William (aka Bill the Godfather)

William (aka Bill the Godfather)

Sunday, November 14, 2010

Debating the Gold Standard

With gold having broken $1400 oz. it is once again in the news. A number of people outside of the usual suspects (so called gold bugs) are starting to whisper or even openly talk about something not seriously discussed since the 1970's, namely reverting to some system where money would be tied to gold, i.e. a gold standard. (See the preceding post.) It might surprise readers to learn this, but I am actually not wild about a rigid gold standard.

Although a sharp critic of the lax monetary policies of the Federal Reserve (which greatly contributed to the current mess we are in), I do actually believe that central banks need some flexibility to deal with emergencies that a rigid gold standard would deny. And of course it is worth noting that no country faced with a major crisis allowed itself to be wrecked (although we came close in the early 30's) by a strict adherence to gold as money. Nations confronted with an urgent need for money that they could not back with gold simply cheated. Or they abandoned the gold standard altogether until the emergency had passed. The United States is no exception. We (both sides) printed money during the Civil War, which gave us a decade of brutal inflation lasting well into the 1870's. And we did it again for a much shorter period during the First World War. The inflation there was short lived and less severe as we quickly returned to gold after the war was over. And of course we abandoned gold during the height of the Great Depression and stayed away from it until the early 1950's.

The combination of brutal depression era unemployment followed by the rationing of the war years kept inflation in check until the late 40's when we began to pay for all of the money printed and the massive debt accumulated. Post war inflation was eventually brought under control by the so called Bretton Woods Agreement which established a modified Gold Standard. Bretton Woods though proved unworkable in the cold war era as a consequence of the large defense budgets most nations had to maintain. There was widespread cheating and the United States kept backing away from gold as our true debts (masked as usual by Washington bookkeeping games) from cold war spending, the so called war on poverty, and the Vietnam War began to rise drastically.

By 1970 it was clear that the illusion could no longer be maintained. In 1971 President Nixon ended the last farcical ties to the old gold standard and the world shifted to a system of free floating paper (fiat) currencies. What followed was predictable. As the FED under then chairman Arthur Burns kept interest rates low (but not nearly as low as Greenspan and Bernanke have) the price of gold, now freely traded on the open market began to rise against paper money. By the mid-late 1970's we began to see the effects of more than a decade of loose money policies with a sharply rising CPI. The Great Inflation which had been building arguably since the Kennedy Administration finally exploded and by 1980 we had CPI at near 12%.

Throughout that period gold (and silver) rose faster than either the stock market or the bond market. Beginning in the early 80's following the appointment of Paul Volker the FED moved to crush the inflation with massive interest rate hikes. This temporarily plunged the United States into the worst post war recession until the current one. But it started to pass by 1983 (just in time for Reagan’s famous 1984 re-election campaign). The inflation was broken and for the next fifteen years the United States enjoyed a period of relative prosperity with only a minor recession in the early 90's. During most of this period inflation remained tame and gold after peaking in 1981 entered a twenty year bear market.

The lesson from all of this is that gold when adopted formally as currency is both unreliable (nations cheat at will) and undesirable (it denies any flexibility to central bankers to deal with legitimate emergencies). That doesn't mean I am against gold. I am not. Rather I believe gold is more or less where it should be today in terms of function.

Today gold is essentially an extra-national reserve currency. It is the one form of money not tied to any central bank and impervious to the depredations of the printing press. Investors can buy and hold it at will, or leave it alone if they think paper money is being managed wisely, and collect the interest on bonds. (Gold of course famously pays no dividends and has no yield.) By keeping government hands off gold private citizens in effect have their own safety net that they can add to or subtract from at will according to their confidence level in fiat currency.

Gold is the ordinary man's means of protecting himself from foolish actions on the part of governments and casting a "no confidence" vote when it looks like the FED is getting a little too hinky with the printing press. In this respect it also functions much as it did in the early 1970's when first opened up for public trading, in effect as a sort of early warning system. Gold today is pretty much where it was in the mid-70's (adjusting for inflation) and it is sending the same message. "We are in trouble."

In the final analysis gold is the canary in the coal mine. Gold does not trade at $1400 oz unless something is seriously wrong in Central Bank land and the halls of Congress.

A final observation for those who despise gold or or who are confirmed gold bugs. Gold has had a good run over the last decade thanks to Mr. Greenspan and Mr. Bernanke. But it won't last. At some point Washington will get its act together and we will swallow the bitter pills and stop printing money and racking up staggering deficits. This current policy is unsustainable, just as it was in the 1970's. When that happens gold will correct downward again as confidence in currency returns. I think we may be some years from that point though, and it is quite possible, even likely, that things will get much worse before hand.

Of the last four decades gold hugely outperformed the bond markets and stock markets for two of them. But gold also smelled like last week's trash left to ferment in 90+ degree temperatures during most of the 80's and 90's when stocks and bonds did extremely well. The lesson: Put not your faith in any one asset class. They all have their cyclical swings. Stay diversified and be prepared for whatever the future might bring. And be careful about predicting future events. If there is one consistent lesson that has been proven over and over again, it is that prognosticating on financial markets is a loosing game. If in doubt on that you are encouraged to read any of Jack Bogle's books.

5 comments:

gdelassu said...

Gold does not trade at $1400 oz unless something is seriously wrong in Central Bank land and the halls of Congress.

Really? Why is this particular commodity (gold) immune to the sorts of forces that drive any other commodity bubble?

John (Ad Orientem) said...

Gdelassu
You just made my point for me. Gold is in a bubble. A bubble being created in large part by a flood of paper money. Lax monetary policies create market distortions, and money like water is a force of nature. It wants to move and looks for places to go. People are concerned (with good cause) that our currency is being deliberately debased. They are therefor buying gold because they perceive it as as a more stable store of value. You can't print gold.

Anonymous said...

It's one of those things: the only thing worse than what we have would be a gold standard. The only reason to support gold is ideology.

The Anti-Gnostic said...

The reason to support gold is that it can't be inflated by central banks. Absent some unexpected motherlode being discovered, there is a finite supply of gold, silver and copper. Digitized dollars are infinite and can (and will) be increased. Inflation of the money supply benefits current recipients of the new money--government, banks and debtors--at the expense of later recipients of the new money--net tax payors, depositors and creditors. Note too that increasing the money stock only transfers wealth, it does not create wealth: later generations are that much poorer.

One problem with the debate is that nobody now alive remembers when 'dollar' was nothing other than a specific weight of silver. That is a true 'gold' standard. As soon as government sets the exchange ratio between 'dollars' and precious metals, the distortions begin.

gdelassu said...

You just made my point for me. Gold is in a bubble.

I am fairly certain that I am not making your point for you. You claim (unless I am misreading your initial post) that the only way one can achieve a bubble in the gold market is if the Fed has done something wrong. This is not true. Bubbles can arise in any commodity market (gold included) without any mistakes on the Fed's part. Some bubbles are caused by central bank errors, but not all of them.