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vaults. This creates a powerful self-policing mechanism: If the federal government creates dollars too quickly, more people will doubt the peg and turn in their

gold to banks, which then will turn in their gold and drain the government’s gold. This forces governments to rein in spending and inflation lest their gold reserves

become depleted.

One concern raised against commodity backing is that there is not enough gold in the federal government for all the dollars in existence. This is solved by making sure that the initial peg on gold is correct. Also, in reality, a very small number of users trade for gold as long as they believe the government will stick to the price peg. The mere fact that people could exchange dollars for gold is what acts as the enforcer. After all, if one is confident that a dollar will still be worth 1/2000 ounce of gold in a year, it is much easier to walk about with paper dollars and use credit cards than it is to mail tiny $80 coins. People would redeem en masse only if they feared the government would not be able control itself, for which the only solution is for the government to control itself.

Beyond full backing, alternate paths to gold backing might involve gold-convertible Treasury instruments” or allowing a parallel gold standard to operate temporarily alongside the current fiat dollar.*° These could ease adoption while minimizing disruption, but they should be temporary so that we can quickly enjoy the benefits of gold’s ability to police government spending. In addition, Congress could simply allow individuals to use commodity-backed money without fully replacing the current system.

Among downsides to acommodity standard, there is no guarantee that the government will stick to the price peg. Also, allowing a commodity standard to operate along with a fiat dollar opens both up for a speculative attack. Another downside is that even under a commodity standard, the Federal Reserve can still influence the economy via interest rate or other interventions. Therefore, at best, a commodity standard is not a full solution to returning to free banking. We have good reasons to worry that central banks and the gold standard are fundamentally incompatible—as the disastrous experience of the Western nations on their “managed gold standards” between World War I and World War II showed.

K-Percent Rule. Under this rule, proposed by Milton Friedman in 1960,” the Federal Reserve would create money at a fixed rate—say 3 percent per year. By offering the inflation benefits of gold without the potential disruption to the financial system, a K-Percent Rule could be a more politically viable alternative to gold.

The principal flaw is that unlike commodities, a K-Percent Rule is not fixed by physical costs: It could change according to political pressures or random economic fluctuations. Importantly, financial innovation could destabilize the market’s demand for liquidity, as happened with changes in consumer credit patterns in the 1970s. When this happens, a given K-Percent Rule that previously delivered stability could become destabilizing. In addition, monetary policy when