Gold’s Volatility Is No Argument Against a Gold-Backed Dollar

Gold hit $4,300 last week before falling to $4,166 on Tuesday. (SEBASTIAN DERUNGS/AFP via Getty Images)

About the author: Alexander William Salter is a research fellow with the Independent Institute, an economics professor at Texas Tech University, and a researcher at the university’s Free Market Institute. He also holds a fellowship with the American Institute for Economic Research.

It’s a complicated time for the gold standard camp.

The precious metal’s price has surged 60% this year, recently topping $4,300 for the first time. For investors looking for a hedge against economic uncertainty, including a softening labor market and a U.S.-China trade war, gold seemed to be a haven.

But its price is highly volatile. Gold dropped nearly 6% on Tuesday—its largest fall in more than a decade. Although gold steadily rises over the long run, investors who go all-in on gold at the wrong time can lose their shirts. What goes up, often comes down.

Critics of gold use this fact to chastise the proponents of a return to a gold-backed dollar. They say gold’s volatility undercuts the argument that a gold-peg is a stabilizing force for currencies and that returning to it would help soothe inflation. Since gold’s price varies so much, they argue, tying the dollar to gold again would be disastrous. The dollar’s purchasing power would constantly be in flux, making it impossible for households, businesses, or the government to make rational financial decisions.

This seems like a reasonable concern. But it overlooks a basic principle: If the government reliably enforced the gold standard, there wouldn’t be big swings in gold supply or demand.

Gold is indeed volatile when it is untethered to the dollar, but prices would behave differently if there were a credible peg. And economics teaches us not to generalize data trends when the “rules of the game” change.

Suppose the dollar’s value was set at 1/4000th of an ounce of gold; a gold-backed dollar would tell us how much gold it takes to buy things. Gold skeptics worry these prices would jump around unpredictably in response to changed supply and demand in the global gold market. More troubling, a big increase in the global demand for gold could cause unexpected deflation—even a recession, they say.

But such demand fluctuations would be highly unlikely. If Uncle Sam’s commitment to gold is credible, there is no reason to buy gold as an investment or speculative asset. The U.S. Treasury (or private financial firms, with the government’s backing) will have pledged to honor dollar claims for 1/4000th of an ounce of gold per claim. No trades should occur except those that are consistent with the dollar’s stated gold content.

Contrary to some objections, this isn’t a price control. It is akin to defining a weight or measure. The gold content of the dollar becomes the hub around which the economic wheel revolves.

Supply is tricker. But even here we should expect relative stability; mining companies add gold to the global stock each year.

Big increases in gold flows might have a large effect on the global gold supply, which would cause a gold-backed dollar to lose some of its purchasing power. But this is unlikely. Mining companies wouldn’t want to expand production unless the global gold price significantly exceeds the costs of production.

In this scenario, the benefit of mining one more ounce of gold is $4,000—the definition established by the U.S. government. This seems like a lot. But remember that easily minable gold has already been extracted, and that all mining companies will find it very difficult to expand simultaneously without bidding up production costs. There might be a one-time increase in gold flows once redeemability kicks in, but after that, production rates will settle down. There wouldn’t be a huge spike in the cost of living. And there wouldn’t be the sustained dollar depreciation we take for granted under modern paper money.

It might seem paradoxical, but returning to a gold standard would result in much less volatility in the global gold market. This is an application of a general economic principle made famous by the monetary economist Charles Goodhart of the London School of Economics and the late Robert Lucas of the University of Chicago, who won the Nobel Prize for his contributions to macroeconomics. To wit: Economic policy evaluations based on historical data (the gold price) aren’t reliable if policy changes (adopting a gold standard) alter peoples’ behavior.

Of course, this only works if the government’s pledge is credible. For the U.S., with its massive economy and powerful government, it would be. But for smaller economies with weaker governments, such as Mexico, it wouldn’t. They simply aren’t hefty enough to stabilize the global gold price with a currency redemption promise. In the language of economics, it is a bad idea for small, open economies to adopt commodity money. For superpowers, however, it can be a winning proposition.

Like all currency regimes, gold-backed money has both costs and benefits. It isn’t obvious we should want to ditch the fiat dollar. But we can’t make rational policy decisions unless we know which objections are valid and which aren’t. The argument against gold on volatility grounds simply doesn’t work. That, at least, makes gold worth another look.

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