All Commentary
Wednesday, March 23, 2011

Gold and Money, II

Last month we examined some propositions about gold as money, drawing from theory and history. This month we ask whether and how gold might once again serve a monetary function.

Money of any sort, commodity-based or not, derives its value in large part from what economists call a “network effect.” Like a fax machine, whose value depends largely on how many other people have fax machines, we value money because other people value it. We feel confident our money will buy us what we need tomorrow. A strong network effect means that something drastic has to happen before people will give up their familiar form of money.

Something drastic was happening when U.S. Rep. Ron Paul’s Gold Commission was set up in 1979. By the time the commission’s report was issued in 1980, inflation had reached alarming levels: The consumer price index was at 14 percent and rising. The prime rate was over 20 percent, and in 1980 silver exploded to $50 an ounce and gold surpassed $800 (about $2,300 in today’s dollars). Bestselling books urged people to buy gold, silver, diamonds, firearms, and rural hideouts.

We now know that inflation was peaking and that the silver price spike was a fluke caused by a failed attempt to corner the silver market. But none of this was apparent at the time, so it was reasonable to wonder whether our monetary system would survive. What did happen, of course, was that the new Fed chairman, Paul Volcker, stepped on the monetary brakes hard enough to break the back of inflation. Two back-to-back recessions resulted but were followed by a long period of recovery in which both inflation and interest rates dropped steadily. The Gold Commission was largely forgotten, though the U.S. Mint did get into the business of producing gold coins in a big way.

We have a crisis of a different sort at present, featuring unprecedented levels of public and private debt rather than inflation. In addition, global trade has advanced significantly and worldwide financial markets are tightly linked. Many new financial innovations have emerged since 1980, not just the sophisticated derivatives that were at the center of the 2008 crisis, but also innovations such as exchange-traded funds (ETFs) that are available to everyone. The euro is in trouble, and there is a real possibility that a Chinese property bubble is about to burst. Gold is above $1,400 an ounce, up from $250 a decade ago, while silver has advanced from about $5 to over $30 an ounce.

Ron Paul is no longer a lone voice calling for a return to gold. Robert Zoellick, president of the World Bank, astonished everybody recently when he wondered out loud whether gold should again play a monetary role. Although he drew praise from some quarters, most comments were dismissive. Berkeley economist Brad DeLong, for example, nominated Zoellick for the “Stupidest Man Alive.” One is reminded of Gandhi’s four steps to victory: First they ignore you, then they ridicule you, then they fight you, then you win.

In 2010 the Central Bank of China imported over 200 tons of gold, more than offsetting recent IMF sales. This is in addition to the 350 tons that are mined in that country annually. Wealthier Chinese citizens are adding it to their portfolios. While substantial, Chinese gold holdings are still dwarfed by their holdings of U.S. Treasury securities. The gold purchases may be intended mainly as a signal of its displeasure with dollar hegemony. Other central banks are acquiring gold in smaller amounts.

Monetary Links to Gold

Within just a few years ETFs have attained a prominent place in the investment world. None has been more amazing than the SPDR Gold Trust (GLD), which purchases and stores gold bullion for the benefit of its shareholders. This fund was launched in 2002 by the World Gold Council, an industry group, as a means of stimulating demand. The results have exceeded their wildest dreams. GLD now holds about 1,300 tons of gold bullion, a hoard larger than that of any central bank save four. (A metric ton of gold would fill a large suitcase and have a market value of about $45 million.) Competing funds of the same sort now offer silver, platinum, and palladium in addition to gold.

Gold coins are also selling at a brisk pace. The U.S. Mint offers Gold Eagles along with an array of silver and platinum coins. But it’s difficult to get one-ounce Eagles at present, and the smaller sizes have been discontinued entirely because the Mint has run short of bullion inventory. Presumably this is bureaucratic ineptness, because the bullion markets are highly liquid. Canadian Maple Leafs, South African Krugerrands, and others that compete with the U.S. coins are readily available. These are all “bullion coins,” so-called because their value is only marginally above their gold content.

The one-ounce Gold Eagle and the Maple Leaf have an interesting feature: They are legal tender, the Eagle for $50 and the Maple Leaf for C$100. While the gold price will surely never again see such low levels, it is interesting that the authorities saw fit to establish this modest link between gold and money.

Soaring prices for precious metals and unprecedented demand for bullion gold and silver coins are an obvious sign that investors are worried. Anyone who buys bullion or coins has to be concerned enough to forgo interest income and pay, directly or indirectly, storage and insurance costs. If and when confidence in the world’s monetary and banking institutions returns, we can expect a rush out of precious metals and into productive assets.

Now to the central question: Will gold again be money?

Don’t Call It a Comeback. Yet.

Gold is too volatile, say some. If, for example, the Fed were to adopt a stable gold price as its monetary target, it would be hitching the U.S. economy to a wild horse. If the Fed had tried to track gold’s recent rise, it would have had to engage in massive quantitative “dis-easing.” Monetary deflation added to falling aggregate demand would have been a disaster.

The problem with this argument is that it takes the gold price as given. Had the Fed hitched its wagon to gold some years ago, it would have added significant inertia to the “wild horse” and it is likely that the run-up would have been milder or nonexistent.

Still, gold targeting by the Fed is probably not a good idea. The Fed has lost a great deal of credibility of late, thanks in part to Chairman Ben Bernanke’s recent declaration on 60 Minutes that the Fed would not “print money” to carry out the next round of quantitative easing. The chairman’s life will only get more complicated now that Ron Paul has become chairman of the House Subcommittee on Domestic Monetary Policy. Should the Fed adopt gold targeting, markets would need to be shown over a long period that it was serious about hewing to gold in the face of political pressures to the contrary.

One hundred years ago it was common to link contracts such as railroad bonds to gold. I have in my possession such a bond, issued in 1893 (it’s a beautifully engraved document, incidentally), which promises to pay at maturity “one thousand dollars in gold coin of the present standard of weight and fineness.” Borrowers probably didn’t expect to be paid with a stack of 50 gold coins, which would have been inconvenient. Rather, the phrase was meant to protect the borrower from future government debasement of money. But sanctity of contract went out the window in 1933, when Franklin Roosevelt abrogated all such private contracts at a stroke. Predictably, 50 one-ounce gold coins now fetch nearly $70,000.

Gold Clauses

A comeback of gold clauses in business contracts is a realistic possibility, provided they could survive legal challenges based on legal tender laws. Imaginative clauses could be created that guaranteed a return in dollars at least partially linked to the gold price. Such things already exist, in fact. Everbank, an online bank, currently offers, among other innovative products, a five-year certificate of deposit whose return is tied to the price of a basket of precious metals. At worst, investors get their principal back. At best, their five-year return is capped at 50 percent. Everbank is not, of course, issuing gold-backed money, but it is coupling gold to money’s role as a store of value.

Another possibility is that shares of GLD could assume an informal monetary role. Those shares currently trade for about $135 each. Originally they represented one-tenth of an ounce but have lost some value as administrative charges have been deducted. New sub-shares, perhaps representing one gram each, would equate to $45. Getting such sub-shares into circulation would be much easier via the Internet than getting paper shares into circulation. Such schemes would of course require government forbearance backed by political pressure. That pressure would not likely arise until and unless the current financial crisis grew to alarming proportions.

In 2003 was established as an online gold-payment service, growing to five million accounts in 2008, according to its owners. That year the company pleaded guilty to conspiracy to engage in money laundering and conspiracy to operate an unlicensed money-transmitting business. The company’s problems seem to have had more to do with security than with gold per se. Still, the e-gold case serves as a reminder that innovators in gold payments may face legal problems.

Recently J.P. Morgan Chase announced that in addition to Treasury securities, it would begin accepting gold as collateral for certain loans. “Many clients are holding gold on their balance sheets . . . and are looking to make these assets work for them as collateral,” said a company spokesman. “It gives another use to gold as a cash instrument,” added a commodities analyst, exaggerating only slightly. Indeed, Treasury securities are considered very close to money itself in terms of safety and liquidity, so it is rather remarkable to see gold accepted as substitute collateral even in this minor sector of the financial markets. It suggests a gradual movement of gold toward monetary status.

New Currencies

What about a new currency backed by the Fort Knox holdings? There would be practical difficulties, assuming most of the gold is in 400-ounce bars, each with a dollar value exceeding a half-million. It would be expensive to convert all this to coin, and besides, the smallest practical coin, perhaps five grams, would still represent over $200. A $10 gold note would fetch a mere speck of gold. More realistic than gold notes would be a spinoff of a new gold exchange-traded fund. Shares of that fund might gain gradual acceptance as money, especially if a dollar crisis were in progress.

U.S. public or private institutions aren’t the only possible sources of a return to gold. Though globalization has been fostered by declining trade barriers and transportation costs, we still lack the considerable advantages of a uniform worldwide currency or rigidly linked currencies. In the late nineteenth century, when all major currencies were tied to gold, the dollar/pound exchange rate was no more worrisome than the inch/centimeter exchange rate. As things stand now, firms doing business in different currencies must divert significant resources away from satisfying customers and into managing exchange-rate risk. Currency fluctuations have not been minor, as Milton Friedman expected when he first proposed floating exchange rates. During 2010, for example, the euro ranged between $1.19 and $1.45—a variation wide enough to turn a multinational firm’s yearly profit into a loss or vice versa. The need for a new global currency may be an opportunity for some enterprising central bank—China’s perhaps—or some private firm to establish a new international form of gold-linked money or near-money.

There are those who defend the gold standard on ideological grounds, claiming near perfection for it. This is unrealistic. For example, price inflation can happen under a gold standard. Ironically, as confidence increases in a fractional-reserve gold standard, people are less inclined to hold monetary gold. The multiplier increases, and there is price inflation—mild, gradual, and predictable. Increasing prosperity and the consequent increasing demands for nonmonetary applications of gold such as jewelry or technology would work in the opposite direction: The supply of monetary gold would drop, causing deflation. New gold discoveries or better mining techniques dilute gold’s purchasing power—another inflationary development likely to be mild and gradual. But it is conceivable that someone could invent an economical process for converting base metals into gold—the alchemists’ dream. This very unlikely development could be a major disruption to an economy using gold-backed money. The most likely situation under a gold standard would be gradual, mild deflation as happened in the late nineteenth century. In short, a totally stable price level, if such could be defined, is not something to expect from a gold standard.

Resource Costs and Stability

We cannot overlook the resource cost of gold locked away as backing for money. Monetary gold cannot be used for jewelry or electronics. Friedman once dismissed a return to gold on the grounds that the resource cost would amount to 2 percent of GDP. But his estimate was predicated on 100 percent backing of the wider M2 money supply. Under a fractional reserve system, the cost would be much lower.

Of course, monetary gold lying “idle” in a vault is only idle in a naive physical sense. A gold bar sitting undisturbed in a vault is producing security for holders and users of money day in and day out. The irony here is that while the amount of monetary gold would likely decrease as a fractional-reserve gold system gained confidence, our present system seems to require the retention of 8,000 tons at Fort Knox, while leaving the control of money under the increasingly politicized Federal Reserve—the worst of both worlds.

It is possible that stability will return to our current monetary and banking systems. We could have a repeat of 1980 and a couple of decades of stability and growth. If not, there is good reason to believe that gold will make a return in some form.

  • Warren Gibson teaches engineering at Santa Clara University and economics at San Jose State University.