If Gold Were Money Again

Why not gold? Even though it made an advance to some $1,000 per ounce by mid-year 2008, shortly thereafter it plunged to less than $700 per ounce. At $800, on an inflation-adjusted basis it would only be worth a little over $300 per ounce in 1980 dollars. After fully feeling the monetary discipline of Volcker and reflecting the collapse of oil in the glut of the mid-1980s, it could not sink much below $250, a level of support it maintained for years. One could overanalyze the investment rationale of our trading partners, but for those who are not blessed with generous supplies of oil, holding reserves in gold at these levels rather than in U.S. dollars would appear to be a no-brainer.

However, there are some reasons why these countries would not. Foreign governments operate fiat currencies, and these are a backdoor means of taxing wealth and also forcing it to remain inside their borders. As for the oil exporters, gold being very closely correlated with oil would magnify commodity risk for them, so they might not opt for this solution, unless perhaps asked to do so for political reasons by influential fundamentalists.

The largest stumbling block toward the adoption of gold as a currency reserve is the severe discipline it injects into the fiscal and monetary policy-making process. In recent years, the U.S. government has maintained an approximately $3 trillion budget in a $13 trillion economy with annual deficits in the hundreds of billions.

Its monetary authority, the Federal Reserve System, has permitted the money supply to double in the last seven years, continuing a post-war trend of quantitative looseness. In contrast, the world’s supply of gold grows slowly over time, roughly in line with population. Annual mine production is 2.2 million tonnes.

However, much of this output becomes one or more steps removed from satisfying future demand, because it is mixed with alloys for American grade jewelry or it goes into gold bonding wire or gold-plated contacts and connectors used in industry. Above-ground stocks are estimated at 161,000 tonnes (5.2 billion ounces) by GMFS Limited, an independent research organization in London, which says that these have increased by 2 percent per year over the 10 years through 2007.

All the gold in the world could fit into two Olympic-sized swimming pools. During the Internet boom, goldbugs used to say that the value of all gold was lower than the market capitalization of Microsoft. With gold set at a high price, such as the $10,000-an-ounce level, mine production would rise from its current 2 percent tendency to increase the total world supply of gold to something greater, but nowhere near the double-digit M3 growth rates seen in the early part of the 21st century.

Whether or not we adopt gold, we may be forced to choose between national default combined with massive private bankruptcies or accepting deliberately manufactured inflation. The Federal Reserve has attempted to liquefy the system with trillions of dollars of loans, but loans do not restore equity, per se.

TARP funds placed into preferred stock of financially strapped banks and brokers may be converted to common equity or repaid with Fed loans. However, under a quasi-nationalized banking system managers of these institutions appear capable of destroying this equity through following orders to shovel in good money after bad for multibillion-dollar commercial real estate loans to failing gambling houses in Las Vegas or hopelessly high-cost automakers.

Although the bond market obligingly consumed large quantities of newly issued Federal debt at almost nonexistent interest rates throughout 2008, at some point investors might care less about liquidity and more about national creditworthiness. Such a switch in sentiment would then force the issue, causing the Federal Reserve to become a large direct buyer of Treasury bonds, as it was in the early 1950s. The country might then be in a position similar to where it was in 1817, when the Second Bank of the United States cut a deal with the states to inflate bank credit-based money by $6 million, a very large sum at the time, to entice them to agree that any notes they had issued that were not redeemable in specie would no longer be considered legal tender for the payment of federal obligations. In essence, it might be necessary to avoid default with one last inflationary push before resumption.

If the United States were to back its currency with gold, it would have two options: It could replenish its gold reserves through purchases at market rates, or it could revalue the dollar today by announcing it would be convertible at a specific price, using the backing that it currently has. No one could know what percent of the currency would need to be backed by gold, for public confidence is the most essential input to that equation.

With less confidence, a higher ratio is necessary. The government could double its quantity of physical metal by buying gold in the open market, but that would certainly escalate the price to at least $2,000 per ounce. With that guess, the total outlay would be some $570 billion, a large number, but not all that different from those bandied about by the Fed and the Obamian stimulus wonks. However, this would still leave the heavy lifting of taking gold backing from roughly 4 percent to 20 percent to devaluation, which would be measured in orders of magnitude.

Even this small initial purchase would require finding sellers willing to part with 2.3 times the annual supply of gold, so the effect on price would probably be larger. Moreover, other governments might want to soak up some of the roughly 100,000 tonnes not held by central banks. An equilibrium price of gold of some $11,000 per ounce could arise from a base case of our not buying any metal openly. If the Treasury were able to double its stock of gold through open market purchases, it would ameliorate some of the devaluation.

In his short but trenchant analysis in 1994 of fractional reserve banking, The Case Against the Fed, Murray Rothbard laid out another methodology for establishing an benchmark price of gold based upon liquidation value of the Federal Reserve. For perspective, in 1994 gold closed the year at $384/ounce, while the broadest measure of money having been printed in the United States (M3) stood at $4.4 trillion, or only 31 percent of its 2008 quantity. When he performed this exercise using the balance sheet of April 6, 1994, he calculated that shutting down the Federal Reserve and distributing gold bullion to its creditors would reset the dollar’s value to $ 1,555 per ounce.

The balance sheet of the Fed ballooned during 2008 in response to the freezing up of the credit markets and the collapse of equities. Basically what Rothbard does in his liquidation is cancel any government-to-government obligations, regardless on which side of the balance sheet they reside.

What remains are reserve deposits of the commercial banking system and currency (the monetary base) less any assets of the Fed that might be sold off. At the time of Rothbard’s writing, these other assets might be buildings or miscellaneous accounts. Today there are a host of credits provided by the Fed to weak banks, which are collateralized by troubled assets.
There has also been a large swap program with foreign central banks. For the purpose of this update, the loans to weak banks are assumed to have zero value, for calling these loans and reinjecting the collateral back into the system now might initiate rapid monetary contraction. (However, it might be possible to extract some value from these for the taxpayers by transferring them to the Social Security trust fund.) The Fed has been opaque in disclosing precisely what is occurring with its currency swap lines; it is unclear whether these are tied directly to the Treasury’s supplemental financing account, which is projected to run off. Regardless how one sees these fine points, the basic notion is that the gold would need to be revalued to match the monetary base.

What is interesting is that, as the credit crisis unfolds, there is a convergence between the Rothbard approach and the conclusion drawn if gold were to simply back 20 percent of the broad money supply. The reason is that central bankers have been injecting borrowed reserves into the banking system, which expands the monetary base, the numerator above the divisor of Fed gold holdings.

The banking system needs to deleverage, and the borrowed reserves need to be converted into equity or non–borrowed reserves. At that point, borrowers and lenders would probably feel comfortable with the amount of debt they carry, and normal lending might resume. However, this unabashed printing of money would likely create inflation (making debt repayment easier for the private and public sectors alike), so it is entirely possible that the public would regard borrowing as a hedge against the loss in purchasing power that would result.

By announcing a definitive date for the resumption of a gold standard, even if it were to occur at an undetermined price or solely by weight (free metallism), the public and the federal government would be put on notice that inflation would not be a permanent condition, and in fact slow, controlled deflation would be the new long-term tendency. Such was the case in the six years leading up to the resumption of 1879.

Confiscation of gold was an option that Roosevelt employed in the last great crisis. In the 1930s, many citizens were still alive who had lived under the gold standard of the late-19th century. This especially socialistic and totalitarian presidential order was pernicious, because it essentially was a tax that could not even be offset against income. However, today it would be unlikely to happen, since gold is no longer broadly owned.

Globally, investment holdings are estimated at 26,500 tonnes, or just 16 percent of all above-ground stocks at the end of 2007. At $800 per ounce (about 32,150 troy ounces per tonne), the value of private holdings of everyone in the world is just $700 billion, or just over 1 percent of U.S. household net worth as of June 2008. By comparison at that same date, in the U.S. alone net equity in real estate was $8.8 trillion, stocks and mutual funds were worth $9.8 trillion, and accrued pensions held $12.3 trillion.

Confiscation of gold today would arbitrarily target those few who fear the consequences of government policies that caused the banking system to become uniformly weak over the last century, and who rationally made a decision to avoid risky paper assets.

Probably most of those who read Rothbard’s musings when they were published well before the credit meltdown began in 2008 doubted that the fiat currency system could ever unravel to the extent that it did. All of us suffer from a recent past bias that makes us disbelieve great financial changes might occur.

The monetary history of the United States clearly shows a pendulum-like tendency of swinging between hard money and fiat currency, but transitions can take decades. During times of fiat currency use, anyone who prophesied that a complete collapse would usher in hard money would have been dismissed by the experts of his time.

Likewise, once gold and silver had been written into the Constitution, no one might have thought that it would be replaced by paper within 60 years. Skeptics of greenbacks probably got a better hearing and were able to successfully push for an agenda of gold resumption. But before the London Economic Conference of 1933, the world would be shocked by Roosevelt’s rejection of the gold standard.

It is possible that somehow the simple injection of massive amounts of fresh credit might forestall the crisis unleashed in 2008 from leading to a call for hard money. But if leverage remains high, almost certainly a series of crises such as was the case in Rome might ultimately bring the pendulum back toward gold.