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Why a "Gold Standard" is Not the Answer (Part Three of a Three Part Series)

Posted on Tuesday, January 08, 2013

Recent debt problems in the United States and across the world at large have brought the notion of a “gold standard” for the currency back into vogue.  The allure of a gold standard is easy to see, since it means that there is a commodity backing for the currency.  Many people believe that pegging the currency to a metal such as gold or silver is an effective mechanism for generating prudent government decisions.  Unfortunately, there is a considerable degree of misunderstanding about what a gold standard really is, and what it really does.


Simply put, a gold standard is a situation where gold bullion is the standard exchange currency for an economy.  In a strict gold standard, this means that all exchange takes place in the form of gold coins.  In a de facto gold standard, the government holds gold that can be exchanged for its issued currency.  Under the Breton Woods system adopted after World War II, currencies were pegged to gold at a fixed exchange rate.  On August 15, 1971 President Richard Nixon ended the Breton Woods gold standard due to a rapid increase in demands for gold in exchange for dollar reserves.  Many people point to this act as the “End of the Gold Standard” for the United States.  (Although the act did allow individuals to own physical gold again)


However, there is a much more important event in regards to gold that occurred long before 1971 that effectively ended any rational semblance of a gold standard for the US currency.  That event was Executive Order 6102, signed on April 5, 1933 by President Franklin Delano Roosevelt.  This order required U.S. citizens to deliver on or before May 1, 1933, all but a small amount of gold coin, gold bullion, and gold certificates owned by them to the Federal Reserve, in exchange for $20.67 per troy ounce.  Subsequent to this order, the Gold Reserve act of 1934 made gold clauses unenforceable, and changed the value of gold from $20.67 to $35 per ounce.  These events effectively seized the gold owned by private citizens, then de-valued the dollars that they had paid in compensation by 40% and prohibited private citizens from owning gold.  This effectively ended any kind of real gold standard for the United States of America.  

With all of this in mind, it is useful to examine some of the advantages and disadvantages of a “real” gold standard for the US currency:


Advantages:


Long-term price stability is the principal virtue of a gold standard.  Under the gold standard, high levels of inflation are rare, and hyperinflation is nearly impossible as the money supply can only grow at the rate that the gold supply increases.  Widespread price increases caused by ever-increasing amounts of currency chasing a constant supply of goods are rare.  The gold supply for monetary use is limited by the available gold that can be minted into coin.


High levels of inflation under a gold standard are usually seen only when warfare destroys a large part of the economy, reducing the production of goods, or when a major new source of gold becomes available.  In the U.S., one of those periods of warfare was the Civil War, which destroyed the economy of the South, while the California Gold Rush made large amounts of gold available for minting.


The gold standard limits the power of governments to inflate prices through excessive issuance of paper currency.  It provides fixed international exchange rates between those countries that have adopted it, and thus reduces uncertainty in international trade.  Historically, imbalances between price levels in different countries would be partly or wholly offset by an automatic balance-of-payment adjustment mechanism.


The gold standard makes chronic deficit spending by governments more difficult, as it prevents governments from inflating away the real value of their debts.  A central bank cannot be an unlimited buyer of last resort of government debt. They could not create unlimited quantities of new money, since there is a limited supply of gold.


These advantages all sound very appealing.  Most people are in favor of stable prices, limited power for the central bank and responsible government policy.  On the surface, a gold standard seems to accomplish all of these things.  However, a few disadvantages must be considered as well.


Disadvantages:


The total gold reserves of the United States government are approximately 286.9 million ounces.  At the current market price of approximately $1,400 per ounce, this represents approximately $400 billion dollars in value.  In order for the United States to adopt a gold standard with its existing reserves, the value of gold would need to equal the M2 money supply of $8.9 Trillion dollars.  This results in a pegged price for gold of $30,986 per ounce.  This transition would immediately increase the purchasing power of all gold owned by foreign countries by over 600%.  In this case, the US would be obligated by nature of its currency policy to exchange over $30,986 worth of products and services for each ounce of gold that is sent into the US.  There would be an immediate flood of gold into the US in exchange for exports of real products and services by foreign entities.  (It is most likely that domestically owned gold would be confiscated in conjunction with this kind of shift in monetary policy)  It should be noted that this phenomenon is more descriptive of the transition to a gold standard than the standard itself.  


The principal inherent challenge of a gold standard is by-product of its principal

 advantage, namely a (relatively) static money supply.  Since the supply of money would only grow at the same rate as new gold reserves, it means that increases in economic productivity will cause deflation.  The reason for this is because prices in an economy are the result of total real output relative to the total money in circulation.  When real output rises without an increase in circulating money, prices decrease.  (Less goods chasing more money)  When the amount of money rises without an increase in real output, prices increase.  (More money chasing fewer goods)  Thus, in a gold-based monetary system, deflation will almost certainly accompany any significant gain in economic productivity.


It is important to understand that under a gold-based monetary system, the economic gains of the 1980’s and 1990’s would have created a large deflationary force that caused many people to delay investment or default on their loans.  Consider that deflation rewards savers and punishes debtors by increasing the real value of dollars over time.  When market values of underlying assets fall over time, the borrower cannot sell for enough to cover their debts. This results in a perpetual increase of real debt burdens for all borrowers.  As this phenomenon ripples out to the wider economy, it is likely to stall credit markets when less people want to borrow since it is more advantageous to hold dollars that are increasing in real value.  When economic growth creates price volatility, it is almost certain that the political authorities will act to “solve” the deflation problem by slowing down the economy.


Under a gold standard, monetary policy is ultimately determined by the rate of gold production.  Fluctuations in the amount of gold that is mined could cause inflation if there is an increase, or deflation if there is a decrease.  Although the gold standard gives long-term price stability, it does so at the expense of higher short-term price volatility.  In the United States from 1879 to 1913, the coefficient of variation of the annual change in price levels was 17.0, whereas from 1943 to 1990 it was only 0.88.  It has been argued by, Anna Schwartz among others that this kind of instability in short-term price levels can lead to financial instability as lenders and borrowers become uncertain about the value of debt.


Finally, a gold-based standard initiates a vast, complex game of exchanging a particular commodity for real goods and services.  In this type of scenario, it is inevitable that many players will attempt to ‘game’ the system and acquire gold through ‘questionable’ methods or attempt to move counterfeit gold.  Ironically, this difficulty is almost identical to many of the problems inherent in a fiat currency system, with the exception that gold is considerably more heavy and much more difficult to transport.  Ultimately, currency (or gold for that matter) have no intrinsic value in and of themselves.  They are merely measuring sticks that facilitate smooth voluntary transactions between people in a large, complex economy.  In the end, it seems that the desired result is economic productivity and responsible government.  


Insights


The gold standard carries some very distinctive advantages and disadvantages that can be simultaneously beneficial and destructive.  The principal feature of a gold-based currency is the limitations it sets on the power of central authorities. When a government cannot inflate indefinitely, it is forced into more prudent decisions.  However, there doesn’t appear to be a definitive reason why a commodity based currency is the optimal means to create this outcome.  


Changing to a gold standard will require new laws from the legislature. However, a different law could be authored that places limits on the power of the central banks to print money and buy/sell debt securities.  By limiting the ability of the central bank to print money, it would avoid inflationary spikes while allowing for modest growth in the supply of money during times of economic expansion.  By limiting the ability of the central bank to trade in debt securities, it would force the government to pay a true market rate of interest and act as a natural curb on irresponsibility.  This strategy accomplishes the principal goals sought by a gold standard, without incurring its dangerous risks.


Many people will argue that the government is unlikely to create laws limiting its own power.  To this, we would reply that banking reforms such as this would encounter much less resistance than completely shifting to a gold standard.  To the extent that either scenario is politically feasible, it is safe to say that simply limiting the powers of the central bank would be far easier to accomplish than confiscating physical gold to back the national currency or increasing the pegged value of gold by over 600% and handing massive purchasing power to foreign entities.  In the end, it is best to focus your efforts in the realm of the “real” economy, and avoid speculating based on what monetary policies are expected to unfold.


Action Item: Buying-up gold and silver in an anticipation of a return to commodity-based currency is not a smart investment.  The only possible way for the US to gather enough gold and silver to back the currency stock is through confiscation and de-valuation, which is effectively the same as our current fiat currency system.  Focus on controlling assets that provide real value to real people.


The JasonHartman.com Team

"The Complete Solution for Income Property Investors"



* Gold Image by Salvator Vuono (http://freedigitalphotos.net)

* Silver Image by Salvator Vuono (http://freedigitalphotos.net)

 


Comments (2)

  1. Tiny_1399666016-avatar-ireallylikethis

    This is interesting reading, but if you would, please take a step further and make this relevant to real estate investment. What relationship does gold have with the value of real estate?


  2. Tiny_1399656930-avatar-jasonhartman1

    Hi John, Thanks for the question. The relevance I see in regard to the gold vs. real estate issue is that, through advertisers and commentary, the financial media has positioned precious metal as the “savior” for the small investor against the ravages and wild swings of the stock market. To my way of thinking, gold, though probably preferable to Wall Street offerings, suffers from two of the same intrinsic drawbacks when compared to real estate. Problem #1: You can’t rent out gold and collect a monthly cash flow like you can with rental property - at least, I’ve never figured out a way to get someone to pay me for the privilege. Maybe I’m doing something wrong. The reality is it’s silly to even think about it. Who wants to rent gold? Exactly the point. Problem #2 - The other big advantage real estate enjoys over any precious metal is leverage. With what other asset can you put down 20% of the purchase price, turn around and rent out the asset, and then own the asset free and clear at some point in the future, never having actually paid any more money out of your pocket than the original down payment? It’s like enjoying an 80% price discount for borrowing the money to buy rather than paying cash. These are the two main reasons I think income property investing enjoys a distinct advantage for gold. Thanks again! Jason


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