The following is excerpted from commentary that originally appeared on the Euro Pacific Capital website.
As it is now being considered, the [Republican] platform stops short of recommending a return to the gold standard, but does advocate a commission to consider the possibility. However, judging by the reaction with which many Republicans have greeted the idea, one would think that the platform might as well have called for the return of slavery.
The fact that so many supposed conservatives liken a belief in a gold standard as the monetary equivalent of membership in the Flat Earth Society shows just how far the American public has come from a true understanding of how money works within an economy. But, if there were a parallel to be made between gold enthusiasts and flat earthers, then it should strike many as curious that the world's top central bankers, who can be seen as the equivalent to the most advanced astronomers, continue to hold so much gold in their vaults. If gold were so obsolete, why would these bankers hedge their positions?
The general idea among most economists is that gold would be a step backward for our modern monetary system -- the equivalent of trading in an automobile for a horse and buggy. However, paper money is not new. It's been around for centuries, and has been tried many times, on many continents. But every time it has been used, it has led ultimately to economic disaster.
At the time of America's founding, the uses and abuses of paper money were well understood. The Founding Fathers could have empowered the Federal Government to print paper money, a power enjoyed by the Continental Congress under the Articles of Confederation. However, the Constitution represented an improvement on that system. The framers, having just experienced the horrors of the Continental currency (which had been used to finance the War of Independence) opted to limit Federal monetary powers to coining money, which for legal tender purposes they defined as gold and silver.
As a result of that wise choice, our national economy thrived, and eventually became the richest on earth. In contrast, since the time that the standard was abandoned in 1971, America has become the world's largest debtor nation and is now teetering on the brink of financial ruin. It's ironic that gold standard critics look back to Nixon's decision to close the gold window as proof that the standard does not work. In reality, it was precisely because the gold standard was working so well that Nixon felt he had no choice but to abandon it.
In 1971, adherence to the gold standard meant the Nixon administration faced a politically difficult decision. Big increases in government spending associated with the Great Society programs, the war on poverty, the Vietnam War, and the Space Race, resulted in large deficits (by 1971 standards of course). This led the government to print lots of money, thereby hitting Americans with large doses of inflation. As a result, general prices had by then tripled from the levels seen in 1932. But the price of gold had been held at 35 dollars per ounce. This led America's foreign creditors to exchange their paper dollars for gold (It was illegal for American citizens to do likewise). This created a drain on our gold reserves, and if something were not done, it was likely that the U.S. would lose all of its reserves.
Staying on the gold standard left the government with only two options. One was to devalue the dollar and raise the price of gold consistent with the increase in the CPI. That would have required a gold price of over 100 dollars per ounce. Alternatively, the government could have removed the excess dollars from circulation, bringing consumer prices back in line with 35 dollar gold. In other words, the choice was devaluation or deflation. Neither was politically appealing, and both would have brought deficit spending to a halt.
The gold standard forced the government to responsibly confront irresponsible fiscal policy. At first Nixon tried devaluation, but the amounts were far too small to stop the gold drain. As an escape hatch, he instead abandoned the gold standard (although he said that the move was temporary). Without this "relic", government could continue to finance its spending with ever larger deficits without losing any more gold. So instead of devaluation or deflation, we chose inflation instead. Many consider the impossibility of running perpetual deficits under the gold standard as proof of its unsuitability to the modern economy. As I see it, this is precisely why the gold standard is so desirable and so badly needed today.
Proponents of the centrally planned pump-priming, deficit-spending welfare state see the gold standard as the enemy of a healthy economy. However, if you believe in individual liberty and limited government, then the gold standard is your best ally. Had Nixon made a more responsible decision, the initial pain might have been worse, but we would have ended the decade in much better shape. And had we stayed that course, our nation would be far wealthier today as a result. We would not have been enabled to bleed away our wealth through two generations of deficit spending.
Many people also look badly on the gold standard because it prevents central banks from using monetary policy to manage the economy. This, of course, may be its greatest attribute. Under a gold standard, the free market determines money supply and interest rates. Under our current system of paper money a few politically connected bankers make those determinations. The results have been disastrous, with the recent housing bubble and financial crisis being just the latest iterations.
In a market economy, prices must be discovered by supply and demand. Interest rates, which can be described as the price of money, are arguably the most important prices of all. The only way to get it right is to let the market do its work. Empowering politically motivated central bankers to fix the price instead is a recipe for disaster. Unfortunately, we have now all had a good taste, and a return to the gold standard is the only way to refresh the palate. I hope the Republicans have the stomach to see it through.
Peter Schiff is the CEO and chief global strategist for Euro Pacific Capital. This commentary originally appeared in the July issue of the firm's Global Investor Newsletter.