This article was originally published at Forbes.com.
I often suggest that a currency should be "linked to" gold. Others might say that a currency should be "redeemable in" gold or "backed by" gold.
These terms are perhaps vague. But they have important differences.
When I say a currency is "linked to" gold, I mean that there is some active system of supply management, much like a currency board, which maintains the real market value of the currency at its specified gold parity. A currency might be "linked to" gold, but not "redeemable in" or "backed by" gold. This is in fact perfectly Ok, because as long as we have an active supply-adjustment process of some sort, the system will be successful.
A currency that is "redeemable in" gold is one in which the issuing body (typically a central bank) would agree to trade paper currency for gold bullion at some specified price. However – note this carefully – a currency can be "redeemable in" gold but not "linked to" gold. In other words, despite the redeemability feature, there is no properly-functioning supply-adjustment process.
This was the case at the end of the Bretton Woods period, in the late 1960s for example. Dollars could be redeemed in gold bullion – by European central banks, not U.S. citizens – but there was no active supply-adjustment process. In other words, the currency was not "linked to" gold.
Instead, the Fed had a sort of open-ended Keynesian interest rate target policy, which is inherently a floating-currency construct. Without an active supply-adjustment process, the currency-board-like automatic mechanism, the value of the dollar naturally deviated from its gold parity and sank well below this level. As a result, Europeans requested that these depreciating dollars be redeemed for gold bullion. Bullion inventories declined, and the system fell apart.
Thus, we can see that a currency that is "redeemable in" gold will fail if the currency is not also "linked to" gold by some supply-adjustment process.
Let's take an example. I'm going to issue a currency which is indistinguishable from a cocktail napkin. This napkin currency is "redeemable" in a brand-new Mercedes 500SL. Do you think that maybe you might ask for your napkin to be redeemed? Of course. I would soon run out of luxury cars. There is no mechanism to manage the value of the cocktail napkin, to keep it in line with its "Mercedes parity."
The term "backed by" gold is extremely vague, and essentially means nothing at all. It suggests a large amount of gold bullion stored in a vault somewhere. This term tends to be used by people who have almost no understanding of the proper techniques to manage a currency – the "link to" gold – and instead have a sort of superstitious faith that a pile of brainless metal will somehow manage their currency for them. Of course this is a recipe for instant failure.
I could have a whole parking lot full of Mercedes 500SL convertibles. But the cocktail napkin is still a cocktail napkin.
Personally, I think that it is preferable to have a currency that is "redeemable in" gold, but it must also be "linked to" gold. Historically, systems without a redeemability feature tend to be abused by unscrupulous politicians and central bankers. However, this "redeemability" is not strictly necessary. I would note that, as long as a currency is "linked to" gold, you would be able to trade your paper currency for bullion at the parity price at any private gold bullion dealer.
What terminology do you use? Do you know what it means? I would suggest that if you have been using the term "backed by" gold, you have a little studying to do.
Nathan Lewis is the author of Gold: the Once and Future Money (2007). His website isnewworldeconomics.com.
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