Which offers more long-term assurance of sound money and a strong economy--a gold standard or Alan Greenspan?

Alan Greenspan has again lowered the price of short-term credit (the interest rate that he controls) in an effort to keep the economy from falling into recession. Rather than speculate on whether this will work, I'd like to raise a different set of questions.

What is it about our monetary system that permits Greenspan and a handful of others to make such momentous decisions? In a free market, prices are determined by the voluntary actions of individuals who buy and sell. Errors in such a system tend to be self-correcting.

Why is money treated differently? And how can we know whether Greenspan is doing the right thing? How can he know?

Under a free-market system of money management, such decisions are left to the market, not monetary central planners. We once had such a system, and it was called the gold standard. But in a step-by-step process over the course of the 20th century, the U.S. government has gradually departed from any direct link between its paper dollars and gold.

Some economists regret this and believe that the United States may someday feel the same way.  While there is no remaining formal link between gold and the dollar, many economists (even some who are not advocates of a gold standard) do believe that there is still a residual and necessary link—even if it is only psychological—between paper money and the value the paper is supposed to represent.  For example, many people would take a mass sale by the U.S. government of its gold as a reason for having less confidence in the dollar and the government's ability to maintain its value.  This sentiment is not unjustified.

Gold, in my view, still retains a certain mystique and a government that strips its shelves of gold, so to speak, runs the risk of a loss of confidence.  This is because at least instinctively, many market participants believe that maintaining a gold supply is a sign of discipline and responsibility and they would see the sale of that gold as a sign that government wants more room to inflate or otherwise mismanage the money supply.  That would likely mean a resumption of dangerously high rates of paper money creation, which would send prices higher and imperil the stability of both the currency and the economy.

The idea behind a gold standard is to remove from the hands of politicians or their political appointees the discretion of determining a nation's supply of money.  The opposite of a gold standard would be a fiat paper standard, whereby the monetary authorities of government have complete discretion: They can inflate or contract the money supply at will.  Historically, because such situations grant enormous power to government without restricting the potential for abuse, vastly destructive abuses have, in fact, occurred.  History is littered with many examples of governments printing their paper money (to pay for everything from elections to foreign military adventures to welfare programs) until it becomes utterly worthless, destroying people's savings and confidence in the economy.  Hence, the reasonable yearning throughout history for some sort of "sound money" that will retain its value and allow an economy to function without monetary upheavals.

Gold emerged as the marketplace's preferred medium of exchange because it tends to retain its value over long periods of time.  That's the real advantage to a gold standard.  The gold supply tends to grow at about a 2 percent rate per year, which some economists believe to be "about right" when it comes to the growth rate of the money supply (though this point is open to debate). 

When paper money emerged, it first appeared as simply a "receipt" for the real thing, gold.  It was later that governments discovered that if they took it over, they could gradually or swiftly sever the connection between the paper and the gold, and then print lots of paper money to pay their bills.  Of course, that destructive policy may serve the short-term needs of a spendthrift government, but it ultimately destroys the money, the economy and sometimes the government itself in a blizzard of inflation.

There's a lot of wisdom to what someone once said: "Governments don't like gold because they can't print it."  Even when governments adopt a formal link between their paper money and gold, they come under great pressure to erode it, so that they eventually can be free to print more paper.  Think of a gold standard as a kind of discipline on the monetary authorities.

From 1900 until the 1930s, one dollar equaled 1/20th of an ounce of gold.  That limited how many paper dollars either the government or the nation's banks could print, since their quantity had a legal connection to the amount of gold on deposit.  That sounds like a pretty strict gold standard, except that at the same time, the government took progressive steps to gradually weaken the gold-to-paper link, such as the establishment of the Federal Reserve System in 1913. 

President Franklin Roosevelt changed the ratio from 1/20th of an ounce to 1/35th of an ounce (to the dollar) early in his first term.  This gave government more room to inflate the paper money supply.  Roosevelt also took the dramatic step of making gold ownership by private individuals illegal, which was a huge step away from the gold standard.  What little was left of an American gold standard was eliminated by Richard Nixon in 1971, when he announced the United States would no longer redeem dollars in gold for foreigners.

Today we don't have a gold standard in any form.  We have paper money issued by government fiat.  Although it would appear that the monetary authorities have exercised proper restraint in recent years to prevent inflation, there is no law on the books to prevent them from printing as much paper money as they wish.  No formal connection with gold exists, leaving open a door through which less scrupulous leaders than our current batch might someday walk with impunity. By lowering rates yet again, Greenspan may or may not be on the right track. As the designated monetary central planner, he has an impossible job, one which the gold standard accomplished without the intervention of central bankers.