Thursday, November 24, 2011

Why a gold standard is a bad idea (II)

I have always stood firmly against a gold standard, but I remain a long-term commodity bull (yes that includes gold). I believe that while individuals should hold some precious metals or precious metal linked investments in their portfolios as a hedge against asset inflation, a gold standard introduces too many unnecessary rigidities in the system which creates economic volatility.

A gold standard is unnecessarily rigid
I came out against a gold standard back in December 2008 and I stand by my previous comments. There are numerous problems with a gold standard, which is another form of fixed exchange rate regime.

Most proponents of the gold standard tend to lean libertarian, which generally means the embrace of free markets and less government. There an inherent contradiction among this crowd that I just don't understand: How can someone who believes in free markets prefer government mandated fixed rates, which creates structural rigidities, to market determined floating exchange rates, which allows the system to adjust to changes in real-time?

Back in 2008, I wrote:
A gold standard also creates economic volatility in the economy. Monetary theory is based on the elegant formula MV = PQ. Holding V (monetary velocity) constant, changes in money supply directly changes the GDP level. Under a gold standard, money supply is restricted by the supply of gold, based on world mine output. National gold supply could shrink because of shocks. As an example, the Roman empire was subjected to credit crunches during wartime when hostile forces captured Roman gold and territory.
In other words, changes in money supply (gold) may not correspond to changes in the real economy - and that creates unnecessary booms and busts.

The eurozone crisis a poster child for fixed exchange rate regimes
The gold standard is a fixed exchange rate regime and the current eurozone crisis illustrates everything that's wrong with a fixed exchange rate regime. When Greece gets in over its head in debt but can't print money and can't devalue because they are locked into the euro, you have the recipe for the disaster that faces Europe.

Sure, gold standards discourage fiscal profligacy and forces countries into austerity programs to make the numbers work. That sounds great in theory, but that road could also lead to popular revolts. Don't forget that Greece was ruled by a military junta not that long ago.

Did the gold standard cause the rise of Nazism?
Dylan Grice of SocGen (via FT Alphaville) believes that Germany's adherence to the gold standard caused the rise of the Third Reich.
Germany’s ‘hard money’ principles and opposition to Quantitative Easing by the ECB are, more often than not, framed with reference to the hyperinflation in the Weimar Republic.
Indeed, it’s a widely accepted truth that the horrors of the Third Reich were caused by the three year period of hyperinflation between June 1921 and July 1924.
But not in the way many people think, reckons Dylan Grice. The SocGen strategist believes the reaction to the policies of Reichsbank president Rudolf E. A. Havenstein played a more important part in Hitler’s rise to power.
Grice noted that Hitler tried to first seize power in the November 1923 “Beerhall Putsch" but was unsuccessful. At the time, the Nazis were still a fringe party. Then things changed as more and more countries devalued [emphasis added]:

But as the world economy collapsed in the early 1930s the gold standard broke up. Successive countries chose to devalue their currencies and inflate their way out of painful deleveraging (chart below). Germany was the exception. Haunted by von Havenstein's ghost, it fatefully chose to bear instead the brunt of gold standard deflation, experiencing a depression arguably greater even than America’s. It was then that something broke in Germany’s collective psyche. With resurgent Nazi support, Hitler won power in 1933, his rise facilitated not only by the 1923 inflation, but by the subsequent fear of inflation.

FT Alphaville recounted that adherence to the gold standard make the German downturn worse compared to its trading partners:
Now, Germany did actually leave the gold standard in 1931 (via the imposition of capital controls) but it kept the value of the Mark pegged against gold. And more importantly, says Grice, Germany kept a gold standard mentality – the dictates of high interest rates and economic deflation were strenuously adhered to. Indeed, by 1932/3, unemployment had risen above 30 per cent.
Contrast the purist and rules-based attitude with the more flexibility approach as demonstrated by the speech given yesterday by Mark Carney, Governor of the Bank of Canada [emphasis added]:
We make monetary policy in the real world, where shocks are a fact of life. That is why the Bank responds with a flexible approach, taking decisions guided by considered analysis and informed judgment rather than mechanical rules.

He went on to say:
Flexibility is required because, when taking monetary policy actions to stabilize inflation at target, the Bank must also manage the volatility that these actions may induce in the economy.
Purists who wish for the return of a Golden Age of a gold standard should be careful about what they wish for. We might see the consequences of such inflexibility in Europe very soon.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.


Franklin Chen said...

First of all, as part of my personal Thanksgiving resolution, I'd like to say "thank you" for your intriguing blog I have been following silently for some time now. I find your observations on economics, culture, and current events to be sober and wary, in contrast to some of the information I see elsewhere on the Web.

A case in point: when it comes to gold, I've noticed a lot of emotional making fun of a gold standard or extreme advocacy of it, and not enough calm discussion of it like yours.

BDA_GUY said...

I agree with Franklin in I truly appreciate your insightful blog which I was recently made aware of.

As for gold, the other way to look at the MV=PQ equation is that M can be broken down into the quantity of gold held times the price standard for each unit of gold. If V and the gold price standard remain constant and it was desired for P not to change, gold is a workable currency standard only if gold can be produced in quantities equal to changes in (global) economic production. If gold production was greater than economic production, this would inflationary in nature although central banks would likely hold back amounts from being counted within the money supply. Conversely, gold production less than economic production would be deflationary in nature unless there was an increase in the gold price standard which produces a system not that different from what we have right now.

Based on data from the US Geological Survey, I've estimated that the annualized growth rate of gold from 1900 to 2009 has been 2.0% although current rates are now closer to 1.6% and declining. Therefore, this 1.6% growth rate basically becomes the target at which economic production needs to grow at. Without the ability to modify the gold price standard, there is little that a policy maker can do to control inflation outside of setting policy to influence V, the velocity of money. Not an easy task, if you ask me. And the 1.6% rate of course assumes that there are parties interested in excavating a metal that is automatically confiscated by some government or another at some artificially surpressed price.

Finally, I believe that a gold standard could only work if gold is produced by a nation in proportion to their economic output. However, gold resources are spread out very unevenly throughout the world making this changeover problematic unless nations with gold would receive another country's economic production in proportion to the gold that they would need to transfer. The only feasible way to resolve this would be to implement the standard on a truly global basis. So good luck with that!!

While I understand the sentiment of going to a gold standard, how could this ever be a workable system? If this is workable, someone please point out the flaws in my logic!