Friday, June 26, 2009

Gold Standard

In most countries central banks control the supply of money. In the United States the Fed increases the supply of money by buying treasury bills on the open market or by buying bonds issued directly by the U.S. Treasury. The Treasury Secretary (currently Geithner) is a cabinet member in the presidential administration and can thus be pressured to sell bonds to allow the federal government to increase spending. If the Fed submits to the will of the Treasury by buying bonds whenever the federal government wants to spend money, there is a significant danger of inflation. Marriner S. Eccles was important in American history because he was a strong advocate of Fed independence. There is an inverse correlation between central bank independence and inflation.

Many people have argued that a gold standard is one way to ensure that federal government lives within its means. A gold standard, in theory, could prevent central banks from printing too much money and thereby causing rampant inflation.

One problem with a gold-backed currency (or a silver-backed currency, or any other –backed currency) is that the government determines the value of the currency. It mandates that, say, $20 is equal to an ounce of gold. If the government sets the gold/dollar exchange rate (as it did throughout the 1800s), the government can modify the exchange rate to reduce debt through inflation. The U.S. federal government did exactly this prior to World War II.

According Milton Friedman: “I think those people who say they believe in a gold standard are fundamentally being very anti-libertarian because what they mean by a gold standard is a governmentally fixed price for gold.” Of course, a gold standard where the dollar/gold exchange rate is determined by the market would not have the same “immoral” problem, but that’s not what most people argue for when they say we should return to the gold standard.

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