Going for gold: perils of entering the goldzone

By Lorenzo

Who would want the global monetary system to be at the mercy of the Bank of China?  Not conservative, free market types in the United States and elsewhere, one guesses.

Actually, it turns out lots of them do; all the people who support some sort of return to the gold standard, who think that the US (and other countries) should recreate the goldzone. Let me explain.

Gold shines
Some folk are quite impressed by the way the price of gold has shot up in recent years (all gold statistics are from the World Gold Council website).

Gold price in US$: on the up and up

As the price has shot up, so has gold’s attraction as an investment. It is a striking illustration of the mystique of gold that folk who, if any other asset quadrupled in price in 6 years, would call “bubble”, see the surge in the gold price as saying something profound about the global economic situation and monetary system.

Mined and recycled gold increasingly flows into (private) vaults

While industrial and dental use of gold has remained fairly constant, there has been a strong shift from demand for gold being dominated by jewellery to increasing interest in coins and bullion. With investment hitting 40% of mined and recycled gold, it is likely at about the levels that flowed into monetary gold at the height of the gold standard; movement between monetary and non-monetary uses of gold being an important feature (pdf) of the 1873-1914 gold standard.

After surging in price in 1979-80, gold was actually losing value as an investment in real terms until 2005, when it began a price surge which has seen it storm past its 1980 highpoint: but low real interest rates make gold a better investment (pdf). While Asian demand had tended to dominate the market, the striking change in demand for gold as an investment has been the dramatic European (particularly German) embrace of gold from 2008 onwards.

Investment gold, in tonnes

A certain Euro-nervousness perhaps.  Looking at jewellery and investment demand together, the way Asian demand dominates the gold market is clear.

Big in Asia: demand for gold for jewellery and investment in 2011, in tonnes.

India has long been a strong market for gold and, as they and the Chinese are getting richer; this (along with the aforementioned Euro-nervousness) is reflected in the demand for gold. For all the (largely American) goldbug chatter, Americans are not nearly as in love with gold as others are.

Still, there are voices calling for us all to enter the goldzone, to “go back to gold” as the basis for the international monetary system. But doing so would have implications they may not have considered fully.

Entering the goldzone
Money is a transaction good: the value of money is what it can be swapped for. In a monetary exchange economy, the price level (P) is the average swap value of money in circulation for goods and services. Using the Fisher-Friedman equation of exchange (money stock x rate of turnover of money for goods and services = prices x output: i.e. MV = Py), then P = MV/y.

The cost of production of money is merely a minimum constraint on its supply. For notes, this clearly not much of a constraint. (For coins, some premium over metal value for transaction utility can also be a factor.) In the case of a monopoly provider of non-convertible notes, there is no other constraint on its supply except that adopted by the monopoly provider. In economist George Selgin’s words:

The disadvantage of fiat money [.i.e. non-convertible money], relative to commodity money, rests precisely in the fact that its scarcity, being thus contrived, is also contingent. A matter of deliberate policy only, it is subject to adjustment at the will of the monetary authorities or, if those authorities are bound by a monetary rule, at that of the legislature. Consequently, although a fiat money can be managed so as to not only preserve its purchasing power over time, but also so as to achieve the greatest possible degree of overall macroeconomic stability, there is no guarantee that it will be so managed, and market forces themselves offer no effective check against its arbitrary mismanagement.

Hence the appeal of money being convertible, to provide an anchor for monetary stability not dependant on the monetary authorities (or, more accurately, that constrains them in specific ways). The money is then backed by whatever it is the money can be redeemed for (in the case of the gold standard, a set amount of gold).

That money can be “swapped out” by being redeemed in its set gold value means that the supply of convertible notes can be increased or decreased in line with shifts in propensity to hold notes, with no effect on the price level, and tend to do so in an equilibrating way, due to the constraint of people being able to swap out notes for gold. Cover ratios, a required ratio of notes to gold reserves, can be set but are not a necessary feature. The constraint is the right to redeem, not the number of notes.

Under the gold standard, since the price of gold in terms of money is fixed, increases in the demand for gold greater than the supply thereof (which would otherwise mean higher money prices for gold) can only manifest through lower prices for goods and services. To put it another way, under the gold standard, the price of gold is inverse to the price level; they move in opposite directions. (Though there is no price of gold except as registered in the price level; there is just the fixed rate of exchange of money for gold.).

If, as was the case in the 1873-1895 period, countries are entering the gold standard faster than the gold supply could match, the increased demand for monetised gold puts downward pressure on the price of goods and services. As the supply of monetised gold was not keeping up with the demand for monetised gold, this pushed the overall price level downwards (the only way the increased price of gold could register). Hence, output of goods and services expanding faster than the level of gold tended to have the effect of pushing down prices, just as the supply of gold increasing faster than output of goods and services tended to have the effect of pushing up prices.

Similarly, with the return to the gold standard after WWI, since the wartime surge in price levels were not compensated for by setting higher money prices for gold (i.e. more monetary units to purchase a given amount of gold), unless the demand for gold was restrained, there was going to be downward pressure on prices for goods and services (the only way upward movement in the price of gold could register). A problem exacerbated as countries re-entered the goldzone.

Demand for gold could be restrained by abandoning gold coins, by using gold-convertible foreign exchange as reserves (both of which were done) and by being willing to relax cover ratios (ratio of notes to gold reserves), which was not. The deflationary pressures registered in the falling commodity prices which were a feature of the 1920s.

When the Bank of France began to dramatically increase its cover ratio from 1928 onwards by continually raising its gold reserves without monetising the extra gold holdings, it dramatically increased the demand for gold, setting off (along with similar action by the Fed) a disastrous fall in prices throughout the goldzone, the only way the increased price of gold could register. As prices fell, output fell, spending fell, incomes fell and debt burdens surged, leading to a wave of credit crises and bank failures; the catastrophic slump (collapse in transactions/glut of goods and services) known as The Great Depression. The solution was to leave the goldzone; as countries did, they began to recover.

All in it together
For that is the thing about the goldzone; you cannot stop other countries entering. But it is worse than that; for you cannot stop them driving up the demand for gold. And the point of the system is to provide a fixed “swap value” for money, a fungible anchor for the value of money. Hence driving up the price of gold means driving down the price level for every country in the goldzone. (Remembering that, if you are in the goldzone, then you have a fixed exchange rate with gold and with every other currency in the goldzone.)

So, what it means to be in the goldzone is to be at the mercy of, not only your central bank, but every other central bank in the goldzone, entry into which cannot be blocked.  The danger is not even the average level of goldzone central bank incompetence, but the outlier level of central bank incompetence.

Indeed, a central bank outside the goldzone but able to affect the gold price could have much the same effect (as the failure of Franco-German monetary cooperation as Germany went off the silver standard helped destabilise the silver standard in the 1870s). Though being in the goldzone gives much greater ability to “suck in” gold. Simply undervalue your currency in terms of gold, so gold is overvalued–as the franc was when France went back on the gold standard in 1928–then gold buys more in your country and so will flow towards you. While it would be possible for other central banks to counteract such behaviour by releasing their own gold reserves, that would obviously have limits–not to mention creating a perverse incentive.

The European Central Bank is even currently giving us an object lesson in how stupid a central bank can be. (As Nobel laureate Thomas Sargent says, the euro is basically an artificial gold standard–remember that point about fixed exchange rates.)

So, how many central banks do you trust?

Which brings me back to where I came in–do you want an international monetary system where the price level in your country is at the mercy of the Bank of China? (Or, come to that, the Bank of Iran?) And what chances do you think there are of any set of national policy makers deciding that would be a good idea?

It is not as if this is remotely a made-up scenario. It was precisely because the interwar goldzone was at the mercy of the Bank of France and its insane policy (abetted by the stupid policies of the Fed) that the goldzone of the time was driven into that disastrous deflation and collapse in incomes we call The Great Depression. But, if you don’t notice the role of the Bank of France in precipitating the massive deflation–perhaps because you are obsessing over the alleged inflationary boom of the 1920s (which wasn’t an inflationary boom in any useful sense)–then this problem will likely not occur to you.

Even Friedrich Hayek who, in his Denationalisation of Money (pdf), declares that:

as long as the management of money is in the hands of government, the gold standard with all its imperfections is the only tolerable safe system

Also notes

the undeniable truth that the gold standard also has serious defects


Though gold is an anchor–and any anchor is better than a money left to the discretion of government–it is a very wobbly anchor. It certainly could not bear the strain if a majority of countries tried to run their own gold standard. There is just not enough gold about. … the increasing demand for gold, would probably lead to a rise (and perhaps also violent fluctuations) of the price of gold that, although might still be widely used for hoarding, it would soon cease to be convenient as the unit for business transactions and accounting

(Hayek also has an enthusiasm for fixed exchange rates I do not share; not only has a floating exchange rate been an excellent “shock absorber” for Australia, but the wider evidence is rather against them.)

It is all very well to want to have a gold standard without central banks, but that is not the way it would work. After all, your country can decide not to have a central bank, but what about any other country that enters the goldzone? Wanting a gold standard to replace or restrain central bank discretion turns out to be making your situation much more vulnerable to the discretion of many central banks.

Golden delusions
Some of what is going on in such golden hankerings–apart from an understandable wish for monetary stability (but have a look at that gold price graph again)–is an odd (and very ahistorical) notion that somehow thousands of years of monetary history was all naturally leading up to a gold standard which, in its classical form, lasted 40 years. (A blessed state we have since lapsed from.)

Admittedly, the UK was on the gold standard much longer than 40 years (roughly 200 in fact). But that had been a fully British–largely Bank of England–managed system. The 1873-1914 international gold standard was also largely managed by the Bank of England; in a sense, a pound sterling for everyone, just as the eurozone is a deutschmark for everyone.

On eurozone as goldzone redux, take a wild guess at which countries were forced back off the C19th gold standard during its 1873-1895 deflationary period. If you guessed Italy, Spain, Portugal, and Greece (amongst others), well done.  These words about the painful strictures of the gold standard when it was deflationary may sound strangely familiar:

Deflation forced a difficult choice between deteriorating borrowing conditions and painful adjustments. Countries starting with relatively low debt levels could compromise, letting their debt drift slightly and making only partial fiscal adjustments. But for those that already had fairly high debt levels, such as the southern European countries, the adjustment cost required for continued participation in the gold standard could be very large, especially since the market mechanism implied that a sustained deterioration in public debts meant accelerating premia for new loans. The opportunity cost of being part of the gold standard was becoming very substantial, increasing the pressure to switch to seignorage finance, and go on inconvertible paper to escape gold deflation.

Conversely, the US Federal Reserve–which dominated gold reserve holdings after WWI, and still does–failed to manage the interwar gold standard, particularly after the death of Benjamin Strong.

The notion that the C19th gold standard could be a pound-sterling-for-everyone was the same delusion as the euro-as-deutschmark-for-everyone; that money can be just money. But there is no such thing as just money. Not merely in that money is a multidimensional phenomenon but because money operates within webs of institutions and presumptions; adopting a monetary system does not bring those institutions and presumptions with it, the transacting parties using money bring their presumptions and social placements with them.

If you see money as some naturally evolved specific thing, or even as just a tool, you will be misled. Austrian school economist William Garrison puts the notion of the gold standard as a natural evolution clearly:

(1) Left to its own devices, a market economy will give rise to medium of exchange.(2) The commodity that emerges as the medium of exchange will be one that possesses a certain set of characteristics. (3) This set of characteristics has its clearest and most pronounced manifestation in gold. So conceived, the gold standard—at least in its purest form—neither requires nor permits the State to exercise control over the money supply. …. The proponents of gold are not suggesting that irresponsible tinkering is inevitable—whatever the nature of the monetary system; they are instead making the sharp distinction between a designed institution and an evolved institution.

Yet even the UK entered the gold standard by accident. Historically, silver has been a much more important monetary metal than gold. (The pound sterling was originally a weight of silver.) Across the centuries, there was a shifting ratio between gold and silver, depending on the ebb and flow of discoveries and sources for each, though generally not too far from the 1:17 gold/silver ratio in the Earth’s crust. (The Wizard of Oz is a political allegory on [pdf] the silver-gold debates of the late C19th in the US that sparked one of the great political speeches.) In 1717, the then Master of the Mint, a person with some prominence in intellectual history, set a ratio between gold and silver coins that overvalued gold and undervalued silver, so gold bought more in Britain and silver bought more overseas. Naturally, gold flowed into Britain and silver flowed out, effectively (and accidentally) putting Britain on the gold standard. Which it was then on continually, apart from wartime suspensions in 1797-1821 and 1914-1925, until 1931.

As for the 1873 breakdown of the highly functional system of a gold bloc (led by Britain), a (mostly Asian-Germanic) silver bloc and a bimetallism bloc (led by France), in economic historian Marc Flandreau’s words (pdf):

far from being preordained for structural, technological or political reasons, the making of the gold standard was an accident of history.

A result of the breakdown in international monetary cooperation between France and Germany after the Franco-Prussian War and the German imposition on a defeated France of a huge war indemnity (equal to about a third of French GNP; the French paid it off in three years–puts German whining about post-WWI reparations in perspective).

When one examines the actual history of money, as distinct from Just So stories about money, the most important factor in monetary history has been that rulers and states being–as a consequence of their coercive power, and so the scale of their expropriations and spending–the largest transactors, they have therefore had the biggest stake in, and the most power over, monetary systems. The history of money has been a long history of the interaction between the power of rulers and the exigencies of transacting, with monetary innovations often being the response to past abuses. (Coins have regular bumps on their edges, reeded edges, to prevent clipping, for example; though rulers have been the main source of monetary abuses, a history of abuse that greatly predates central banking.)

It is a profound delusion, this notion that the gold standard would protect us from the failures of central banks; only remotely plausible if you think that somehow inflation is all you have worry about central banks inflicting on us. Sadly, they have many more ways of screwing up than merely inflating.

Personally, I don’t fancy being in a monetary system at the mercy of the Bank of Iran. How about you?

[UPDATE: In Chapter 7 of his Monetary Mischief: Episodes in Monetary History, Milton Friedman details how US silver purchases under FDR–in order to get support from Senators of silver mining States for his New Deal legislation–drove China offer the silver standard.  Another example of how being on a metal commodity standard can make one’s monetary system, and so economy, highly vulnerable to the actions of other governments.]


  1. Posted July 24, 2012 at 7:33 am | Permalink

    [email protected]

    Although to be fair to Churchill the notion that the Great Depression was cause by monetary phenomena in the first instance is also dubious in my view.

    Then you are against the view which has been dominant in the economic profession since Friedman and Schwartz published A Monetary History of the United States. The work since has been mainly filling in the details.

  2. Posted July 24, 2012 at 10:53 am | Permalink

    If the French were dumping sterling for gold it was caused by the British monetary policy of overvaluing sterling.

    Can you rule out that they might have been performing a speculative attack on the British gold reserves?

  3. Mel
    Posted July 27, 2012 at 12:07 pm | Permalink

    Lrrenzo @47:

    [email protected] No, it is clearly the case that the power of Nazi, fascist etc movements was directly proportional to the intensity of local left-revolutionary parties.”

    The reality is more complicated than that and you are overlaying a pattern on data that will not support it. It is easy to find counter-examples, for examples the Communists in Finland polled more than the Communists in Germany ever did without having a major, history-changing fascist movement. Ditto the post WWII Euro-Communists. Conversely Austria’s communist party was not strong but its fascist movement thrived regardless.

    Your hatred of Marxism has clouded your judgement.

    It is no coincidence that the share of income going to Capital and corporate elite has increased with the collapse of fears of a revolutionary Left. It is also no coincidence that in America, where the revolutionary left has been weak almost to the point of irrelevance, that the corporate honchos at Corporation X can take home more loot than a pillaging Mongolian Khan while the company’s janitor lives in a run down trailer park.

    There is a pattern, but it doesn’t support your argument.

  4. Posted July 27, 2012 at 3:23 pm | Permalink

    [email protected] The issue isn’t Marxism–the SPD was Marxist, the only relevance that had was it led the SPD to write off rural voters (an error that the broad Left in France and Northern Europe did not make).

    The issue is Leninism (including Stalinism as a subset thereof). And Finland is obviously a special case, given its war of independence from Russia and consequent civil war.

    Anything that happened after WWII is completely irrelevant, given how thoroughly Fascism and Nazism were discredited by their defeat and various revelations.

    Also, the outbreak of mass prosperity and the success of the liberal capitalist Anglosphere rejuvenated liberal democratic movements (in the broad sense). It was not as if anti-communism wasn’t a major element in postwar politics; effective anti-communism was part of mainstream democratic politics.

    As for increase in capital’s share of GDP, that has a lot more to do with the breakdown of Bretton Woods and “the great factor price equalisation” and consequent financial deregulations than anything to do with revolutionary politics.

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