Why the idea of a gold standard is best relegated to the dustbin of history.
- By Mark T. WilliamsMark T. Williams teaches finance at Boston University School of Management and is a senior advisor to the Brattle Group, a former U.S. Federal Reserve Bank examiner, and author of Uncontrolled Risk: The Lessons of Lehman Brothers and How Systemic Risk Can Still Bring Down the World Financial System.
As the G-20 gathers in South Korea on Nov. 10, fears of a currency war are looming. The battle lines are being drawn between those countries that export and those that import. Big exporters want to boost their sales — a reason to make their currencies (and hence their products) cheaper. But debt-laden importers would prefer that China, among others, allow its currency to appreciate so that Chinese consumers could buy more of those goods. Japan has already cut the value of its currency; the dollar has also fallen 10 percent this year. So perilous is the diplomatic terrain that U.S. President Barack Obama sent a letter to G-20 leaders before they arrived in Seoul, prevailing on them to act with calm.
Amid the tensions and a fragile global economic recovery, it might be tempting to hear a certain monetary siren song: gold. On Monday, World Bank President Robert Zoellick proposed instituting a modified gold standard using a basket of big-five currencies — the dollar, euro, yen, pound, and renminbi — claiming it would help control inflation, deflation, and currency movement. The plan had something for everyone: a reality check for currencies that are undervalued, and a moderator for those too strong.
In times of economic uncertainty, gold has been the global currency of choice. It has no country and no central bank, so its price is entirely market driven. But don’t be fooled: Whether it’s a long-term investment, a quick-fix to stabilize global currencies, or a tool to keep central banks in check, gold is pyrite. And using a gold standard — even a modified one — would be a fool’s errand.
Today, gold is in a bubble. The price stands at an all-time (non-inflation adjusted) high of about $1,400 per ounce. This is remarkable given that inflation remains well under 2 percent and the cost of mining the stuff has remained $450 to $550 per ounce. In other words, as soon as it is out of the ground, you can turn around and sell it for three times what it cost you to dig it up. Since 2000, this has been the story: Gold prices have known only one direction — up. Despite economic ups and downs, it has produced an annualized return of 17 percent. Many speculators, hedgers, and contrarians have made a killing. New gold exchange traded funds (ETFs) have brought even more — and more diverse — investors on board. Those who bought gold in 2002 doubled their money by 2006 and repeated this financial alchemy by 2008. Investors that caught the gold bug as late as 2009 are up over 50 percent. This year alone, gold is up over 25 percent. A decade ago, it would have been heresy for institutional investors to invest in gold. Today, a 2 to 5 percent allocation of one’s portfolio is increasingly viewed as prudent.
But investment theory teaches us that double-digit returns can just as easily turn into double-digit losses. Gold’s proponents seem to have forgotten this lesson: They say it’s a hedge against inflation, economic uncertainty, declining currencies, and rising oil prices. When currencies are unstable, the evangelists sing, gold always holds strong. Concerns over mounting government deficits have only entrenched this notion. As the United States and other industrialized economies owe more and more, they’ll be forced to deflate their currencies to dig their way out. But gold won’t devalue, they say: while you need cartloads of money to buy a loaf of bread, investors who bought gold won’t feel the shock.
The problem is that all these theories hold true in a recession, but they will fall flat once the global economy moves from chaos back to economic prosperity. When stocks start to rise and bonds offer a higher interest rate, gold won’t look so good. And its price will fall — just like it would for any other investment. The drop could happen as soon as 2011 or 2012.
Already, there are signs that gold is poised to burst. The market has been good for too long and the hype is too intense. Many investors are too young to remember the last gold bubble in 1980, when prices peaked at $850 per ounce and then plummeted 60 percent in a single year. For the following two decades, money invested in gold was dead money. Even investments made as recently as 1988 and held to 2004 generated zero return. The real money made in gold has only happened in the last six years. The last gold bubble took four years to inflate; the latest bubble is six years in the making.
It’s remarkable that the gold mania has reached the rarified halls of the World Bank — a staid, sensible institution that should know better. Still, it’s understandable why it might be popular to suggest gold as a way out of current crisis. Proponents of a gold standard claim it provides long-term price stability, reduces the chance of hyper inflation and the abuse of monetary policy, and reduces incentives for central banks to inflate away their debt. It’s no coincidence that gold has soared as confidence in central banks worldwide seems at an all-time low. Bringing back the gold standard would indeed limit central banks’ ability to independently manipulate currency or increase the money supply and stimulate the economy. But remember, that also means gold would tie the hands of central banks in trying to do good.
Pegging a basket of currencies to a volatile commodity such as gold, in the middle of a bubble, is also just plain risky. (Zoellick seems to have realized this, walking back his statement a bit, today in the Wall Street Journal.) Gold has not always been a winner, nor will it always be. Historically, it has exhibited many longer periods of stagnation and declining value. And if we were to link the world’s most important currencies to gold, their values would suddenly and absurdly depend on mining. That’s problematic, since gold production can’t be scaled up quickly to meet the demands of a growing economy. If the economy were to grow faster than the gold supply, the result would be deflation — a period of downward price spirals, job cuts, and a decline in economic output. Many economists now claim that the Great Depression was prolonged as the gold standard limited the U.S. Federal Reserve’s ability to loosen monetary policy and apply needed economic stimulus.
Furthermore, the total value of all gold ever mined globally is only $6.5 trillion. Given that the U.S. money supply alone is much greater than this number, when adding the other big-five currencies, such a standard would send gold prices to the moon. Some analysts estimate that a new gold standard would push gold up somewhere between $6,000 to $10,000 an ounce. This would be great for hedge funds and other speculators, but bad for creating a stable economy.
High gold prices are a symptom of — not a solution to — a problem: lost confidence in the Federal Reserve’s and other central banks’ abilities to create jobs and maintain economic stability. That mistrust has allowed a gold bubble to develop. And while putting such constraints on central banks might rein in excesses, history shows that gold standards are neither safe nor reliable ways to create long-term economic stability. No one knows when the gold bubble will pop, but it will — and when it does, many investors will be harmed.
It’s for all these reasons that the G-20 should forget about a gold standard. Far more could be achieved if central banks take the gold debate as a wake-up call, moving quickly to regain their creditability. The Fed needs to address concerns about inflation and balance that with real job growth. Getting the U.S. unemployment rate down to 8 percent by 2011 must be a top priority. Once the economy has strengthened, gold prices will fall, stability will return, and the gold standard will revert to academic discussions relegated to chalkboards.