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I've said over and over
that a central bank (or other currency manager, such as a private bank) need hold
no gold at all to operate a gold standard. What they must do is add and
subtract base money appropriately to maintain the value of their currency at
its gold peg. This is the same operation as a proper currency board today.
This really irks some
people, who have become comfortable with the idea that a large
"backing" or "reserve" of gold means "greater
safety." This is really just superstition among people who don't
understand how the mechanisms work, akin to the large bank vault with huge
heavy door on prominent display at many retail bank branches, which is
supposed to give the impression that your money is "safe" inside
the safe. This is nonsense, of course -- a bank deposit is merely a loan to a
bank, and the bank then goes and does what it pleases with your money, such
as making bridge loans to troubled SIVs.
Last week, we looked at
the Bretton Woods period, in which the US maintaned the dollar's peg to gold
while other countries pegged to the dollar. However, the dollar's peg with
gold came into constant conflict with the urge to manipulate interest rates
and the economy in general, and in practice the proper currency-board-like
adjustment of base money was rarely practiced. Instead, the Fed and the
government attempted to bully the dollar/gold market into place with large,
mostly sterilized (no effect on base money) sales of gold bullion, in
addition to some other Fed tactics including higher interest rate targets.
This ultimately failed.
The way in which Bretton
Woods failed -- by apparently "running out of gold" -- drove many
to conclude that the problem was, obviously, not enough gold! This is
completely backwards. The problem was that they didn't know what to do except
selling gold, which was really just a stopgap. That's why I focus incessantly
on the technical mechanisms of managing base money as a way to manage
currency value, while the gold reserve itself is all-but-irrelevant.
If anything, the Bretton
Woods period serves as a good example of the idea that it doesn't really
matter how much gold you have, as long as you know how to properly manage a
currency through base money adjustment. At the beginning of Bretton Woods in
1944, the United States started with a mammoth amount of gold. In 1942, the
US government/Fed held 78% of all the gold held by all governments/central
banks in the world, and 52% of all the aboveground gold in all of existence!
This figure was and will probably never be topped by any government,
anywhere, at any time. In 1942, the US goverment held a whopping 630 million
ounces of gold. For comparison, the Bank of England, in 1910 -- the very
height of the "classical gold standard," and after the pound had
been the world's premier international currency for over 200 years -- held
7.2m ounces, or about 1/87th as much gold. This was a mere 4% of the total
gold held by central banks, and approximately 1.2% of all the gold in the
world. The BoE's gold reserves didn't decline, either. In 1860, when London
was the center of the financial universe, the BoE held 2.5m oz. Obviously, the BoE knew what it was doing.
So, I'll say it again:
the currency manager that knows what it is doing (BoE of 1900) needs
virtually no gold at all. The currency manager that doesn't know what it is
doing (Fed/Treasury of 1965) will eventually find that no amount of gold can
correct their fundamental ignorance.
Despite beginning with US
reserve holdings of the maximum extent imaginable, the system failed in a
relatively brief 27 years. Obviously, this was not a problem of "not
enough gold," but rather, a lack of understanding of how to operate a
gold standard system. Even when the Bretton Woods system was abandoned in
1971, the US government still held about 15% of all the gold in the world, or
291m oz., which was 40 times more than the BoE had when the pound was the
world's premier gold-linked currency.
* * *
A reader asked for a
review of base money adjustment systems. "Base money" is the
technical term for money. There are other "forms of money" but
these are really forms of credit, so base money is the only "money"
that is actual money. Base money today is about 90% coins and bills, and 10%
bank reserves, held electronically at the central bank. The Fed, or other currency
manager, is only capable of adjusting the base money supply. Increasing the
base money supply (aka "printing money") is done through the
purchase of an asset, typically a government bond. The Fed buys a bond, in
the regular market, and pays for its purchase with newly-created money, in
the form of bank reserves. These bank reserves are exchangeable on demand
with paper currency, and vice versa. To reduce the amount of base money, the
Fed sells an asset, typically a government bond, on the regular market. The
proceeds from the sale disappear, which reduces the amount of base money
(again typically bank reserves). In this way, the currency manager can
"run the printing presses" both forward and in reverse, to
virtually any extent necessary.
Nathan
Lewis
Nathan Lewis was formerly the chief international
economist of a leading economic forecasting firm. He now works in asset
management. Lewis has written for the Financial Times, the Wall Street
Journal Asia, the Japan Times, Pravda, and other publications. He has appeared
on financial television in the United States,
Japan, and the Middle East. About the Book: Gold: The Once and Future
Money (Wiley, 2007, ISBN: 978-0-470-04766-8, $27.95) is available at
bookstores nationwide, from all major online booksellers, and direct from the
publisher at www.wileyfinance.com or 800-225-5945. In Canada,
call 800-567-4797.
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