Wednesday, December 05, 2007

Dollar Backed by Gold

When people buy gold, many seem to have the misconception that the US dollar is backed by gold. Well ... it used to be. The US currency, like many other currencies at the time, was backed by physical gold kept in Fort Knox and other places.

In 1933 the US abandoned the Gold standard along with many other nations, such as Italy in '34, Belgium in '35 and others during the 1930s. Switzerland was one of the last countries to drop the gold standard and this was done in 1999 by the approval of a new constitution that eliminated the traditional requirement for the country's currency to be backed by gold.

The gold standard monetary system is a system in which the standard economic unit of account is a fixed weight of gold. Under such a gold standard, currency issuers guaranteed to redeem notes, upon demand, for that amount of gold. Also governments that employed such a fixed unit of account, were able to redeem their notes to other governments in gold and share a fixed-currency relationship.

However, these days, the gold standard is not currently used by any government or central bank, having been replaced completely by fiat currency. Money is NOT, therefore backed by gold, or any other precious metal but, instead, is backed by faith. The money is, in other words, as good as people believe it is good. People are generally educated to regard money as a precious commodity in itself by virtue of the amount needed to purchase desirable and needed items.

By controlling the interest rate and the amount of money in circulation together with the use of a tax monitoring system, makes it easier to manipulate the economy.

Since the abandonment of the gold standard, economies around the globe have shown the apparency of a healthy economy, but in reality what has happened is that there has been little or no check on inflation resulting in a decreasing value of the currency, such as the US dollar so that it now requires many more dollars to purchase the same items as it did many years ago.

The value of gold has remain the same however with one ounce of gold still purchasing the same as it did 20 or 50 years ago.

What we use today is a system of fiat money. One glossary defines money as "money that is intrinsically useless; and suitable only as a medium of exchange. A more accurate definition perhaps is that money is, "an idea backed by confidence."

The main benefit of a gold standard is that it insures a relatively low level of inflation. In articles such as "What is the Demand for Money?" , we see that inflation is caused by a combination of four factors:

1. The supply of money goes up.
2. The supply of goods goes down.
3. Demand for money goes down.
4. Demand for goods goes up.

So long as the supply of gold does not change too quickly, then the supply of money will stay relatively stable. The gold standard prevents a country from printing too much money. If the supply of money rises too fast, then people will exchange money (which has become less scarce) for gold (which has not). If this goes on too long, then the treasury will eventually run out of gold.

A gold standard restricts the Federal Reserve from enacting policies which significantly alter the growth of the money supply which in turn limits the inflation rate of a country. This may give an inkling of the reasoning behind the removal of the gold standard.

So it would appear that the major benefit to the gold standard is that it can prevent long-term inflation in a country. However, as Brad DeLong points out, "if you do not trust a central bank to keep inflation low, why should you trust it to remain on the gold standard for generations?" It does not look like the gold standard will make a return to the United States anytime in the foreseeable future with the dollar being back by gold.

None of this should make any difference when it comes to buying gold of course. In fact, to buy gold is probably a better idea than to buy currency!


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