Would a Gold Standard Save the Dollar?

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"It's been an extremely long time since we've been on the gold standard and it's hard to remember the problems that were associated with it," says Andrew Bernard, director of the Center for International Business at Dartmouth University's Tuck School of Business.

By the early 1970s, U.S. fiscal policy was in disarray, American goods had lost their competitiveness in international markets and the balance of payments surplus of the late 1960s had reversed to a soaring deficit. Worried that it wouldn't be able to meet increased demand by foreign central banks to convert their growing dollar reserves into gold at $35 per ounce, the Nixon administration ended the Bretton Woods system. In August, 1971, the U.S. closed the gold window that allowed foreign governments to convert their dollar assets into gold. A few months later, the imposition of a temporary 10% surcharge on all imports helped convince U.S. trading partners to let the value of the dollar drop against their currencies. The dollar was devalued by roughly 10.4% on average against the currencies of 14 countries with which the U.S. did about two-thirds of its trading.

Giving up the gold peg makes a country's currency more vulnerable to rising price levels. But the rewards include greater monetary flexibility, which can be used to help fight unemployment or recession, says Richard Barnett, assistant professor of economics at the Villanova School of Business outside Philadelphia.

"It smooths out the business cycle a little," he said.

If the goal of monetary policy is a stable currency, central bankers should be able to achieve that with the appropriate target on the inflation rate, Barnett says. He concedes that's more of a challenge for a large country like the U.S. than for smaller countries, because U.S. monetary policy has much bigger implications worldwide.

Treasury Bill Sell-Off Is Unlikely

The growing crisis of confidence in the dollar has recently generated speculation that China's central bank may be thinking of selling a major portion of the dollar assets it has accumulated over the past decade or more to shift into euro assets.

For the past several years, China and Japan have been buying U.S. Treasury bills and other U.S. assets in an effort to maintain a fixed exchange rate relative to the dollar. But with the euro's value rising against that of the dollar, they may be less and less willing to hold dollar assets to prop up the dollar's value.

When Germany decided in 1971 that it couldn't afford to keep importing inflation, it pared its dollar reserves and freed the Deutsche mark to appreciate against the dollar. Germany's abandonment of the fixed exchange rate was one of the factors that led to the demise of the Bretton Woods system. If China and Japan were to stop holding so many dollar assets, it could signal the end of the fixed exchange policy between their currencies and the dollar, Barnett said.

"The big concern is that they'd sell off all these T-bills and the price of T-bills would fall," Barnett said. "And because of the inverse relationship between T-bills and interest rates, interest rates would rise."

The Fed could respond to that by buying up Treasury bills, causing a surge in the U.S. money supply, which would send inflation soaring, he said.

But considering that the Chinese decided to bulk up on dollar assets in the 1990s in order to instill confidence in the Chinese banking system, that may be a reason for them to want to continue to hold dollars, Barnett added.

Any new currency reserve purchases by the Chinese and others are likely to be in euro assets instead of dollar assets, says Bernard at Dartmouth's Tuck School, But countries that hold large quantities of dollar reserves won't sell them because they don't want the value of their dollar assets to fall, he said.

How Far Will It Fall?

For Lewis, the dollar's current weakness is an unsettling reminder of the last time the dollar came under extreme pressure in the 1970s, "I've seen that once [the pace of depreciation] gets moving, it tends to keep going until someone gets aggressive to do something about it," he said.

Just as former Federal Reserve Chairman Paul Volcker had to pump up interest rates in order to arrest the dollar's declining value—a tactic Alan Greenspan also adopted in the late 1980s—Lewis predicts it's just a matter of time before Ben Bernanke turns to the same instrument to keep the dollar from falling further.

The major difference, however, between then and now is that the U.S. economy is currently fairly strong and inflation is pretty low, says Barnett. That's likely to help the dollar avoid a protracted downtrend, he said.

But as long as the greenback's woes remain front and center, some members of the small but enthusiastic gold crowd will continue to insist that a better path for the U.S. currency lies on the Yellow Brick Road.

Bogoslaw is a reporter for BusinessWeek's Investing channel .