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The Gleam of Gold

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Gold’s appeal as an investment is bound up with its historic role as a form of money and linchpin of the monetary system. Gold prices tend to rise in times of skepticism about the capacity of fiat currency to maintain its value against inflation or depreciation. Such concerns are widespread among both enthusiasts of gold as an investment and proponents of restoring a gold standard (and there is considerable overlap between these two groups).

The surge of gold prices over the past year reflected, in significant part, fears that a new round of inflation is on the way. Such concerns are not easy to dismiss, given the expansive monetary and fiscal policies currently in place. But the flight into gold as a store of value carries its own dangers. For one thing, gold prices are volatile. The metal’s highly variable returns make it a speculative investment, and one that performs unevenly even as an inflation hedge, since its price often fails to keep up with consumer prices. (Treasury Inflation-Protected Securities offer a more consistent inflation hedge, albeit one with considerably less upside.)

The downside risks of gold are particularly sobering in light of the metal recently having traded at all-time nominal highs, raising concerns that market psychology has produced a fragile bubble. The spot price per ounce, which began 2009 at around $870, moved to heights above $1,200 in December, before declining to below $1,100 by late January. In inflation-adjusted terms, however, gold has remained well below its January 1980 peak of $850 (which translates into over $2,200 in current dollars), raising the possibility that a replay of 1970s-style inflation could bring further spikes in gold.

Another consideration is that it is unlikely that the United States or other nations will revert to a gold standard anytime soon, if ever. In taking such a move, governments would be giving up a great deal of flexibility in their monetary and fiscal policies. This is seen by gold-standard advocates as a selling point — that governments would be constrained in their ability to spend money — but it also means policymakers would have far less leeway to take measures to stabilize economies and grapple with crises.

Nor is it clear that a resurrected gold standard would have credibility. To a greater degree than in earlier eras, governments today would have to convince markets that they would not simply abandon a gold standard during times of economic stress. Such credibility was easier to achieve when metal-backed money was the norm and before the world saw multiple historical episodes of commodity standards being cast aside.

In the event that the U.S. adopted a new gold standard, one plausible consequence would be an enormous increase in gold prices. Substantial gold backing of the money supply could require the government to establish convertibility at a price several times higher than current levels. (Alternatively, to keep gold prices stable, policymakers would have to allow the money supply to contract drastically, leading to severe deflation.)

Some market analysts are bullish on gold based on expectations that central banks will engage in stepped-up gold purchasing to strengthen their credibility as stewards of the money supply, even if they never embrace an actual gold standard. While this scenario is more plausible than an actual return to gold convertibility, it would mark a dramatic historic reversal from a long-running decline in gold’s importance in monetary policy.

Barry Eichengreen, University of California, Berkeley economist and author of Golden Fetters: The Gold Standard and the Great Depression, 1919-1939 notes that gold has comprised a declining share of official reserves going as far back as 1880. “I think the long-term trend over the last century or more has been to move away from the peculiar system where we dug gold out of the ground in one place and we deposited it in the ground in another place,” Eichengreen tells Research. “I think that is an entirely sensible and understandable trend [in] that it’s more efficient to rely on paper money and electronic money than it is to rely on heavy pieces of gold and silver and copper.”

Shifting Standards

The gold standard’s heyday was in the late 19th and early 20th centuries, when most major currencies had a link to gold (and those that did not were linked to silver). This arrangement, now known as the “classical” gold standard, depended heavily on international cooperation, with central banks engaging in monetary and gold-market actions in concert in order to keep exchange rates stable.

No one nation, including Great Britain, then the world’s leading economic power, had the wherewithal to maintain a gold link without periodic stabilizing efforts by multiple nations. In Golden Fetters, Eichengreen details how this system worked in the decades prior to World War I, and how efforts to resurrect it in the years after the war failed amid international tensions over German war reparations and other issues.

Political commentator David Frum, writing about Golden Fetters at his website, recently made some pointed comments about the implications of such history for current policy debates: “It’s super hilariously ironic that modern monetary cranks of the Ron Paul variety now combine enthusiasm for gold with opposition both to an American central bank and hatred of international monetary cooperation — the two ingredients absolutely essential to sustaining the ancient currency regime for which they claim to yearn.”

The U.S., moreover, participated only to a limited extent in the international cooperation that bolstered the classical gold standard. Partly this was because the nation did not have a central bank at the time, the Fed not being created until 1913. But partly it was also because the U.S., with universal male suffrage, was the most democratic of the major nations prior to World War I. That meant in turn it was the most susceptible to populist agitation against the gold standard, as when presidential candidate William Jennings Bryan railed against “a cross of gold” at the 1896 Democratic convention.

It is hard to imagine a political consensus forming in 21st-century America that would enable a gold standard to be reestablished and maintained. Much as in the 19th century, such an arrangement would spark anger that it benefits lenders over borrowers, rich over poor; moreover, it would require slashing government to a degree unlikely to win broad public support. Even amid rising worries about federal spending, prospective inflation and a weakening dollar, the gold solution appears unlikely to be tried again.


Napoleon’s Gold

It has been a commonplace of history for nations on a gold standard to abandon it in times of war, so they could finance their military efforts without constraint. Most combatant nations got rid of their links to gold in World War I and in the Napoleonic Wars, for instance.

A notable exception was Napoleon himself, who kept France on a gold standard during two decades of war against multiple enemies. The French leader’s enthusiasm for hard money likely was driven by his country’s experience with assignats, paper currency issued shortly after the French Revolution. The unbacked paper quickly became worthless, helping pave the way for Napoleon to come to power.


A Gold Timeline

1792: As recommended by Treasury Secretary Alexander Hamilton, Congress passes a Coinage Act defining the dollar in terms of both silver and gold. The dollar is set as equal to 371.25 grains of pure silver or 24.75 grains of pure gold. Hamilton notes that the 15:1 ratio may need to be readjusted in the future as supplies of the respective metals shift.

1834: Congress shifts the ratio to 16:1. This ends a period in which market price changes had placed the U.S. effectively on a silver standard. Gold now becomes the predominant monetary metal, something President Andrew Jackson wanted so that gold coins could replace the paper notes of his enemies at the Second Bank of the United States.

1861: As the Civil War rages, the U.S. government suspends gold convertibility.

1869: On expectations that a gold standard will return, speculators James Fisk and Jay Gould attempt to corner the gold market, sparking a panic known as Black Friday.

1873: A new Coinage Act omits the dollar’s historic link to silver. Proponents of a silver standard would call this “the crime of 1873.” By the end of the 1870s, the dollar is again convertible into gold.

1893: With federal gold supplies running low during a financial crisis, J.P. Morgan Sr., organizes a private consortium to lend gold to the government.

1896: William Jennings Bryan runs as presidential candidate of the Democratic, Populist and National Silver parties. A central theme of his unsuccessful campaign is restoring a silver standard, which would mean a looser monetary policy than one based on gold.

1914: The U.S. remains on the gold standard, even while most combatant nations in World War I are moving to suspend convertibility. This sets the stage for the U.S. to emerge as the preeminent economic and financial power during and after the war. In the 1920s, Britain and other nations will return to a gold standard, but the new system will soon prove unwieldy and then fall apart entirely in the Great Depression.

1934: President Franklin D. Roosevelt signs the Gold Reserve Act, outlawing most private ownership of gold and resetting the official gold price from $20.67 per ounce to $35. This marked either the end of the gold standard in America or a substantial weakening of that standard, depending on definitions.

1971: President Richard Nixon’s administration closes the U.S. “gold window,” whereby foreign central banks had been allowed to convert dollars into gold at $35 an ounce. The official price will subsequently rise to $38 and in 1973 to $42.22 (where it remains today) but this is a mere formality. The gold standard is over.