Thursday, March 19, 2009

Why I Don’t Like Gold As The Monetary Base

After yesterday’s verbal diarrhea, this post will hopefully be shorter and easier to digest. I argued yesterday that using gold as the basis for money is inappropriate, as the slow rate of increase means money will always have a deflationary impact on real output, and the conflation of gold-as-money=wealth results in mercantilism with all its evils. The second contention is largely ideological, and can be disputed. The first contention is more amenable to examination, along with its implications such as the function of gold as a store of value.

The following is based on the estimate of a stock of 145,000 tonnes of gold as of 2001 (source: World Gold Council), global gold production data from the US Geological Survey, and real GDP growth data from the IMF World Economic Outlook Oct 2008:

So much for that - I think its pretty clear that over the last half century, gold supplies could not have kept up with global growth. This implies that this growth would not have happened under a gold standard or a continuation of Bretton Woods, as deflation and recession would have been required to equalize growth with the real money supply. Incidentally, here’s the corresponding comparison for silver:

As further proof, I converted a number of commodity series* from USD value to gold value (specifically, per troy ounce). I expected to find relatively flat and declining price trends over time. What I found instead was absolutely fascinating, and requires some explanation. Here, I’m showing the price of Beef in troy ounces:

The rest of the charts are broadly similar, with the exception of pepper, which was highly cyclical against gold (incidentally, pepper looks like a 5 year bull market waiting to happen). What struck me immediately were three things:

1. The relatively low volatility from the 1980s onwards;
2. The sharp decline in price in the 1970s, which I more or less expected;
3. The relatively high volatility both in and prior to the 1970s.

My take on this is that because of the expansion of the USD money supply in the mid to late 1960s due to Vietnam and Lyndon Johnson’s domestic policies, the USD became increasingly overvalued relative to its convertible price to gold – i.e. real activity in excess of the monetary base. When Nixon took the USD off gold convertibility, the next decade saw a combination of inflation and stagnation, which may have been an adjustment process of real goods and services with the nominal money supply. Equivalently, the USD had to fall to its ‘true’ value against gold. Thereafter in the 1980s, market forces (and Paul Volcker) took over and gold became just another commodity.

The 1960s however, is harder to explain, with volatility an order of magnitude higher than the 1980s. It is somewhat ironic to me that Bretton Woods (which was essentially a gold standard but without the necessity of holding gold reserves) provided nominal price stability, but real price instability, and the floating rate period the exact opposite. While this is insufficient empirical evidence against using gold as the monetary base, it tends to confirm my doubts about the stability of such a system.

Gold Stocks - World Gold Council
Silver stocks -
Gold and silver production data - US Geological Survey
Commodity price statistics - Unctad Handbook of Statistics

*Beef, Cocoa, Coffee, Cotton, Palm Oil, Pepper, Rice, Rubber, Tin, Wheat


  1. Hi HishamH

    Just saw your insightful blog today.
    May I ask you are supporter of which School of Economics ?
    What is the mainstream school of Economics for M'sian economists ?

    On the subject of this post,
    do you think a new money linked to a basket of commodities (a index) will work well ?

  2. Hi HishamH,

    what are your topic of interests/researchs in economics ? Wish to learn from you.

    I came across this website:
    It has a lot of economists' blogs inside.
    Many big names too. has lots of resources inside.
    Wonder M'sian economist such as you can join in and give a M'sian/Asian voice in it.

  3. WY, thanks for your comments.

    Which school I support? Watch for the next blog post.

    As for the rest, in academia I would say it's about even between new classicals and new keynesians. In the private sector, definitely new classicals.

    I don't think money linked to anything would work well. You will always run into a divergence between growth in monetary aggregates and the underlying asset(s), which means either inflation and bubbles or deflation and recession, irrespective of the state of real economic activity. I don't think the benefits of 'sound' money outweighs the implied welfare costs.

    My area of interest tends to fall mainly in monetary economics, but I branch out sometimes.

    I do know about RFE, but gave up following their feeds because it can get overwhelming. These days I mainly concentrate on a few select economics blogs like Brad Delong, Hamilton and Chinn, and VoxEU.

  4. Thx for your reply.

    I'm still trying to digest the paragraph abt divergence. I wonder whether a basket of commodities can be a good proxy for price level. If it is so, a money anchored to price level should be good.
    I saw this idea on Steven N.S Cheung's chinese blog. He is of Chicago School.

    Well, shall wait for your next blog while I explore your other posts.

  5. The entire structure of the Chicago School thesis relies on the velocity of money being constant or at least stable. If it isn't constant, you cannot control inflation through manipulation of the money supply. See my post on monetary policy evaluation to get an idea of what I'm talking about. Empirically, the velocity of money is not a constant.

    With respect to the divergence idea, that's the basis of my post on gold here. Since there's a negative difference between growth in gold and the money supply, hard convertibility requires that real output growth must fall or velocity must rise to maintain the link between money and gold.

    Changing gold to a basket of commodities doesn't change this underlying logic, though it might soften the required adjustments if the growth in supply of these commodities is adequate. I can't think of any hard commodities where that could be true however, which is why I posted the chart on silver supply growth. Hong Kong's currency board system is a good example of what's required under such a system - keeping hard convertibility may require a deliberate policy of inducing recession due to exogenous events, and not due to cycles in the economy.

    Soft convertibility, as in the US dollar standard under the Bretton Woods agreement, runs the same type of risk, except that because money supply is ostensibly independent, the conversion price between money and the underlying commodity(ies) will over time diverge substantially enough to the point where the system no longer becomes credible.

    Both types of systems can require at times pro-cyclical economic policies rather than counter-cyclical policies, exacerbating booms and busts rather than smoothing them out, thus increasing welfare costs for the dubious benefit of smoothing nominal price increases.

    Let me put it this way: a floating price system features volatility in nominal prices but stability in real prices and activity, while a fixed price system features stability in nominal prices but volatility in real prices and activity, which was the point of the last chart in this post.

  6. Thx for your insightful reply.
    Will try to digest it.

    Wonder whether a basket of soft commodities will handle the problem of divergence in growth.

    But the volatility due to hard convertibility & soft convertibility remains.