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Many mainstream economists, perhaps a majority of those who have an opinion, are opposed to tying a central bank’s hands with any explicit monetary rule. A clear majority oppose the gold standard, at least according to an often-cited survey. Why is that?

First some preliminaries. By a “gold standard” I mean a monetary system in which gold is the basic money. So many grains of gold define the unit of account (e.g. the dollar) and gold coins or bullion serve as the medium of redemption for paper currency and deposits. By an “automatic” or “classical” gold standard I mean one in which there is no significant central-bank interference with the functioning of the market production and arbitrage mechanisms that equilibrate the stock of monetary gold with the demand to hold monetary gold. The United States was part of an international classical gold standard between 1879 (the year that the dollar’s redeemability in gold finally resumed following its suspension during the Civil War) and 1914 (the First World War).

Why isn’t the gold standard more popular with current-day economists? Milton Friedman once hypothesized that monetary economists are loath to criticize central banks because central banks are by far their largest employer. Providing some evidence for the hypothesis, I have elsewhere suggested that career incentives give monetary economists a status-quo bias. Most understandably focus their expertise on serving the current regime and disregard alternative regimes that would dispense with their services. They face negative payoffs to considering whether the current regime is the best monetary regime.

Here I want to propose an alternative hypothesis, which complements rather than replaces the employment-incentive hypothesis. I propose that many mainstream economists today instinctively oppose the idea of the self-regulating gold standard because they have been trained as social engineers. They consider the aim of scientific economics, as of engineering, to be prediction and control of phenomena (not just explanation). They are experts, and an automatically self-governing gold standard does not make use of their expertise. They prefer a regime that values them. They avert their eyes from the possibility that they are trying to optimize a Ptolemaic system, and so prefer not to study its alternatives.

The actual track record of the classical gold standard is superior in major respects to that of the modern fiat-money alternative. Compared to fiat standards, classical gold standards kept inflation lower (indeed near zero), made the price level more predictable (deepening financial markets), involved lower gold-extraction costs (when we count the gold extracted to provide coins and bullion to private hedgers under fiat standards), and provided stronger fiscal discipline. The classical gold standard regime in the US (1879-1914), despite a weak banking system, did no worseon cyclical stability, unemployment, or real growth.

The classical gold standard’s near-zero secular inflation rate was not an accident. It was the systemic result of the slow growth of the monetary gold stock. Hugh Rockoff (1984, p. 621) foundthat between 1839 and 1929 the annual gold mining output (averaged by decade) ran between 1.07 and 3.79 percent of the existing stock, with the one exception of the 1849-59 decade (6.39 percent growth under the impact of Californian and Australian discoveries). Furthermore, an occasion of high demand for gold (for example a large country joining the international gold standard), by raising the purchasing power of gold, would stimulate gold production and thereby bring the purchasing power back to its flat trend over the longer term.

A recent example of a poorly grounded historical critique is provided by textbook authors Stephen Cecchetti and Kermit Schoenholtz. They imagine that the gold standard determined money growth and inflation in the US until 1933, and so they count against the gold standard the US inflation rate in excess of 20% during the First World War (specifically 1917), followed by deflation in excess of 10% a few years later (1921). These rates were actually produced by the policies of the Federal Reserve System, which began operations in 1914. The classical gold standard had ended during the Great War, abandoned by all the European combatants, and did not constrain the Fed in these years. Cecchetti and Schoenholtz are thus mistaken in condemning “the gold standard” for producing a highly volatile inflation rate. (They do find, but do not emphasize, that average inflation was much lower and real growth slightly higher under gold.) They also mistakenly blame “the gold standard” — not the Federal Reserve policies that prevailed, nor the regulatory restrictions responsible for the weak state of the US banking system — for the US banking panics of 1930, 1931, and 1933. Studies of the Fed’s balance sheet and activities during the 1930s have found that it had plenty of gold (Bordo, Choudhri and Schwartz, 1999; Hsieh and Romer, 2006, Timberlake 2008). The “tight” monetary policies it pursued were not forced on it by lack of more abundant gold reserves.

There are of course serious economic historians who have done valuable research on the performance of the classical gold standard and yet remain critics. Their main lines of criticism are two. First, they too lump the classical gold standard together with the very different interwar period and mistakenly attribute the chaos of the interwar period to the gold standard mechanisms that remained, rather than to central bank interference with those mechanisms. In rebuttal Richard Timberlake has pertinently asked how, if it was the mechanisms of the gold standard (and not central banks’ attempts to manage them) that destabilized the world economy during the interwar period, those same mechanisms managed to maintain stability before the First World War (when central banks intervened less or, as in the United States, did not exist)? Here, I suggest, a strong pre-commitment to expert guidance acts like a pair of blinders. Wearing those blinders, even if it is seen that the prewar system differed from and outperformed the interwar system, it cannot be seen that this was because the former was comparatively self-regulating and the latter was comparatively expert-guided.

Second, it is always possible to argue in defense of expert guidance that even the classical gold standard was second-best to an ideally managed fiat money where experts call the shots. Even if central bankers operated on the wrong theory during the 1920s, during the Great Depression, and under Bretton Woods, not to mention during the Great Inflation and the Great Recession, today they operate (or can be gotten to operate) on the right theory.

In the worldview of economics as social engineering, monetary policy-making by experts must almost by definition be better than a naturally evolved or self-regulating monetary system without top-down guidance. After all, the experts could always choose to mimic the self-regulating system in the unlikely event that it were the best of all options. (In the most recent issue of Gold Investor, Alan Greenspan claims that mimicking the gold standard actually was his policy as Fed chairman.) As experts they sincerely believe that “we can do better” by taking advantage of expert guidance. How can expert guidance do anything but help?

Expert-guided monetary policy can fail in at least three well-known ways to improve on a market-guided monetary system. First, experts can persist in using erroneous models (consider the decades in which the Phillips Curve reigned) or lack the timely information they would need to improve outcomes. These were the reasons Milton Friedman cited to explain why the Fed’s use of discretion has amplified rather than dampened business cycles in practice. Second, policy-makers can set experts to devising policies to meet goals that are not the public’s goals. This is James Buchanan’s case for placing constraints on monetary policy at the constitutional level. Third, where the public understands that the central bank has no pre-commitments, chronically suboptimal outcomes can result even when the central bank has full information and the most benign intentions. This problem was famously emphasized by Finn E. Kydland and Edward C. Prescott (1977).

These lessons have not been fully absorbed. A central bank that announces its own inflation target (as the Fed has), and especially one that retains a “dual mandate” to respond to real variables like the unemployment rate or the estimated output gap, retains discretion. It is free to change or abandon its inflation-rate target, with or without a new announcement. Retaining discretion — the option to change policy in this way – carries a cost. The money-using public, uncertain about what the central bank experts will decide to do, will hedge more and invest less in capital formation than they would with a credibly committed regime. A commodity standard — especially without a central bank to undermine the redemption commitments of currency and deposit issuers — more completely removes policy uncertainty and with it overall uncertainty.

Speculation about the pre-analytic outlook of monetary policy experts could be dismissed as mere armchair psychology if we had no textual evidence about their outlook. Consider, then, a recent speech by Federal Reserve Vice Chairman Stanley Fischer. At a May 5, 2017 conference at the Hoover Institution, Fischer addressed the contrast between “Committee Decisions and Monetary Policy Rules.” Fischer posed the question: Why should we have “monetary policy decisions … made by a committee rather than by a rule?” His reply: “The answer is that opinions — even on monetary policy — differ among experts.” Consequently we “prefer committees in which decisions are made by discussion among the experts” who try to persuade one another. It is taken for granted that a consensus among experts is the best guide to monetary policy-making we can have.

Fischer continued:

Emphasis on a single rule as the basis for monetary policy implies that the truth has been found, despite the record over time of major shifts in monetary policy — from the gold standard, to the Bretton Woods fixed but changeable exchange rate rule, to Keynesian approaches, to monetary targeting, to the modern frameworks of inflation targeting and the dual mandate of the Fed, and more. We should not make our monetary policy decisions based on that assumption. Rather, we need our policymakers to be continually on the lookout for structural changes in the economy and for disturbances to the economy that come from hitherto unexpected sources.

In this passage Fischer suggested that historical shifts in monetary policy fashion warn us against adopting a non-discretionary regime because they indicate that no “true” regime has been found. But how so? That governments during the First World War chose to abandon the gold standard (in order to print money to finance their war efforts), and that they subsequently failed to do what was necessary to return to a sustainable gold parity (devalue or deflate), does not imply that the mechanisms of the gold standard — rather than government policies that overrode them — must have failed. Observed changes in regimes and policies do not imply that each new policy was an improvement over its predecessor — unless we take it for granted that all changes were all wise adaptations to exogenously changing circumstances. Unless, that is, we assume that the experts guiding monetary policies have never yet failed us.

Fischer further suggested that a monetary regime is not to be evaluated just by the economy’s performance, but by how policy is made: a regime is per se better the more it incorporates the latest scientific findings of experts about the current structure of the economy and the latest models of how policy can best respond to disturbances. If we accept this as true, then we need not pay much if any attention to the gold standard’s actual performance record. But if instead we are going to judge regimes largely by their performance, then replacing the automatic gold standard by the Federal Reserve’s ever-increasing discretion cannot simply be presumed a good thing. We need to consult the evidence. And the evidence since 1914 suggests otherwise.

Contrary to Fischer, there is no good reason to presume that expert-guided monetary regimes get progressively better over time, because there is no filter for replacing mistaken experts with better experts. We have no test of the successful exercise of expertise in monetary policy (meaning, superiority at correctly diagnosing and treating exogenous monetary disturbances, while avoiding the introduction of money-supply disturbances) apart from ex post evaluation of performance. The Fed’s performance does not show continuous improvement. As previously noted, it doesn’t even show improvement over the pre-Fed regime in the US.

A fair explanation for the Fed’s poor track record is Milton Friedman’s: the information necessary for successful expert guidance of monetary policy is simply not available in a timely fashion. Those who recognize this point will be open to considering the merits of moving, to quote the title a highly pertinent article by Leland B. Yeager, “toward forecast-free monetary institutions.” Experts who firmly believe in expert guidance of monetary policy, of course, will not recognize the point. They will accordingly overlook the successful track record of the automatic gold standard (without central bank management) as a forecast-free monetary institution.

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We live in an age of advanced monetary surrealism. In Q1 2017 alone, the largest central banks created the equivalent of almost USD 1,000 bn. worth of central bank money ex nihilo. Naturally the fresh currency was not used to fund philanthropic projects but to purchase financial securities1. Although this ongoing liquidity supernova has temporarily created an uneasy calm in financial markets, we are strongly convinced that the real costs of this monetary madness will reveal themselves down the line.

We believe that the monetary tsunami created in the past years, consisting of a flood of central bank money and new debt, has created a dangerous illusion: the illusion of a carefree present at the expense of a fragile future. The frivolity displayed by many investors is for example reflected by record-low volatility in equities, which have acquired the nimbus of being without alternative, and is also highlighted by the minimal spreads on corporate and government bonds.

Almost a decade of zero and negative interest rates has atomised any form of risk aversion. While the quantitative easing programmes are still going at full throttle in many places without the media paying much attention, the situation in the USA looks decidedly different: seven years after the Fed funds rate had been set to zero, the first interest rate hike by the Federal Reserve in December 2015 marked the end of the longest period of immobility in terms of interest rate policy in history. To many market participants, this overdue step towards normalising the monetary policy is the confirmation of the much-desired comeback of the US economy.

However, the interest rate reversal that had been announced for years got off to a sluggish start. Market participants became increasingly nervous in 2016 when it started turning out that central banks would not be remotely able to stick to the speed of four interest rate hikes as announced. After the FOMC meeting in March 2016, the first question that CNBC journalist Steve Liesman asked Janet Yellen was:

“Does the Fed have a credibility problem […]?”2

We believe that the absence of the often-quoted sustainable economic recovery is one factor to blame for the passivity of the Fed. The depreciation of the Chinese currency and the still falling yields at the long end of the yield curve in 2016 are two others, as a result of which the Fed had to procrastinate until December 2016.

The gold price celebrated a remarkable comeback during this hesitant phase of the Fed. Last year we confidently opened the “In Gold We Trust” report with the line “Gold is back!”. We had anticipated the passivity of the Fed as well as the return of the bull market. The gold price seemed to have experienced a sustainable trend reversal in USD, and we felt our bullish stance had just been confirmed.

But our gold(en) optimism was stopped in its tracks again in autumn 2016. The gold price declined significantly, in particular in the last quarter of 2016, even though the maximum drawdown has never exceeded 20%. We can therefore still call the status quo a correction within the confines of a new bull market, but we want to openly admit that we had not foreseen the dent in the gold price performance. Our target price of USD 2,300 for June 2018 may therefore prove overly optimistic. But what was the trigger of the sudden reverse thrust of the gold price?

Ironically, it was Donald J. Trump. The election of the presidential candidate originally unloved by Wall Street fuelled hopes of a renaissance of America on the basis of a nationalistic growth policy. President Trump brought about a change in sentiment, especially among a class of society that had lost its trust in the economic system and political institutions. Stocks received another boost, and the increase in the gold price was (temporarily) halted.

The Fed seems to be keen to use the new euphoria on the markets in order to push the normalisation of monetary policy. Even if the journalistic mainstream is abundantly convinced of the sustainability of the US interest rate reversal, a contradiction is embedded in the narrative of the economic upswing triggered by Trump: if the economic development, as claimed by the Fed in the past years, was actually rosy even prior to Trump’s victory, the candidate promising in his central message to make America great AGAIN would presumably not have won. The narrative of a recovering US economy is the basis of the bull market in equities.

The valuation level of the US equity market is nowadays ambitious, to put it mildly – both in absolute numbers and in terms of the economic output. This prompts the conclusion that the U.S. is caught up for the third time within two decades in an illusionary bubble economy created by money supply inflation and equipped with an expiry date. In comparison with the earlier two bubbles, however, the excess is not limited to certain sectors (technology in 2000, credit in 2008), but it is omnipresent and includes various asset classes, especially also bonds and (again) property. In view of the current situation, the renowned analyst Jesse Felder rightly talks about an “Everything Bubble”.4 From our point of view, the concept of the classic investment portfolio, which calls for shares to satisfy the risk appetite and bonds as safety net, must be critically questioned.

While markets are already celebrating the future successes of Trumponomics, the structural weakness of the US real economy is revealed yet again in the latest growth figures. According to the most recent estimate, the US economy expanded in Q1 2017 by a meagre 1.2 % y/y. In combination with an inflation rate of more than 2%, this means that the U.S. is at the edge of stagflation – a scenario we have warned about on several prior occasions. But markets are obviously taking a different view than we are. At least for now.

Moreover, the ratio of real assets to financial assets is currently the lowest since 1925.5 In a study worth reading, Michael Hartnett, chief strategist at Bank of America Merrill Lynch, recommends to “get real”, i.e. to reallocate investments from financial assets into real assets.

“Today the humiliation is very clearly commodities, while the hubris resides in fixed-income markets”

as Hartnett explains. Gold, diamonds, and farmland show the highest positive correlation with rising inflation, whereas equities and bonds are negatively correlated with increasing prices, a finding that we have pointed out repeatedly. The political trend towards more protectionism and stepped-up fiscal stimuli will also structurally drive price inflation.6

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Scarcely more than a year since it was signed, the Smithsonian Agreement, the “greatest monetary agreement in the history of the world” (in the words of President Nixon) lay in shambles. And so the world vibrates, with increasing intensity, between fixed and fluctuating exchange rates, with each system providing only a different set of ills. We apparently live in a world of perpetual international monetary crises.

In this distressing situation, the last few years have seen the burgeoning of a school of economists who counsel a simple solution for the world’s monetary illness. Since fixed exchange rates between currencies seem to bring only currency shortages and surpluses, black markets and exchange controls, and a chronic series of monetary crises, why not simply set all these currencies free to fluctuate with one another? This group of economists, headed by Professor Milton Friedman and the “Chicago School,” claims to be speaking blunt truths in the name of the “free market.” The simple and powerful case of the Friedmanites goes somewhat as follows:

Economic theory tells us the myriad evils that stem from any attempt at price controls of goods and services. Maximum price controls lead to artificially created shortages of the product; minimum controls lead to artificial unsold surpluses. There is a ready cure for these economic ills; they are caused not by processes deep within the free market economy, but by arbitrary government intervention into the market. Remove the controls, let market processes have full sway, and shortages and surpluses will disappear.

Similarly, the monetary crises of recent years are the product of government attempts to fix exchange rates between currencies. If the government of Ruritania fixes the “rur” at a rate higher than its free market price, then there will be a surplus of rurs looking for undervalued currencies, and a shortage of these harder currencies. The “dollar shortage” of the early postwar years was the result of the dollar being undervalued in terms of other currencies; the current surplus of dollars, as compared to West German marks or Japanese yen, is a reflection of the overvaluation of the dollar compared to these other currencies. Allow all of these currencies to fluctuate freely on the market, and the currencies will find their true levels, and the various currency shortages and surpluses will disappear. Furthermore, there will be no need to worry any longer about deficits in any country’s “balance of payments.” Under the pre-1971 system, when dollars were at least theoretically redeemable in gold, an excess of imports over exports led to a piling up of dollar claims and an increasingly threatening outflow of gold. Eliminate gold redeemability and allow the currencies to fluctuate freely, and the deficit will automatically correct itself as the dollar suppliers bid up the prices of marks and yen, thereby making American goods less expensive and German and Japanese goods more expensive in the world market.

Such is the Friedmanite case for the freely fluctuating exchange rate solution to the world monetary crisis. Any objection is met by a variant of the usual case for a free market. Thus, if critics assert that changing exchange rates introduce unwelcome uncertainty into world markets and thereby hinder international trade, particularly investment, the Friedmanites can reply that uncertainty is always a function of a free price system, and most economists support such a system. If the critics point to the evils of currency speculation, then Friedmanites can reply by demonstrating the important economic functions of speculation on the free commodity markets of the world. All this permits the Friedmanites to scoff at the timidity and conservatism of the world’s bankers, journalists, and a dwindling handful of economists. Why not try freedom? These arguments, coupled with the obvious and increasingly evident evils of such fixed exchange rate systems as Bretton Woods (1945–1971) and the Smithsonian (1971–1973), are bringing an increasing number of economists into the Friedmanite camp.

The Friedmanite program cannot be fully countered in its details; it must be considered at the level of its deepest assumptions. Namely, are currencies really fit subjects for “markets”? Can there be a truly “free market” between pounds, dollars, francs, and so on?

Let us begin by considering this problem: suppose that someone comes along and says, “The existing relationship between pounds and ounces is completely arbitrary. The government has decreed that 16 ounces are equal to 1 pound. But this is arbitrary government intervention; let us have a free market between ounces and pounds, and let us see what relationship the market will establish between ounces and pounds. Perhaps we will find that the market will decide that 1 pound equals 14 or 17 ounces.” Of course, everyone would find such a suggestion absurd. But why is it absurd? Not from arbitrary government edict, but because the pound is universally defined as consisting of 16 ounces. Standards of weight and measurement are established by common definition, and it is precisely their fixity that makes them indispensable to human life. Shifting relationships of pounds to ounces or feet to inches would make a mockery of any and all attempts to measure. But it is precisely the contention of the gold standard advocates that what we know as the names for different national currencies are not independent entities at all. They are not, in essence, different commodities like copper or wheat. They are, or they should be, simply names for different weights of gold or silver, and hence should have the same status as the fixed definition for any set, of weights and measures.

Let us bring our example a bit closer to the topic of money. Suppose that someone should come along and say, “The existing relationship between nickels and dimes is purely arbitrary. It is only the government that has decreed that two nickels equal one dime. Let us have a free market between nickels and dimes. Who knows? Maybe the market will decree that a dime is worth 7 cents or 11 cents. Let us try the market and see.” Again, we would feel that such a suggestion would be scarcely less absurd. But again, why? What precisely is wrong with the idea? Again the point is that cents, nickels, and dimes are defined units of currency. The dollar is defined as equal to 10 dimes and 100 cents, and it would be chaotic and absurd to start calling for day-to-day changes in such definitions. Again, fixity of definition, fixity of units of weight and measure, is vital to any sort of accounting or calculation.

To put it another way: the idea of a market only makes sense between different entities, between different goods and services, between, say, copper and wheat, or movie admissions. But the idea of a market makes no sense whatever between different units of the same entity: between, say, ounces of copper and pounds of copper. Units of measure must, to serve any purpose, remain as a fixed yardstick of account and reckoning.

The basic gold standard criticism of the Friedmanite position is that the Chicagoites are advocating a free market between entities that are in essence, and should be once more, different units of the same entity, that is, different weights of the commodity gold. For the implicit and vital assumption of the Friedmanites is that every national currency—pounds, dollars, marks, and the like—is and should be an independent entity, a commodity in its own right, and therefore should fluctuate freely with one another.

Let us consider: what are pounds, francs, dollars? Where do they come from? The Friedmanites take them at face value as things or entities issued at will by different central governments. The British government defines something as a “pound” and issues or controls the issue of whatever number of pounds it decides upon (or controls the supply of bank credit redeemable in these “pounds”). The United States government does the same for “dollars,” the French government the same for “francs,” and so on.

The first thing we can say, then, is that this is a very curious kind of “free market” that is being advocated here. For it is a free market in things, or entities, which are issued entirely by and are at the complete mercy of each respective government. Here is already a vital difference from other commodities and free markets championed by the Chicago school. Copper, steel, wheat, movies are all, in the Friedman scheme, issued by private firms and organizations, and subject to the supply and demand of private consumers and the free market. Only money, only these mysterious “dollars,” “marks,” and so on, are to be totally under the control and dictation of every government. What sort of “free” market is this? To be truly analogous with free markets in other commodities, the supply of money would have to be produced only by private firms and persons in the market, and be subject only to the demand and supply forces of private consumers and producers. It should be clear that the governmental fiat currencies of the Friedmanite scheme cannot possibly be subject only to private and therefore to free market forces.

Is there any way by which the respective national moneys can be subject solely to private market forces? Is such a thing at all possible? Not only is the answer yes, but it is still true that the origin of all these currencies that the Friedmanites take at face value as independent entities, was, each and every one, as units of weight of gold in a truly private and free market for money.

To understand this truth, we must go back beyond the existing fiat names for money and see how they originated. In fact, we need go back only as far as the Western world before World War I. Even today, the “dollar” is not legally defined an independent fictive name; it is still legally defined by U.S. statute as a unit of weight of gold, now approximately one-forty-second of a gold ounce. Before 1914, the dollar was defined as approximately one-twentieth of a gold ounce. That’s what a “dollar” was. Similarly the pound sterling was not an independent name; it was defined as a gold weight of slightly less than one-fourth of a gold ounce. Every other currency was also defined in terms of a weight of gold (or, in some cases, of silver). To see how the system worked, we assume the following definition for three of the numerous currencies:

1 dollar defined as one-twentieth of a gold ounce;
1 pound sterling defined as one-fourth of a gold ounce;
1 franc defined as one-hundredth of a gold ounce.

In this case, the different national currencies are different in name only. In actual fact, they are simply different units of weight of the same commodity, gold. In terms of each other, then, the various currencies are immediately set in accordance with their respective gold weights, namely,

1 dollar is defined as equal to one-fifth of a pound sterling, and to 5 francs;
1 franc is defined as equal to one-fifth of a dollar, and to one twenty-fifth of a pound;
1 pound is defined as equal to 5 dollars, and to 25 francs.

We might say that the “exchange rates” between the various countries were thereby fixed. But these were not so much exchange rates as they were various units of weight of gold, fixed ineluctably as soon as the respective definitions of weight were established. To say that the governments “arbitrarily fixed” the exchange rates of the various currencies is to say also that governments “arbitrarily” define 1 pound weight as equal to 16 ounces or 1 foot as equal to 12 inches, or “arbitrarily” define the dollar as composed of 10 dimes and 100 cents. Like all weights and measures, such definitions do not have to be imposed by government. They could, at least in theory, have been set by groups of scientists or by custom and commonly accepted by the general public.

This “classical gold standard” had numerous and considerable economic and social advantages. In the first place, the supply of money in the various countries was basically determined, not by government dictates, but—like copper, wheat, and so on—by the supply and demand forces of the free and private market. Gold was and is a metal that has to be discovered, and then mined, by private firms. Its supply was determined by market forces, by the demand for gold in relation to the demand and supply of other commodities and factors; by, for example, the relative cost and productivity of factors of production in mining gold and in producing other goods and services. At its base, the money supply of the world, then, was determined by free market forces rather than by the dictates of government. While it is true that governments were able to interfere with the process by weakening the links between the currency name and the weight of gold, the base of the system was still private, and hence it was always possible to return to a purely private and free monetary system. To the extent that the various currency names were kept as strictly equivalent to weights of gold, to that extent the classical gold standard worked well and harmoniously and without severe inflation or booms and busts.

The international gold standard had other great advantages. It meant that the entire world was on a single money, that money, with all its enormous advantages, had fully replaced the chaotic world of barter, where it is impossible to engage in economic calculation or to figure out prices, profits, or losses. Only when the world was on a single money did it enjoy the full advantage of money over barter, with its attendant economic calculation and the corollary advantages of freedom of trade, investment, and movement between the various countries and regions of the civilized world. One of the main reasons for the great growth and prosperity of the United States, it is generally acknowledged, was that it consisted of a large free-trading area within the nation: we have always been free of tariffs and trading quotas between New York and Indiana, or California and Oregon. But not only that. We have also enjoyed the advantage of having one currency: one dollar area between all the regions of the country, East, West, North, and South. There have also been no currency devaluations or exchange controls between New York and Indiana.

But let us now contemplate instead what could happen were the Friedmanite scheme to be applied within the United States. After all, while a nation or country may be an important political unit, it is not really an economic unit. No nation could or should wish to be self-sufficient, cut off from the enormous advantages of international specialization and the division of labor. The Friedmanites would properly react in horror to the idea of high tariffs or quota walls between New York and New Jersey. But what of different currencies issued by every state? If, according to the Friedmanites, the ultimate in monetary desirability is for each nation to issue its own currency—for the Swiss to issue Swiss francs, the French their francs, and so on—then why not allow New York to issue its own “yorks,” New Jersey its own “jersies,” and then enjoy the benefits of a freely fluctuating “market” between these various currencies? But since we have one money, the dollar, within the United States, enjoying what the Friedmanites would call “fixed exchange rates” between each of the various states, we don’t have any monetary crisis within the country, and we don’t have to worry about the “balance of payments” between New York, New Jersey, and the other states.

Furthermore, it should be clear that what the Friedmanites take away with one hand, so to speak, they give back with the other. For while they are staunchly opposed to tariff barriers between geographical areas, their freely fluctuating fiat currencies could and undoubtedly would operate as crypto-tariff barriers between these areas. During the fiat money Greenback period in the United States after the Civil War, the Pennsylvania iron manufacturers, who had always been the leading advocates of a protective tariff to exclude more efficient and lower cost British iron, now realized that depreciating greenbacks functioned as a protective device: for a falling dollar makes imports more expensive and exports cheaper.1 In the same way, during the international fiat money periods of the 1930s (and now from March 1973 on), the export interests of each country scrambled for currency devaluations, backed up by inefficient domestic firms trying to keep out foreign competitors. And similarly, a Friedmanite world within the United States would have the disastrous effect of functioning as competing and accelerating tariff barriers between the states.

And if independent currencies between each of the fifty states is a good thing, why not go still one better? Why not independent currencies to be issued by each county, city, town, block, building, person? Friedmanite monetary theorist Leland B. Yeager, who is willing to push the reductio ad absurdum almost all the way by advocating separate moneys for each region or even locality, draws back finally at the idea of each individual or firm printing his own money. Why not? Because, Yeager concedes, “Beyond some admittedly indefinable point, the proliferation of separate currencies for ever smaller and more narrowly defined territories would begin to negate the very concept of money.”2 That it would surely do, but the point is that the breakdown of the concept of money begins to occur not at some “indefinable point” but as soon as any national fiat paper enters the scene to break up the world’s money. For if Rothbard, Yeager, and Jones each printed his own “Rothbards,” “Yeagers,” and “Joneses” and these each amng billions freely fluctuating on the market were the only currencies, it is clear that the world would be back in an enormously complex and chaotic form of barter and that all trade and investment would be reduced to a virtual standstill. There would in fact be no more money, for money means a general medium for all exchanges. As a result, there would be no money of account to perform the indispensable function of economic calculation in a money and price system. But the point is that while we can see this clearly in a world of “every man his own currency,” the same disastrous principle, the same breakdown of the money function, is at work in a world of fluctuating fiat currencies such as the Friedmanites are wishing upon us. The way to return to the advantages of a world money is the opposite of the Friedmanite path: it is to return to a commodity which the entire world can and does use as a money, which means in practice the commodity gold.

One critic of fluctuating exchange rates, while himself a proponent
of “regional currency areas,” recognizes the classical argument for one world money. Thus, Professor Mundell writes:

It will be recalled that the older economists of the nineteenth century were internationalists and generally favored a world currency. Thus John Stuart Mill wrote in Principles of Political Economy, vol. 2, p. 176:

… So much of barbarism, however, still remains in the transactions of most civilized nations, that almost all independent countries choose to assert their nationality by having, to their own inconvenience and that of their neighbors, a peculiar currency of their own.

… Mill, like Bagehot and others, was concerned with the costs of valuation and money changing, not stabilization policy, and it is readily seen that these costs tend to increase with the number of currencies. Any given money qua numeraire, or unit of account,fulfills this function less adequately if the prices of foreign goods are expressed in terms of foreign currency and must then be translated into domestic currency prices. Similarly, money in its role of medium of exchange is less useful if there are many currencies; although the costs of currency conversion are always present, they loom exceptionally larger under inconvertibility or flexible exchange rates. Money is a convenience and this restricts the optimum number of currencies. In terms of this argument alone, the optimum currency area is the world, regardless of the number of regions of which it is composed.3

There is another reason for avoiding fiat paper currency issued by all governments and for returning instead to a commodity money produced on the private market (for example, gold). For once a money is established, whatever supply of money exists does the full amount of the “monetary work” needed in the economy. Other things being equal, an increase in the supply of steel, or copper, or TV sets is a net benefit to society: it increases the production of goods and services to the consumers. But an increase in the supply of money does no such thing. Since the usefulness of money comes from exchanging it rather than consuming it or using it up in production, an increased supply will simply lower its purchasing power; it will dilute the effectiveness of any one unit of money. An increase in the supply of dollars will merely reduce the purchasing power of each dollar, that is, will cause what is now called “inflation.” If money is a scarce market commodity, such as gold, increasing its supply is a costly process and therefore the world will not be subjected to sudden inflationary additions to its supply. But fiat paper money is virtually costless: it costs nothing for the government to turn on the printing press and to add rapidly to the money supply and hence to ruinous inflation. Give government, as the Friedmanites would do, the total and absolute power over the supply of fiat paper and of bank deposits—the supply of money—and we put into the hands of government a standing and mighty temptation to use this power and inflate money and prices.

Given the inherent tendency of government to inflate the money supply when it has the chance, the absence of a gold standard and “fixed exchange rates” also means the loss of balance-of-payments discipline, one of the few checks that governments have faced in their eternal propensity to inflate the money supply. In such a system, the outflow of gold abroad puts the monetary authorities on increased warning that they must stop inflating so as not to keep losing gold. Abandon a world money and adopt fluctuating fiat moneys, and the balance-of-payments limitation will be gone; governments will have only the depreciating of their currencies as a limit on their inflationary actions. But since export firms and inefficient domestic firms tend actually to favor depreciating currencies, this check is apt to be a flimsy one indeed.

Thus, in his critique of the concept of fluctuating exchange rates, Professor Heilperin writes:

The real trouble with the advocates of indefinitely flexible exchange rates is that they fail to take into sufficient consideration the causes of balance-of-payments disequilibrium. Now these, unlike Pallas Athene from Zeus’ head, never spring “fully armed” from a particular economic situation. They have their causes, the most basic of which [are] internal inflations or major changes in world markets.

“Fundamental disequilibria” as they are called … can and do happen. Often however, they can be avoided: if and when an incipient inflation is brought under control; if and when adjustments to external change are effectively and early made. Now nothing encourages the early adoption of internal correctives more than an outflow of reserves under conditions of fixed parities, always provided, of course, that the country’s monetary authorities are “internationally minded” and do their best to keep external equilibrium by all internal means at their disposal.4

Heilperin adds that the desire to pursue national monetary and fiscal policies without regard to the balance of payments is “one of the widespread and yet very fallacious aspirations of certain governments … and of altogether too many learned economists, aspirations to ‘do as one pleases’ without suffering any adverse consequences.” He concludes that the result of a fluctuating exchange rate system can only be “chaos,” a chaos that “would lead inevitably … to a widespread readoption of exchange controls, the worst conceivable form of monetary organization.”5

If governments are likely to use any power to inflate fiat currency that is placed in their hands, they are indeed almost as likely to use the power to impose exchange controls. It is politically naive in the extreme to place the supply of fiat money in the hands of government and then to hope and expect it to refrain from controlling exchange rates or going on to impose more detailed exchange controls. In particular, in the totally fiat economy that the world has been plunged into since March 1973, it is highly naive to expect European countries to sit forever on their accumulation of 80-odd billions of dollars—the fruits of decades of American balance-of-payments deficits—and expect them to allow an indefinite accumulation of such continually depreciating dollars. It is also naive to anticipate their accepting a continually falling dollar and yet do nothing to stem the flood of imports of American products or to spur their own exports. Even in the few short months since March 1973 central banks have intervened with “dirty” instead of “clean” floats to the exchange rates. When the dollar plunged rapidly downward in early July, its fall was only checked by rumors of increased “swap” arrangements by which the Federal Reserve would borrow “hard” foreign currencies with which to buy dollars.

But it should be clear that such expedients can only stem the tide for a short while. Ever since the early 1950s, the monetary policies of the United States and the West have been short-run expedients, designed to buy time, to delay the inevitable monetary crisis that is rooted in the inflationary regime of paper money and the abandonment of the classical gold standard. The difference now is that there is far less time to buy, and the distance between monetary crises grows ever shorter. All during the 1950s and 1960s the Establishment economists continued to assure us that the international regime established at Bretton Woods was permanent and impregnable, and that if the harder money countries of Europe didn’t like American inflation and deficits there was nothing they could do about it. We were also assured by the same economists that the official gold price of $35 an ounce—a price which for long has absurdly undervalued gold in terms of the depreciating dollar—was graven in stone, destined to endure until the end of time. But on August 15, 1971, President Nixon, under pressure by European central banks to redeem dollars in gold, ended the Bretton Woods arrangement and the final, if tenuous, link of the dollar to redemption in gold.

We are also told, with even greater assurance (and this time by Friedmanite as well as by Keynesian economists) that when, in March 1968, the free market gold price was cut loose from official governmental purchases and sales, that gold would at last sink to its estimated nonmonetary price of approximately $10 an ounce. Both the Keynesians and the Friedmanites, equal deprecators of gold as money, had been maintaining that, despite appearances, it had been the dollar which had propped up gold in the free—gold markets of London and Zurich before 1968. And so when the “two-tier gold market” was established in March, with governments and their central banks pledging to keep gold at $35 an ounce, but having nothing further to do with outside purchases or sales of gold, these economists confidently predicted that gold would soon disappear as a monetary force to reckon with. And yet the reverse has happened. Not only did gold never sink below $35 an ounce on the free market, but the market’s perceptive valuation of gold as compared to the shrinking and depreciating dollar has now hoisted the free market gold price to something like $125 an ounce. And even the hallowed $35 an ounce figure has been devalued twice in the official American accounts, so that now the dollar—still grossly overvalued—is pegged officially at $42.22 an ounce. Thus, the market has continued to give a thumping vote of confidence to gold, and has brought gold back into the monetary picture more strongly than ever.

Not only have the detractors of gold been caught napping by the market, but so have even its staunchest champions. Thus, even the French economist Jacques Rueff, for decades the most ardent advocate of the eminently sensible policy of going back to the gold standard at a higher gold price, even he, as late as October 1971 faltered and conceded that perhaps a doubling of the gold price to $70 might be too drastic to be viable. And yet now the market itself places gold at very nearly double that seemingly high price.6

Without gold, without an international money, the world is destined to stumble into one accelerated monetary crisis after another, and to veer back and forth between the ills and evils of fluctuating in exchange rates and of fixed exchange rates without gold. Without gold as the basic money and means of payment, fixed exchange rates make even less sense than fluctuating rates. Yet a solution to the most glaring of the world’s aggravated monetary ills lies near at hand, and nearer than ever now that the free-gold market points the way. That solution would be for the nations of the world to return to a classical gold standard, with the price fixed at something like the old current free market level. With the dollar, say, at $125 an ounce, there would be far more gold to back up the dollar and all other national currencies. Exchange rates would again be fixed by the gold content of each currency. While this would scarcely solve all the monetary problems of the world—there would still be need for drastic reforms of banking and central bank inflation, for example—a giant step would have been taken toward monetary sanity. At least the world would have a money again, and the spectre of a calamitous return to barter would have ended. And that would be no small accomplishment.

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I’m adding a position in the Gold Miners here at circa $19 and change. They are pretty volatile, so there should be plenty of opportunities to trade around the position.

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The gold/silver ratio is pretty high by historical standards. This suggests that a trade back to the mean/average might be worthwhile. Something along the lines of a pair trade: long silver, short gold.

The tricky part is duration of the trade. Things could get worse before they get better. But worth keeping an eye on.


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So somewhere around the $400/oz mark is where the next great bull market in gold will likely start. This probably makes sense as interest rates really have only one direction to move [higher] which means lower for gold.



Swedroe: Debunking Gold Mythology

August 19, 2015
In mid-July 2012, Merrill Lynch added its voice to the many that were predicting gold would hit $2,000 an ounce by the end of that year. Francisco Blanch, head of global commodities research at the investment bank, said: “We think that $2,000 an ounce is sort of the right number.” Gold was then trading at about $1,577.

At about the same time, in an interview with, money manager Peter Schiff, who has attracted much media attention with his doomsday forecasts, offered up this prediction: “I’m looking for another leg up … it’s going a lot higher. It’s hard to tell where the next move is going to take it. But it’s going thousands of dollars higher than it is now.” When asked how high, he responded: “I think a minimum of $5,000. But it could go a lot higher than that.”

These kinds of predictions almost certainly helped drive investor interest in gold. In fact, a 2011 Gallup poll found that 34 percent of Americans said gold was the best long-term investment, far more than those who chose real estate, stocks or bonds.

The question is: Were, and are, individuals investing in gold for the right reasons? Well, one reason for investor interest in gold is the belief that it’s a great inflation hedge. Another is that it provides a hedge against currency risk. And a third is that gold can act as a haven of safety in bad times. Are these valid reasons?

The Evidence

In their June 2012 study, “The Golden Dilemma,” Claude Erb and Campbell Harvey examined these issues. In terms of being a currency hedge, they found that the change in the real price of gold seems to be largely independent of the change in currency values. In other words, gold is not a good hedge of currency risk.

As for gold serving as a safe haven, meaning that it’s stable during bear markets in stocks, Erb and Harvey found gold wasn’t quite the excellent hedge some might think. It turns out that 17 percent of monthly stock returns fall into the category in which gold is dropping at the same time stocks have negative returns. If gold acted as a true safe haven, then we would expect very few, if any, such observations. Still, 83 percent of the time on the right side isn’t a bad record.

In terms of gold’s value as an inflation hedge, the following example should help provide an answer. On Jan. 21, 1980, the price of gold hit a then-record high of $850. On March 19, 2002, gold was trading at $293, below where it was 20 years earlier.

Note that the inflation rate for the period from 1980 through 2001 was 3.9 percent. Thus, its loss in real purchasing power was about 85 percent. How can gold be an inflation hedge when, over the course of 22 years, it loses 85 percent in real terms?

As further evidence of gold’s inflation hedging abilities, Goldman Sach’s “2013 Outlook” contained the following finding: In the post-World War II era, in 60 percent of the episodes when inflation surprised to the upside, gold underperformed inflation. That said, gold has been a good hedge of inflation over the very long run (such as a century). Unfortunately, that’s a much longer investment horizon than that of most investors.

Updated Findings
In August 2015, Erb and Harvey updated their paper. They begin by examining the argument that gold is an inflation hedge, or what they call a “golden constant.”

The authors explain: “One way to think about the golden constant perspective is as a collection of statements that assert that: 1) over a very long period of time the purchasing power of gold remains largely the same; 2) in the long run, inflation is a fundamental driver of the price of gold; 3) deviations in the price of gold relative to inflation will be corrected; and 4) in the long run, the real return from owning gold is zero.”

The study covered the period beginning in January 1975. The authors found that, over the period, the average real price of gold is 3.46 times the U.S. Consumer Price Index (CPI). In June 2015, the CPI level was 237.8. Multiplying gold’s average real price by the current CPI (3.46 x 237.8) delivers a price of approximately $825. This represents what the nominal price of gold should be today—if we assume the real price of gold is constant.

Of course, over time, prices have strayed far from the golden constant. And, as Erb and Harvey note, the golden constant isn’t a fact, just a hypothesis.

But if your reason for buying gold is that it’s an inflation hedge, your expectation should be that gold will revert to its golden constant over time. And despite haven fallen from its peak of almost $1,900 in September 2011 to stand at about $1,100 as I write this, it’s still about 20 percent above the golden constant.

When Gold Deviates From Its Constant
Erb and Harvey then asked: If the golden constant provides a guide to the value of gold, what typically happens when the price of gold is above or below its golden constant value? They found that the high real price of gold has been about 8.73, the low real price of gold has been about 1.47, and that the current real price of gold is about 4.63.

The charts they present show that while there is a tendency to revert to the golden constant, the price of gold can vary greatly from the golden constant, and stay well above or below the constant for a long time. And as they note, there is no way of knowing if the “future high and low real prices of gold may be more or less extreme than in the past.”

The authors add: “The high and low real prices of gold highlight that even if there is on average a golden constant the real price of gold has strayed, and probably will stray, far from this possible central tendency. It is also possible that the future will be unlike the past.”

They thus warn that if the “real price of gold falls, the golden constant level is not a floor—a protective line in the sand that the real price of gold will not cross.” With this caveat, they did go on to examine the outlook for gold returns given where the price is relative to the golden constant.

Expected Returns To Gold

Erb and Harvey examined what happened to the return on gold when prices were above or below the golden constant. As you might expect, they found that “below average real gold prices have been followed by above average 10-year real gold returns and above average real gold prices have been followed by below average 10-year real gold returns.” Because the real price of gold is currently above its historical average, this “suggests that over the next 10 years real gold returns could be below average.”

Erb and Harvey also looked at the downside risk of owning gold. To do so, they asked the question: How low might the price of gold go if the previous low real price of gold is revisited? Given the value of the U.S. CPI for June 2015 and the previous low real price of gold, a possible low price for gold is about $350 an ounce.

This, of course, does not mean that the price of gold will immediately decline to $350 an ounce. Rather, it’s a suggestion that, given the volatile history of real gold prices, because the real price of gold once fell to 1.47, it could fall to that level again.

A Return To Highs
The authors also examined what would happen if gold went back to its previous highest real price. If that occurred, it means the price of gold would again have reached about $2,080.

Erb and Harvey then looked at what would happen to real and nominal returns on gold if we assumed inflation of 2 percent a year for the next 10 years. Why 2 percent? It’s roughly the difference between the yield on 10-year Treasurys and 10-year TIPS, as well as similar to the consensus forecast of economists gathered by the Federal Reserve Bank of Philadelphia.

They found that the golden constant value of gold would increase from $825 an ounce to $1,006 an ounce, and the “overshoot” price would rise from $350 an ounce to $427 an ounce. If, over a 10-year investment horizon, the price of gold fell from $1,096 an ounce to $1,006 an ounce, it would experience a nominal return of ‐0.9 percent per year and a real return of ‐2.8 percent per year.

If the price of gold dropped from $1,096 an ounce to its 10-year “overshoot level,” the nominal and real returns would be ‐9.0 percent per year and ‐10.8 percent per year, respectively. Keep in mind that, regardless of the future inflation rate, the real rate of return is ‐2.8 percent per year if gold falls to its golden constant fair value over the 10-year period.

Erb and Harvey concluded that, even though there is little relation between the nominal price of gold and inflation when measured over 10‐year periods, the evidence suggests that gold does hold its value over the very long run.

For example, in a prior paper, they presented historical evidence that the wage of a Roman centurion (in gold) was approximately the same as the pay earned by a U.S. Army captain today. They also showed that the price of bread (in gold) thousands of years ago is about the same as we would pay today at an upscale bakery.


The conclusion we can draw is that, while gold might protect against inflation in the very long run, 10 years is not the long run. As Erb and Harvey note: “In the shorter run, gold is a volatile investment which is capable and likely to overshoot or undershoot any notion of fair value.”

I’d add to that another insight that becomes important in the long term. While the laws of economics can be defied in the short term, history demonstrates that investors ignore them at their peril. For instance, a basic economic principle is that, over the long term, prices tend to move toward the marginal cost of production.

In its “2013 Outlook,” Goldman Sachs estimated that the marginal cost of producing gold is less than half the current price (around $750 an ounce). The financial services firm also observed that more than 80 percent of gold production costs less than $1,000 an ounce—or about 10 percent below the current price. Another important point to consider is that, unlike with other commodities, all the gold that’s ever been mined is basically available for sale today.

And, as Dimensional Fund Advisors’ Weston Wellington recently pointed out: “It’s also conceivable that a significant real price increase would encourage development of electrochemical extraction of the estimated 8 million tons of gold contained in the world’s oceans, dwarfing the existing gold supply.” That’s a lot of supply that could potentially hit the market.

The bottom line is that, while my crystal ball always remains cloudy, based on the fundamentals and the historical evidence, there doesn’t really seem to be a case that gold is likely to provide strong investment returns, even though it has already fallen about 40 percent from its peak nominal value (and even more in real terms). Forewarned is forearmed.

If you have been considering an investment in gold—perhaps you see the 40 percent drop from its high as a buying opportunity—hopefully the information in this article will enable you to make a more informed decision.

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