Tuesday, July 17, 2012

Going for gold: perils of entering the goldzone

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.

[Read the rest at Skepticlawyer or at Critical Thinking Applied.]

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