The pros and cons for a new gold standard
In another extract from his comprehensive 90-page Special Report on Gold, Ronald Stoeferle examines the pros and cons of the case for a return to some form of gold standard.
Posted: Wednesday , 06 Jul 2011
VIENNA (Erste Bank) -
"The modern mind dislikes gold because it blurts out unpleasant truths"
Joseph Alois Schumpeter
We have pointed at the gradual remonetisation of gold since our very first Gold Report. While it had formerly been up to a handful of critical minds to question our monetary system, high-profile politicians and central bankers have meanwhile offered their opinion, too. Last year we saw numerous signals that indicated the fact that gold was gradually becoming "politically correct". Robert Zoellick, President of the World Bank and former member of the Bush cabinet, had this to say about 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. The development of a monetary system to succeed "Bretton Woods II", launched in 1971, will take time. But we need to begin."
Such statements would have been unthinkable only a few years ago. Since the mid-1970s hardly any high-ranking US politician has mentioned the gold standard in a positive context. This confirms the broad paradigm shift we are currently going through. Unfortunately many people interpreted the World Bank President's statements wrongly, and he was immediately discredited. He did not argue in favour of an explicit return to the gold standard, but he commended its stability. On top of that he just wanted to launch a discussion and critically question our monetary system.
We assume that Zoellick is thinking of a basket of goods that among other goods contains gold. Thomas Hoenig, President of the Federal Reserve Bank of Kansas City also called the gold standard a "legitimate monetary system" . Moreover Prof. Robert Mundell - the "Father of the Euro" - urged gold convertibility for the euro and the dollar. Steve Forbes, publisher and former Republican presidential candidate, was also optimistic that the USA could return to a gold standard because of its fiscal imbalances.
"People only accept change when they are faced with necessity, and only recognize necessity when a crisis is upon them" Jean Monnet
The thought of a currency not pegged to gold would have probably been absurd 100 years ago. That's how illusory a gold standard sounds to us today. However, 20 years ago mobile telephones with internet connection, digital cameras, and a digital music collection (aka Smartphones) were equally illusory. And we are in a similar situation with regard to the gold standard today. Today even the thought that back in 1971 every 35 US dollars were backed by one ounce of gold is absurd.
We believe that a return to the gold standard is no major economic or organisational problem. Rather, what we have on our hands is a highly political and philosophical question of principle that has to be answered. We therefore believe that the strain has to become much bigger still before specific action will be taken.
Money is measured in terms of gold - the price of gold vs. the price in gold
The central feature of a gold standard is the fact that gold is used as measuring unit, much like litre, kilometre, kilogramme etc. To this extent, a system that measures gold in units of euros, dollars, or globos cannot be a gold standard, given that it refers to a paper money standard. This is what Nikolaus Kopernikus confirmed already in 1517 when he said "Money is coined gold or silver and is used to calculate and pay the prices of items for sale, whether fixed by society or the ruler. In a certain way, it is therefore the measuring unit for valuations. But said unit has to be of a fixed and stable magnitude, or else the order of society would certainly be disrupted" .
Gold is therefore in the centre of the system while the currencies oscillate around it. In his classic work "When Money dies", Adam Fergusson writes "Nevertheless, it was the natural reaction for most Germans, or Austrians, or Hungarians - indeed, as for any victims of inflation - to assume not so much that their money was falling in value as that the goods which it bought were becoming more expensive in absolute terms; not that their currency was depreciating, but - especially in the beginning - that other currencies were unfairly rising, so pushing up the price of every necessity of life. It reflected the point of view of those who believe the sun, the planets and the stars revolve with the moon around the earth..."
Therefore we could see a future where rather than asking for the price of gold, people will much more often ask for the price in gold.
Although many have said that a gold standard would be deflationary and eat into wealth, we advise taking yet another look into the history books or on the following charts. The period of 1870 to 1914 recorded the highest real growth rates worldwide and was among the most peaceful ones in history.
GDP per capita since 1870 (shaded area = Gold Standard until 1914)
Source: Angus Maddison, Erste Group Research
Most of the budgets were balanced, and there was a free flow of capital across borders. The only job of the central banks was to exchange gold for paper or vice versa. Alan Greenspan has recently commended the stability of those days: "There are numbers of us, myself included, who strongly believe that we did very well in the 1870 to 1914 period with an international gold standard". On top of that, in the very same interview he questioned the point of having a central bank at all.
CPI since 1881 (shaded area = Gold Standard until 1914)
Source: Online Data Robert Shiller, Yale University, Erste Group Research
Currencies covered by gold seem to contribute significantly to the economic, political, and social stability. Many eras (the Roman Empire, the Venetian Republic) recorded centuries of price stability. It was only when the content of precious metal in the coins was reduced that rapid decline set in.
Gold and economic freedom are inseparably linked.
In 1914 the world abandoned the gold standard because the European governments could not afford to fight a war given the restrictions of the gold standard. Since the gold standard was dropped, we have seen almost 30 periods of hyperinflation worldwide. A gold standard also serves as regulative framework for the budget in that it practically enforces a balanced budget. This is probably also the reason why politicians hate it so much. On top of that a gold standard also does not hinge on the different political convictions of the governments. Ludwig von Mieses also commented on the political independence: "The gold currency liberates the creation of purchase power from the influence of politics and from the fluctuating economic philosophies held dear by changing political majorities. This is its advantage." Gold means freedom - a notion also highlighted by the fact that Lenin, Mussolini, and Hitler banned private gold ownership at the outset of their dictatorships.
Gross Public Debt (as a % of GDP) - shaded areas indicates classic Gold Standard and Bretton Woods Agreement
Source: Carmen Reinhart and Kenneth S. Rogoff, "From Financial Crash to Debt Crisis," NBER Working Paper 15795, March 2010, Erste Group Research
A study investigating the increase in money supply in 15 nations from 1820 to 1994 shows that money supply growth and inflation were substantially higher in fiat systems than under a gold or bi-metal standard. According to the study the average inflation in fiat standards was 9.17% as opposed to 1.75% under a gold standard. Bordo and Kydland came up with similar results. The analysis of four different periods (classic gold standard, the period between WWI and WWII, Bretton Woods, post-Bretton Woods) yields a clear result: the stronger the gold pegging, the lower inflation.
This is also what the following chart confirms. The momentum of the Consumer Price Index has increased dramatically since the end of Bretton Woods.
CPI All Urban Consumers from 1913
Sources: Federal Reserve St. Louis, Erste Group Research
"It was not the gold standard that failed, but those to whose care it had been entrusted" Heinrich Rittershausen
One of the central arguments against the gold standard is still the fear of deflation. Broadly speaking, we regard this fear as unfounded. On the contrary, it tends to come in the form of a healthy shakeout. Although this term actually describes a shrinking money supply, it has (falsely) come to denote falling prices. The fact that falling prices can also mean rising returns and thus higher productivity (e.g. software, aviation, and PC industry since the 1980s) tends to be forgotten. The huge fear of deflation is based on the excessive debt in the system, which of course harms debtors more than creditors. The fact that deflation is not permitted in the economy at the moment only increases the problems and delays the cuts. Therefore we believe that the superficial and credit-financed solution to the problems will prevail yet again.
During the Great Depression the majority of nations were adhering to the gold standard. When it was dropped, the latent, strong demand for gold emerged and led to a drastic appreciation of gold. This rarely discussed period represented the first big gold bull market of the past century.
Gold price increase 1929-1934 (relative to gold parities)
Source: ETF Securities, "Golden Fetters: The Gold Standard and the Great Depression", Barry Eichengreen
In the recent past we have not only heard comments by politicians with regard to the gold standard, but we have actually seen the first concrete steps towards a remonetisation. The federal State of Utah has recently recognised gold and silver as official means of payment. It is not the embossed nominal value that determines the value of the coins, but the weight. Similar draft laws are under scrutiny in many other federal States as well. Basically this does not change much, seeing as according to Gresham's Law no gold will be used for payment; however, it does show a paradigm shift. It emphasizes the faltering trust in the US dollar, the smouldering fear of hyperinflation, and the increasing level of dissatisfaction with the work the government has been doing in Washington. The symbolic effect of the "Legal Tender Act" is enormous.
Zimbabwe - not exactly a straight-A student when it comes to a stable monetary policy in its recent past - may introduce a gold standard in the foreseeable future. Central bank governor Gideon Gono wants to revitalise the Zimbabwe dollar by pegging it to gold. The sad example of Belarus also highlights the monetary importance of gold. With rumours of an imminent depreciation of the currency getting stronger, the population bought more than 700kg of gold within just a few months. As a result the central bank prohibited the sale of gold against local currency. And sure enough, in spite of all assertions to the contrary, the Belarussian rouble was depreciated by 54.4% over night.
Vietnam is another interesting example of the monetary stability of gold. The affinity to gold in the country is extremely high. Although the German GDP is almost 40 times higher than the Vietnamese, gold demand per capita in Vietnam almost matches that of Germany. Overall gold demand amounts to roughly 3.1% of GDP (N.B. by comparison in China it is less than 0.5%).
Vietnam is a prime example of Gresham's Law. In simple terms, the law states that"bad money drives out good money from circulation". Actually, the correct version of it would say that legally overvalued money drives out legally undervalued money. Specifically, this means that the money that in physical terms is worth less will be used as means of payment, while the higher valued money - in this case, gold - will flow abroad or be hoarded as a store of wealth and will thus be withdrawn from circulation. Given that inflation was significantly above 15% last year, the foreign exchange reserves were falling rapidly, the trade balance deficit has been growing relentlessly and the Vietnamese dong has already been depreciated six times since 2008, it comes as no surprise that the Vietnamese people hardly trust their currency anymore and have started accumulating gold.
Gold in Vietnamese dong (left scale) vs. exchange rate dong/US dollar (right scale)
Source: Bloomberg, Datastream, Erste Group Research
In the Malaysian province of Kelantan the gold dinar has been introduced. Civil servants can choose to receive up to 25% of their salary in the precious metal currency. The measure is based on an initiative by the former Prime Minister, Dr. Mahatir. Back in 1993 he suggested replacing the US dollar in trade transactions with other Muslim countries with the Islamic gold dinar (IGD). However, as long as the Malaysian ringgit is still circulating, the gold dinar will never actually be used for payments and will therefore not be circulating. Here, too, Gresham's Law is working.
It seems that the Silver Libertad initiated by Hugo Salinas-Price has the biggest chances of gaining a foothold in the monetary system. The draft law for the monetisation of the silver coin is currently under scrutiny by the Mexican legislative authority. But since the Libertad has no value engraved, it cannot (yet) be used for day-to-day transactions. Should the initiative get approval (which is likely at the moment since all parties support it) the Mexican central bank would quote a price that cannot be depreciated.
 "The G20 must look beyond Bretton Woods II", Financial Times, November 2010
 "Fed's Hoenig says gold standard ‘legitimate" system' ", Reuters, January 2011
 „The emerging new monetarism", Ralph Benko, Forbes
 Nikolaus Kopernikus, "Treatise on Debasement"
 Please refer to John Embry "Current decline will be the bottom for gold and silver"
 Please refer to Ferdinand Lips, "Why Gold-Backed Currencies Help Prevent Wars"
 Please refer to "Money, Inflation and Output under Fiat and Commodity Standards", Rolnick A.J und Weber W.E, Journal of Political Economy, December 1997
 Please refer to "The Gold Standard as a Rule: An Essay in Exploration", Bordo M.D und Kydland F.E, Explorations in Economic History, 1995
"Now Zimbabwe talks of a gold standard while warning of US dollar devaluation", Mineweb, Mai 2011
 Please refer to. www.jilnik.com „Kein Gold, keine Dollars, keine Waschmaschinen: Was ist bloß in Weissrusland los? Ein Drama in 10 Akten" (No gold, no dollars, no washing machines: what on earth is going on in Belarus? A drama in 10 Acts)
 Please refer to "The Daily Reckoning, "Gold, Gresham's Law & the Dong"
iPad version: Picture: Wiener Philharmoniker gold coins are pictured at the Ginza Tanaka store in Tokyo: REUTERS/Yuriko Nakao