Many things might have been different had the U.S. decided to promise to exchange dollars for gold at the 2006 price of $600 per ounce of gold. But let's start with some of the things that wouldn't have changed. I contend that we'd be no less worried today about geopolitical events in places like Nigeria, Iraq and Iran. The phenomenal growth of the Asian economies would presumably have continued. The bad mortgage loans made prior to that time would still be on the books and still be problematic, with attendant worries about the financial soundness of many institutions. All of this would have meant an increase in the demand for gold. Equilibrium would then require an increase in the relative price of gold compared to what it had been in 2006. That is, the number of umbrellas, or cars, or chairs that people would be willing to surrender in order to obtain an ounce of gold would have gone up relative to what it had been in 2006.

Now, if the number of dollars you have to surrender to obtain an ounce of gold is fixed by the government's commitment to a gold standard, and the number of umbrellas, or cars, or chairs you'd be willing to surrender for an ounce of gold has gone up, the only way that can be is if the dollar price of umbrellas, cars, and chairs have all fallen. Maintaining a gold standard while the relative price of gold increases requires deflation in the dollar prices of all other goods.

The only way the Fed could engender that deflation is with a monetary tightening. Suppose the Fed had been dutifully implementing that procedure in August 2007, when there was a sudden increase in doubts about the soundness of key financial players. A savvy speculator would then reason as follows.

The U.S. has promised that it will continue to convert dollars to gold at $600 per ounce. But that will require them to raise interest rates at a time of potential financial panic, and I don't believe they have the stomach for that. I'm going to ask for my dollars in gold right now, in the guess that they'll abandon this policy shortly. When they give up the standard, my gold will have appreciated, and I'll have a handsome profit.

And how could the U.S. respond to such a speculative attack? We'd have two choices. One would be to say to the speculators, you're right, this idea of driving interest rates up at a time of financial crisis was a dumb one. Dollars are no longer convertible to gold at the old fixed rate.

Or the other option would be to say, no, we really mean it this time, honest, we're serious about this whole gold standard thing. So, we drive interest rates higher and watch the deflation mount. Outstanding debt that is denominated in dollars becomes more and more costly for people to repay, and we'd see a really impressive level of bankruptcies and business failures. The cycle would continue until the politicians who promised to stay on the gold standard are driven out of office and the deflation spiral could finally be ended by the new leaders choosing option 1 after all.

Now, I know that the gold-standard bugs are howling at this point, "but that's not how a gold standard would actually work, because..." But what I just described was not a hypothetical scenario. Instead, in my opinion it's a pretty accurate description of what happened in the United States during the Great Depression of 1929-33.

In 1929, the U.S. was on a gold standard, with the exchange rate fixed at $20.67 per ounce of gold. Geopolitical insecurity and financial worries warranted an increase in the relative price of gold, which, with the dollar price of gold fixed, required a decline in the dollar price of most everything else. Speculators bet (correctly) that Britain would abandon the standard in 1931, but the U.S. fought against the speculation, with the Federal Reserve Bank of New York raising its discount rate from 1.5% to 3.5% in October 1931. This sharp increase in interest rates at a time of great financial turmoil succeeded in defending the parity with gold, but produced an economic disaster.

A 1991 research paper by Ben Bernanke and Harold James noted the very strong correlation between when a country abandoned the gold standard and when it began to recover from the Great Depression. The top panel above shows their calculations of the average annual growth of industrial production for the 14 countries that decided to abandon their currencies' gold parity in 1931-- they experienced positive growth in every year from 1932 on. Countries that stayed on gold, by contrast, experienced an average output decline of 15% in 1932. The U.S. abandoned gold in 1933, after which its dramatic recovery immediately began. The same happened after Italy dropped the gold standard in 1934, and for Belgium when it went off in 1935. On the other hand, the three countries that stuck with gold through 1936 (France, Netherlands, and Poland) saw a 6% drop in industrial production in 1935, while the rest of the world was experiencing solid growth.

As I pointed out in an article published in 1988, gold-standard advocates think in terms of an institution whose continued operation, once adopted, would never again be doubted. But the problem is, if you can go on a gold standard, then you can go off a gold standard. And uncertainty about if and when the latter will occur can make the system itself a very destabilizing force.