Perhaps one of th biggest mistakes people make when talking about the gold standard, is to do so as if there were just one. In fact, a gold standard system, can work and operate in many different ways, though the main idea is always the same; To adjust the monetary base of the currency so that the value be kept stable(doesn’t change), in relation to gold.
We will now look into these different types of gold standard:
Making change system: This term is coined by Nathan Lewis in his book, Gold: The Monetary Polaris, to describe a system with direct redeemability of gold. This means that the currency issuer promises to exchange the currency, on demand, for its established value in gold. This kind of system operated and worked in the U.S. during the free-banking era as well as after the charter of the first National Bank of the U.S. when currency issuing became more limited and centralized.
You will notice in the top left-corner how it says, redeemable in gold on demand at the united states treasury…
There are some key advantages of using this kind of system. First, people can easily change their money for actual gold, which always inspires more confidence. Secondly, the money supply is adjusted in a decentralized way. In this system, changes in the supply of money come about when people go to the bank and redeemed their cash for gold or convert their gold to cash. Redeeming would decrease the supply of money and support its value, while converting would increase the supply and depress its value.
This system is simple and would work well for a small country, while it may pose some more logistical problems for a big country.
In reality, this kind of system, with purely 100% gold reserves has not been operated since the 17th century with the bank of Amsterdam.
Most forms of the gold standard combined both gold holdings, and other form of reserve assets such as bonds. This means that the currency issuer, be it the State or private banks, would not just have gold, but also assets which pay back interest such as bonds. The fact is, that it wasn’t really necessary to keep around so much gold, since operational transactions could involve at the most around 20% of the reserves. This meant that currency issuers could use interest bearing assets such as bonds, which is what they use now, as part of the monetary base.
This kind of system could also still feature redeemability, or could be managed in a centralized way at the discretion of the currency issuers.
We might call this a discretionary gold standard. In this system, the adjustments in the monetary base would be done at the discretion of the currency issuer. These decisions would still be made by looking at the market price of gold. If the currency is falling in value, the currency manager would sell bonds, or gold, or a combination of both, to again, reduce the amount of base money and support the value. This kind of system was the one operated by the Bank of England in 1850.
Finally, we have our last gold standard system. The no gold gold-standard.
We have seen how we can run a gold standard with gold, with gold and bonds,(interest bearing assets), and finally, we have a gold standard with no gold!
In this case, the currency issuer, would simply denominate the base money in gold indexed bonds. This time, we have no gold, but we can still adjust the money by buying and selling bonds, just the way they do today. As long as what you are pursuing is a stable value, in relation to gold, this gold standard system will work.
This is exactly the kind if system Germany implemented to end its period of hyperinflation in 1927. The new Rentenmark was issued following these directives. All it took was one man and his secretary, and no gold. The hyperinflation ended, and the new Rentenmark maintained its value.
In conclusion, as we have seen, there are many ways to operate a gold standard system. One size doesn’t fit all and each country may benefit more or les from having one system or the other depending on particular circumstances. Overall, however, I find , and so did J.S. Mill, that a system of actual redeemability, where you can actually go and demand gold at the bank, is preferable. This kind of system is decentralized and more “free-market”, since the supply is determined by the interactions of individuals in the market and not by a central agency.Furthermore, gold standard-systems without redeemability tend to have more flaws and currency managers will have more incentives to deviate from their mandate. The redeemability helps to keep the system in line.
I hope this post will shed some light on the mystery that today surrounds the gold standard.
Finally, I invite you all to download Nathan Lewis’ book, recently made free in pdf format. You can download it at newworldeconomics.com
Nathan Lewis is, as far as I know, the most knowledgeable economist on the matter of gold and currencies.