The Death of Money (29 page)

The total gold supply in the world today, exclusive of reserves in the ground, is
approximately 163,000 tonnes. The portion of that gold held by official institutions,
such as central banks, national treasuries, and the IMF, is 31,868.8 tonnes. Using
a $1,500-per-ounce price, the official gold in the world has a $1.7 trillion market
value. This value is far smaller than the total money supply of the major trading
and financial powers in the world. For example, U.S. money supply alone, using the
M1 measure provided by the U.S. Federal Reserve, was $2.5 trillion at the end of June
2013. The broader Fed M2 money supply was $10.6 trillion at the same period. Combining
this with
money supplies of the ECB, the Bank of Japan, and the People’s Bank of China pushes
global money supply for the big four economic zones to $20 trillion for M1 and $48
trillion for M2. If global money supply were limited to $1.7 trillion of gold instead
of $48 trillion of M2 paper money, the result would be disastrously deflationary and
lead to a severe depression.

The problem in this scenario is not the amount of gold but the
price
. There is ample gold at the right price. If gold were $17,500 per ounce, the official
gold supply would roughly equal the M1 money supply of the Eurozone, Japan, China,
and the United States combined. The point is not to predict the price of gold or to
anticipate a gold standard but merely to illustrate that the
quantity
of gold is never an impediment to a gold standard as long as the
price
is appropriate to the targeted money supply.

The second myth is that gold cannot be used in a monetary system because
gold caused the Great Depression
of the 1930s and contributed to its length and severity. This myth is half true,
but in that half-truth lies much confusion. The Great Depression, conventionally dated
from 1929 to 1940, was preceded by the adoption of the “gold exchange standard,” which
emerged in stages from 1922 to 1925 and functioned with great difficulty until 1939.
The gold exchange standard was agreed in principle at the Genoa Conference in 1922,
but the precise steps toward
implementation were left to the participating countries to work out in the years that
followed.

As the name implies, the gold exchange standard was not a pure gold standard of the
type that had existed from 1870 to 1914. It was a hybrid in which both
gold
and foreign
exchange
—principally U.S. dollars, U.K. pounds sterling, and French francs—could serve as
reserves and be used for settlement of any balance of payments. After the First World
War, citizens in most major economies no longer carried gold coins, as had been common
prior to 1914.

In theory, a country’s foreign exchange reserves were redeemable into gold when a
holder presented them to the issuing country. Citizens were also free to own gold.
But international redemptions were meant to be infrequent, and physical gold possession
by citizens was limited to large bars, which are generally unsuitable for day-to-day
transactions. The idea was to create a gold standard but have as little gold in circulation
as possible. The gold that was available was to remain principally in vaults at the
Federal Reserve Bank of New York, the Bank of England, and the Banque de France, while
citizens grew accustomed to using paper notes instead of gold coins, and central bankers
learned to accept their trading partners’ notes instead of demanding bullion. The
gold exchange standard was, at best, a pale imitation of a true gold standard and,
at worst, a massive fraud.

Most important, nations had to choose a conversion rate between their currencies and
gold, then stick to that rate as the new system evolved. In view of the vast paper
money supply increases that had occurred during the First World War, from 1914 to
1918, most participating nations chose a value for their currencies that was far below
the prewar rates. In effect, they devalued their currencies against gold and returned
to a gold standard at the new, lower exchange rate. France, Belgium, Italy, and other
members of what later became known as the Gold Bloc pursued this policy. The United
States had entered the war later than the European powers, and its economy was less
affected by the war. The United States also received large gold inflows during the
war, and as a result, it had no difficulty maintaining gold’s prewar $20.67-per-ounce
exchange rate. After the Gold Bloc devaluations, and with the United States not in
distress, the future success of the gold exchange standard now hinged on the determination
of a conversion rate for U.K. pounds sterling.

The U.K., under the guidance of chancellor of the exchequer Winston Churchill,
chose to return sterling to gold at the prewar rate equivalent to £4.86 per ounce.
He did this both because he felt duty bound to honor Bank of England notes at their
original value, but also for pragmatic reasons having to do with maintaining London’s
position as the reliable sound money center of world finance. Given the large amount
of money printed by the Bank of England to finance the war, this exchange rate greatly
overvalued the pound and forced a drastic decrease in the money supply in order to
return to the old parity. An exchange rate equivalent to £7.50 per ounce would have
been a more realistic peg and would have put the U.K. in a competitive trading position.
Instead, the overvaluation of pounds sterling hurt U.K. trade and forced deflationary
wage cuts on U.K. labor in order to adjust the terms of trade; the process was similar
to the structural adjustments Greece and Spain are experiencing today. As a result,
the U.K. economy was in a depression by 1926, years before the conventional starting
date of 1929 associated with the Great Depression and the U.S. stock market crash.

With an overvalued pound and disadvantageous terms of trade, the U.K.’s gold began
flowing to the United States and France. The proper U.S. response should have been
to ease monetary policy, controlled by the Federal Reserve, and allow higher inflation
in the United States, which would have moved the terms of trade in the U.K.’s favor
and given the U.K. economy a boost. Instead, the Fed ran a tight money policy, which
contributed to the 1929 market crash and helped to precipitate the Great Depression.
By 1931, pressure on the overvalued pound became so severe that the U.K. abandoned
the 1925 parity and devalued sterling. This left the dollar as the most overvalued
major currency in the world, a situation rectified in 1933, when the United States
also devalued from $20.67 per ounce to $35.00 per ounce, cheapening the dollar to
offset the effect of the sterling devaluation two years earlier.

The sequence of events from 1922 to 1933 shows that the Great Depression was caused
not by gold but rather by
central bank discretionary policies.
The gold exchange standard was fatally flawed because it did not take gold’s free-market
price into account. The Bank of England overvalued sterling in 1925. The Federal Reserve
ran an unduly tight money policy in 1927. These problems have to do not with gold
per se
but with the
price
of gold as manipulated and distorted by central banks. The gold exchange standard
did contribute to the Great Depression because it was not a true gold standard. It
was a poorly designed hybrid, manipulated and mismanaged by discretionary monetary
policy conducted by central banks, particularly in the U.K. and the United States.
The Great Depression is not an argument against gold; it is a cautionary tale of central
bank incompetence and the dangers of ignoring markets.

The third myth is that
gold caused market panics
and that modern economies are more stable when gold is avoided and central banks
use monetary tools to smooth out periodic panics. This myth is one of economist Paul
Krugman’s favorites, and
he recites it ad nauseam in his antigold, pro-inflationary writings.

In fact, panics do happen on a gold standard, and panics
also
happen in the absence of a gold standard. Krugman likes to recite a list of panics
that arose during the classical gold standard and the gold exchange standard; it includes
market panics or crashes in 1873, 1884, 1890, 1893, 1907, and the Great Depression.
Fair enough. But panics also occurred in the absence of a gold standard. Examples
include the 1987 stock market crash, when the Dow Jones Industrial Index fell over
22 percent in a single day, the 1994 Mexican peso collapse, the 1997–98 Asia-Russia-Long-Term
Capital market panic, the 2000 tech stock collapse, the 2007 housing market collapse,
and the Lehman-AIG financial panic of 2008.

Panics are neither prevented nor caused by gold. Panics are caused by credit overexpansion
and overconfidence, followed by a sudden loss of confidence and a mad scramble for
liquidity. Panics are characterized by rapid declines in asset values, margin calls
by creditors, dumping of assets to obtain cash, and a positive feedback loop in which
more asset sales cause further valuation declines, which are followed by more and
more margin calls and asset sales. This process eventually exhausts itself through
bankruptcy, a rescue by solvent parties, government intervention, or a convergence
of all three. Panics are a product of human nature, and the pendulum swings between
fear and greed and back to fear. Panics will not disappear. The point is that panics
have little or nothing to do with gold.

In practice, gold standards worked well in the past and remain entirely feasible today.
Still, daunting design questions arise in the creation of any gold standard. Designing
a gold standard is challenging in the same way that designing a digital processor
can be challenging; there is good design and bad design. There are technical issues
that deserve serious consideration, and spurious issues that do not. There is enough
gold in the world—it is just a matter of price. Gold did not cause the Great Depression,
but central bank policy blunders did. Panics are not the result of gold; they are
the result of human nature and easy credit. Puncturing these myths is the way forward
to an authentic debate of gold’s pros and cons.

■
The Scramble for Gold

While academics and pundits debate gold’s virtues as a monetary standard, central
banks are past the debate stage. For central banks, the debate is over—gold is money.
Today central banks are acquiring gold as a reserve asset at a pace not seen since
the early 1970s, and this scramble for gold has profound implications for the future
role of every currency, especially the U.S. dollar.

The facts speak for themselves and require little elaboration. Central banks and other
official institutions such as the IMF were net sellers of gold every year from 2002
through 2009, although sales dropped sharply during that time from over 500 tonnes
in 2002 to less than 50 tonnes in 2009. Beginning in 2010, central banks became net
buyers, with purchases rising sharply from less than 100 tonnes in 2010 to over 500
tonnes in 2012. In the ten-year span from 2002 to 2012, the shift from net sales to
net purchases was over 1,000 tonnes per year, an amount greater than one-third of
annual global mining output. Increasingly, gold is moving directly from mines to central
bank vaults.

Table 1 shows increases in gold reserves for selected countries from the first quarter
of 2004 to the first quarter of 2013, measured in tonnes:

Table 1. Gold Reserves in Selected Countries

All these large central bank acquirers are in Asia, Latin America, and eastern Europe.
Over this same period, from 2004 to 2013, Western central banks were net sellers of
gold, although such sales stopped abruptly in 2009. Since then emerging economies
have had to acquire gold from mine production, scrap gold recycling, or open-market
sales, including sales of over 400 tonnes by the IMF in late 2009 and early 2010.
Taking into account all national central banks, exclusive of the IMF, official gold
reserves increased 1,481 tonnes from the fourth quarter of 2009 through the first
quarter of 2013—a 5.4 percent increase. Central banks have become significant gold
buyers, and the movement of gold is from west to east.

These statistics all need to be qualified by the curious case of China. China reported
a gold reserve position of 395 tonnes for over twenty years from 1980 through the
end of 2001. Then the reported position suddenly leaped to 500 tonnes, where it remained
for a year; then it leaped again to 600 tonnes at the end of 2002, where it remained
for over
six years. Finally, the reported position was increased to 1,054 tonnes in April 2009,
where it has remained for almost five years through early 2014.

Officially, China has reported a series of sudden spikes in its gold holdings of 105
tonnes in 2001, 100 tonnes in 2002, and 454 tonnes in 2009. Increases of this size
are extremely difficult to conduct in a single transaction except by prearrangement
between two central banks or the IMF.
No such prearranged central bank or IMF sales to China have been reported, and no
reported central bank or IMF holdings show the necessary sudden drops at the appropriate
times that would correspond to such increases by China. The conclusion is inescapable
that China is actually accumulating gold in smaller quantities over long periods of
time, and reporting the changes in a lump sum on an irregular basis.