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Why the US Tea Party dreams of a return to the gold standard are a bust

Eichengreen | Why the US Tea Party dreams of a return to the gold standard are a bust Anthony Harrington

A scathing Taiwanese satirical animation of the US Tea Party’s arrival on the Washington political stage depicts the Tea Party representatives as gun-toting babies. Of itself, without commenting on the quality of the rest of the animation, this acts as a wonderfully acute and condensed comment on the peculiar combination of naivety and hitting power which seems to characterize the newcomers – since they can be recruited for just about any crackpot notion the main parties want to fly, or which individuals in that party want to push. (View the animation here on the personal site of my co-blogger Ian Fraser.)

One of the sweeping transformations the Tea Party is keen on promoting is a return to the gold standard. Recently, in a penetrating and quite lengthy article, Barry Eichengreen shreds this idea comprehensively. It was, of course, never going to happen, but Eichengreen does a wonderful job of pointing out what is wrong with the idea and why the Tea Party should pick a different drum to beat on. He points out that not only would the US have to reinstate the gold standard and abolish the Federal Reserve, it would also have to ban fractional reserve banking to meet the Tea Party’s goals.

Ruling with a gold fist

The logic is simple. The Tea Party want a return to the gold standard because, following Hayek and the Austrian school (albeit unwittingly for most of them, who, one suspects, would struggle to tell their Hayek from a kayak) they want to get away from the boom-and-bust cycles that central banks allegedly generate through their ability to control the supply of fiat money. However, it is not only the central bank that creates money, mainstream banks in the US can lend far more than they take in as deposits, and every fresh loan that is not fully covered by the bank’s existing stock of deposits creates new money. So if you want to stop credit-fuelled booms leading to inevitable busts, you have to axe fractional reserve banking.

Even so, Eichengreen points out, there is yet a third step that would have to be taken. If you simply go to a gold standard but allow the market to create massive volatility in the price of gold you’ve pegged your currency to a fire storm. So, the logic of stability then compels government to set the price of gold. Now, the history of governments setting commodity prices, be the commodity gold or orange juice, is not a happy one. Moreover, since the Tea Party essentially wants government to get out the way and to shrink in size, giving government new draconian price-setting powers looks just a tad contradictory. You can’t champion market liberties with the left hand and impose price controls with the right. Life doesn’t work that way.

Moreover, Eichengreen points out, if and when you do manage to impose a pure return to the gold standard, with no fractional reserve banking, you have to answer the question of how you fund growth. Logically, as the economy grows the same stock of money would have to spread itself around ever more goods. The only way this can happen is for prices to fall. Money is scarce, goods are plentiful, so the law of supply and demand will drive up the purchasing power of every dollar. In the Austrian school account of things, this equates to an ever-closer approximation to the good life. The same wage buys you more and more goodies. In reality, of course, as Eichengreen points out, what we’re talking about here is roaring deflation, and wages would be caught up in the downward price spiral. Japan has been struggling since the nineties to extricate itself from the Saragossa Sea of economic stagnation that goes with deflation, so anyone keen on a return to the gold standard would be well advised to study Japan’s fate in depth and detail until light dawns upon them and they grasp that deflation is not a good thing, and certainly not something you want to engineer into the system.

Not worth the paper it's written on

However, an interesting twist to the gold standard argument comes from an article in MoneyWeek. The theme of the piece is that with the price of gold briefly touching $1900 an ounce in August, what we are seeing is a de facto rejection by investors and central banks of paper currencies and a return to gold. In other words, we are getting a kind of home-brewed “lite” version of the reinstatement of a global gold standard. What is happening, the article argues, is not so much that the price of gold is rising, but that the value of fiat currencies is falling. The author argues that paper currencies have been overvalued for at least the last four decades, and that overvaluation is now being grasped by investors, who are voting with their feet and diving for bullion.

Where does that leave the rest of us, never mind the gun-toting babies of the Tea Party? With paper currencies heading for hyperinflation and gold heading for $20,000, and then by as many zeros as you want to add? I somehow doubt that this is what we will see playing out, even if Europe and the US do slide into a fresh recession before the end of 2011.

Further reading on boom-and-bust cycles and the global financial crisis:

Tags: Austrian School of Economics , Barry Eichengreen , boom-and-bust cycles , bullion , commodity prices , fiat currency , fiat money , global financial crisis , global financial reform , gold , gold price , gold standard , Hayek , Ian Fraser , Japan , MoneyWeek , Saragossa Sea , Tea Party , US economy , US Federal Reserve
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