The Truth About Gold as Money

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Combine gold's heady price gains over the last several years, greater access to the gold ownership through products such as the SPDR Gold Shares (NYS: GLD) , and concerns about the monetary stewardship of the Federal Reserve, and it's no wonder the idea of a resumption of the gold standard has gained some currency lately. Proponents would have us believe that the gold standard is a cure-all for government corruption, profligacy, and incompetence. The unvarnished truth, however, is that gold is no panacea -- one need only look at history for examples.

Financial crises are not just a 20th-century phenomenon
Last July, in response to a question from Rep. Ron Paul (R-Texas), Fed Chairman Ben Bernanke reminded the Congressman that "the reason the Federal Reserve was founded a century ago was to try to address the problems arising from financial panics, which did, by the way, occur in an unregulated environment in the 19th century." (See the exchange for yourself.) In fact, a significant proportion of the classical gold-standard era coincided with the Long Depression, which spanned from 1873 to 1896 and included the panics of 1873, 1884, and 1893. Some of these crises were accompanied by significant declines in industrial production.

Joe Davis of the Vanguard Group and the NBER has analyzed the U.S. business cycle between 1796 and 1914. He found that the periods of economic contraction during the post-Civil War period (1866-1914) were a bit more frequent and longer than they have been in the post-World War II era. (Note, however, that his paper was published in 2004 and does not include the Great Recession the U.S. experienced as a result of the credit crisis.)

Who's with me?
There is another problem: The U.S. is not the only country that abandoned the gold standard. Are gold enthusiasts advocating a return to an international gold standard? If the U.S. were to go it alone, macroeconomic stability would be anything but assured. As Dr. Michael Bordo, a professor at Rutgers and an expert on the gold standard, wrote in 1981: "This suggests that one country alone on the gold standard would likely find its monetary gold stock and hence its money supply subject to persistent shocks from factors beyond its control."

Incidentally, Bordo is hardly a rabid statist: He took his doctorate at the University of Chicago and is a fellow of the Hoover Institution.

The fundamental illogic of a gold standard
Hard-money advocates are fixated with removing control of the money supply from the government and/or central bankers, to a point where they appear willing to completely ignore some of the problems with a gold standard.

 Under a genuine gold standard, the money supply is equal to the supply of gold -- and by "genuine," I'm referring to a system in which money is either made of gold or, more realistically, is fully backed by and redeemable in gold. Now, if you want to argue that the Chilean peso should be based on copper -- which makes up the country's major industry -- I can agree that there is at least some logical basis for the notion. However, what's the economic justification for tying the U.S. money supply to world gold mining output?

Under this standard, advancements in gold-mining technologies or discoveries of new, easier-to-mine gold deposits alter the purchasing power of money, i.e., the price level of goods and services in the economy. If gold were money, these developments would imply a direct increase in the money supply. For the "money market" to clear, the price level in the economy must increase. Indeed, you now have more gold chasing the same amount of goods services, with each ounce of gold now buying fewer of those same goods and services.

Although I've described this phenomenon in theoretical terms, this is exactly what happened when gold was discovered in California in 1848. Gold proponents will argue that the resulting inflation was less than the average inflation we are entirely accustomed to under a fiat money system. That's quite true, but my question remains: What is the basis for tying prices to mining activity? On this question, I'm aligned with an Economist reader who wrote: "The money supply is far too important to the health of the economy to be left to the happenings of the mining economy."

Show me
Is fiat money and fractional reserve banking a perfect system for facilitating the stable development of the U.S. economy? No. However, it's quite a leap from that observation to the conclusion that a gold standard would automatically function better. Given gold's record as a currency, the burden of proof we should require from its advocates is much higher than that.

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At the time this article was published Fool contributorAlex Dumortierholds no position in any company mentioned. Check out hisholdings and a short bio. You can follow himon Twitter. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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