The unprecedented credit and monetary meltdown of 2007 – 2008 has prompted many to reconsider the prospects for gold, the currency of last resort, being restored to its traditional role in guiding monetary policy as an alternative to the chaos of the fiat money.  However, it is not immediately obvious how a return to a gold standard of some kind or another might eventually take place.  Americans know intuitively that something is seriously wrong with the monetary system and they readily acknowledge that the dollar should be as good as gold.  However, what does making the dollar as good as gold really mean, and how do we get there from here?

This discussion paper begins the process by focusing on what might be thought of as an equilibrium U.S. dollar price for gold in the event that the dollar is once again anchored to gold which would close the chapter on more than three decades of fiat currency.

The history of the gold standard is punctuated by the recurring pattern of governments reneging on the promise of gold convertibility to accommodate the expedience of war-time budgets, which tends to unleash inflationary pressures as a by product.  After peace is made, governments have often sought to cure the war time inflations by reestablishing the convertible link of their currencies to gold at pre-war parities, rendering in the process even more damaging deflations.

Former Fed Chairman Alan Greenspan exhibited an intrinsic understanding of this risk in a Wall Street Journal Editorial “Can the U.S. Return to a Gold Standard”? on September 1, 1981 when he wrote:  “The immediate problem of restoring a gold standard is fixing a gold price that is consistent with market forces.  Obviously if the offering price by the Treasury is too low, or subsequently proves to be too low, heavy demand at the offering price could quickly deplete the total US government stock of gold, as well as any gold borrowed to thwart the assault.  At that point, with no additional gold available, the U.S. would be off the gold standard and likely to remain off for decades.  Alternatively, if the bid price is initially set too high, or subsequently becomes too high, the Treasury would be inundated with gold offerings.  The payments for the gold drawn on the Treasury’s account at the Federal Reserve would add substantially to commercial bank reserves and probably act, at least temporarily, to expand the money supply with all the inflationary implications thereof.”    

The late Jude Wanniski, a one time associate editor of The Wall Street Journal from 1972 to 1978, who coined the term supply-side economics,

and authored “The Way the World Works”, was well known as a political economist and as an advocate of gold to guide monetary policy. 

One of the conceptual cornerstones of his views on gold is that the optimal price of gold is one that balances the interests of debtors and creditors.  Too high of a gold price would be inflationary and favor debtors as they would be paying back their debts in devalued dollars. 

On the other hand if the price of gold is too low, debtors are saddled with the burden of paying back their loans in currency that is appreciating relative to commodities, goods and services and thus gives a deflationary advantage to creditors, essentially, the same case made by Greenspan in his 1981 WSJ Op Ed. 

Wanniski called for abandoning the Fed’s long time policy of interest rate targeting in favor of targeting the price of gold to establish a gold north star or “Polaris” as he called it to guide Fed monetary policy.  Wanniski’s idea was for the Fed to target the price of gold at a “Goldilocks” price level or relatively narrow range by using its open market operations to buy and sell treasury securities from its portfolio to add or drain reserve balances from the commercial banking system. 

Wanniski had suggested that the average price of gold over the past decade would be an appropriate level for the Fed to target.  As of this writing at year end 2008, the ten year average price of gold weighs in at about $452.75/oz.  To target the price of gold at that price, instead of targeting interest rates would mean that the Federal Reserve would have to inject cash reserves into the commercial banking system if gold falls below $452.75 and drain reserves if it rises above $452.75/oz until the price of gold came back down to the targeted price.  Moreover, by abandoning the interest rate targeting mechanism, it would mean that the Fed would have to allow interest rates to float to find their own natural level based on the free market supply of funds from lenders vs. demand for funds from borrowers.  

As of year end 2008 the price of gold was $870/oz, which illustrates the dilemma the Fed would confront at this point in time with credit markets in turmoil.  If the Fed chose to target gold at $452.75/oz, it would have to drain reserves from the banking system, which is exactly the opposite of what the Fed and Treasury have been doing in recent months since the financial collapse shifted into high gear. 

Ron Paul has spent his entire political career criticizing the fiat monetary policy of the Federal Reserve, and his grilling of former Fed chairman Alan Greenspan and current chairman Bernanke in Congressional testimony are legendary.  His approach in recent years has been to promote the idea of allowing gold and silver to circulate as legal tender along side existing fiat currency.  However, if this idea is to gain traction it makes sense that there should be at least some theoretical gold price at which to reestablish gold convertibility that would achieve the best results. 

In connection with this, Ron Paul is not the only Republican Congressman from Texas who is critical of the Fed and who has ideas of anchoring the dollar to gold.  Texas Congressman Ted Poe of the second Congressional District of Texas also thinks the Fed should abandon interest rate targeting, and instead target the price of gold as a way to stabilize the dollar and he introduced legislation to that effect on July 31, H.R. 6690. 

Poe's approach runs more or less parallel to the monetary reform remedy that Wanniski favored, which was also pushed by Steve Forbes when he ran for president in 1996 & 2000.  In fact, Wanniski was instrumental in convincing Forbes to run for President in 1996. 

Poe's legislation recommends targeting gold at $500/oz, which is a nice round number, but he doesn’t really explain why $500/oz is the right “Goldilocks” price level to target, and as already discussed above, a target gold price that is too low would produce deflation, and one that is too high would be inflationary.  Research conducted by MASSLPA suggests that a price target of $500/oz may be too low.

Moreover, another problem that Congressman Poe’s recommendation shares in common the Wanniski/Forbes approach is that it would rely on the Fed using open market operations of buying/selling treasury securities to influence the price of gold.  As a Fed policy tool, this approach may have some serious flaws that might produce some undesirable monetary results.  That subject goes beyond the scope of this essay but a subsequent paper is being prepared to address why this approach may be flawed.    

Here's the link to Congressman Poe’s proposal.

http://www.realclearmarkets.com/articles/2008/09/congress_must_stabilize_the_do.html

It may not be obvious at first glance what the appropriate price may be to target gold as a monetary anchor for the dollar.  However, as a point of departure it makes intuitive sense that an equilibrium gold price should be based on balancing the interests of borrowers and lenders. 

The classical gold standard in U.S. history acted as a monetary regulator via convertibility of circulating currency which was defined as a fixed weight of gold at $20.67/oz.  A central bank was not needed because the promise to convert dollars for gold at a fixed price functioned automatically not unlike a thermostat.  If too much money was in circulation and holders of dollars sensed a risk of inflation they could redeem their dollars at the gold window for gold.  On the other hand if there was a shortage of dollars in circulation they could deliver gold to the Treasury for dollars.  For a good read on how a classical gold standard is supposed to work try former Fed chairman Alan Greenspan’s essay “Gold and Economic Freedom”, which was included in Ayn Rand’s non-fiction book, “Capitalism, the Unknown Ideal” published in 1967, well before Greenspan went over to the dark side. 

http://www.usagold.com/gildedopinion/greenspan.html

President Roosevelt devalued the dollar to $35/oz in 1933 where it stayed until 1971 functioning from 1944 on under the post WWII Bretton Woods monetary agreement.  The devaluation of the dollar in 1933 was one of the reforms that accompanied the Emergency Banking Act of 1933 which prohibited private ownership of all gold coin, bullion and ownership certificates fully collateralized by physical gold.  

Bretton Woods was a departure from the classical gold standard in that the promise to convert dollars into gold at a guaranteed price was only extended to central banks not everyday U.S. citizens.  Consequently, the case can be made that Bretton Woods was a flawed system which is probably true.  Nevertheless, it worked fairly well until the U.S. government ignored the fiscal discipline required of a gold anchor for the dollar when it embarked on the guns and butter policy of the Vietnam War and the Great Society social programs of the 1960s.

Consequently, imbalances that were allowed to build up during the Bretton Woods era in the 1960s led to repeated runs on the U.S. Treasury’s gold stocks, especially by the Bank of France.  Eventually President Nixon abandoned the Bretton Woods agreement on August 15. 1971 and the U.S. has been off the gold standard ever since. 

Shortly before he died, Jude Wanniski wrote an open editorial memo on his website to Ron Paul in July of 2005, “Ron Paul’s Great Question”.  He commented on the question Dr. Paul asked of Alan Greenspan in Congressional testimony before the House Financial Affairs Committee, not long before Greenspan’s departure from the Fed.  Anyone familiar with Ron Paul’s doggedness in getting under the skin of Greenspan and his successor Ben Bernanke in Congressional testimony will appreciate this exchange. 

Dr. Paul wanted to know from Greenspan if he thought there would be some circumstances under which the Federal Reserve would reconsider backing the dollar with gold.  After all there must be some reason why the Fed and other central banks still hold gold as a monetary asset.  Greenspan’s reply was that he didn’t think it was necessary to go back to gold because the Fed was acting as if it was already back on gold.   

Dr. Paul’s question, Greenspan’s response and Wanniski’s take on the exchange is terrific grist for the mill on how these three men viewed the role of gold and monetary policy.  Here is the link:

http://www.gold-eagle.com/editorials_05/wanniski072705.html

However, if you accept the notion that the optimal price of gold is one that balances the long-term interests of debtors vs. creditors, then it becomes necessary to determine if the ten year average gold price which is currently $452.75 as of year end 2008, would actually be the optimal price to target at this point in time.  Is a simple average price over a period of ten years as Wanniski recommended, the best methodological approach for deriving the optimal price of gold, or is it too simplistic? 

Mortgages, labor agreements, long term leases, long term supply and delivery contracts and so on are entered into and terminated over many years and in some cases they are renegotiated or go into default. 

Certainly, there are still some outstanding contracts that extend as far back as twenty or more years that were entered into when gold weighed in at much lower prices than today’s price of $850/oz.  Perhaps an optimal price in the range of around $452.75 (the 10yr average) would be the right price, but as Greenspan stated in his 1981 WSJ Op Ed quoted from above, if the target price of gold is set too high or too low, it could have serious inflationary or deflationary consequences.

An alternative methodology for deriving an optimal price of gold would be to calculate a duration weighted average price of gold for all outstanding marketable Treasury coupon debt as a proxy for all debtors and creditors, not including T-Bills which mature in one year or less.  The logic behind this approach is three fold. 

First, the current maturity structure of the outstanding Treasury debt encompasses debt issued as far back as the mid 1980’s.  Consequently, this approach takes into account the historical price of gold at the time of issuance for each outstanding Treasury note and bond.

Second, it seems somehow appropriate that Treasury debt, which is only a step or two removed from actual currency, should be used to derive an optimal gold price relative to cash dollar reserves. 

Third, for purposes of analysis and transparency it is useful to model the government in the role of the debtor when it comes to balancing the interests of debtors vs. creditors, because the government has a natural incentive to inflate the currency, as convenient way to default on its debt.  Moreover, as monopoly supplier of currency reserves it has the power to do so.

It makes sense therefore to use a high profile and liquid market like U.S. Treasury notes and bonds as a proxy for modeling all these varied contractual relationships in the economy.  Importantly, all of the outstanding Treasury issues are easily updated with price information available in the newspaper everyday or on electronic vendor screens in real time. 

Research by the MASSLPA indicates that based on this methodology the appropriate equilibrium price for gold is currently about $607/oz, or more than 21% higher than the target price recommended by Congressman Poe, and about 34% higher than the 10-year average price as recommended by Wanniski.  This research implies that if the Federal Reserve tried to target the price of gold at $500/oz or $452.75 or somewhere in between, it might be risking a damaging monetary deflation at the worst possible time.  

The G20 summit meeting which President Bush convened in Washington D.C. in November was touted by many of the global leaders who attended it as a Bretton Woods II.  However, this is a misnomer because the concluding Declaration of the G20 Summit made all types of general commitments to strengthening transparency and accountability, enhancing regulation, promoting financial market integrity, improving risk management practices, reforming international financial institutions, coordinating international cooperation and giving the International Monetary Fund and World Bank new leases on life to oversee all these objectives, but there was not one mention of monetary reform in general and gold in particular. 

However, the G20 summit did agree to meet again in April to take this agenda further.  Meanwhile, those who support making the dollar as good as gold again may want to organize to show the G20 what a real Bretton Woods II conference should be about.  The best way to start is with a debate about the appropriate price level to target for eventual gold convertibility of the U.S. dollar. 

Ed Rombach

January, 2009