Who Should Hold Gold? Jude Wanniski June 20, 1997

Supply-Side Economics Summer School Lesson #2

Memo To: Students of Supply-Side University
From: Jude Wanniski
Re: Who Should Hold the Gold?

Thomas J. Feery poses a great question, most appropriate: "Does a Gold standard require Central Banks to have physical possession of Gold? If not, then why the fiiss over German fed sales of Gold?"

In an absolutely perfect world, no central bank would need to hold any gold. David Ricardo, the great supply-side, classical economist of the 19th century, wrote in his Principles of Political Economy in London of 1821, that When money is working at the peak of efficiency, the central bank need hold no gold. At its peak of efficiency, in the late 19th century, the privately owned Bank of England ran the gold standard for the entire world with only a tiny amount of gold bullion or specie. This is because the world came to trust the Bank's total commitment to maintaining the value of the pound sterling to a specified weight of gold.

In other words, if you are embarking on a gold standard, you should probably have some gold reserves in your central bank portfolio. In this period of history, it would be okay to have dollars or other "hard currencies" in your central bank portfolio, as these could be used to buy gold if there were a sudden shock to the market's confidence in your commitment. You must first demonstrate, through thick and thin, that you are prepared to raise interest rates as high as they have to go in order to persuade the market that you will not devalue the currency. This means selling interest-bearing bonds into the market, to mop up non-interest bearing currency.

Very few opponents of "a gold standard" know what it is or how it works or how many different ways there are to link paper money to gold. The question arises again and again: "How can we be on a gold standard when there is so little gold and so much money needed to finance this enormous world economy?" The answer is that it is the function of the central bank only to maintain the "standard," the "unit of account," and the rest of the world will create its own money around that standard. I first learned this from Karl Marx, who was a great fan of David Ricardo and the gold standard. Marx pointed out that in any village of Europe, everything for sale was quoted in terms of the gold price, even though there was not an ounce of gold within many miles of the village. Gold provided a common understanding of the value of all things, enabling people to reckon how many chickens they would have to bring to market to sell in order to exchange for so many gallons of milk or sticks of lumber.

The question posed this week is an especially a good one because of the recent crisis over the proposed European Monetary Union. The great mistake the Eurocrats are making is in discounting the importance of the role of money as a unit of account. In trying to devise a common currency for all of Europe, the Eurocrats are assuming that the most important function of money is as a medium of exchange — when it is not. The Eurocrats think they will increase the efficiency of the European economy by saving Germans and Frenchmen and Belgians and Brits the trouble of changing one money into another at the borders. That is true enough, if the Eurocrats could ever design a mechanism that will permit that to happen. They are finding it impossible, because their starting assumption is incorrect. The chief function of money is as an accounting unit. If the Eurocrats understood that, they would go back to the drawing boards and build a monetary system from that assumption. This would require them to first fix the Eurocurrency to something the markets would understand as being a reliable unit of account. What? The answer is the dollar, the world's key currency, except that the dollar still wobbles around relative to the gold price. The Euro would be possible, but only if the dollar is first fixed in value to gold. Then, the European nations in the Eurocurrency system would have a credible unit of account as their anchor.

Once the dollar is fixed to gold and the Euro fixed to the dollar/gold price, the Asian nations can also link into the mechanism. There are now 120,000 metric tons of gold in the world. About 40,000 tons are held by central banks. If the system worked perfectly going into the 21st century, central banks would be able to sell off their gold little by little to private consumers of gold. We might imagine the 22nd century opening a hundred years from now with 1,020,000 metric tons of gold in public and private hands, but with much less in public hands as a percentage of the whole. This would be the amount arrived at by mining new gold at 2 1/2% a year over the century. The 2 1/2% number is the average annual increase in gold stocks over the past several centuries. As Ricardo observed in 1821, the population would then be able to use gold for its non-monetary functions, which are in jewelry, dinnerplate, and industrial purposes. It is foolish to hoard bullion in great amounts at Fort Knox if the central bank has the confidence of the markets. Indeed, to have the confidence of the markets and still hold a vast gold hoard is illogical, as the markets will punish a government for making such poor use of gold, keeping it buried in the ground under lock and key.

The downfall of the Spanish Empire can be attributed to the fact that Spain did not have the wisdom of economists like Ricardo. Spain had the edge because of Columbus, but it sent conquistadores to the New  World at great expense, in search of gold, and when the gold was brought back to Spain it was immediately buried in vaults, under lock and key. The British knew that the value of gold was as a unit of account, which gave its bankers pre-eminence in financing practical, dynamic commerce instead of gold hoards. The Spanish practice was at the heart of what became known as mercantilism. Spain went into decline as a world power, hoarding gold a la King Midas. Britain became the center of the universe by a system that directed human investment of resources into other human enterprise, instead of a gold hoard.

The second question Feeley posed: Why the fuss about Germany's proposed sale of gold reserves? In fact, Germany did not propose to sell reserves, only to mark the price of gold up to its current market price. It is carrying gold reserves on its books at the Deutschemark gold price of 1971, when the international monetary system set up at Bretton Woods in 1944 broke down. The DM price of gold today is several times higher. If Germany were to "mark-to-market,11 it could count the "profits" as revenues in its federal budget, thereby lowering the deficit to less than 3% of Gross Domestic Product. In the European negotiations toward a common currency, the euro, it is a requirement of all participants that their national deficits be no higher than 3% of GDP. The government of Helmut Kohl, which proposed the gold maneuver, was shouted down by others in Germany — particularly the Bundesbank — who argued that this was a gimmick, a one-time bookkeeping device that was outside the spirit of the euro requirements that Germany itself helped establish. I would be very surprised if Germany would propose to actually sell gold out of its reserves on the open market. Although Nixon's action in 1971 took all governments off the gold standard, the central banks of the world, especially the German Bundesbank, have been reluctant to assume that the world would not one day need those gold reserves again.

To broadly answer Feeley's question about who should hold the gold, I'd like to wrap up this session by suggesting you think about the proposition that it almost does not matter. That is because there is so little gold in the world. If the Washington monument were made of gold, the entire 120,000 metric tons of gold mined over the last several thousand years would only be enough to build the base of the monument, about a third of the way up. When Alan Greenspan was asked last year why gold is so much more important than any other commodity, he said it was because the stock of gold is so large relative to its flow. By that, he meant the world inventory of gold, at 120,000 metric tons, is enormous relative to its annual "consumption," as new industrial gold use, jewelry and monetary reserves, about 3,000 metric tons. The world reserves, or stock of wheat, on the other hand, are only a fraction of the annual consumption, or "flow." The market is therefore not much concerned about where the gold is held. It is keenly interested in the economic philosophies of the governments and central banks who are managing their currencies with respect to the gold stock.

We should really have a discussion about the euro later in this summer session. In today's Wall Street Journal, there is a survey of eminent economists on "Whither the EMU?" It includes comments from Robert Mundell and Milton Friedman. If you have an opportunity to get the WSJ, I advise you do so, read through the article, pose questions, and save the article for later discussion.