Last week, Alan Greenspan penned an interesting article in Foreign Affairs that praised China’s recent conversion of some of its $4 trillion foreign exchange reserves into gold bullion and gave the gold standard some further adulation in a world where there is relatively little today from mainstream economists.
This marks the first time the gold standard has been seriously discussed by a senior U.S. policymaker (former or present) since 2012, when two GOP presidential candidates, Newt Gingrich and Ron Paul, along with former Congressman Lewis Lehrman and Grant’s Interest Rate Observer founder James Grant, called for a commission to consider readopting the gold standard. The last time a president appointed such a commission was in 1981 when the recently-elected President Reagan fulfilled a campaign pledge to look into reconsidering a dollar-gold link. The commission’s final report called for a continuation of the monetary status quo of fiat currency (interestingly, the commission’s lone dissenters at the time were also Ron Paul and Lewis Lehrman).
Former Fed Chair Alan Greenspan (Photo Credit: Council on Foreign Relations)
How gold standards have historically been mismanaged and have caused price instability
Unfortunately for gold standard backers, a gold standard is not a guarantee of price stability. To begin with, what is the definition of a gold standard? A gold standard is simply a promise made out of thin air to keep the supply of money anchored to the supply of gold at a certain rate of convertibility.
To consider how fragile such a promise can be, consider the following historical example provided by David Andolfatto from the Federal Reserve Bank of St. Louis. On April 5, 1933, President Franklin D. Roosevelt ordered all gold coins and certificates of denominations in excess of $100 turned in for other money by May 1, 1933 at a set price of $20.67 per ounce. In 1934, the government price of gold was increased to $35 per ounce, effectively increasing the value of gold denominated in dollars on the Federal Reserve’s balance sheet by nearly 70 percent. This action allowed the Federal Reserve to increase the money supply by a corresponding amount and led to significant price inflation.
1930s Gold Convertibility Rate ($/troy ounce) Versus CPI Inflation (% y/y)
Source: World Gold Council, FRED, Bureau of Labor Statistics
This historical example demonstrates that the gold standard is no guarantee of price stability. Furthermore, the evidence that price inflation in the U.S. has remained low and stable over the past 20 years since the Fed adopted an inflation target demonstrates that the gold standard is not necessary for price stability. Price stability depends less on whether money is “created out of thin air” as fiat or linked by a certain convertibility rate to a gold standard (also a promise “out of thin air”) and more on the credibility of the monetary authority to manage the economy’s money supply in a responsible manner.
While gold standard proponents argue that the great advantage of the gold standard is that governments cannot manipulate it, history has shown that governments have a great tendency to manipulate a gold standard.
The New York Fed Gold Vault (photo credit: Federal Reserve Bank of New York)
Ben Bernanke, famously wrote in an NBER Working Paper that the deflation that coincided with the Great Depression was “the result of a mismanaged international gold standard.” To give some further historical context, as France held gold in the early years of the Great Depression, countries were forced off the gold standard, and generally recovered in the order they left it.
Log differences in M2 Growth of gold standard countries versus non-gold standard countries during the 1930s
Source: Bernanke and James (1990)
Log differences in industrial production of gold standard countries versus non-gold standard countries during the 1930s
Source: Bernanke and James (1990)
Ramesh Ponnuru makes an excellent argument on National Review that “The drawbacks to a gold standard are well known. If industrial demand for gold rises anywhere in the world, the real price of gold must rise — which means that the price of everything else must drop if it is measured in terms of gold. Because workers resist wage cuts, this kind of deflation is typically accompanied by a spike in unemployment and a drop in output: in other words, by a recession or depression. If the resulting economic strain leads people to fear that the government may go off the gold standard, they will respond by hoarding gold, which makes the deflation worse.”
Price of gold over the past 100 years (1914-2014)
Price of gold per Troy ounce (Photo Credit: Alexander Zhikun He)
UChicago IGM Survey: Mainstream economists unanimously believe the gold standard would not foster price stability or better employment outcomes
Two years ago, the University of Chicago’s Initiative on Global Markets conducted a survey of leading economists across the spectrum of mainstream economists and asked them what their views on the gold standard were. Not one of the 40 of the economists surveyed agreed that “If the US replaced its discretionary monetary policy regime with a gold standard, defining a ‘dollar’ as a specific number of ounces of gold, the price-stability and employment outcomes would be better for the average American.”
Question A: "If the US replaced its discretionary monetary policy regime with a gold standard, defining a ‘dollar’ as a specific number of ounces of gold, the price-stability and employment outcomes would be better for the average American"
Source: University of Chicago Initiative on Global Markets Panel
While opposed to the gold standard, Daron Acemoglu concedes that “a gold standard would have avoided the policy mistakes of the 2000s, but still likely that discretionary policy is useful during recession.” Ed Lazear, a labor economist at Stanford, adds “The gold standard adds credibility when a country lacks discipline. The cost is monetary policy flexibility.” Nancy Stokey, a macroeconomist at the University of Chicago, argues “There are much better ways to avoid excessive inflation, while maintaining the flexibility of a fiat currency.” Robert Hall, a macroeconomist at Stanford, adds “Modern interest-rate feedback rules (Taylor rules) do a vastly better job. The instability of the relative price of gold is way too high.”
Question B: "There are many factors besides US inflation risk that influence the current dollar price of gold"
Source: University of Chicago Initiative on Global Markets Panel
With respect to the second question regarding each economist's opinion on whether “There are many factors besides US inflation risk that influence the current dollar price of gold”, Ed Lazear astutely states that the market for gold “is a market like any other. The supply of gold and other sources of demand affect its price in real terms relative to other goods.”
Regarding how events affecting the supply of gold can create volatility in gold prices, Austan Goolsbee, a University of Chicago economics professor and former Obama economic advisor, adds that many supply side events can rapidly affect the price of gold “new gold reserve discoveries and changes in the technology of extraction, to name two simple examples.”
Bengt Holmstrom, an MIT economist, notes some of the types of events that can affect the demand for gold, stating that “Gold is used as a safe haven in financial crisis. That has little to do with US inflation.” Nancy Stokey agrees noting that “Demand for gold seems to come from concern about the entire financial system. There are better ways to hedge inflation risk.” Daron Acemoglu argues that gold is intrinsically close to useless, so its price is determined as a bubble.
What about a “silver standard” or a basket of metals?
Attempting to refute those who say that the volatility of the price of gold make it an unstable commodity to tie to the dollar, some argue that a bimetal gold-silver standard would be less volatile than a pure gold standard.
The debates over whether to use gold or silver to back the U.S. dollar go back to the 1800s and peaked during the presidential elections of 1896 and 1900, when Democratic presidential candidate William Jennings Bryan was a backer of adopting a full “silver standard.” The issue peaked from 1893 to 1896, when the economy was in a severe depression—also known as the Panic of 1893—characterized by deflation and high unemployment in industrial areas and severe distress for farmers.
The debate pitted the pro-gold financial establishment of the Northeast, along with railroads, factories and businessmen, who were creditors and would ultimately benefit from deflation (resulting from demand pressures on the relatively fixed gold money supply against a backdrop of unprecedented economic expansion), against poor farmers in the Midwest and Deep South who would benefit from higher prices for their crops (resulting from the prospective expansion of the money supply by allowing silver to also circulate as money). “Free silver” advocates also known as “Silverites” were in favor of an inflationary monetary policy using the “free coinage of silver” as opposed to the less inflationary gold standard. The Silverites promoted bimetallism, the use of both silver and gold as currency at the ratio of 16 to 1 (16 ounces of silver would be worth 1 ounce of gold).
While Bryan lost the 1900 election and the “free silver” debate was put to rest, by acts of Congress in 1933 including the Gold Reserve Act and the Silver Purchase Act of 1934, the domestic economy was taken off the gold standard and placed on the silver standard for the first time although international settlements were still in gold.
Price of silver (1960-2014)
Source: RealTerm
Milton Friedman wrote an excellent article in 1990 on the issue of bimetallism revisiting the U.S. historical account. Looking at the time series of the price of silver refutes the bimetallist idea that a gold-silver standard would reduce volatility in the price level since the price of silver has been tremendously volatile, more so than the price of gold over the past century (notice the prices of silver above are on a log scale). Indeed, Milton Friedman exclaims that silver as well as “gold no longer served any useful monetary purpose.”
What about gold in your financial portfolio?
Often among portfolio managers, gold is seen as a safe haven asset that is generally negatively correlated with stock returns as measured by the S&P 500. In some respects it is also seen as an inflation hedge. This begs the question of how much gold should be in your portfolio, if at all? Greg Mankiw and Warren Buffett have a great answer to this question. The World Gold Council estimates that all the gold ever mined amounts to 174,100 metric tons. Using this number, Buffett calculated that if all the gold in the world were made into a single cube, its edge would be only 69 feet long (eg. it could fit well within a baseball infield). The value of this total world gold is about 9% relative to the world’s combined market cap of all stock, bonds, and gold, according to a recent NBER Working Paper by Claude Erb and Campbell Harvey. However, the fraction of available gold in the market relative to the world market cap gets trimmed to 2% when excluding the gold that is in the form of jewelry and the 20% of total world gold held by central banks. Hence to hold the market portfolio of gold, one should hold somewhere around 2% of gold in their portfolio as part of their asset allocation, according to these estimates.
Countries may hold some gold bullion in international reserves, but no country is returning to the gold standard any time soon
While the U.S. still holds roughly $328 billion in gold bullion, perhaps Alan Greenspan is right that China adding some gold to its foreign exchange reserves could improve the renminbi’s strength in the international financial system (it is also important to note that this comes at the same time as increased renminbi exchange rate flexibility is being allowed by the People's Bank of China, China's central bank). However, returning to a gold standard any time soon is not only an unrealistic idea, it is also an imprudent one for any country.
