Deep deflation the downside of gold standard's discipline

It was the sort of thing the goldbugs have been longing to hear for years. Last week, World Bank president Robert Zoellick called for the creation of a new international monetary system 'employing gold as an international reference point'.

In reaction, a thousand headlines screamed 'World Bank demands return to gold standard' or words to that effect, and the price of bullion shot up, hitting an all-time high of US$1,424.60 on Wednesday (see the first chart below).

In reality Zoellick wasn't really calling for a return to the gold standard, as he made clear later in the week. But that didn't stop legions of goldbugs seizing on the idea as the only sure way to avoid economic catastrophe.

Enthusiasts like the notion of a gold standard because they believe it would enforce monetary discipline on incontinent central banks addicted to printing money.

In a country on the gold standard, gold acts as the main monetary anchor for the economy. The value of the currency is fixed in terms of gold, in much the same way that the Hong Kong dollar is tied to the US dollar. And in a strong gold standard system, the currency would be convertible into gold, and the stock of currency in circulation would be backed by reserves of gold, just as Hong Kong dollars are backed by US dollars held by the Hong Kong Monetary Authority.

As a result, operating a gold standard places important constraints on any central bank. With the quantity of money in circulation determined by the amount of gold held in its reserves, the central bank cannot embark on a reckless monetary expansion that threatens to erode the value of savings and debase its currency.