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Catching a Falling Financial Knife

Which Best Way to Return to a Gold Standard?

Commodities / Gold and Silver 2012 Dec 19, 2012 - 02:31 AM GMT

By: Casey_Research

Commodities

Many of us see hair-curling rates of price inflation not too far down the road. Today inflation is hardly noticeable. But what's coming will be so painful and so disruptive that soaring prices will become the voting public's number-one complaint. How will the politicians respond?


They will be responding to an audience for whom the idea of fiat money (even with a picture of a dead president on every bill) has been discredited. The obvious alternative to fiat money will be a return to a gold standard, and it's hard to imagine what competing proposals might get in the way. In such an environment, being pro-gold will be politically smart. Championing the idea of re-linking the dollar to gold would serve any politician nicely as an I-dare-you-to-disagree challenge to his competitors. And supporting such a proposal would be a convenient way for politicians to distance themselves from the mistakes of the past.

I believe we are going to hear a lot of talk about a return to "the" gold standard. But none of the talkers will be saying much unless he tells you what kind of gold standard he has in mind. There are different ways to link the dollar to gold. Each of them involves an official price for gold at which the government is committed to transact with any and all comers. But there are important differences.

Symmetric bullion standard. The government sets an official dollar price per ounce of gold. Then (i) it pledges to buy an unlimited amount of gold from the public and pay for it in paper dollars, and (ii) it pledges to sell an unlimited amount of gold to the public and accept payment for the metal in paper dollars.

Asymmetric bullion standard. The government sets an official dollar price per ounce of gold. Then it pledges to sell an unlimited amount of gold to the public and accept payment for the gold in paper dollars. The asymmetric standard entails no commitment to buy gold; it is nothing more than the sell side of the symmetric bullion standard.

Gold coin standard. The government mints coins containing a fixed quantity of gold (e.g., one ounce per coin) and carrying a fixed legal-tender value, which implies an official price for gold. Then (i) it pledges to exchange an unlimited number of gold coins for the same quantity of gold bullion with anyone willing to make the swap, which implies a pledge to buy an unlimited quantity of gold at the official price; and (ii) it pledges to sell an unlimited number of gold coins to the public and accept payment for the coins in paper dollars.

Bi-metallic standard. The government sets an official dollar price per ounce of gold and an official dollar price per ounce of silver. Then (i) it pledges to purchase unlimited amounts of either metal from the public; and (ii) it pledges to sell unlimited amounts of its choice of either metal to the public and accept payment for the metal in paper dollars.

Notice that every version of the gold standard involves a promise about paper money. In that respect, the gold standard resembles the fiat money system for which it is an alternative. The difference is in the nature of the promise and in how quickly the public will know if it is being broken.

With fiat money, the promise is a soft one – a pledge to protect the currency's value by exercising prudence and restraint in printing more dollars. When the promise is broken, it may take years for that fact to become obvious to much of the public. By then, the parties responsible for breaking the promise may have moved on to other government positions or retired altogether or, in rare cases, moved on to honest work. That leaves their successors nicely positioned to put on a show of dismay, anger, disgust or indignation (every politician has his own theatrical specialty) at what his predecessors have wrought and then get on with the business of renewing the pledge to protect the currency.

Under any version of the gold standard, life for politicians is far less convenient. Keeping the promise to buy gold or silver (which is part of every version except the asymmetric bullion standard) is simple enough – just print however many dollars you need. It's keeping the promise to sell gold or silver to anyone who presents paper money (i.e., redeemability) that is the hard part, and the printing press is no help at all. Moreover, a failure to redeem is immediately and unambiguously obvious. And when such a failure occurs, it's likely that the responsible parties will still be on stage and standing within the delivery zone of tomato-tossing voters.

The pledge to sell unlimited quantities of gold or silver for paper money may seem like an empty one. Obviously, neither the government nor anyone else has an unlimited quantity of metal. But there is a way for the government to keep the promise, provided that it is at least minimally creditworthy. It can do exactly what the government does from time to time when it leans toward protecting the value of the fiat dollar: it can reduce the supply of paper currency by selling Treasury securities. Under a gold standard, doing so drains off excess dollars that the holders otherwise might have redeemed for gold and thus saves the redeemability promise from being broken.

Setting the Price

Returning to a gold standard is a tricky business. The difficulty has little to do with how much gold the government has on the day it makes the big move. Even if it had no gold at all, it could re-link the dollar to gold by setting the official price high enough to attract sellers. The difficulty is in determining an official price that won't leave instability in its wake.

Set the price too low, and gold will start flowing out of the Treasury. If the price is just a little too low, the public's demand for gold (at the official price) will eventually be satisfied and the outflow will end. But if the official price is much to the low side, the politicians will be stuck with an ugly choice. Either (i) stop the gold outflow by contracting the public's supply of paper dollars (e.g., the Federal Reserve sells Treasury securities to the public), which likely would produce an economic recession; or (ii) let the outflow continue until it exhausts the government's gold holdings and then tell the next would-be dollar-redeemer, "Sorry, we fooled you again."

And on the other hand…

Set the price too high, and gold will start flowing into the Treasury. If the price is just a little too high, the public will sell what it cares to sell and then the inflow will end. But if the official price is much to the high side, the politicians will get, for a while, what they enjoy so much – an inflationary boom, as the Treasury prints more paper dollars to pay for the gold the public wants to sell. And like any inflationary boom, it will end in an ugly recession.

So how do you determine the Goldilocks price – not too high, not too low? A tempting indication would be the current open-market price. But that indicator isn't even close to being a sure thing. Consider two extreme circumstances in which the return to a gold standard might occur.

Total surprise. Everyone goes home on Friday with fiat dollars in their pockets. Over the weekend, Congress passes the appropriate legislation, the president signs the bill on Sunday night, and on Monday morning everyone's dollars are convertible to gold at an official price set close to the previous Friday's Comex spot settlement price.

Would the official price that comes out of such a lightning transition be too low or too high?

A return to a symmetric gold standard would increase the demand for dollars by making the dollar seem less susceptible to loss of value through excess printing. It also would increase the demand for gold, since the government's pledge to buy unlimited amounts of gold would put a floor under its price, thereby eliminating gold's biggest negative feature – the risk of a price drop. Which effect would dominate? No one knows (or if someone does know, he hasn't explained it to me). So relying on the Comex for price discovery might lead to an official price that is much too high or much too low. The adoption of a gold coin standard would entail the same quandary.

A sudden adoption of an asymmetric gold standard would increase the demand for dollars for the reason just cited. But it wouldn't increase the demand for gold, since an asymmetric standard does nothing to prevent the open-market price from falling. So at last Friday's Comex price, gold has been made comparatively less attractive than the dollar. And that means that an official price set to match the earlier Comex price would be too high, and likely by a wide margin.

No surprise. We are treated to month after month of debate about a return to a gold standard of one kind or another. The political tide runs strongly toward re-linking the dollar to gold, and the argument gradually shifts to one about the official price. Gold traders, naturally, follow the debate closely. In response, the Comex price gradually shifts from being an indication of the market-clearing price for the metal to being a forecast of what the politicians are going to agree upon as the official price. In that circumstance, regardless of the type of gold standard, adopting the Comex price as the official price would be an absurdity. The result could be very wide of the mark, perhaps drastically too high or drastically too low.

Embracing a bi-metallic standard wouldn't eliminate the price-setting puzzle. In fact, it might add to the puzzle.

Figuring out where we should be and figuring out the right way to get there are two separate matters, each with its own opportunities to be wrong. Even if you see the advocates of a gold standard as models of clear thinking, there is no reliable way for them to be right about the price.

Given the growing recklessness with which the fiat dollar is being managed (QE3 is truly unprecedented – a solemn, furrowed-brow pledge not to protect the dollar's value), the gold standard is almost certainly going to come riding back into town. By restraining the government from interfering in the capital markets, it will lead to greater economic stability – eventually. But the transition to a gold standard could be a bumpy ride.

Even the best investors can leave gains subject to one of the most insidious thieves around: inflation. Many expect its ravages to worsen in both the US and Europe over the coming years... but there are ways to minimize – even avoid – its damage. Learn how to make economic trends your investing friends.

© 2012 Copyright Casey Research - All Rights Reserved

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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Catching a Falling Financial Knife