Return to the Gold Standard
Gold generates more impassioned advocacy, both for and against, than any other subject in international finance. Opponents of a gold standard are quick to pull out the old Keynes quote that gold is a “barbarous relic.” Legendary investor Warren Buffett points out that all the gold in the world put in one place would just be a large block of shiny metal with no yield nor income- producing potential. Establishment figure Robert Zoellick caused elite fainting spells in November 2010 by merely mentioning the world “gold” in a speech, although he stopped far short of calling for a gold standard. Among elites in general, advocacy for gold is considered a trait of the dim, the slow- witted, those who do not appreciate the benefits of a “flexible” and “expanding” modern money supply.
Gold advocates are no less rigid in their view of modern central bankers as sorcerers who produce money from thin air in order to dilute the hard-earned savings of the working class. It is difficult to think of another financial issue on which there is less common ground between the opposing sides.
Unfortunately, the entrenched positions, pro and con, stand in the way of new thinking about how gold might work in a twenty-first-century monetary system. There is an unwillingness, rooted in ideology, to explore ways to reconcile the demonstrated stability of gold with the necessity for some degrees of freedom in the management of the money supply to respond to crises and correct mistakes. A reconciliation is overdue.
Gold is not a commodity. Gold is not an investment. Gold is money par excellence. It is truly scarce—all the gold ever produced in history would fit in a cube of twenty meters (about sixty feet) on each side, approximately the size of a small suburban office building. The supply of gold from new mining expands at a fairly slow and predictable pace—about 1.5 percent per year. This is far too slow to permit much inflation; in fact, a mild persistent deflation would be the most likely outcome under a gold standard. Gold has a high density; a considerable amount of weight is compressed into a small space relative to other metals that could be used as a monetary base. Gold is also of uniform grade, an element with fixed properties, atomic number 79 in the periodic table. Commodities such as oil or wheat that might be used to support a money supply come in many different grades, making their use far more complicated. Gold does not rust or tarnish and is practically impossible to destroy, except with special acids or explosives. It is malleable and therefore easily shaped into coins and bars. Finally, it has a longer track record as money—over five thousand years—than any rival, which shows its utility to many civilizations and cultures in varied circumstances.
Given these properties of scarcity, durability, uniformity and the rest, the case for gold as money seems strong. Yet modern central bankers and economists do not take gold seriously as a form of money. The reasons go back to CWI and CWII, to the causes of the Great Depression and the crack- up of Bretton Woods. A leading scholar of the Great Depression, Ben Bernanke, now the chairman of the Federal Reserve, is one of the most powerful intellectual opponents of gold as a monetary standard. His arguments need to be considered by advocates for gold, and ultimately refuted, if the debate is to move forward.
Bernanke’s work on gold and the Great Depression draws in the first instance on a large body of work by Peter Temin, one of the leading scholars of the Great Depression, Barry Eichengreen and others that showed the linkages between the operation of the gold exchange standard from 1924 to 1936 and the world economy as a whole. Bernanke summarizes this work as follows:
Countries that left gold were able to reflate their money supplies and price levels, and did so after some delay; countries remaining on gold were forced into further deflation. To an overwhelming degree, the evidence shows that countries that left the gold standard recovered from the Depression more quickly than countries that remained on gold. Indeed, no country exhibited significant economic recovery while remaining on the gold standard.
Empirical evidence bears out Bernanke’s conclusions, but that evidence is just illustrative of the beggar-thy-neighbor dynamic at the heart of all currency wars. It is no different than saying if one country invades and loots another, it will be richer and the victim poorer—something that is also true.
The question is whether it is a desirable economic model.
If France had gone off the gold standard in 1931 at the same time as England, the English advantage relative to France would have been negated. In fact, France waited until 1936 to devalue, allowing England to steal growth from France in the meantime. There is nothing remarkable about that result—in fact, it should be expected.
Today, under Bernanke’s guidance, the United States is trying to do what England did in 1931—devalue. Bernanke has succeeded in devaluing the dollar on an absolute basis, as evidenced by the multiyear rise in the price of gold. Yet his effort to devalue the dollar on a relative basis against other currencies has been more protracted. The dollar fluctuates against other currencies but has not devalued significantly and consistently against all of them. What is happening instead is that all the major currencies are devaluing against gold at once. The result is global commodity inflation, so that beggar- thy-neighbor has been replaced with beggar-the-world.
In support of his thesis that gold is in part to blame for the severity and protracted nature of the Great Depression, Bernanke developed a useful six- factor model showing the relationships among a country’s monetary base created by the central bank, the larger money supply created by the banking system, gold reserves broken down by quantity and price, and foreign exchange reserves.
Bernanke’s model works like an upside-down pyramid, with some gold and foreign exchange on the bottom, money created by the Fed on top of the gold, and even more money created by banks on top of that. The trick is to have enough gold so the upside-down pyramid does not topple over. Until 1968, U.S. law required a minimum amount of gold at the bottom of the pyramid. At the time of the Great Depression the value of gold at a fixed price had to be at least 40 percent of the amount of Fed money. However, there was no maximum. This meant that the Fed money supply could contract even if the gold supply was increasing. This happened when bankers were reducing their leverage.
Bernanke observes:
The money supplies of gold-standard countries—far from equaling the value of monetary gold, as might be suggested by a naive view of the gold standard—were often large multiples of the value of gold reserves. Total stocks of monetary gold continued to grow through the 1930s; hence, the observed sharp declines in . . . money supplies must be attributed entirely to contractions in the average money-gold ratio.
Bernanke gives two reasons for these contractions in money supply even in the presence of ample gold. The first reason involves policy choices of central bankers and the second involves the preferences of depositors and private bankers in response to banking panics. Based on these choices, Bernanke concludes that under the gold exchange standard there exist two money supply equilibria. One equilibrium exists where confidence is high and the leverage ratios are expanded. The other exists where confidence is low and the leverage ratios contract. Where a lack of confidence causes a contraction in money through deleveraging, that process can depress confidence, leading to a further contraction of bank balance sheets and declines in spending and investment. Bernanke concludes, “In its vulnerability to self-confirming expectations, the gold standard appears to have borne a strong analogy to a . . . banking system in the absence of deposit insurance.” Here was Merton’s self-fulfilling prophecy again.
For Bernanke, Eichengreen, Krugman and a generation of scholars who came into their own since the 1980s, this was the smoking gun. Gold was at the base of the money supply; therefore gold was the limiting factor on the expansion of money at a time when more money was needed. Here was analytic and historic evidence, backed up by Eichengreen’s empirical evidence and Bernanke’s model, that gold was a significant contributing factor to the Great Depression. In their minds, the evidence showed that gold had helped to cause the Great Depression and those who abandoned gold first recovered first. Gold has been discredited as a monetary instrument ever since. Case closed.
Despite the near unanimity on this point, the academic case against gold has one enormous flaw. The argument against gold has nothing to do with gold per se; it has to do with policy. One can see this by accepting Bernanke’s model and then considering alternative scenarios in the context of the Great Depression.
For example, Bernanke points to the ratio of base money to total reserves of gold and foreign exchange, sometimes called the coverage ratio. As gold flowed into the United States during the early 1930s, the Federal Reserve could have allowed the base money supply to expand by up to 2.5 times the value of the gold. The Fed failed to do so and actually reduced money supply, in part to neutralize the expansionary impact of the gold inflows. So this was a policy choice by the Fed. Reducing money supply below what could otherwise be achieved can happen with or without gold and is a policy choice independent of the gold supply. It is historically and analytically false to blame gold for this money supply contraction.
Bernanke points to the banking panics of the early 1930s and the preference of banks and depositors to reduce the ratio of the broad money supply to the monetary base. In turn, bankers expressed a preference for gold over foreign exchange in the composition of their reserves. Both observations are historically correct but have no necessary relationship to gold. The reduction in the ratio of broad money supply to narrow money supply need not involve gold at all and can happen at any time—it has in fact been happening in the aftermath of the Panic of 2008. The substitution of gold for foreign exchange by central banks involves gold but represents yet another policy choice by the central banks. Those banks could just as easily have expressed the opposite preference and actually increased reserves.
In addition to this refutation of Bernanke’s particular historical analysis, there are a number of actions central bankers could have taken in the 1930s to alleviate the tight money situation unconstrained by gold. The Fed could have purchased foreign exchange with newly printed dollars, an operation comparable to modern central bank currency swap lines, thereby expanding both U.S. and foreign reserve positions that could have supported even more money creation. SDRs were created in the 1960s to solve exactly this problem of inadequate reserves encountered in the 1930s. Were a 1930s-style global liquidity crisis to arise again, SDRs could be issued to provide the foreign exchange base from which money creation and trade finance could flow—exactly as they were in 2009. This would be done to head off a global contraction in world trade and a global depression. Again, this kind of money creation can take place without reference to gold at all. Any failure to do so is not a failure of gold; it is a failure of policy.
Central bankers in the 1930s, especially the Fed and the Banque de France, failed to expand the money supply as much as possible even under the gold exchange standard. This was one of the primary causes of the Great Depression; however, the limiting factor was not gold but rather the lack of foresight and imagination on the part of central banks.
One suspects that Bernanke’s real objection to gold today is not that it was an actual constraint on increasing the money supply in the 1930s but that it could become so at some point today. There was a failure to use all of the money creation capacity that bankers had in the Great Depression, yet that capacity was never unlimited. Bernanke may want to preserve the ability of central bankers to create potentially unlimited amounts of money, which does require the abandonment of gold. Since 2009, Bernanke and the Fed have been able to test their policy of unlimited money creation in real-world conditions.
Blaming the Great Depression on gold is like blaming a bank robbery on the teller. The teller may have been present when the robbery took place, but she did not commit the crime. In the case of the Great Depression, the crime of tight money was not committed by gold but by the central bankers who engaged in a long series of avoidable policy blunders. In international finance, gold is not a policy; it is an instrument. Laying the tragedy of the Great Depression at the feet of the gold standard has been highly convenient for central bankers who seek unlimited money printing capacity. Central bankers, not gold, were responsible for the Great Depression and economists who continue to blame gold are merely looking for an excuse to justify fiat money without bounds.
If gold is rehabilitated from the false accusation of having caused the Great Depression, can it play a constructive role today? What would a gold standard for the twenty-first century look like?
Some of the most vociferous advocates for a gold standard on the ubiquitous blogs and chat rooms are unable to explain exactly what they mean by it. The general sense that money should be linked to something tangible and that central banks should not be able to create money without limit is clear. Turning that sentiment into a concrete monetary system that can deal with the periodic challenges of panic and depression is far more difficult. The simplest kind of gold standard—call it the pure gold standard—is one in which the dollar is defined as a specific quantity of gold and the agency that issues dollars has enough gold to redeem the dollars outstanding on a one-for-one basis at the specified price. In this type of system, a paper dollar is really a warehouse receipt for a quantity of gold kept in trust for the holder of the dollar and redeemable at will. Under this pure gold standard, it is impossible to expand the money supply without expanding the gold supply through new mining output or other purchases. This system would inject a mild deflationary bias into the economy since global gold supply increases about 1.5 percent per year whereas the real economy seems capable of consistent 3.5 percent growth under ideal conditions. All things equal, prices would have to fall about 2 percent per year to equilibrate 3.5 percent real growth with a 1.5 percent increase in the money supply, and this deflation might discourage borrowing at the margin. The pure gold standard would allow for the creation of credit and debt through the exchange of money for notes, but it would not allow for the creation of money beyond the amount of gold on deposit. Such debt instruments might function in the economy as money substitutes or near-money, but they would not be money in the narrow sense.
All other forms of gold standard involve some form of leverage off the existing gold stock, and this can take two forms. The first involves the issuance of money in excess of the stock of gold. The second involves the use of gold substitutes, such as foreign exchange or SDRs, in the gold pool on which the money is based. These two forms of leverage can be used separately or in tandem. This type of gold standard—call it a flexible gold standard—requires consideration of a number of design questions. What is the minimum percentage of the money supply that must be in gold? Is 20 percent comfortable? Is 40 percent needed to instill confidence? Historically the Federal Reserve maintained about a 40 percent partial gold reserve against the base money supply. In early April 2011 that ratio was still about 17.5 percent. Although the United States had long since gone off a formal gold standard, a kind of shadow gold standard remained in the ratio of gold to base money, even in the early twenty-first century.
Other issues include the definition of money for purposes of calculating the money-gold ratio. There are different definitions of “money” in the banking system depending on the availability and liquidity of the instruments being counted. So-called base money, or M0, consists of notes and coins in circulation plus the reserves that banks have on deposit at the Fed. A broader definition of money is M1, which includes checking accounts and traveler’s checks, but does not count bank reserves. The Fed also calculates M2, which is the same as M1 except that savings accounts and some time deposits are also included. Similar definitions are used by foreign central banks. In April 2011, U.S. M1 was about $1.9 trillion and M2 was about $8.9 trillion. Because M2 is so much larger than M1, the selection of a particular definition of “money” will have a large impact on the implied price of gold when calculating the ratio of gold to money.
Similar issues arise when deciding how much gold should be counted in the calculation. Should only official gold be counted for this purpose, or should gold held by private citizens be included? Should the calculation be done solely with reference to the United States, or should some effort be made to institute this standard using gold held by all major economies?
Some consideration must be given to the legal mechanism by which a new gold standard would be enforced. A legal statute might be sufficient, but statutes can be changed. A U.S. constitutional amendment might be preferable, since that is more difficult to change and could therefore inspire the most confidence.
What should the dollar price of gold be under this new standard? Choosing the wrong price was the single biggest flaw in the gold exchange standard of the 1920s. The price level of $20.67 per ounce of gold used in 1925 was highly deflationary because it failed to take into account the massive money printing that had occurred in Europe during World War I. A price of perhaps $50 per ounce or even higher in 1925 might have been mildly inflationary and might have helped to avoid some of the worst effects of the Great Depression.
Taking the above factors into account produces some startling results. Without suggesting that there is any particular “right” level, the following implied gold prices result when using the factors indicated:
In order to impose discipline on whatever regime was chosen, a free market in gold could be allowed to exist side by side with the official price. The central bank could then be required to conduct open market operations to maintain the market price at or near the official price.
Assume that the coverage ratio chosen is the one used in the United States in the 1930s, when the Fed was required to hold gold reserves equal to 40 percent of the base money supply. Using April 2011 data, that standard would cause the price of gold to be set at $3,337 per ounce. The Fed could establish a narrow band around that price of, say, 2.5 percent up or down. This means that if the market price fell 2.5 percent, to $3,254 per ounce, the Fed would be required to enter the market and buy gold until the price stabilized closer to $3,337 per ounce. Conversely, if the price rose 2.5 percent, to $3,420 per ounce, the Fed would have to enter the market as a seller until the price reverted to the $3,337 per ounce level. The Fed could maintain its freedom to adjust the money supply or to raise and lower interest rates as it saw fit, provided the coverage ratio was maintained and the free market price of gold remained stable at or near the official price.
The final issue to be considered is the degree of flexibility that should be permitted to central bankers to deviate from strict coverage ratios in cases of economic emergency. There are times, albeit rare, when a true liquidity crisis or deflationary spiral emerges and rapid money creation in excess of the money-gold coverage ratio might be desirable. This exceptional capacity would directly address the issue pertaining to gold claimed by Bernanke in his studies of monetary policy in the Great Depression. This is an extremely difficult political issue because it boils down to a question of trust between central banks and the citizens they ostensibly serve. The history of central banking in general has been one of broken promises when it comes to the convertibility of money into gold, while the history of central banking in the United States in particular has been one of promoting banking interests at the expense of the general interest. Given this history and the adversarial relationship between central banks and citizens, how can the requisite trust be engendered?
Two of the essential elements to creating confidence in a new gold-backed system have already been mentioned: a strong legal regime and mandatory open-market operations to stabilize prices. With those pillars in place, we can consider the circumstances under which the Fed could be allowed to create paper money and exceed the coverage ratio ceiling.
One approach would be to let the Fed exceed the ceiling on its own initiative with a public announcement. Presumably the Fed would do so only in extreme circumstances, such as a deflationary contraction of the kind England experienced in the 1920s. In these circumstances, the open market operations would constitute a kind of democratic referendum on the Fed’s decision. If the market concurred with the Fed’s judgment on deflation, then there should be no run on gold—in fact, the Fed might have to be a buyer of gold to maintain the price. Conversely, if the market questioned the Fed’s judgment, then a rush to redeem paper for gold might result, which would be a powerful signal to the Fed that it needed to return to the original money- gold ratio. Based on what behavioral economists and sociologists have observed about the “wisdom of crowds” as reflected in market prices, this would seem to be a more reliable guide than relying on the narrow judgment of a few lawyers and economists gathered in the Fed’s high-ceilinged boardroom.
A variation of this approach would be to allow the Fed to exceed the gold coverage ratio ceiling upon the announcement of a bona fide financial emergency by a joint declaration from the president of the United States and the speaker of the House. This would preclude the Fed from engaging in unilateral bailouts and monetary experiments and would subject it to democratic oversight if it needed to expand the money supply in case of true emergencies. This procedure would amount to a “double dose” of democracy, since elected officials would declare the original emergency and market participants would vote with their wallets to ratify the Fed’s judgment by their decision to buy gold or not.
The implications of a new gold standard for the international monetary system would need to be addressed as well. The history of CWI and CWII is that international gold standards survive only until one member of the system suffers enough economic distress, usually because of excessive debt, that it decides to seek unilateral advantage against its trading partners by breaking with gold and devaluing its currency. One solution to this pattern of unilateral breakouts would be to create a gold-backed global currency of the kind suggested by Keynes at Bretton Woods. Perhaps the name Keynes suggested, the bancor, could be revived. Bancors would not be inflatable fiat money like today’s SDRs but true money backed by gold. The bancor could be designated as the sole currency eligible to be used for international trade and the settlement of balance of payments. Domestic currencies would be pegged to the bancor, used for internal transactions and could be devalued against the bancor only with the consent of the IMF. This would make unilateral or disorderly devaluation, and therefore currency wars, impossible.
The issues involved in reestablishing a gold standard with enough flexibility to accommodate modern central banking practices deserve intensive study rather than disparagement. A technical institute created by the U.S. White House and Congress, or perhaps the G20, could be staffed with experts and tasked with developing a workable gold standard for implementation over a five-year horizon. This institute would address exactly the questions posed above with special attention paid to the appropriate price peg in order to avoid the mistakes of the 1920s.
Based on U.S. money supply and the size of the U.S. gold hoard, and using the 40 percent coverage ratio criteria, the price of gold would come out to approximately $3,500 per ounce. Given the loss of confidence by citizens in central banks and the continual experience of debasement by those banks, however, it seems likely that a broader money supply definition and higher coverage ratio might be required to secure confidence in a new gold standard. Conducting this exercise on a global basis would require even higher prices, because major economies such as China possess paper money supplies much larger than the United States and far less gold. The matter deserves extensive research, yet based on an expected need to restore confidence on a global basis, an approximate price of $7,500 per ounce would seem likely. To some observers, this may appear to be a huge change in the value of the dollar; however, the change has already occurred in substance. It simply has not been recognized by markets, central banks or economists.
The mere announcement of such an effort might have an immediate beneficial and stabilizing impact on the global economy, because markets would begin to price in future stability much as markets priced in European currency convergence years before the euro was launched. Once the appropriate price level was determined, it could be announced in advance and open market operations could commence immediately to stabilize currencies at the new gold equivalent. Finally, the currencies themselves could become pegged to gold, or a new global currency backed by gold could be launched with other currencies pegged to it. At that point the world’s energies and creativity could be redirected from exploitation through fiat money manipulation toward technology, productivity improvements and other innovations. Global growth would be fueled by the creation of real rather than paper wealth.
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