Last week, Dr. Jeffrey Herbener (a professor of mine at Grove City College) testified before Congress on the issue of the Federal Reserve and sound money. Among many things, here is one particular statement he made in his written testimony that often proves quite contentious:
“The primary step in monetary reform, then, is to turn [Federal Reserve Notes] into 100-percent-reserve redemption claims for gold coins.”
In layman’s terms, Dr. Herbener is arguing here that to establish sound money, the Federal Reserve ought to issue notes that can be backed by some commodity (gold) and thus regulated by profit-and-loss, like the production of every other economic good. Seems reasonable. But at least one part of the reason why such a claim is often contended is that it is commonly believed that the gold standard will limit the size of the American economy. If the Federal Reserve cannot print more money as it is needed, how will the economy grow?
This concern is a myth, however. The gold standard–while certainly not conducive to a policy of artificial credit expansion–by no means “limits” the growth of the American economy. Indeed, a gold standard will likely facilitate greater economic stability and, in turn, more rapid growth over time.
The belief that a gold standard will limit the size of the economy is established on the faulty premise that the money supply must grow in order for economic growth to occur–that money sustains economic activity. This is shown to be false by the mere fact that doubling or tripling the money supply in third-world countries will (obviously) not create better economic conditions (see Zimbabwe). Increasing the money stock may create the illusion of prosperity, but it cannot possibly do anything to raise actual standards of living for an extended period of time.
That said, commodity money (like gold) operates according to the profit-and-loss system. Entrepreneurs will not simply concede to the fact that there is not enough money going around for them to possibly make a profit. They will seek to lower their costs in order to lower prices and thereby raise the purchasing power of money. Consider personal computers, for example. Once requiring several million of dollars to construct, personal computers now cost an average of about $1000, and the purchasing power of money has thus increased as entrepreneurs innovated to account for the fact that consumers cannot simply create money with which to buy computers. Similar examples exist in the market for almost every other good.
In an extreme case, some markets operating under a gold standard may begin to use different media of exchange if gold does not satisfy. In the event that there begins to be large fluctuations in the supply of gold (for whatever reason), for example, it is likely that the market may choose another commodity to act as the general medium of exchange. This whole scenario is very unlikely, however, as the supply of gold has not been prone to supply shocks of this sort.
In sum, Frank Shoshtak explains this best:
“In a free market the price of money is determined by supply and demand, just like the price of other goods. Consequently, if there is less money, its exchange value will increase. Conversely, the exchange value will fall when there is more money. Hence within the framework of a free market, there cannot be such thing as ‘too little’ or ‘too much’ money. As long as the market is allowed to clear, no shortage of money can emerge.
“Consequently, once the market has chosen a particular commodity as money, the given stock of this commodity will always be sufficient to secure the services that money provides.”
(Note: I am not advocating the view that money is neutral. Indeed, injections of new money into the economy can have real effects on total output and real prices. Over time, however, such injections create harmful business cycles and are not effective means of stimulating economic growth.)