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Fed Chairman Bernanke, Gold and the Gold Standard

By Marc Chandler

In yesterday’s lecture, Federal Reserve Chairman rejected the idea that a return to a gold standard is desirable or practical. His pointed remarks come as Republican presidential candidate Ron Paul has fanned ideas in some quarters of the benefits of the discipline of a gold standard. Previously the outgoing World Bank head Robert Zoellick had also advocated a return to a gold standard. In addition, there have been press reports suggesting that some central banks have recently stepped up their purchases of gold for monetary (reserve) purposes.

Bernanke’s objections were essentially four-fold. First, a gold standard prevents adjusting policy in response to shifting economic conditions. No matter how high unemployment rose, for example, under the strict adherence to a gold standard, monetary policy tools could not be used.

Second, by participating in a gold standard, countries would be more vulnerable to developments in other countries. It would increase the transmission mechanism, leaving countries more sensitive to developments of other participants.

Third, Bernanke cited the challenge of credibility. Participants have to convince investors that they will sacrifice all domestic goals for the sake of maintaining the gold standard. This seems hardly politically feasible under representative governments. If there is any doubt whatsoever, there would be a speculative attacks. Bernanke noted that the gold standard did not prevent frequent financial crises/panics.

Fourth, Bernanke acknowledged that a gold standard did promote price stability over the very long run. However, he noted that over the medium run, it sometimes caused periods of inflation and deflation. He cited the second half of the 19th century when a shortage of gold reduced US money supply and fueled deflation.

Bernanke warned that the gold standard often produced pro-cyclical impulses. During periods of strong growth, money supply would increase and interest rates would fall, which is exactly the opposite of modern central banking and the withdrawal of the proverbial punchbowl just as the party gets going.

Bernanke cited practical difficulties as well. Essentially he argued there is simply not enough gold. Consider that at the end of last week, the press reported that several central banks had taken advantage of the drop in price to step up their gold purchases. Some 4-6 tonnes of gold were said to have been purchased (through the BIS). The "street value" is around $250-$300 mln. This is mere pittance by nearly any metric.

After unilaterally severing the link between gold and the dollar in Aug 1971, as "friendly" countries like France and the UK insisted on exchanging their Treasuries for gold, the US retained the most monetary gold, with about 8100 tonnes. This is more than twice he second largest holder, Germany with about 3400 tonnes. As of the end of last year China had the sixth largest, if one were to include the IMF in the rankings. China’s gold holdings were a little more than 1000 tonnes (street value ~$62.5 bln). Recall China has over $3.2 trillion in reserves. If it were to double its gold holdings, would that really amount to a meaningful diversification of its reserves away from dollars?

Global currency reserves are valued at about $10.2 trillion. Central banks’ monetary gold holdings are roughly 31,000 tonnes. The value of that gold is about $2 trillion. Simple back-of-envelop calculations suggest that it would require a 4-fold increase in the price of gold in order to bring the value of monetary gold to the value of the currency reserves.

As a thought experiment, we can ask what price of gold is needed to back not only US money supply (given that the last gold link was unilaterally broken) but also say the euro zone’s and Japan’s money supply. It appears it would take at least a 10-fold increase in gold prices. Less than that would risk triggering a depression and deflation. The US and many European countries’ gold holdings account for around 3/4 of their total reserves (currencies plus gold). The BRICs holdings are considerably lower. China’s gold holdings account for less than 2% of its reserves. Russia and India’s gold holdings account for about 10% of their reserves. Brazil holds practically no monetary gold.

The fact that the possibility of a return to a gold standard is so remote does not mean that countries will abandon gold purchases. Central banks were net sellers of gold between 1990 and 2010. This year will likely be the third year of net purchases. However, the amounts of money seem so modest compared with the currency reserves that diversification away from paper money (dollars?) does not seem a very satisfying explanation. Status/prestige of rising powers seem to be a more compelling explanation than moving to any sort of efficient frontier of portfolio diversification.

Marc Chandler

About 

Marc Chandler joined Brown Brothers Harriman in October 2005 as the global head of currency strategy. Previously he was the chief currency strategist for HSBC Bank USA and Mellon Bank. In addition to frequently providing insight into the developments of the day to newspapers and news wires, Chandler's essays have been published in the Financial Times, Barron's, Euromoney, Corporate Finance, and Foreign Affairs. Marc appears often on business television and is a regular guest on CNBC and writes a blog called Marc to Market. Follow him on twitter.

13 Comments

  1. The Euro has been compared to the gold standard for their policy of low inflation. I think that gold may have been the main asset used for RPO agreements by the ECB before the euro debt crisis but I need to do more research. If the European banks had dollar assets then they could exchange those assets for gold to borrow from the central bank. Perhaps this helped to drive gold prices.

    However, with the European debt crisis banks did not have as much gold for the RPO agreements so the central banks had to accept lower quality assets instead in their RPO agreements.

    I don’t think a gold standard would change the fact that banks are able to lend out more money then they have unless the central bank had more gold then all of the other banks combined. However, in this case how would the central bank get all that gold and why would it be beneficial to the economy for the bank to hold it. Why even gold anyway. A large part of the value of gold is notional in that people (banks included) hold it to store value and thus drive it up beyond it’s worth in terms of utility.

    Perhaps Marx was right when he based value on labor. However I think he may have been right not though because we must pay labor to make goods (value added) but instead because a good is worthless if no one has the money to buy it. We can inflate assets (gold included) all we went but if people don’t have the money to purchase these assets then the bubble must eventually collapse.

    What makes gold a good asset for money is that it is scarce and easy to store and transport (value wise). However, when someone has a monopoly on a given valued asset (as perhaps banks have on gold. I need to do research), then they can control the supply to extract the maximum rents for their capital. Why should gold be money and not some other reasonably stable store of value?

  2. gnk says:

    Chandler states:

    “Status/prestige of rising powers seem to be a more compelling explanation than moving to any sort of efficient frontier of portfolio diversification.”

    I disagree with this characterization of central bank buying, especially by emerging economies.

    As George Soros rightly put it, the system has already collapsed. I believe that the current ongoing currency wars and resource wars by proxy are indicative of a global economy in a state of transition. There are only two outcomes: 1)the system eventually rebalances global debts and global productivity or 2) it eventually breaks down.

    Currency wars and resource wars (mostly by proxy today) tell me that the conflict route is the more likely outcome, followed by breakdown.

    So in this scenario, why are central banks net buyers of gold? Gold is insurance. It’s the fallback option. When the US’s trading partners began redeeming dollars for gold, it was due to mistrust of the currency – mistrust of a trading partner’s stewardship of its currency, and by association, its economy.

    In the purely fiat system we have today, one can not do that – there is nothing to redeem. So what does a sovereign do? It engages in geopolitical resource games, competitive devaluations of currencies, slowly (and eventually quickly) enacts trade restrictions, and finally, it also buys insurance – gold.

    The price of gold is affected by many factors, generally, it is speculators in the short term, and central bank purchases (let’s calll it the insurance premium”) over the long term.

    Long term, this “insurance premium” rises as the risk of a global breakdown in trade rises.

    The worst case scenario is global war.

  3. Dave Holden says:

    Some of the things Bernanke says a Gold standard wouldn’t let you do are why it’s attractive however here’s a thoughtful piece on how a fiat money system can accomplish the aims of a Gold standard without some of it’s drawbacks.

    http://www.positivemoney.org.uk/2012/03/fiat-money-or-gold-standard/

  4. I udnerstand David what you are saying about some of the criticism Bernanke levied about the gold standard, like the iron discipline needed to make it work, is a virtue to some, but when we drill down and see who that “some” is, do we find any policy makers? I ask because of the seemingly political naivete of expecting politicians of any ilk to indefinitely sacrifice domestic priorities to preserve a peg.

    • Dave Holden says:

      I agree, political reality is crucial. Certainly I see little chance at present of any sizable change to our monetary system. For that to happen would require a collapse of the system or near collapse of the system in a way that affects those that pull the levers of power. Even then personally I’d prefer a move to a non debt based fiat system as advocated by these guys http://www.positivemoney.org.uk/.

      The best I hope for at present is a recognition that there needs to be a better system for the allocation of credit by private sector banks – it’s in this area that most of the damage was done and where change would be most beneficial.

  5. GNK wants us to believe that central bank purchases of gold set the long-term trend. Quite the opposite, it appears. European central banks sold gold just beofre gold rose sharply. Moreover, central banks are not a unfied group. In part what has been happening is a transfer of gold from the high income countries to lower income countries. He many not agree with my point that the amount of gold low income countries are buying hardly is sufficient to be considered diversification of reserves in any meaningful way, but I don’t see an compelling alternative explanation. Look at the dollar value of the gold bought and look at the dollar holdings in reserves. QED ?

  6. Max says:

    The attraction to gold seems to be nostalgia based. Gold used to be money, but so what? If you just want to hold liquid hard assets, there is no reason to prefer gold over other precious metals. They’re all equally valid investments.

  7. gnk says:

    Yes, but central banks decided on gold – not silver, not platinum, etc. That decision is not ours to make. It has already been made by the institutions that create money ex nihilo.

    The current global purely electronic fiat system between nations is merely 41 years old. In the grand scheme of history, I don’t see gold’s prior use reaching a “nostalgia” characterization just yet. I think it may be still too early to call it a relic.

    • gmk–that some cbs have bought gold not silver or plat does not challenge my thesis of status/prestige and any link of gold purchases to money creation is purely imaginery as clearly there is no link. Yes befoer WWI there was a gold standard, though it did not work as well or as much without central bank actions as many suggest. But since 1971, claims are reverting back to a gold standard seem quaint rather than politically realistic. Goal here is not to dream of an ideal but to see what is likely to materialize. Probability distribution. Gold is simply not it, even if there are some theoretical virtues (which I for one am not sold on). The complete sacrifice of domestic agenda for preserving some link to gold does not strike me as always desirable let alone democratic or practical. Lastly, I would point out that numerous countries have strategic reserves in oil and often foodstuffs. Yet few talk about a broader commodity based system or a petrol based monetary system.

      • gnk says:

        “Goal here is not to dream of an ideal but to see what is likely to materialize.”

        I agree. I’m making a forecast.

        Whether gold is a better system or not is a different argument.

  8. gnk says:

    Central Bank buying is providing a floor on gold. Not sure what it is though – it’s anyone’s guess.

    Yes there has been a transfer of gold. But I would not just characterize it as between high income v. low income counties, but rather high aggregate debt v. low aggregate debt countries. Between trade surplus and trade deficit countries. (Yes, there are exceptions)

    But that transfer has slowed down markedly in the last few years. The West is holding onto its gold, and the East is looking for it wherever it can.

    It’s a geopolitical shift. Nations that are used to high debt loads are the last to want a gold standard. Yet they have dramatically slowed down their gold dumping. That’s not a coincidence, I think.

    I’m just saying that we will have a gold standard of sorts involuntarily because the system will not eventually correct. It will break down, and that unfortunately will likely include war.

    Finally, why hasn’t the US ever sold off its gold? The US too, needs it as insurance. When Nixon closed the gold window, he characterized it as a temporary move. The gold window was closed to stop the “gold bleeding” if you will.

    I believe that few, if any could have guessed what type of world a purely fiat system would create – and that world includes the FIRE economy as well as a massively lopsided and unsustainable global system of trade.

    I’ll be the first to admit, it was a great ride, but I think it is ending.

    Global monetary systems are not created as improvements to prior ones. There’s too much of a cost as well as vested interests that lose in the process. Instead, global monetary systems are created after a prior system collapses.

    I know it doesn’t feel like it, but we’re in collapse mode right now.

  9. CD says:

    Yet few talk about a broader commodity based system or a petrol based monetary system

    Hi Marc, is this not best explained by the fact that the marginal utility of gold declines at a lesser rate than any other commodity.