Thursday, September 27, 2012

Is A Gold Standard Possible?

From Deutsche Bank's Daniel Brebner:
A Future Gold Standard?
A common theme in discussing the gold market is the prospect for a new gold standard in the future. That such a topic is now common says much about the change in attitudes by investors, many who would have ridiculed the mere mention of such a thing as little as five years ago. It also, perhaps, gives a hint as to the desperation of investors in their search for assets which they believe may protect their wealth over the long-term, a period which may experience more than its fair share of event risk.
If gold were to regain its crown as the primary medium of exchange it would dramatically change the way that governments manage their economies – which some would say is a good thing given the results of their management skills thus far. Nevertheless, the imposition of a gold standard would limit the ability of government to affect the supply of money in the economy. The supply of money would rest entirely with the volume of gold holdings that a country would possess and grow in line with its trade balances plus domestic gold production (depending on domestic resources and whether these resources in fact became state property – which we expect should be of consideration).
Why it can work
Many economists shudder at the notion of a gold standard; this is understandable given the school of thought to which most adhere: Keynesian or Keynesian derivative. Keynes saw flexible monetary policy as an important tool in optimising an economy. Gold ostensibly removes this flexibility – and was therefore derided as a ‘barbarous relic’ by Keynes himself. In fact we agree that during certain periods of extreme economic imbalance, such as the Great Depression, substantial monetary flexibility may be required.
Most economists see the great problem of gold as twofold: 1) there is insufficient supply and 2) there is insufficient supply growth.
The first argument is spurious. The volume of gold is not important; instead it is the value that is ascribed to this gold that is important. A zero can easily be added to a paper bill to change its value; similarly it can be added to the value of an ounce of gold. Absolute values are in fact unimportant. As we have already asserted, gold is infinitely divisible. Does it matter that a paper bill is backed by a gram or a kilogram of gold? Theoretically it shouldn’t matter in our view.
The second argument, in addition to being fallacious, shows a certain lack of humility. In order to achieve reasonable price stability within a growing economy money supply also needs to grow. The critical question is, how fast. The rate is important, grow the money supply too quickly and inflation results, too slowly and deflation is the consequence (assuming money velocity is constant in both situations).
We believe there are two key elements which are needed to approach an appropriate rate of money supply growth.
The first: population growth – as the number of users of money changes, a money supply adjustment is needed to prevent the distortions in pricing that this would create.
The second: unleveraged productivity – an estimate of the increase in per capita productivity (or value creation) that a society experiences over time – without the assistance of credit growth.
We start by using general metrics for economic activity. There are several, including GDP and trade figures. The difficulty however is stripping out the impact of significant credit growth on these figures to get the genuine, unassisted, growth for a specific economy. For example, over the past 32 years real US GDP has averaged 2.7% (CAGR). Over the same time frame the US population has grown by 1.1% on average. On this basis average US GDP growth after a population adjustment is around 1.6%. Of this rate, what has been the debt contribution to growth? If, to keep things simple, we assume that credit has contributed roughly 0.5% per year, this leaves an average 1.1% per annum increase in value or productivity for the US. For this reason we believe that humility is a necessity – there is considerable evidence to suggest that the impressive growth rates and productivity advances experienced over the past several decades have been temporarily boosted by the assumption of unprecedented quantities of debt, on a global level. Perhaps we are not the geniuses we think ourselves to be.
On this basis our expectation would be that the US would need to grow its monetary base by only about 2.2% or so. Long-term gold supply growth trends show a CAGR of 1.6%. While this is close to the necessary 2.2% rate needed to avoid deflationary pressure, it could still be asource of concern for those looking at gold as a viable currency alternative. However this need not invalidate gold as a preferred medium of exchange for while volume growth may remain a challenge, the exact value is still determinable by government – in fact periodic valuation adjustments for gold could conceivably be an ongoing option. Thus a low growth rate in gold volumes could be offset by a small revaluation of the metal itself, thereby preventing deflationary price pressure in an economy.
The problem with the above solution for gold’s apparent excessive scarcity is that it puts government monetary policy makers back in a position whereby they can misprice money with consequential capital distortions a possibility. This is something that market purists would rather not see, but may make a transition to gold more palatable for those accustomed to the flexibility that a fiat currency affords.
Why it probably won’t
While a gold standard could work, we remain sceptical that it will be considered (barring a serious financial crisis, perhaps associated with highly volatile inflation).
In large part we blame the low probability on culture. The world economy has, over the past century, morphed into a highly integrated, government dominated system guided by conventional wisdom (group think). The self-reliant, individualism of the free market has been left behind in favour of a ‘new age’ of coddled consumerism. Culturally this represents a very powerful force in our view, one which minimises creative options/solutions to economic impasses. On this basis we are cautious of predicting such a radical solution to monetary imbalances.

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