Renaissance of the Gold Standard?

by Martin Hutchinson... LINK...

Global opposition to Fed Chairman Ben Bernanke's policy, World Bank President Robert Zoellick's "trial balloon" and statements by some of the new Republican Congressional caucus have caused a modest revival in consideration of the Gold Standard. In my view, the chances of its revival by official means in the next 10 years remain infinitesimal, but there is an increasing probability of private sector activity in that direction. Not only politically, the bombed-out Gold Standard stock may have reached bottom and be beginning a modest revival.

The Gold Standard did not disappear because it caused the Great Depression (it had only modest fingerprints on that disaster) nor because Maynard Keynes called gold a "barbarous relic." In reality, its demise had a much simpler cause: the rising rate of global population growth, which caused it to become damagingly deflationary.

The gold supply is limited. At the end of 2009, the total of all the gold ever mined was about 165,000 tons, worth $7 trillion at today's prices. Most of that total is still in existence, gold being essentially indestructible. However, new mine production in 2008 and 2009—both years enjoying near-record gold prices—was only around 2,500 tons, according to the World Gold Council. Thus even at the peak of the market, gold production is only 1.5% of existing supply. This hard limit on the world's gold supply exerts a considerable monetary effect on a Gold Standard world, limiting its money supply. Without an increase in monetary velocity, the world's gold supply can accommodate global growth of only about 1.5% per annum while maintaining prices constant. If global GDP growth is higher than that, the Gold Standard will be deflationary—prices will decline. If global growth is less than 1.5% per annum, prices may increase somewhat.

During the 18th century, for example, global population rose by 0.4% per annum, from 640 million in 1700 to 980 million in 1800, according to United Nations estimates. Accordingly, if world gold supplies had increased by 1.5% per annum during that century and monetary velocity had remained constant, a global Gold Standard would have accommodated about 1.1% per annum per capita economic growth. In practice global growth during that century averaged 0.56% per annum or 0.15% per capita, so gold supplies were ample to support it, even if mining was less active and successful than in some other periods. Indeed, in actuality the century saw mild inflation in Gold Standard countries.

During the 19th century, global economic growth accelerated, to 1.85% per annum, being 1.34% growth per capita (the result of the Industrial Revolution) and 0.51% per annum population growth. Thus the gold supply became much tighter, particularly towards the end of the century as economic and population growth accelerated. There was a shortage of specie and deflation during the "Hungry Forties" before the Californian gold discoveries of 1849 and another more prolonged period of deflation in 1873-96, before the discovery of new gold deposits in South Africa and the Yukon. During those years, the gold supply was increasing at a rate below its long-term average of 1%-1.5%, so global growth above that level caused the money supply to decline in terms of Gross World Product, and deflation to occur. By the early 1890s, there were multiple calls to abandon the Gold Standard, with proposals for bimetallism and William Jennings Bryan's "Cross of Gold" presidential campaign of 1896.

In practice, mild deflation is not a major economic problem, contrary to Ben Bernanke's theories. With an interest rate close to zero, even prolonged deflation of up to about 1% annually can be tolerated, as real interest rates remain containable. The 1880s, however, showed this to be close to the maximum tolerable level—U.S. prices declined by 22% from 1880 to 1896, an annual 1.5% deflation, and the strains showed.

In 1900-25, with world population growth of about 0.8% per annum, economic growth averaged 2.6% per annum, in spite of the depredations of World War I. Not surprisingly, the Gold Standard came under huge strain. Thus the failure of the 1925-31 British return to the Gold Standard was probably inevitable; by that time, global population and economic growth had reached a level at which the Gold Standard's deflationary effect had become intolerable.

For the quarter-century 1925-50, Keynes was right; with global population growth above 1%, even World War II could not hold economic growth below 2.7%. For the next 20 years, the heyday of the Bretton Woods Agreement monetary system, the equation was even worse. Population growth averaged 1.9%, while economic growth, recovering after World War II, averaged a startling 5.6% annually, with per capita economic growth of 3.7% annually. Even if the Bretton Woods system had been designed as a true Gold Standard, with private gold holding and trading permitted, it would never have stood a chance. In practice, since politically motivated governments controlled the Bretton Woods system, the breakdown came in the form of an explosion in the gold price rather than a tight deflation squeeze.

The good news for gold bugs is that the rate of global population increase peaked in 1963 and has now declined to about 1.1% annually. Judging by 1900-25's experience, that is still too high for a Gold Standard to be comfortable. However, the rate of population increase is continuing to decline; on current UN projections, it will by 2045 have fallen below 0.5% annually. At that level, as the 19th century showed, a Gold Standard is perfectly feasible and not excessively deflationary. Hence the young of today can perhaps hope to lead the world back to a Gold Standard in their later years.

The Gold Standard, however, remains anathema to the political class. This not surprising; as the U.S. is currently showing with its repeated bouts of quantitative easing, the seigniorage of money creation is highly profitable to governments strapped for cash owing to unaffordable social welfare programs. Even by 2045, absent a major economic crisis, it is unlikely that elite political opinion will have moved sufficiently to make Gold Standard re-introduction at an official level anything but a long and bitter struggle.

One advantage of commodity-based money over fiat currency, however, is that it does not require official sanction to come into existence. Whereas paper money requires a central bank and a national credit rating behind it to attain credibility (and even with this sometimes fails to do so, as in Zimbabwe, Weimar Germany or Latin America for much of the 20th century), gold-based money can come into existence through private activity.

There is some evidence that this is happening. Austria's Raiffesen Zentralbank now offers its clients gold-based accounts, and other banks are likely to follow. The SWIFT international payments system now allows payment in gold, an essential element in a currency's infrastructure in today's markets. Governments worldwide are competing to depreciate their currencies (or, like the hapless EU, watching their currencies come under fire as the weaker members of their union get into difficulties). At some point, a major exporter with a good competitive position—if you asked me to guess, from China or Germany—could start invoicing its customers in gold.

When that happens, a very important barrier will have been crossed. Once gold-denominated trade paper comes into existence, it will form the nucleus of a short-term money market, in the same way as the eurodollar market for assets and liabilities outside the United States arose in Europe after 1957 or so. Within a few years, gold bonds will be issued—once a company has gold-denominated receivables, it will have a natural hedge for such financing, which will remain cheap in interest terms even after conventional currency interest rates rise. It has happened before, in the formation of the eurodollar and eurobond markets in 1957-65. This time, once gold invoicing happens, the gold money and bond markets are likely to spring up quite quickly.

Banks, even outside Austria and Switzerland, will quickly get up the curve of offering gold-denominated accounts once their corporate customers demand them. They will find that a substantial demand exists at the retail level also. Here, modern technology will be very helpful. An ordinary citizen will be able to use a gold-denominated account for day-to-day transactions by means of a debit card, without the need to carry round expensive sovereigns or double eagles. A payment of $9.50 for a sandwich will be satisfied by the debit card, which will pay dollars (say) to the sandwich bar while debiting the account about 0.007 ounces of gold, using that day's gold price.

The card holder will pay perhaps 1% extra for everything, to cover the cost of the gold/dollar exchange transactions; but on the other hand, since his cash holdings are in gold, he will very likely gain much more than that percentage in dollar terms each month. His wealth will be expressed as so many ounces of gold (or kilos, if he is European), but he will never need to hold physical gold at all—or any other currency, though probably he will get a few dollars from the bank's cash machine each month for expenditures for which his debit card is not accepted.

In this way, both corporate and individual users will be able to move their transactions and holdings to gold, with the banks adapting to meet their needs. The banks will remain regulated by national authorities, and will have to manage their gold assets, liabilities and capital in such a way as to avoid breaching the authorities' leverage ratios, based on the gold price at the end of each reporting period.

If the world's monetary authorities come to their senses quickly enough, adopting Volckerite/Bundesbank monetary policies to restore confidence in their currencies, this private Gold Standard will remain a minor addition to the global financial landscape, perhaps dying away after a few years. If the authorities attempt to suppress the market, it will move underground or offshore, like the eurobond market in its early years—and their suppression attempts will in most countries be rebuked by an angry electorate. If they continue with sloppy monetary policies, then since the gold price will continue rising against all other currencies, gold will come to be seen as the most reliable available store of value and a perfectly acceptable unit of account.

At that point, the private gold standard could come to replace national currencies for most transactions. Governments will attempt to enforce usage of their currencies for tax payments, etc., but they will find themselves at a considerable disadvantage through doing so. They will also lose the vast majority of the seigniorage profit they have enjoyed since paper currencies became universal after World War II. Needless to say, this will cause a financial crisis, and a loss of confidence in the governments' own bonds. Their only remedy at that stage will be to move to gold themselves, cementing the dominance of a global monetary system entirely outside the control of governments and monetary authorities.

Central banks will find themselves unable to meddle with the new monetary system, since they do not control it—only the residual paper currencies will be subject to central bank monetary policy. A true Gold Standard on the basis of free banking will have been created more or less by accident. Banks will find that Basel III leverage requirements are much too generous in a Gold Standard system, so will have to deleverage themselves or face a liquidity crisis and apply for a bailout. Doubtless governments forced to bail out banks would insist that they reorient their business towards the shrinking economic area in which paper money is used—in which case such banks would quickly find themselves irrelevant to the new economic order. Their competitors, seeing the disastrous business- and bonus-destroying results of bailouts, would deleverage to a safe level.

For the world's governments, this would be a disaster. For everyone else, it would be a huge liberation. That is reason enough to encourage the beginnings of the private sector Gold Standard development now, rather than waiting until 2045 in the hope that governments will then establish an official Gold Standard.

As for deflation, don't worry too much about it. The day-to-day debit card-based Gold Standard will initially use very little metallic gold, so will not be particularly deflationary. The money supply will be established by trial and error, as banks that over-leverage and keep inadequate gold reserves discover the perils of fiat money banking without fiat money. In equilibrium, the money supply will be constrained by the physical gold supply, but by that time, we may be approaching 2045.