Policy Analysis No. 16

The Gold Standard: An Analysis of Some Recent Proposals

By Joseph T. Salerno
September 9, 1982

Executive Summary

The case for a free-market commodity money as provided by a genuine gold standard is simple yet decisive. It is based on the insight that the root cause of inflation in the modern world is the almost absolute monopoly over the supply of money which all national governments possess within their respective political jurisdictions. That such an arrangement necessarily produces inflation is not difficult to explain.

To begin with, almost all governments obtain the bulk of their revenues through taxation which, regardless of its particular form, ultimately involves — indeed, is definable as — a coerced levy upon the monetary incomes or assets of its citizens, i.e., the net taxpayers. However, whatever ethical or practical considerations may be brought forward to justify taxation, since it is essentially coercive, tax increases have always found little favor among the citizenry So, ever fearful of arousing popular unrest, governments naturally sought alternative means for augmenting their revenues from taxation. It was for this purpose that all national governments eventually secured for themselves a legal monopoly of issuing money, empowering them to inflate, i.e., to create new money, virtually at will.

Especially under today’s various national fiat-money standards, inflation provides a relatively simple, costless, and secure means for amassing money assets. In substance, all a government needs to do to increase its real income is slap some ink on paper and spend the proceeds on commodities and services produced by the private market. In this way, the national government is able to divert scarce resources from private uses and utilize them for its own purposes, while circumventing the popular discontent which invariably accompanies an overt imposition of higher taxes. Actually, in the world of modern monetary and financial institutions and practices, inflation entails a much more arcane process than the mere printing and spending of new units of currency This fact obscures the true cause of inflation from the public and permits the government to shift the blame for the monetary unit’s shrinking purchasing power and other undesirable consequences of inflation from itself to other groups or to circumstances beyond its control. These include OPEC, monopolistic corporations, powerful labor unions, spendthrift consumers, unfavorable weather conditions. etc.

It should be no surprise, then, that all government-monopolized fiat moneys exhibit symptoms of inflationary disorder — just as it is no surprise when other groups in the economy exploit the monopoly privileges granted them by law to increase their money incomes, e.g., via tariffs, occupational licensure, exclusive public franchises, etc. Indeed, it is a general lesson of history as well as a rule of common sense that an individual or group endowed with a legal monopoly over any area of the economy will use it to its own pecuniary advantage. To put it rather bluntly, government is an inherently inflationary institution and will ever remain so until it is dispossessed of its monopoly of the supply of money.

Indeed, lately an increasing number of economists have come to regard inflation as a necessary consequence of the political control of money. Most prominent among them is F. A. Hayek, Nobel laureate in economics, who has forcefully argued that the recurring bouts of macroeconomic instability which have always afflicted market economies are “a consequence of the age-old government monopoly of the issue of money.”[1] According to Hayek, furthermore:

… there is no justification in history for the existing position of a government monopoly of issuing money. It has never been proposed on the ground that government will give us better money than anybody else could. It has always, since the privilege of issuing money was first explicitly represented as a Royal prerogative, been advocated because the power to issue money was essential for the finance of government — not in order to give us good money, but in order to give to government access to the tap where it can draw money it needs by manufacturing it. That, ladies and gentlemen, is not a method by which we can hope ever to get good money. To put it into the hands of an institution which is protected against competition, which can force us to accept the money, which is subject to incessant political pressure, such an authority will not ever again give us good money.[2]

Even “mainstream” economists have begun to express similar views. For example, respected monetary theorist Robert J. Barro concludes in a recent study:

In relation to a fiat currency regime, the key element of a commodity standard is its potential for automaticity and consequent absence of political control over the quantity of money and the absolute price level… The choice among different monetary constitutions — such as the gold standard, a commodity-reserve standard, or a fiat standard with fixed rules for setting the quantity of money…may be less important than the decision to adopt some monetary constitution. On the other hand, the gold standard actually prevailed for a substantial period (even if from an “historical accident,” rather than a constitutional choice process), whereas the world has yet to see a fiat currency system that has obvious “stability” properties.[3]

And William Fellner of the American Enterprise Institute reluctantly admitted recently that there is a “substantial element of truth involved in the assertion that fiat money has been misused in all history — has always led to the corruption of the currency.”[4]

At this point, it should be noted that the fatal flaw in the monetarist program for monetary stability lies in the fact that its policy prescriptions completely fail to address the fundamental cause of inflation, namely, the governmental monopoly over money. The monetarist “quantity rule,” according to which a governmental agency such as the Fed is to maintain a stable rate of growth in the quantity of money, is not an anti-inflation policy at all. It is merely the enunciation of a request that the political authorities exercise restraint in exploiting their monopoly of issuing money, which, under the monetarist program, would remain virtually intact. Such a request, I might add, is incredibly naive in the light of theory and history.

The virtue of a genuine, 100-percent gold standard, in contrast, is precisely that it establishes a free market in the supply of money and, in doing so, brings about a complete abolition of the governmental monopoly in this most sensitive and vital area of the market economy. Under a pure commodity money, the money-supply process is totally privatized: The mining, minting, certification, and storage of the money commodity as well as the issuance of fully covered, i.e., 100-percent gold-backed, bank notes and deposits are carried out by private firms operating in a free market.

The complete “denationalization” of money which thus occurs under a genuine gold standard yields a money whose value is fully secured against arbitrary political manipulations of its supply. Under the gold standard, the quantity of money and hence its value is determined solely by market forces, such as the demands of the public for money and the costs associated with digging up gold. While the purchasing power of a pure commodity money such as gold, like the price of any commodity on the free market, therefore tends to fluctuate according to changes in its supply and demand, there exists an inherent long-run tendency to stability in the value of such a money.[5] This contrasts sharply with a government-monopolized fiat money which, as noted above, is inherently inflationary and subject to large, unpredictable fluctuations in value over both the short- and long-terms.

It is noteworthy that, although he regards a pure commodity standard as ultimately undesirable because of its high resource cost, Milton Friedman recognizes its unique potential as a guarantee of monetary stability. Writes Friedman:

If money consisted wholly of a physical commodity…in principle there would be no need for control by the government at all…

If an automatic commodity standard were feasible, it would provide an excellent solution to the liberal dilemma of how to get a stable monetary framework without the danger of irresponsible exercise of monetary powers. A full commodity standard, for example, an honest-to-goodness gold standard in which 100 percent of the money consisted literally of gold, widely supported by a public imbued with the mythology of a gold standard and the belief that it is immoral and improper for government to interfere with its operation, would provide an effective control against government tinkering with the currency and against irresponsible monetary action. Under such a standard, any monetary powers of government would be very minor in scope.[6]

To briefly sum up, advocacy of the gold standard is based on the view that governments are inherently inflationary institutions; therefore, the only realistic and lasting solution to the problem of inflation is to completely separate the government from money and return the latter institution to the free market whence it originally emerged.

Read the Full Policy Analysis

Joseph T. Salerno is an assistant professor of economics at Rutgers University.