Gold and Money
Gibson, Warren C., Freeman
Last month we examined some propositions about gold as money, drawing from theory and history. This month we ask whether and how gold might once again serve a monetary function.
Money of any sort, commodity-based or not, derives its value in large part from what economists call a "network effect." Like a fax machine, whose value depends largely on how many other people have fax machines, we value money because other people value it. We feel confident our money will buy us what we need tomorrow. A strong network effect means that something drastic has to happen before people will give up their familiar form of money.
Something drastic was happening when U.S. Rep. Ron Paul's Gold Commission was set up in 1979. By the time the commission's report was issued in 1980, inflation had reached alarming levels: The consumer price index was at 14 percent and rising. The prime rate was over 20 percent, and in 1980 silver exploded to $50 an ounce and gold surpassed $800 (about $2,300 in today's dollars). Bestselling books urged people to buy gold, silver, diamonds, firearms, and rural hideouts.
We now know that inflation was peaking and that the silver price spike was a fluke caused by a failed attempt to corner the silver market. But none of this was apparent at the time, so it was reasonable to wonder whether our monetary system would survive. What did happen, of course, was that the new Fed chairman, Paul Volcker, stepped on the monetary brakes hard enough to break the back of inflation. Two back-to-back recessions resulted but were followed by a long period of recovery in which both inflation and interest rates dropped steadily. The Gold Commission was largely forgotten, though the U.S. Mint did get into the business of producing gold coins in a big way.
We have a crisis of a different sort at present, featuring unprecedented levels of public and private debt rather than inflation. In addition, global trade has advanced significantly and worldwide financial markets are tightly linked. Many new financial innovations have emerged since 1980, not just the sophisticated derivatives that were at the center of the 2008 crisis, but also innovations such as exchange-traded funds (ETFs) that are available to everyone. The euro is in trouble, and there is a real possibility that a Chinese property bubble is about to burst. Gold is above $1,400 an ounce, up from $250 a decade ago, "while silver has advanced from about $5 to over $30 an ounce.
Ron Paul is no longer a lone voice calling for a return to gold. Robert Zoellick, president of the World Bank, astonished everybody recently when he wondered out loud whether gold should again play a monetary role. Although he drew praise from some quarters, most comments were dismissive. Berkeley economist Brad DeLong, for example, nominated Zoellick for the "Stupidest Man Alive." One is reminded of Gandhi's four steps to victory: First they ignore you, then they ridicule you, then they fight you, then you win.
In 2010 the Central Bank of China imported over 200 tons of gold, more than offsetting recent IMF sales. This is in addition to the 350 tons that are mined in that country annually. Wealthier Chinese citizens are adding it to their portfolios. While substantial, Chinese gold holdings are still dwarfed by their holdings of U.S. Treasury securities. The gold purchases may be intended mainly as a signal of its displeasure with dollar hegemony. Other central banks are acquiring gold in smaller amounts.
Monetary Links to Gold
Within just a few years ETFs have attained a prominent place in the investment world. None has been more amazing than the SPDR Gold Trust (GLD), which purchases and stores gold bullion for the benefit of its shareholders. This fund was launched in 2002 by the World Gold Council, an industry group, as a means of stimulating demand. The results have exceeded their wildest dreams. GLD now holds about 1,300 tons of gold bullion, a hoard larger than that of any central bank save four. …