The Gold Exchange Standard

During World War One, the combatant nations suspended the gold standard in order to inflate away war debt, standard practice. A recession and later depression just after the war's end, prompted those nations to seek to go back on the gold standard. The Genoa Conference (1922) was held to discuss ways to improve on the gold standard, and John Maynard Keynes of the British delegation moved the conference toward a hybrid scheme with the dollar as the world reserve currency, backed by gold, and the pound sterling a reserve currency for exchanges of gold-bar-sized transactions. Other currencies would "float" against these two. This was implemented in 1926, and immediately started causing problems.

The first problem was the valuation of the pound, which had been battered down to $3.50 by the war. It was restored to its pre-war value of $5.00, an utter fiction. Though it goes largely unmentioned, this was a leading cause of the Wall Street Crash of 1929.

The second problem was that the dollar had become effectively the world's sole reserve currency leading to the unfamiliar problem of it being overly strong (What do the terms weak dollar and strong dollar mean?). In 1930, the US countered the overly strong dollar with the disastrous Smoot–Hawley Tariff Act and immediately plunged itself into a full depression.

The third ugly rooster landed in 1931 when France, tired of British foot-dragging on war payments, demanded gold in return for its stash of 4B pounds (or $20B, the equivalent of almost a third of a trillion dollars today). The final Keynes fiction was that British gold reserves had been largely depleted by purchase of war materiel from the US. When Britain reneged, the whole world joined the US in the Great Depression.

Nothing that Hoover did and little that Roosevelt did was of particular help in stemming the depression. The major turnaround came when a Republican undersecretary of agriculture caught FDR's ear and pointed out that if our growing enemies abroad wanted to harm us, all they had to do was redeem their dollars for our gold as we had overprinted dollars. FDR, over the apoplectic resistance of Bernard Baruch and other of his advisors, repegged the dollar to being worth 0.85 grams of gold. Everybody who owned dollars had just taken a 43-percent haircut, but the dollar was no longer strong and American goods started flowing overseas, while at the same time governments overseas were happy to pay us in gold now that FDR was offering top dollar (not to mention that our 8500 tons of gold had just shot up in value).

Productivity as the Standard

Not long after FDR repegged the dollar, the new chancellor of Germany, Adolph Hitler, declared that the "accident of gold" should not stand as the basis for the value of money. Rather, he stated, national productivity should.

Despite the fact this was a quite rational suggestion, Bernard Baruch went apoplectic again.  However, even though wealth is denominated in money, money is not wealth. Wealth is produced by Fixed assets, but neither do they count as wealth. The fixed assets are used to create products, but neither those products nor the parts and materials used in their manufacture constitute wealth. What is wealth? It is generally considered that portion of generated revenues that can be used to expand rather than maintain operations or that can be put to other discretionary usage.

Or as Adam Smith defined wealth:
 

It is resources available for all discretionary purposes - profound or frivolous - consumption or investment - private or government. It is a measure of economic power - either in terms of money or in its labor and commodity equivalents- that is available without diminishing the productive capacity of the nation.

Given that the formula that determines inflation and deflation would suggest that the volume of money should increase commensurate with the increase in wealth, Hitler's seems like an eminently practical suggestion. But that's not what we did.

Bretton Woods

The Bretton Woods Conference in 1944 was the World War Two counterpart to the Genoa Conference. It introduced a number of innovations but of interest here is the lesson Keynes learned in the meantime. The US dollar would be the sole reserve currency--no more fictions about British gold. And to prevent the dollar from becoming too strong again, the US would commit to give away a fixed percent of its budget to foreign aid and to overseas military deployment. If you wonder how we became the "world's cop," there it is.

What Keynes failed to solve was the reserve currency problem--in order for countries around the world to be able to use the dollar as a second currency, a too-large quantity has to be printed. The risk of inflation here is mitigated by the fact those dollars tend to stay overseas. However, by 1971 it was costing us forty cents to mint a quarter, and we again faced the problem that if our enemies wanted to gang up on us, they could deplete our gold reserves. And so we got the Nixon Shock as Nixon took us off a gold standard. (Last I looked, a dollar bought 0.04 grams of gold rather than 0.85.)

Growth

The dollar, like other currencies has become Fiat money, that is, money backed by "the full faith and credit" of the issuing nation and nothing more (the Swiss have been in the news lately for dealing with this). There are a lot of implications of this, but economic growth is not one of them. You can have growth with a gold standard, as we did. You can have growth with fiat money, as we have (though much less so). You can have growth despite inflation or during deflation. You can even--another way Keynes was wrong--have inflation and recession and high unemployment together, or stagflation.

Growth is about the availability of capital stocks to be invested toward the productive cycle. It is growth that should be the guide to our money supply.
 
Basically, here's the problem. Economies of half a millennium ago were like the cast pewter soldier figurines of the time--absolutely rigid. Now, they are more like Play-Doh figures--too flexible. In between, they were like Lego figures, barely articulated. What we need is an economic system more like a super-hero action figure--highly articulate and fun to play with confident it won't come flying apart on you. Using productivity/growth as the standard would get us closer to that goal than can gold or the faith and credit of governments all too prone to act faithlessly.