Would a Gold Standard Save the Dollar?

With the greenback hitting 40-year lows, some argue for a return to a system where the U.S. dollar is linked to the yellow metal

by David Bogoslaw

These are uncertain times for the U.S. dollar as every day seems to bring fresh all-time lows for the buck against other major currencies. And an uncertain present tends to make people pine for a rose-colored past.

The most extreme expression of this longing is the call by some for a return to the gold standard.

The longing for the stable currency values seen under the fixed exchange rate system of earlier years is understandable as people fret over the effects of the greenback's fall: everything from a loss of purchasing power at home to higher prices for goods and services on overseas trips.

The value of the dollar has been declining since 2002. The U.S. dollar index, a futures contract offered by the New York Board of Trade, which reflects the dollar's standing vs. other major currencies, has been hovering at 40-year lows since the subprime-fueled liquidity crisis this past summer. On Nov. 20, the euro climbed to a new all-time record high of $1.4815, partly in response to the Federal Reserve's more dire forecast for U.S. economic growth.

Trade Partners Diversify Currencies

Lately, there have been plenty of headlines about the loss of confidence in the dollar by key U.S. trade partners, which could accelerate the dollar's devaluation if any of them decide it's time for a policy change.

Take some of the leading oil-producing countries in the Middle East. With the price of oil poised to break through the $100-per-barrel threshold, countries such as the United Arab Emirates and Qatar are said to be considering moving away from pricing crude in terms of dollars in favor of a basket of currencies. Kuwait exchanged its strict dollar peg for a currency basket earlier this year and there's concern that if other countries follow suit, it could reduce demand for the buck and spur other central banks to diversify their holdings, The Wall Street Journal reported on Nov. 20.

The buck's weakness makes this a perfect time for a return to the gold standard, according to Nathan Lewis, author of Gold: The Once and Future Money. Lewis is advising the UAE to consider adopting a gold peg instead of a basket of currencies if it moves away from a dollar peg for its oil.

Is Gold the Answer to Stability?

Gold bugs like Lewis argue that the ideal currency is one whose value is stable, and they hold that gold is historically the most stable form of money. They believe an unstable currency such as "fiat money," the value of which is determined by governments, is all too vulnerable to manipulation by corrupt politicians and increases the risk of inflation and deflation.

The gold standard that Lewis is advocating wouldn't be the same as the one whose heyday was between 1870 and 1914, when central banks were required to hold a certain portion of gold in reserves to ensure their currencies' stability. Instead, he's pushing for a mechanism under which the value of the dollar would be fixed to a predetermined quantity of gold rather than a targeted interest rate. He proposes that the Fed be replaced by a currency board with only one responsibility—to adjust the money supply in order to maintain a constant value of the dollar in terms of gold. Under such a system, interest rates would be set by the market and the money supply would be set by gold itself.

"You just simply change your target, from an interest rate targeting policy to more like a currency board policy," Lewis says. "Functionally, the dollar would no longer go up and down."

We've Tried It Before

But that's flat-earth thinking to some. Economic historians such as Barry Eichengreen, author of Golden Fetters: The Gold Standard and the Great Depression, 1919-1939, believe that the commitment to the gold standard was a key factor that prevented governments from taking the necessary actions to fight the Great Depression, such as expanding the money supply to encourage business growth. Fearing a bank run, the U.S. finally abandoned the gold standard in 1933 but returned to a modified version of it in 1945, when the Bretton Woods international monetary system of fixed exchange rates was established.

Critics of the gold standard, including most mainstream economists, argue that countries experiencing downward pressure on the value of their currencies are forced to contract their economies, while no comparable adjustment is required of countries whose currencies are gaining value. In fact, under the gold standard, there's a tendency for countries that run trade surpluses to prevent their money supply from expanding when gold flows in from countries with trade deficits by boosting their sales of government bonds and retiring the money they get for them. This disrupts the natural rebalancing of trade and prolongs the suffering of countries whose currencies are under pressure.