its impact is concentrated on gold markets, and simply results in a higher dollar price for gold. With a gold standard, the necessary deflation only occurs because every other area of the economy is faced with surpluses—an inability to sell at current price levels and wages. In other words, a situation that looks like a recession.

One common misconception regarding a gold standard is that it requires gold to serve as “backing” for paper money or else to be made into coin. To the degree that gold is used to “back” money or is made into coin, the demand for gold is higher and the price level is lower. The key connection between money and a gold standard is redeemability. Checks or paper currency denominated as a dollar can be redeemed for the amount of gold that defines the dollar. The quantity of paper money is limited to the demand to hold that money at the contractually-fixed price.

When redeemability ends, so does the gold standard. This can be temporary, as happened when the U.S. left the gold standard during the Civil War, but then returned to gold in 1879. On the other hand, it can be permanent, as occurred beginning with the Roosevelt administration in 1933 and completed by Nixon in 1971,

When the unit of account is defined in terms of paper money, then the Fed controls the price level. Since the paper is solely used as money, the price level adjusts so that the real quantity of money is equal to the amount of real purchasing power people want to hold. The Fed can adjust the quantity of money to meet the demand at a stable price level. At the same time, this adjusts total spending in the economy to meet the productive capacity of the economy. And it also generates market interest rates that balance saving and investment.

While paper money has great potential benefits, perfection requires that the Fed have God-like knowledge. While the demand for most goods can be gauged by watching purchases, the demand for money cannot be directly observed. People demand more money by spending less. The Fed adjusts the quantity of money to keep the interest rate on overnight loans between banks on target. However, their approach requires the Fed to adjust the level of that particular interest rate consistent with balancing saving and investment. Perfection is not a real option.

The most serious threat created by paper money is the temptation of irresponsible politicians to create money to spend rather than simply issue the quantity people are willing to hold. In the extreme, an irresponsible government can easily create Zimbabwe-like hyperinflation.

We are on the cusp of creating such a risk. It is time to consider a return to redeemability. But rather than a gold standard, economist Scott Sumner’s proposal for index futures redeemability should be tried. The Fed should be required to buy or sell an index future’s contract on nominal GDP at a price that reflects growth in total spending consistent with the long run trend growth in the productive capacity of the U.S. economy.

An intentional policy of inflation by the Fed would result in excessive growth in spending in the economy. GDP would rise above target, and profits would be available to anyone who “redeemed” money by selling index futures to the Fed. Settling those contracts would impose financial losses on the Fed, taking way any financial benefit from inflation.

More importantly, index futures redeemability creates a market process for investors to keep spending on target. Those expecting low GDP would expect to make money from buying futures contracts from the Fed, while those expecting excessively high GDP would expect to make money by selling the contracts to the Fed. By purchasing or selling securities and adjusting the quantity of money, the Fed can impact expected spending so that the market expects GDP to remain on target. If the Fed fails to make the necessary adjustments, it would bear the risk of financial loss.

The Fed has failed to keep nominal GDP growing with the productive capacity of the economy. It is time to impose restrictions on the Fed and begin to harness market forces to provide for macroeconomic stability.

Copyright © 2009 by William Woolsey and The Free Enterprise Foundation. All rights reserved

About the author: Professor William Woolsey is a member of The Free Enterprise Foundation's editorial staff and senior writer on national economy reporting. Dr. Woolsey is a distinguished Professor of Economics in the Citadel’s School of Business Administration and a former Libertarian candidate for Congress.

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