Gold, Gold, Gold

Gold.  Look at it ... its ... golden.  Shiny, heavy and ... real ... unlike money which is all a shared illusion.  When the real collapse of the global economy comes, people will laugh at your worthless dollars but rob you of your gold!  So buy gold now!  Hurry!

See, the fundamentals of gold are can't miss:

And now, even people as serious as the president of the World Bank are becoming gold bugs and arguing for a return to the gold standard:

The system should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values. Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today.

In fact, right now with the Fed creating money left and right people are starting to worry about how their wealth could rise or fall dramatically with the whims of the econo-bureaucrats in Washington. Gold, it is thought, takes the human element out of the equation - anchor our money to something real and tangible, the argument goes, and never again will you have to worry about ... anything.

So why not? Well, Martin Wolf does a good job of explaining:

...the obvious form of a contemporary gold standard would be a direct link between base money and gold. Base money — the note issue, plus reserves of commercial banks at the central bank (if any such institution survives) — would be 100 per cent gold-backed. The central bank would then become a currency board in gold, with the unit of account (the dollar, say) defined in terms of a given weight of gold.

In a less rigid version of such a system, the central bank might keep an excess gold reserve, which would allow it to act as lender of last resort to the financial system in times of crisis. That is how the Bank of England behaved during the 19th century, as explained by Walter Bagehot in his classic book, Lombard Street.

So what would be the objections to such a system? There are three: difficulties with the transition; instability; and lack of credibility.

The biggest transition problem is the mismatch between the value of official gold holdings and the size of the monetary system. The value of gold held by central banks is apparently about $1,300bn, while global deposits of the banking system were about $61,000bn in 2008, according to the McKinsey Global Institute. To survive the slightest financial panic, the ratio of gold to bank money would need to be perhaps an order of magnitude higher.

One obvious objection is that this would generate huge windfall gains to holders of gold. More important, if policymakers set this initial price wrong, as they certainly would, they could unleash either deflation or inflation: the latter is far more likely, in fact, because private holders would start selling their gold to the central banks at such a high price. Apparently, about 90 per cent of gold is now privately held. So the expansion in the monetary base could be enormous.

Moreover, gold reserves are distributed quite erratically around the world. So some currencies would have to experience inflation and others severe deflation. A similar problem explains why it was impossible to recreate the gold standard after the First World War: too much of the world’s gold reserves were then held by the US.

What, then, about the problems of the steady state? One obvious point is that we would be back to the world in which the balance of payments would be settled by physical shipment of gold or, as it was later, by movements within central bank vaults. That would, at the least, be absurd.

A far more important problem is that of financial stability. Economists of the Austrian school wish to abolish fractional reserve banking. But we know that this is a natural consequence of market forces. It is wasteful to hold a 100 per cent reserve in a bank, if depositors do not need their money almost all of the time. Banks have a strong incentive to lend some of the money deposited with them, so expanding the aggregate supply of money and credit.

The government might seek to impose narrow banking: banks would have to back any deposits with notes or reserves at the central bank. But entrepreneurs could then create quasi-banks (let us call them “shadow banks”). These would hold deposits in the safe narrow banks and offer higher returns to customers, because they lend out surplus reserves for profit.

Such a system is unstable. In good times, credit, deposit money and the ratio of deposit money to the monetary base expands. In bad times, this pyramid collapses. The result is financial crises, as happened repeatedly in the 19th century. To prevent this one would have to move into the world of limited purpose banking recommended by Larry Kotlikoff, in which no financial institution would be allowed to promise redemption at par unless it held matching assets.* If so, the pure gold standard would require abandonment of the current banking system altogether.

A further danger is that the response to all shocks would have to come via nominal wage and price flexibility. A less obvious point is that the gold standard does not guarantee price stability. Depending on the supply conditions for gold, the price level might move up or down. In the long-run, however, the price level would probably tend to fall (because the supply of gold fails to keep pace with global activity). Such a world of trend deflation is liable to depressions if or when the equilibrium real rate of interest is less than the rate of deflation.

Another and, in my view, even more serious, threat to the stability of any gold standard regime is international. A peg to gold may prove radically destabilising for any currency if other significant countries failed to sustain domestic monetary and financial stability. There could then be floods of gold into or out of a currency that is well managed. The monetary and financial consequences could be dramatic, with severe deflation one obvious threat. This is precisely what happened in the interwar years, with the chaos emanating mainly from the US.

Finally, there is the fundamental problem of credibility - or rather lack of it. As Bennett McCallum of Carnegie Mellon University also notes in the Cato Journal, the forces that now demand inflation from time-to-time would demand a change in the gold weight of the currency as happened in the 1930s. “Historically”, he notes, “the gold standard provided a reasonable degree of price level stability over long spans of time because the population at large had at that time a semi-religious belief that the price of gold should not be varied but should be maintained ‘forever’.”

That faith has perished. Moreover, everybody knows it has perished. So whenever the economy was in difficulty, the only question would be how soon the gold price would be changed or the link abandoned.

The fact is that gold is no different than any other commodity - subject to the whims of the market. And especially so since it has little real use to most of its holders. When people worry about the value of their dollars they convert to gold and the price is driven up, but when things settle down the price will fall. There is nothing magic about gold other than it is shiny and rare.  Its historical hold on our collective human psyche is impressive though.

And now time to repost a classic:

The Colbert Report	Mon - Thurs 11:30pm / 10:30c
Prescott Financial Sells Gold, Women & Sheep
http://www.colbertnation.com/
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Crisis-o-nomics: Gold, Inflation and the US Dollar

While I was in Brazil, a former student sent me an e-mail with this question (sorry for taking so long to answer it):

"I'm curious what your opinion or knowledge is of currency commodities like gold and silver in inflationary or deflationary periods. Does gold or silver really hedge against the risk of inflation by giving similar purchasing power over time while a paper currency is losing purchasing power over time? I've been thinking over some issues revolving around these ideas a lot in light of our current economic situation. It seems as if there is a possibility for some high inflation in the near future. Will the infusion of capital into the market through different means such as the economic bailouts cause inflation? Also, as consumer confidence lowers and international confidence in the dollar is lost - the desire to hold something other than dollars would flood the supply and cause inflation of the dollar, right?"

This is a great and timely question, in fact, Bloomberg just today has an article about the surge in gold prices.

First let's address the question of gold as a hedge against inflation. Before I start with this, let me just say that right now, I am more worried about deflation than inflation. While it is true that loose monetary policy (and it is as loose as we can make it at the moment) could ignite inflation, we generally look at wages as the key channel, and with unemployment going berserk I am not expecting wages to be going up any time soon.

Okay, so there is some truth to the idea that gold has some 'intrinsic' value: it is awfully pretty and malleable so works well for jewelery, it is a good conductor and doesn't corrode, so good for electronics, etc. And there is only so much of it in the world and mining adds to the total stock of gold about 2% a year (from one estimate I have read) so it does not, in general, keep up with average growth. That is to say, there is a fundamental demand for it more than just because it is pretty and there is a limited supply which means that there is a sense in which its value is secure. But one must be careful with this logic, for the demand for gold can fluctuate wildly for many reasons, one of them being investors trying to hedge against inflation. Below is the 30 year dollar gold price graph. Notice that during the high inflationary period of the late seventies gold prices skyrocketed, but they collapsed almost as quickly after Volcker put the clamps on the money supply.
So if you got it just right and bought gold in Jan 77 and sold in Jan 80, you did really well, but if you bought in 80 and sold later, you did not. Another thing to keep in mind is that we have learned many lessons from the late seventies loose monetary policies, and should not ever expect a repeat of that again. Monetary policy for the last 25 years is almost always first and foremost used to keep inflation low and predictable. By the way, notice that gold has risen quite a lot in the last few years, partly because of the huge pools of money looking for outlets, partly because of high industrial and consumer demand and partly because of the relatively weak dollar. So buying now (while the price is already high) does not to me seem like a very good bet. As soon as the panic subsides, people will be looking for investment opportunities and pulling out of gold.

The next question is whether the bailout plans could ignite inflation. Well, in theory yes, but the economic situation is so terrible right now, even though we are talking about potentially billions of dollars being spent, it is still unlikely to do much more then staunch the bleeding. There will come a time, however, when the recovery begins, lots of hiring happens along with lots of new investment and this will be the crucial time for the Fed to keep money loose enough to allow this to happen robustly, but not too loose as to cause high inflation (higher than 3%).

The third question is about whether loss of confidence in the US and in the Dollar will lead to Dollar depreciation. Yes, we should see a loss in the Dollar in general when the US economy goes south, interest rates in the US are near zero so there are better returns elsewhere, etc. But, up until just recently we have actually seen an appreciation in the Dollar. This is coming from the fact that, one, the credit crisis is so terrible, people are hoarding their cash and putting it in the safest place on earth: US Treasuries which are Dollar denominated. And two, that this economic downturn is global, so while the US economy is tanking, so are most of the rest of the major economies in the world. So there really isn't a lot of competition for the Dollar right now.

So, I don't recommend investing in gold if you are worried about inflation and trying to protect yourself from a high inflationary episode. If you want to do this, there are extremely effective ways that come straight from the US government: Treasury Inflation-Protected Securities (TIPS). But, in general I would not be worried about inflation at the moment - I would be (as I am) deeply distressed about the potential for a deflationary episode. I believe we need fiscal stimulus big time and right away.