Goldmender October 2012

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Goldmender
Would a return to a gold standard help?


Republican policy drafts suggest the establishment of a Gold Commission ,
and the possible return to a gold standard and abandonment of Bernankes QE
policies. We review the implications of a gold standard, and what it would
likely mean for financial markets.
Ever since Governor Rick Perry suggested that Ben Bernankes QE policies were
Treasonous, intimating that the policy was an unpatriotic currency debasement, the
Republican campaign has been in search of an alternative to the Feds current monetary
strategy. As well as probably replacing Ben Bernanke as Chairman of the Fed, and
possibly an audit and complete reformulation of the Federal Reserve, this party has
recently toyed with the re-introduction of some form of gold standard, an anchor for the
USD, and for monetary policy.
In what follows, we consider the pros and cons of a return to some form of gold standard
in terms of how it addresses the economic problems suffered in the US today. However,
we have to say from the outset, that we can find few arguments that would support such
a policy shift.
The starting point for this discussion is to set out what such a gold standard might entail,
and of course, until and unless this Gold Commission is set up and deliberates, we have
almost nothing to go on here, so we will limit this first part to a few generalisations.
Fi g 1 US GDP and I nf l at i on dur i ng and out si de gol d st andar ds
-15
-10
-5
0
5
10
15
20
25
Dec-30 Dec-40 Dec-50 Dec-60 Dec-70 Dec-80 Dec-90 Dec-00 Dec-10
CPI, YoY% Real GDP, YoY%
YoY%
periods of US gold
standards
(excluding World
War II)
=

Source: EcoWin, ING

In its pure form, a specie gold standard circulates the currency in the form of coins with a
fixed gold content (sometimes a gold and silver specie). But we have moved on a bit
since those lute-playing times. An American-Eagle based US economy is probably more
of a post-nuclear apocalyptic alternative than a serious contender to todays Fed.
A gold bullion standard seems a more likely candidate, where US dollar notes are freely
exchangeable for gold bullion at a fixed price. This could be combined with a gold
exchange standard, in which other countries fix their currencies to a gold backed USD, to
FINANCIAL MARKETS RESEARCH
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Economics
1 October 2012

Gol d spot pr i c e ($/oz)
0
500
1000
1500
2000
64 70 76 82 88 94 00 06 12
Source: EcoWin

Gol d and oi l
1000
1200
1400
1600
1800
2000
J an 10 J an 11 J an 12
70
80
90
100
110
120
130
Gold bullion spot,
lhs ($/oz)
Oil Brent $ bbl, rhs
$/oz $/bbl
Source: EcoWin

Gol d and US money st oc k s
0
2
4
6
8
10
Gold* M1 M2
$tr
Source: EcoWin
* Official holdings


Rob Carnell
Chief International Economist
London +44 207 767 6909
rob.carnell@uk.ing.com


Goldmender October 2012

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produce something that would look very like the Bretton-Woods system that took over
from existing Gold standards after the Second World War up until 1971.
Simply put, backing the currency with gold provides a limit to the monetary expansion
possible by the central bank. With a 100% gold reserve standard, the money supply is
fully backed (a bit like a currency board) and convertible into gold bullion. An economy
under this regime could only expand its money supply to the extent that it accumulated
gold through running current account surpluses, or through an increase in the rate at
which it mined gold. Such increases would likely be very limited indeed unless the
currency was substantially undervalued.
In contrast, todays financial world allows central banks to influence in both directions the
money multiplier of a fractional banking system by altering money market rates, and in
extremis, can create (and destroy) money electronically, giving far greater flexibility to
monetary policy to offset growth or contractions.
Flexibility sounds like a good thing to have, and indeed, this is how it sounds to the vast
majority of economists. That said, Austrian school advocates will argue that a less than
fully backed gold reserve standard, say with only partial backing, would allow for a much
more flexible approach of the central bank to monetary policy, whilst also providing
benefits in terms of enhanced anti-inflation properties.
The Federal Reserve Act of 1913 set out just such a partial reserve system, in which the
Federal Reserve Banks would have to maintain reserves in gold of lawful money of not
less than 35% of its deposits, and not less than 40% against its Federal Reserve notes.
In practice, this gave the Federal Reserve the power to use discount rate policy to choke
off or unleash credit growth according to the state of the domestic economy. However,
such a partially backed currency regime would preclude the sort of long-running stimulus
that the Fed has been running since the global financial crisis. In times of crisis such as
this, gold reserves would quickly become depleted, undermining confidence in the
currency and eventually breaking the link with gold, as it did multiple times during the
somewhat chequered history of gold standards.
Indeed, the litany of crisis and economic disaster, both during, and frequently because of
previous instances of gold standards, is so long and chequered, that it seems remarkable
that anyone with any inkling of economic history would go down this path:
Britain, which prior to the First World War, had enjoyed global reserve currency status,
attempted to rejoin the gold standard at its pre-war parity of $4.8665 in April 1925,
following a bout of deflation that had brought its price level down by 50% since 1920. The
high interest rates that the Bank of England had to maintain to achieve this parity
condemned Britain to further years of economic stagnation, which was brought to a sticky
end in 1931 after market panic in Austria and Germany following the collapse of
Kreditanstalt leading to the liquidation of sterling deposits in exchange for gold.
With Britains abandonment of the gold standard, the USD became the default gold
standard reserve currency, whilst central banks in Europe had opted to adopt a gold
bullion standard rather than a gold exchange standard to limit gold outflows. These banks
continued to run down foreign exchange, and the steady outflow of gold from the US was
only partially sterilised by the Federal Reserve through stimulatory open market
operations. The Great Depression in 1929 led to a flight of funds from the US, and by
1933, thanks in part to the tight policy implemented to defend the gold standard, stock
prices were down 80% from the 1929 peak, and output, wholesale prices and the money
supply were all down by about two thirds of their 1929 level. In March 1933, the gold
standard was abandoned once more.
A gold backed currency loses
the flexibility of an unfettered
money supply
and generally, more
flexibility is a good thing
Austrian school economists
argue that you can have your
cake (gold standard) and eat
it too (partially backed)
Partially backed systems
were use din the US before
World War 1
The history of gold standards
is not an untroubled one
Britain ruined itself on poorly
judged parities with gold
resulting in the USD taking
over as the worlds gold
reserve currency
Goldmender October 2012

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Following the Second World War, the Bretton Woods system re-established a gold
exchange standard with the USD fixed to gold, and other countries pegging their
currencies to the USD. But failure of the US to play by the rules, mainly because of the
heavy fiscal costs of the Vietnam War, and a resumption of steady gold outflows, led to
the abandonment of this system in August 1971. Interestingly, it was the death throws of
this system that gave rise to the first episode of the Twist policy. This policy was
originally designed to prevent gold outflows by selling short-dated paper to raise short-
dated interest rates, buy buying long maturity bonds to provide some stimulus through
lower long term rates. It didnt work then either.
Aside from its disappointing history, critics of a gold standard suggest that the current
stock of gold is insufficient to back a currency like the US. A snapshot of the current
situation suggests they are right. The US Fed holds about 8,150 tonnes of gold,
approximately 23% of total world gold reserves, which themselves amount to about 18%
of the total world stock of gold (the rest is held in jewellery etc). At the current value of
$1771 per troy ounce, and with 32,150.754 troy ounces in a tonne, this equates to a
value of $460bn or thereabouts. This contrasts with the stock of currency in circulation
plus demand deposits of $1.6tr. Of course, this might provide a starting point for a partial
reserve standard (of about 25%), though we would imagine that the US might want to
substantially increase its gold backing to the 30-40% level as in the past if it were to go
down this route.
Of course, this would add a new source of demand for gold bullion, together with
increased demand by other global central banks wishing to bolster reserves. There could
really only be one effect on the price of gold to substantially raise it.
Fi g 2 Of f i c i al Gol d Reser ves (t op 20)
0
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2,000
3,000
4,000
5,000
6,000
7,000
8,000
9,000
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Source: Wikipedia

A second consideration is the growth in the stock of gold. This growth rate would provide
a medium term cap on growth in the money supply and on nominal GDP growth. World
gold output has been fairly steady at about 2,500 tonnes in recent years. Compared to
the total world stock of gold, this is about a 1.5-2.0% growth rate. We imagine that in the
face of much higher prices, it might be possible to boost this production. But production
has been fairly stable against a very substantial rise in gold prices in recent years, and
we would not want to overdo this optimism. Even allowing for a 3% growth rate in output,
this would limit nominal GDP growth to a similar range. So unless you allow for large and
persistent negative inflation (deflation) real growth rates will probably struggle to exceed
2.0% p.a.
Bretton Woods also ended
messily
Existing stocks of gold might
be enough for a partially
backed system
and would provide a new
source of gold price
appreciation
But the growth in gold stocks
is not easily increased, and
could be a real constraint on
economic growth
Goldmender October 2012

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And this takes us to the other aspect of this discussion. What is it that we need to mend
in the US (global) economy? And does a gold standard deliver the goods? Our subjective
list of what ails the US economy is as follows:
Low real and nominal growth / deflation concern;
High unemployment;
Weak consumer and business confidence;
Relatively tight credit availability;
Deleveraging in the public and household sectors.
But a gold standard, whilst it may do a variety of things, including stabilising exchange
rates (though not guaranteeing a fair rate), and preventing hyperinflation (until it is
abandoned) also has historically tended to deliver substantial real and nominal GDP
volatility, depressions, and deflation. If anything, this sounds more like what ailed the US
economy in the depths of the global financial, not something we should be rushing to
embrace once more. A Gold standard would provide many of the handicaps of the single
currency in Europe, an abdication of monetary and exchange rate autonomy, and a
tendency to drift into depression and deflation. The benefits of inflation and currency
stability are debatable, and achievable by other means.
Fi g 3 US Ec onomy - dur i ng and out si de of gol d st andar ds
CPI Real GDP Nominal GDP Inflation std dev GDP std dev
Gold Standards 1.7 2.5 4.2 5.5 5.9
Non GS periods 4.4 2.8 7.3 3.0 2.2
Source: EcoWin, ING

In the chart on the front page, we show inflation and GDP during periods of gold standard
(including Bretton Woods) and compare it with the subsequent period. And although the
starting period does encompass the great depression, which some might argue is unfair,
critics of gold standards would point out that the length and depth of the great depression
was largely attributable to the perverse policy incentives that the gold standard had on
policy makers for example, encouraging tighter monetary policy to offset accelerating
outflows of gold. In any case, despite lower and more stable inflation, growth was slower,
and more volatile. Inflation also tended to converge on zero, whilst many economists
(including this author) tend to agree that a little (1-3%) of inflation is a good thing.
The criticism of those who see QE as debasing the currency do have some merit, and is
one of the reasons why gold demand and the price of gold has been so high following the
introduction of QE policies around the developed world. But the current EUR/USD
exchange rate of around 1.30 is about where most analysts would put their central
estimate for the range encompassing fair value. Moreover, as we have pointed out in
recent notes (see also Quirks of QE), the likelihood of QE resulting in any weakness of
the USD against the other major currencies, whilst the Eurozone, J apan and UK are all
also engaged in forms of QE, is slim. Indeed, more reasonably, weaker major currencies
versus the rest of the world might reasonable be argued as part of the adjustment
process to the excesses of the late 1990s and 2000s, coming through currency
movements now, not just the real and financial economies. Without this, the
manufacturing sectors of these countries, some of which continue to show glimmers of
life, might well be all but extinguished.
To wrap up, gold standards may have a long tradition in Europe and the US. But then we
also used to send children up chimneys and burn witches. There is little to argue for a
return to such practices today.
What a gold standard claims
to cure
is not what is the matter
with the US or the rest of the
developed world
Gold standards are implicit in
past episodes of depression
and deflation
QE may be a form od
currency debasement but
that is not necessarily a net
negative outcome
There are few cogent
arguments for a return to a
gold standard
Goldmender October 2012

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