Any currency is only truly “backed by gold” if it is convertible to gold.
There is something intuitively appealing about the idea of a gold-backed currency –money backed by the tangible value of gold, i.e. “the gold standard.”
Instead of intrinsically worthless paper money (fiat currency), gold-backed money would have real, enduring value–it would be “hard currency”, i.e. sound money, because it would be convertible to gold itself.
Many proponents of sound money identify President Nixon’s ending of the U.S. dollar’s gold standard in 1971 as the cause of the nation’s financial decline. If our currency was still convertible to gold, the thinking goes, the system would never have allowed the vast pile of debt to accumulate.
The problem with this line of thinking is that it is disconnected from the real-world mechanisms of capital flows and the way money is created in our financial system.
This article explains why Nixon took the USD off the gold standard: since the U.S. was running trade deficits, all of America’s gold would have been transferred to the exporting nations. America’s gold reserves would have disappeared, leaving nothing to back the dollar. The U.S. Empire Would Have Collapsed Decades Ago If It Didn’t Abandon The Gold Standard.
The problem to sound money proponents is trade deficits: if the U.S. only had trade surpluses, then the gold would not drain away.
But Triffin’s Paradox explains why this doesn’t work for a reserve currency: a reserve currency has two distinct sets of users: domestic users and global users. Each has different needs, so there is a built-in conflict between the two sets of users.
Global users of the USD need enormous quantities of dollars to use as reserves, to pay debts denominated in USD and to facilitate international trade.
The only way the issuing nation can provide enough currency to meet this global demand is to run large, permanent trade deficits–in effect, “exporting” dollars in exchange for goods and services.
This is the paradox: to maintain the “exorbitant privilege” of a reserve currency, a nation must “export” its currency in size; a nation that runs trade surpluses cannot supply the world with enough of its currency to act as a reserve currency.
And any nation running large trade deficits will soon empty its gold reserves as international holders of the currency choose to convert their currency into gold, which is exactly what happened in the late 1960s in the U.S.
OK, so a nation can’t back a reserve currency with gold. How about backing a non-reserve currency with gold? There are still problems with backing currencies with gold.
Number 1 is convertibility–without it, you don’t have a gold standard, you have an illusion of a gold standard. If the gold-backed currency isn’t convertible to gold, it’s simply another form of fiat currency.
An example illustrates why. Let’s take the fictional nation of Slobovia, which has accumulated $10 billion of gold to back its currency, the quatloo.
To protect its reserves from being drained away, the quatloo isn’t convertible to gold; the Slobovian central bank simply declares the currency is “backed” by gold.
But consider what this entails. The price of gold globally is set by the market (setting aside manipulation by major players), not by the central bank of Slobovia. This means the value measured in gold of the quatloo is fluctuating as the value of gold fluctuates.
If the global value of gold plummets, so does the purchasing power of the quatloo. This peg to the price of gold becomes consequential if the quatloo loses purchasing power.
Problem 2: what happens to the purchasing power of the quatloo when the central bank issues more currency? If the central bank issues an additional $10 billion in currency, if it doesn’t add $10 billion in gold reserves, the purchasing power of the quatloo measured in gold declines by 50%.
So the quatloo is supposedly “backed” by gold, but its purchasing power can drop in half as the central bank issues more fiat currency? Then what value is the supposed “backed by gold” claim?