Originally posted by
Emil El Zapato
My personal opinion is that any power broker who advocates for a gold standard is fishing for personal power. Anyone else, as stated in the article is simply fantasizing.
This paper is based on a study commissioned by the World Gold Council
The attraction of returning to a (unilateral) gold standard
What is the attraction of returning to the gold standard?
As Wolf writes, the attraction of a link to gold (or some other commodity) is that the value of money would apparently be free from manipulation by the government. The aim, then, would be to “de-politicise” money. The argument in favour of doing so is that in the long-run governments will always abuse the right to create money at will. Historical experience suggests that this is indeed the case.
Hayek therefore called for “[p]rotecting money from politics”.
Several economic historians have highlighted the merits of the classical gold standard, which have been attributed as facilitating the first period of globalisation. In their seminal work A Monetary History of the United States, 1867-1960, Friedman and Schwartz write that
[t]he blind, undesigned, and quasi-automatic working of the [classical] gold standard turned out to produce a greater measure of predictability and regularity – perhaps because its discipline was impersonal and inescapable – than did deliberate and conscious control exercised within institutional arrangements intended to promote monetary stability.
Bordo argues that “in several respects, economic performance in the United States and the United Kingdom was superior under the classical gold standard to that of the subsequent period of managed fiduciary money.”
Bordo and Rockoff referred to the gold standard as a “good housekeeping seal of approval”, suggesting that governments will be bound to pursue prudent policies. Proponents of the gold standard expect more fiscal discipline, as governments will no longer be able to monetise debt. Proponents of a return to a gold standard therefore argue that it will help to instill greater investor confidence in the currency, restore macroeconomic stability and stop capital outflows.
It should be noted that one advantage of a global gold standard would not be achieved through the unilateral adoption of a gold-backed currency, that is, exchange rate stability among the countries linked to gold. Accordingly, the disciplining pressure on current account imbalances, which under the full-fledged gold standard is linked to David Hume’s specie flow mechanism, will remain limited.
Unilateral arrangements of the kind described above could help to increase the credibility of a country’s monetary policy, as they diminish room for discretionary policy in nearly the same way as currency boards do. Moreover, if the central bank’s credibility is low, steadily building up (gold) reserves may help to restore confidence in the currency and improve the central bank’s credibility over time. But as long as the arrangements stay unilateral, they do not have any effect on the international monetary system.
Preventing excessive money growth and inflation represents the central argument in favour of fixing one’s currency to the price of gold or some other nominal anchor. What are the disadvantages? The main argument against such a rigid anchor is that a strict rule prevents monetary policy from responding to the needs of the domestic economy. The mismatch problem between the constraints of the anchor and the needs of the economy can take three forms: (i) loss of monetary independence, (ii) loss of automatic adjustment to export shocks and (iii) extraneous volatility. These problems will be discussed in greater depth below. First, however, we discuss how a return to a gold standard could be managed.
What kind of gold standard?
The first and most important question for a country that seeks to introduce a gold standard is: what kind of gold standard? Wolf lists four different variants for adopting a gold standard. The first and “most limited reform”, according to Wolf, “would be for the central bank to adjust interest rates in light of the gold price”. However, as Wolf points out, “that would just be a form of price-level targeting” and there is “no reason why one would want to target the gold price, rather than the price of goods and services, in aggregate”.
The second and most extreme option, according to Wolf, “would be a move back into a world of metallic currency”, an option that is entirely unrealistic given that in a modern economy “money in circulation will continue to be predominantly electronic, with a small quantity of paper, as today”.
Wolf also dismisses the third option, “a return to the Bretton Woods system, in which the US promised to convert dollars into gold, at a fixed price, but only for other governments”, for “lack[ing] any credibility, since there would then be no direct link between gold stocks and the domestic money supply”. It should be added that a revived Bretton Woods-type system would also be entirely unrealistic politically.
The fourth variant, according to Wolf’s classification, “would be a direct link between base money and gold”, which Wolf regards as the “obvious form of a contemporary gold standard”.
A further option, discussed by White, is allowing a private, parallel gold standard alongside fiat currency issued by the state. While this option would be relatively unproblematic, similar to the emergence of various virtual crypto currencies, it would not help to achieve the original goal of creating a stable currency issued by a credible central bank. In the following, the discussion will therefore focus on variant four, the backing of base money – notes and coin issue plus commercial bank deposits with the central bank – by gold.
The adequate amount of gold reserves
There is no common agreement about the adequate amount of gold reserves needed to back a credible gold standard arrangement. A very rigid option would be to require the monetary authority to back base money 100 per cent by gold, “with the unit of account ... defined in terms of a given weight of gold”. Such a system would be like a currency board regime operating on gold, where the monetary authority promises to back the domestic currency by 100 per cent with gold instead of foreign exchange reserves.
However, as Wolf correctly points out, “It is wasteful to hold a 100 percent reserve in a bank, if depositors do not need their money almost all of the time.” White therefore argues that “[t]he most efficient form of a contemporary gold standard makes gold the base money – that is, the medium of redemption and unit of account – while currency and other common media of exchange are the fractionally backed gold-redeemable liabilities of commercial banks.”
Taking history as a guide, the credibility of a gold standard system does not necessarily correspond with the amount of reserves. As Lewis points out,
If a government aims to break its promise with the people, it does not matter if gold has been piled to the rafters in Midas’s treasury. With a stroke of the pen, as Roosevelt did in 1933 and Nixon did in 1971, the government can confiscate the gold and tear the gold standard to tatters.
Indeed, historically, a 100 per cent gold backing has been the exception rather than the norm. The Federal Reserve Act of 1913, which “legally preserved gold as the ultimate monetary standard in the United States ... required that Federal Reserve Banks maintain ... a minimum ratio of gold reserves to currency and deposits”28 of 40 per cent and 35 per cent, respectively. According to Lewis, the bullion reserve held by the US Treasury fluctuated “[f]rom 1880 to 1920 ... between about 10% and 40% of banknotes outstanding. It was never 100%. … The 100% reserve gold standard that people sometimes talk about today is a fantasy.”
Apparently, the amount of gold reserves held by central banks depended on the credibility of the central bank’s promise to convert notes into gold, and not vice versa:
As England’s pound sterling grew to become the center of the entire world monetary and financial system in the latter nineteenth century and early twentieth, the reserves did not increase. Trust in the Bank of England’s sound monetary policies was so great that not only did people happily accept the bank’s consols (short for “consolidated,” government bonds that never matured), but from the 1880s to 1914 the bank’s gold reserves could be kept between £20 million and £40 million, while France and Russia kept over £100 million each. … An increase or decrease in reserves does not in itself imply a deviation of the currency from its gold peg, although it could be evidence of such.
Economic history shows that the standing of banks like the Bank of England and the Banque de France was such that they could get away with a lower ratio of gold to M2, whereas the central banks of peripheral countries needed to hold higher reserves. Moreover, it should be highlighted that not all countries participating in the gold standard were fully credible. Analysing currency risk premia, Mitchener and Weidenmier find that “[i]n contrast to core gold standard countries, such as France and Germany, the persistence of large premia, long after gold standard adoption, suggest that financial markets did not view the pegs in emerging markets as credible and expected devaluation”.
In this context, Frankel raises an important point, namely that in principle it should not matter whether currency reserve holdings are in dollars or gold, but “there may be something ‘empowering’ in the public mind of a gold-producing country to back its currency by gold”.
Overall, the implication from this discussion for a country that seeks to adopt a gold standard today is that it should not strive for an illusionary 100 per cent backing of base money with gold reserves. Yet for the system to develop credibility, the monetary authority would probably need to build up gold reserves relative to base money in the area of 30 to 50 per cent. However, there is no scientifically founded approach which would enable us to exactly determine the adequate gold coverage.
Managing the transition to a gold-backed currency
A stern transition challenge “is the mismatch between the value of official gold holdings and the size of the monetary system”. A crucial question is: how should the conversion rate between gold and domestic currency be fixed? This is no trivial question, given that the international gold price has been fluctuating widely in recent decades and there is no reason to expect this to change.
Given that around 90 per cent of gold is privately held today and that no single central bank will be able to control the international gold price, the question of the apposite parity needs to be linked with the question of who will be allowed to convert domestic currency into gold. As Wolf points out, “if policymakers set [the] initial price wrong, as they certainly would, they could unleash either deflation or inflation: the latter is far more likely, in fact, because private holders would start selling their gold to the central banks at such a high price” – given the central bank would allow individuals to do so. This could lead to a large expansion in the monetary base. Moreover, if the international gold price rises above the domestic parity rate and the system is not fully credible, this would create incentives to convert domestic currency into gold and sell the latter internationally, creating a drain of gold out of the domestic economy that would result in deflationary pressure.
To prevent in- and outflows of gold from the economy, the authorities could install capital controls. But it is doubtful that these could be effective, given that gold can be melted and cast into any shape. (One is tempted to think of the James Bond film where the film’s villain, Auric Goldfinger, uses the bodywork of his Rolls-Royce to smuggle gold across Europe.)
How would a country seeking to back its currency with gold go about accumulating sufficient gold reserves? The answer seems straightforward: the respective country should try to achieve current account surpluses and, assuming appreciation pressure on the domestic currency, intervene in the foreign exchange market. It could then use the resulting foreign currency reserves to purchase gold from private hands. Moreover, it could sell state assets and use the proceeds to buy gold.38 Moreover, as pointed out by Frankel, “a gold producer has the alternative of earning some of its gold reserves by domestic mining”.
Monetary policy under such a regime
Under the classical gold standard, the Bank of England, the exemplary central bank of the system, would raise the “bank rate” whenever Britain had a balance-of-payments deficit and gold flew out of the country. The higher rates would reduce the domestic spending and the price level and stop capital outflows. White, however, argues that no monetary policy would be necessary, as the money stock would be in any case endogenous under a gold standard.
A question with far-reaching implications for the operation of such a system is whether gold would be exchangeable for currency. We would not see it as a viable option for the central bank of the unilaterally gold-backing country to commit to converting domestic currency into gold. If, for instance, the international gold price began sky-rocketing and the convertibility promise of the central bank grew less than fully credible, private holders of the gold-backed domestic currency would have an incentive to convert their domestic currency holdings into gold and exchange it into international currency (e.g. the US dollar) at international market prices. In an extreme case, this could lead to a “bank run for gold”. If gold-backing is not fully credible, one would cash in one’s money against gold in cases of doubt.
Moreover, foreign central banks could print their own national currency, use it to buy gold-backed currency, and then ask the issuing central bank to exchange it for dollars. For example, the Fed – endowed with the “exorbitant privilege” to print unlimited supplies of the world’s key currency – could easily benefit from a foreign central bank’s promise to convert money into gold and simply ramp up its own gold reserves.
It should be noted that foreign central banks, with the exception of the Banque de France, would not have taken advantage of arbitrage opportunities in gold markets under the former Bretton Woods system, not least because this system was also a political system where, say, the Bundesbank would not have dared to ridicule the US government. Hence, in a unilateral gold-backed system, any obligation of the central bank to convert currency into gold would not make much sense, even though this would undermine the credibility of the entire system, which, after all, is built on the promise to back the currency with gold. Hence, we do not see how convertibility of a gold-backed currency can be maintained for foreign central banks.
A further important question is whether gold is permissible as collateral at the central bank. There is no obvious contradiction with the principle that, under the arrangement of a unilateral gold-backing of the domestic currency, money creation takes place (at least partly, if gold-backing is partial) proportionally to gold on the central bank’s balance sheet. On the contrary, Reynolds argues with respect to the usage of gold as collateral for open market operations in the early 1990s: “Yet the familiar central bank manipulation of fiat money cannot possibly work in Russia. There is no efficient market in safe securities, therefore no possibility of conducting open market operations in anything but gold or hard currencies.” This view is supported also by Angell: “Alternative vehicles for open market operations, such as gold or foreign assets, perhaps could be best viewed as necessary during the transition phase. Their merits after a transition period might then be usefully re-examined.” Moreover, there is a clear analogy with the usage of gold-backed sovereign debt as collateral if the credibility of the country taking part in monetary policy operations is low.
An explicit blueprint for how such a system might work in practice is not available in the academic literature. However, unilateral gold backing may be equated with a modified gold standard à la Fisher, as explained in a slightly different context by Hofmann and Sell.44 The application of a modified Fisher rule of course presupposes that the institution in charge of monetary policy has some means of coverage, such as gold, at their disposal, whose purchase and sales price it is steering.
In order to reduce price volatility, Fisher suggested in 1923 a modified version of the gold standard. He proposed that when the price level changes, the central bank should consciously deviate from the fixed parity between the national currency and gold.
The gold dollar is now fixed in weight and therefore variable in purchasing power. What we need is a gold dollar fixed in purchasing power and therefore variable in weight ... As readily as a grocer can vary the amount of sugar he will give for a dollar, the government could vary the amount of gold it would give or take for a dollar.
Applied to any domestic currency like the rouble, this would imply the following: if the purchasing power of gold in the domestic currency area falls and thus leads goods prices to rise (the gold/goods ratio in Equation (1) rises), the central bank has likewise to increase the amount of gold per domestic currency (e.g. the rouble). This, in turn, would lead to a fall in the gold price in domestic currency (e.g. the rouble). In other words, the domestic currency/gold ratio in Equation (1) falls.
Domestic currency/Goods = Domestic currency/ Gold + Gold/Goods (1)
Monissen summarises the above transmission mechanism as follows:
Even if one ignores the effects of reduced gold production or of an outflow of gold as a result of rising imports (which foster the adjustment process), the non-bank sector will increase its purchases of gold. The effective money supply will diminish and the original inflationary tendency will be eliminated.
According to Fisher, exactly the opposite would be conducted should the general price level fall, with the aim that the overall purchasing power of the domestic currency (domestic currency/goods) will remain constant in the long run.
Necessary preconditions for the effectiveness of his ingenious and at the same time simple plan are that gold is also sought-after and held for non-pecuniary reasons and that a central policy body buys and sells gold at the stipulated gold price without restrictions.
Exchange rate policy work under such a regime
If the currency is tied to gold, the exchange rate of the home currency would move concurrently with the gold price (of course with a discount if the domestic central bank lacks credibility). This implies that the domestic country would in effect lose control over its exchange rate; as Frankel points out, “For most countries, a peg to gold translates extraneous fluctuations in world gold market conditions into needless fluctuations in local monetary conditions.” However, the situation may look different for gold-producing economies where gold production makes up a dominant part of total goods production, seeing that “[t]he gold exporter gets the best of both the fixed and floating worlds: a nominal anchor and automatic adjustment to terms of trade shocks”.
This result, however, would apply only to an economy where gold exports make up a significant amount of exports. For other economies pegging to gold, a collapse of the gold price in terms of dollars would be less favourable: it would not only lead to a depreciation of the gold-backed domestic currency against the dollar but could also have strong inflationary effects through imported inflation.
Changes in the dollar price of gold could also have significant fiscal effects if the unilaterally gold-backing country is an exporter of commodities beyond gold, such as oil, because commodities are usually priced in US dollars. Hence, commodity income and thus the fiscal situation of the respective economy may be strongly affected by gold price movements. This nexus could even have a political dimension.
Gros, for instance, argues that for Russia, falling oil prices may be the harbinger of a much less aggressive Russian political and military stance, because oil income makes up a significant part of the Russian public budget. Oil revenues play an important role within Russia’s fiscal framework because of the taxes levied on private oil companies and because of the profits the treasury obtains from government-owned producing facilities. Exactly for this reason, the prevailing strategy – until recently – was to let the rouble slide in tandem with falling oil prices to balance its rouble-denominated government budget.
To summarise, the main message here is that gold-backing of the domestic currency leads to a loss of control of the exchange rate and potentially massive consequences for the domestic economy. These consequences can be good or bad. If the gold price falls, the domestic currency depreciates. There will be imported inflation and for a commodity exporter, import earnings in dollar terms remain unchanged but go up in terms of the domestic currency, with a positive fiscal effect.
If, instead, the dollar price of gold rises, the home currency appreciates. This in turn increases the purchasing power of the national currency and (in the extreme case) may lead to imported deflation. For a commodity exporter, this means that import earnings in dollar terms remain unchanged but go down in terms of the domestic currency, with a negative fiscal effect. In both cases, political consequences may arise as described by Gros.
Conclusions
Our main conclusion is that a system of a unilateral gold-backed currency would not necessarily bring price stability, as the country would not be able to control the international gold price. While a gold-backed currency may be attractive in a global high-inflation environment, the attractiveness of gold standard proposals is significantly lower in the current context of low inflation.
Moreover, as discussed above, a gold peg does not make sense for countries preponderantly exporting commodities other than gold.
Finally, in order to be effective, the adoption of a gold-backed currency (if done by a country for which there are some incentives to do so, such as Russia) cannot be fully convertible by construction. This may limit its acceptance in international trade, and the new currency would not differ very much from a normal fiat currency. This can actually be regarded as the central argument against introducing a unilateral gold-backed currency.
“El revolucionario: te meteré la bota en el culo"
Posting Permissions
Reply With Quote
Bookmarks