What Would Happen If We Returned to the Gold Standard?

Gold certificates, used as paper currency in the United States from 1882 to 1933, were freely convertible into gold coins. CREDIT: Public domain View full size image

Among the many factions of Americans who believe the country is headed in the wrong direction, one fervent group traces its wrong turn back to Aug. 15, 1971. On that day, President Nixon eliminated the gold standard — a monetary system in which dollars were backed by and could be exchanged for a fixed amount of gold. Since then, the United States has used a fiat currency, in which dollars are valuable simply because the government says they are.

A recent upsurge in pining for the gold standard among tea partiers and libertarians has led 13 conservative states to adopt or consider laws in the past year that would allow gold and silver coins to be used as legal tender. Meanwhile, Republican presidential candidates Ron Paul and Newt Gingrich are both urging policymakers to consider a nationwide return to the gold standard — a move they say would rein in inflation and take the country back to an era of financial stability, by barring the government from putting new paper money in circulation unless an equal amount of gold is mined.

However, mainstream economists are overwhelmingly against a return to the gold standard. Why? What effects would it have if it were reinstated today? We've polled several experts to find out just that.

Ups and downs

Contrary to the belief that gold standards stabilize prices, the most dramatic historical episodes of deflation and inflation occurred when the United States had one in place. According to William Gavin, an economist at the Federal Reserve Bank of St. Louis who has conducted research on the effects of a gold standard on price levels, pegging the dollar to gold would make prices fluctuate wildly. "With the gold standard you have far too much price volatility," he told Life's Little Mysteries.

This is because, even if the price of gold is fixed, demand for it continues to wax and wane. People tend to hoard gold during periods of economic uncertainty, and this causes prices to fall (deflation). "When you take money out of the system by hoarding gold, that makes the available money able to support transactions and economic activity go down," Gavin explained. Less money in circulation means prices fall and unemployment rises, and the government must adjust interest rates in response to try to stimulate economic activity.

Historically, when a gold standard was in place, the average unemployment was almost 2 percentage points higher, and a measure of price volatility called the "coefficient of variation" was 13 times higher.

Furthermore, with the gold standard, the financial system frequently experienced shocks and rapid inflation due to new gold discoveries, such as the California Gold Rush of the 1840s and '50s. These unpredictable increases in the money supply tended to be less beneficial to the economy than the kind of controlled increases enacted by the Federal Reserve today.

In Gavin's opinion, people who support the gold standard are "looking at history through rose-colored glasses." [Why Did Gold Become the Best Element for Money?]

Hard money, hard times

If the United States returned to the gold standard and then faced an economic crisis, the government would not be permitted to use monetary policy (such as injecting stimulus money into the economy) to avert financial disaster. Similarly, the government would no longer have the option of creating money in order to fund a war.

This inflexibility means any small economic downturn would be expected to rapidly intensify, because there would be few mechanisms available for stopping a plunge. Barry Eichengreen, an economist at the University of California, Berkeley, argues that this economic rigidity greatly exacerbated and prolonged the Great Depression during the 1930s. If, after the 1929 stock market crash, the government had immediately abandoned the gold standard and taken measures to curb deflation and job losses, the crisis could have been minimized.

Even during the period that many gold supporters view as a golden era of economic prosperity — the years from 1880 to 1914, when the majority of countries went on a gold standard together — financial crises occurred repeatedly and were severe and disruptive and led to sharp recessions. "The idea that this was a smoothly functioning monetary system is not correct," Eichengreen told Life's Little Mysteries.

Supporters of the gold standard may wrongly attribute the economic growth and boom in international trade during that post-Civil War period to the monetary system that was in place, when in fact the gold standard caused frequent problems in a time that was otherwise experiencing the glory of the Industrial Revolution.

In a recent article about the recession of 2008-09, Eichengreen and economist Peter Temin of the Massachusetts Institute of Technology argue that it was the government's aggressive fiscal stimuli that helped the United States avoid a Depression-level catastrophe three years ago. If we had still been on the gold standard, the government would not have been permitted to take palliative measures, and the downfall would have been disastrous.

In short, gold standards "intensify problems when times are bad," the economists wrote. [5 Facts about the Wealthiest 1 Percent]

Gold at a price

The immediate consequences of pegging the dollar to gold would depend on what dollar amount was chosen, according to Michael Bordo, an economist at Rutgers University who is recognized as a leading expert on the gold standard. And picking the right price would be extremely difficult.

"If the price at which gold is pegged is too low, then we would get long-run deflation as in the 1920s and '30s," Bordo said. In effect, the attractively low price of gold would cause people to trade in their dollars, and gold hoarding would drive prices down. If, however, the price set for gold is too high, "then we would get long-run inflation," Bordo said — exactly what advocates of the gold standard despise most.

On top of all the other drawbacks, it would cost a tremendous amount to produce and maintain the gold coins we would need for a return to the gold standard. In 1960, the economist Milton Friedman estimated that maintaining a  gold coin standard costs 2.5 percent of the Gross National Product, or more than $350 billion today.

Follow Natalie Wolchover on Twitter @nattyover. Follow Life's Little Mysteries on Twitter @llmysteries, then join us on Facebook.