Ron Paul and many of his supporters in the tea party want a return to the gold standard and the elimination of the Federal Reserve. The argument is that the supply of gold is limited and thus governments are constrained in their ability to inflate a gold backed currency. Gold has traditionally been highly valued by humans and thus able to serve as a store of value. But golds limited supply is also its weakness, and the human desire to hold gold in times of uncertainty causes its value to be volatile. Gold’s value can move independently of other values in the economy, especially during times of uncertainty. If your currency is on the gold standard, then your debts are denominated in gold, when a speculative rise occurs in the value of gold, then your level of debt has increased. The value your employer or the economy places on your work may not have increased with your level of debt, in fact, employers are unlikely to hire and may have to layoff employees in times of uncertainty, and may prefer holding gold to employing your labor during times when the value of gold is high. The gold standard is one of the factors that contributed to the great depression. The uncertain international financial situation caused a rush to the safety of gold and currencies like the dollar that were denominated in gold. Prices of goods had to fall in gold terms and this price deflation is much harder to economies to adjust to, especially when debt is denominated in gold.
Is gold really a reliable store of value? How valuable is gold, and what would be the effect of forcing currencies to be backed by gold? Gold has been a remarkably consistent store of value over the ages, but that ignores its volatility. The price of gold was over $700 in the late 1970s, but was back down to around $300 for a couple decades after that, and is now priced at over $1400. Gold’s high prices limit its economic usefulness. As a good conductor of heat, it would be useful in pots and pans and computer heat sinks, but it is too expensive for those uses. Very small amounts of gold coatings can protect materials such as electronic connectors from corrosion, but most gold is used in dentistry and jewelry and as a store of value. At high prices, even its usage in dentistry and jewelry is reduced or deferred in the hope of lower prices.
An economy or culture that values gold highly will expend effort and resources to produce or obtain more. Is an economy that devotes more resources to mining, refining or trading gold a better economy? Which economy is more likely to grow more rapidly, one that invests in gold, or one that invests in capital equipment that increases the productivity of labor, or invests in research and development? Isn’t an investment in gold, really an admission that you can’t find a more productive use for your money?
The high value of gold is subjective and speculative. A cultural recognition in India for instance, that it would be better off investing in capital equipment, could flood the market with gold.
But what is the value of a fiat currency? Doesn’t just printing more steal value from those that already hold it, and cause prices to rise? What backs a fiat currency? It’s value seems less intrinsic and even more subjective than that of gold? Yes, the value of a fiat currency is mainly symbolic, its value is the fact that so many are willing to honor it. Ultimately, it is legal tender for paying the taxes of the issuing state. The dominate roll of the US dollar in the world economy gives it a privileged position as the worlds reserve currency. Many countries keep reserves of dollars to back their currencies, and set or manipulate the value of their currencies relative to the dollar.
So what backs the value of the dollar? All the people that will honor it. In the current economic situation in the United States, there are 20 million un- and under- employed workers willing to honor the dollar. China and Europe are keeping the value of their currencies low or stable relative to the dollar, so they are willing to honor it.