The Gold Standard – Gold Fever or Golden Idea?

In the wake of the Global Financial Crisis with the debt clock ticking, some people believe that we should return to the gold standard.

Is it the case that these people have been listening to Cher’s 1980’s – “If I Can Turn Back Time” – and long to relive Clint Eastwood’s 1969 hit “Gold Fever”? Or, are they on to something?

For some, particularly in the United States, gold is seen as a cure-all for; a weakening dollar, controlling government spending and restoring value.

So, what is the gold standard? Why do people want to bring it back? What was its effect? Why did we get rid of it? Why do its supporters see it as a panacea? And, will it be reinstated?

Why is there a debate bring back the gold standard?

Proponents of a new gold standard argue that it provides long-term economic stability and growth. They believe that it prevents inflation, and would reduce the size of government. They say a gold standard would restrict the ability of government to print money at will, run up large deficits, and increase the national debt. They say the economy has historically performed best under a gold standard.

Proponents also argue that the current system of currency value, which in effect is based on the confidence in the issuing countries economy, prevents citizens from saving money because it causes them to fear that their money will decrease in value.

What was the gold standard and its role?

The classical gold standard saw the domestic money supply tied to a country’s gold stocks. Many believe that 100% of the currency’s value was tied to the gold reserves. This was not the case, only around 40% of the value was held as physical gold. In its heyday, the gold standard was seen by economists as increasing the international efficiency of production. In theory, it would eliminate the volatility of input and output prices.

The standard was believed to prevent inflation from eating into the savings of the dominant classes, and encouraged the supply of goods and food for a fast-growing population.

The classic gold standard assumes fixed exchange rates. Export and import of physical gold is used as a tool to bring domestic prices back to equilibrium. In short, if Australia had a trade surplus, gold would flow in from our trading partners.

An inflow of gold tended to be inflationary because citizens had more money to spend on imports, that increased spend eventually corrected the surplus.

Countries in deficit consume less of their own production, focusing instead on export to surplus nations, in order to rebalance. These exports tend to become more attractive in the market as they have a lower price point, whilst imports from nations with surplus standard become more expensive, meaning a deficit nation will export more and import less thereby self-correcting the deficit.

The attraction to gold standard revivalists is that a gold standard system would automatically restrain credit expansion in surplus countries, and contractions in deficit countries. 

How Did the Classical Gold Standard Perform in Practice?

At the peak of its power, the British Empire operated a gold standard. The British experienced a range of economic contractions directly attributable to the system. In the 1880s, a trade depression occurred when gold stocks were exhausted, and when there was an explosion of gold hoarding.

In 1914, a time when half the world’s trade was financed by the British, stock markets in the main shut due to World War One. As a result, bills couldn’t be rolled over, or paid with the usual ease. A crisis of confidence locked up the discount and acceptance markets. This in turn led to a run on the Bank of England’s gold facility, which then led to a suspension of specie payments.

The attraction of gold endured and a “new gold standard” came into existence in the 1920’s. It didn’t survive the monetary and trade chaos of the 1930’s. Some argue that it failed because the new standard was not as strict as the “classical standard”.

Despite two significant fails the attraction of gold endured. Maybe the notion of fixed money supply curbing the human instinct to spend was the attraction. But this attempt despite a few small successes stories when faced with the Great Depression, unsuccessful trade restrictions, stubborn unemployment, and political meltdowns, the gold standard collapsed again in 1933.

The United States also left the gold standard during the Great Depression, at a time when the metal was being extensively hoarded.

The great powers met at Bretton Woods,  after World War Two to outline financial arrangements for a post-war era. Excluding France, who’d previously benefited from the gold standard, no other power suggested a return to the system.

Two competing views emerged. Briton, John Maynard Keynes, argued unsuccessfully for an International Clearing Union. That would allow members to have some control over their exchange rates. Keynes wanted everything based around one theoretical super currency with gold subscriptions limited to a small percentage of national quotas.

American, Harry Dexter White, garnered Russian support for a stabilisation fund of fixed sterling dollar exchange rates with; limited liability for America, control over gold-backed dollars by Congress, and a fund structure rather than that of a bank. White, a Russian spy, succeeded in making the American dollar, with its considerable gold reserves, the only gold convertible currency. All other global currencies could devalue against the dollar, the dollar could only devalue against gold.

Further Iterations of a Gold Standard

In 1971, President Nixon, confronted with high inflation and unemployment, ended trading of gold at the fixed price. For the first time in history, formal links between the major world currencies, and real commodities were severed.

The United States did consider some form of the gold standard again. In the 1980’s, the Reagan Administration considered the move, but it was knocked on the head. In 2012, the idea raised its head again at the Republican Conference in Florida.

What is the Benefit of Our Current System?

The current system of currency, sometimes called the fiat money system, is based on paper notes, with no gold backing. The value of a currency is based on the demand for that currency. It reflects the confidence that buyers of that currency have in the underlying country and its system.

American economist, Milton Friedman, identified that the advantage of this system is that it frees policymakers to focus on national economic objectives, rather than their balance of payments. On the other hand, Austrian economist, Friedrich Hayek did not share Friedman’s view of floating exchange rates, believing the consequence would be volatile for capital flows.

Australia’s experiences with a fixed exchange rate were less than positive. Australia is a net importer of capital, and a fixed exchange rate cut off the supply of that capital. It entrenched the Governments’ focus on the balance of payments. This often created conflicts with the Government’s domestic policy objectives.

A floating dollar has benefited Australia significantly, particularly during the 1997 Asian Financial Crisis. In many ways, this crisis posed greater threat to Australia than the GFC . The Government was able to manage Australia’s economic position by allowing the Australian dollar’s value to fall.

By allow the value of currency to devalue, exports become more attractive and imports more so. The Australian strategy during the Asian Crisis was a success and in the main the suppression of the US Dollar’s value has “onshored” many industries and jobs who had previously left.

So, who’s got the gold, and how much would we need? 

For the world to move to a gold standard, the first changeover would need to occur in the United States.

Gold 2

Given that the current accrued American Federal debt stands at approximately US$16 trillion, the Federal Reserve’s gold holding would cover about half a trillion of that debt. It’s also worth noting that all the gold on the planet equates to around US$8 trillion.

It should also be noted that the gold standard applied to notes on issue, and that the United States stopped keeping track of how many notes are on issue a long time ago.

So, why Gold?

Some believe that gold has an intrinsic value as a commodity. However, in the modern world it could be argued that water has a higher intrinsic value as does oil. Gold supporters say that oil’s value is impacted by market forces; indeed it is, but so is gold.gold 3

The real answer is it’s emotional and historical. For years in the United States, the symbolism of gold had no greater monument than Fort Knox, Kentucky, where much of the country’s gold is held and protected by the American Army’s elite battle tank units. All that changed in 2012, when the Tank Corp moved out.

In the modern world gold has little real use as the illustration opposite demonstrates. Only 12% of the metal is used for productive applications. The rest is held for trinketry, or investment.

Warren Buffett, is on the record with his views - “the one thing I can tell you is it [gold] won’t do anything between now and then except look at you. Whereas, you know, Coca-Cola  will be making money, and I think Wells Fargo will be making a lot of money, and there will be a lot — and it’s a lot — it’s a lot better to have a goose that keeps laying eggs, than a goose that just sits there and eats insurance and storage and a few things like that.”

For the record, gold was around $900/oz then, and it rose about 45%; Coke stock over the same period went up 100% and Wells Fargo by 200%. That doesn’t include dividends.#

Great Depression vs the Great Recession

All this renewed debate about gold standards is based on a simple theory; if governments can’t print or spend too much money, prices should be stable.gold 5

Consider the chart below, which shows headline CPI inflation under the gold standard from June 1919 to March 1933*.

The theory says that the gold standard should guarantee price stability in the long run, but you know what they say about the long run – we’re all dead. In the short run, prices can change violently under the gold standard, as the balance of trade changes, or the physical stock of gold changes. We should note that price stability isn’t just about avoiding inflation; it’s about avoiding deflation too.

The gold standard was not successful in controlling either.

Now let’s consider headline CPI inflation, this time since the Federal Reserve began quantitative easing in November 2008.

The price volatility under quantitative easing is 23 times less volatile than there was under the gold standard.

While it is true that the United States Federal Reserve has expanded its balance sheet to unprecedented levels, it is also highly likely that had they not pursued  this course of action, asset prices would probably still be falling.

The big question is how the Federal Reserve and their European colleagues will mop up all this liquidity they have created.

Has it lit the fuse of an inflation time-bomb? That is a question for another time.

So, why all the ballyhoo?

Things have been economically uncomfortable; part of that discomfort has created a re-examination of how things should be done.

gold 6

The debate about the gold standard is fundamentally an American one.  They have great concerns about the level of Government debt, most of which is owned by entities in the United States.

Amidst all this, investors should remember that the United States is far from broke. Indeed its citizens have a net asset position of around US$70 trillion+ in household terms meaning that America has a loan to valuation ratio of 22%.

Not bad really. The real challenge for the United States is the level of tax they are willing to pay and what level of Government services their voters wish to receive.

Within this environment there is great discussion about of the level of debt carried by governments.

 Will the gold standard return?

 No – there is not sufficient gold on the planet to cover the notes currently on issue, by all countries, not even 40% of the notes on issue. Even if the United States re-implemented the gold standard, it is unlikely that its trading partners would do the same. Additionally, the United States would have forgone its ability to revalue the currency, and in so doing, give away an important economic tool.

The idea that the world would return to transferring bullion around the world in the modern digital landscape is almost ludicrous. The commodity itself has lost relevance, and its productivity growth falls annually. Finally, the United States has a long history of borrowing money, usually cheaply, to expand its economy. They are unlikely to give up that opportunity any time soon.

 Disclaimer and about Shartru Group

About Shartru Capital Group
The Shartru Capital Group is an independently owned, Australian boutique investment and advisory firm. Shartru Capital is a significant investor in a number of businesses including Shartru Wealth Management and Apricity Finance

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Disclaimer: Written by Shartru Wealth Management Pty Ltd. ABN 46 158 536 871 AFSL 422409. The advice is general advice only and we have not considered your personal circumstances. Before making any decision on the basis of this advice you should consider if the advice is appropriate for you based on your particular circumstances.

Sources and notes:

 ^http://www.usatoday.com/story/money/business/2014/03/22/wall-st-cheat-sheet-nations-gold/6709493/

http://www.marketwatch.com/story/why-buffet-thinks-investing-in-gold-is-stupid-2013-04-18

! Global Gold Mine and Deposit Rankings 2013

http://www.visualcapitalist.com/

* It’s not clear cut when exactly the United States was on or off the gold standard. They suspended it in July 1914 with the onset of World War One precipitated a domestic financial crisis. They re-established the full gold standard in December 1914 after an aggressive policy response stabilised the financial system. This continued until they entered that war, and subsequently partially embargoed gold exports starting in September 1917. The gold standard was still in effect domestically – meaning people could trade dollars for specie – but not internationally. These restrictions on gold exports continued until June 1919, at which point they returned to the full gold standard. The chart started from this last date, because there is no question that they were operating under the gold standard at this point. For more, read this superb Federal Reserve paper on the history of the gold standard from World War I through the Great Depression.

http://www.theatlantic.com/business/archive/2012/08/why-the-gold-standard-is-the-worlds-worst-economic-idea-in-2-charts/261552/

http://finance.yahoo.com/blogs/the-exchange/americans-wealth-hits-record-most-don-t-feel-195817649.html

http://www.gold.org/reserve-asset-management/central-bank-gold-agreements