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I've been
having some discussions with a friend about technical operating mechanisms
for a gold standard system. What would be best?
In some of my recent writing for Forbes.com, I've made the point that a
"gold standard system" is actually a rather broad and vague term.
It means a policy of maintaining a currency's value equivalent to gold, at
some parity ratio. However, within that context can be a great many
variations on exactly how it gets done.
November 17,
2011: My Thoughts on Lewis Lehrman's Gold Standard
Our discussions are regarding redeemability of gold
bullion, and the use of open market operations using bonds. These are both
ways to manage the base money supply, by buying and selling assets. When you
buy an asset, the asset (gold bullion, bonds, or perhaps something else) is
paid for by creating money "out of thin air." This money appears in
the seller's bank account, but it is not debited from an existing account.
When you sell an asset, the money received in payment disappears, thus
shrinking the monetary base.
December 1, 2011:
What is Money?
Let's assume that you have a policy of gold redeemability.
In other words, the monetary authority is willing to sell gold, and take base
money in return, at a certain price. This might be the parity price, or it
might be a percent or two away, creating a "trading band" around
the parity price. When the monetary authority sells gold in this fashion, the
money received disappears, and thus the base money supply shrinks. You can
also have a gold standard system without gold redeemability
-- one that uses non-gold assets such as bonds exclusively -- but this has
been rare historically.
Let's say you have a conventional currency board, that
links one currency with another. Country A has a currency board that links
its currency to the euro at a rate of 5:1. Thus, A$5 per €1. There is
base money of A$500 million, and the currency board authority holds
€100 million. The currency board authority is willing to either buy or
sell A$ in any quantity, in trade for euros, at A$5 per euro. Or, maybe there
is a little trading band or bid/asked spread, so the currency board authority
will buy A$5 at €0.98 and sell A$5 at €1.02. When the currency
board authority sells A$, it does this by creating new A$ "out of thin
air," and taking euros in return. Thus, the amount of A$ in existence
(A$ base money) increases, and the reserve holdings of euros increase. When
the currency board authority buys A$, and gives euros in return, these A$
disappear from existence, and the reserve holdings of euros decrease.
The currency board authority rarely holds an actual €100 million of
euro base money -- literal bundles of banknotes, or a reserve deposit at the
ECB. Typically, the currency board authority might hold a little euro base
money, perhaps €10 million (10% of reserve assets), and the rest of the
reserve asset holdings will be in the form of euro-denominated German
government bonds.
The currency board authority can also adjust its reserve holdings. For
example, if it feels that it has too much non-interest-bearing euro base
money, it can use the euros to purchase a bond asset, such as
euro-denominated German Treasury bonds. If it feels that it doesn't have
enough euro base money, it can sell some German Treasury bonds and receive euro
base money in payment. These actions don't change the monetary base.
It looks something like this:
 
Note that both buys and sells in this system, which create changes in A$ base
money, arise wholly from someone approaching the currency board authority
(the "private market participant"), to buy or sell A$ at the prices
indicated. The currency board authority does not instigate any buys or sells
on its own. Thus, the currency board system is wholly automatic, with no
discretionary element, even on a day-to-day basis.
The quantities in this example are rather large. Normally, the changes as a
percentage of assets would be quite modest. Also, most foreign exchange
transactions (buying/selling A$ and euros) would be between two private
market participants. The CBA's contribution would be if there were more
buyers than sellers, or more sellers than buyers, at the indicated parity
price.
This system, a "currency board" system, links one currency with
another currency. We can use the same mechanisms to link a currency to gold.
In this case, the gold standard authority (GSA) is willing to buy or sell
gold at, let's say, A$1000. Of course there could be
a little buy/sell spread of a couple percent as described earlier. For now,
let's assume that the GSA's reserve asset is gold bullion exclusively, or a
"100% bullion reserve" system. Note below that I'm using
"thousands of gold oz." and "millions of A$", so there's
the 1000:1 ratio right there. It looks like
this:
The
terminology "buys A$100m, pays 100,000 oz." is a little odd, but
the transaction is exactly the same as our euro currency board example. When
I say that they "pay 100,000 oz.," I mean that they actually
deliver 100,000 of physical gold bullion to the GSA, and receive A$100m in
return.
This kind of "100% reserve" system basically did not exist in the
last three hundred years. The Gold Standard Authority (in practice commercial
banks, and later central banks) typically held most of their reserve in the
form of government bonds, or perhaps high-quality corporate bonds. However, unlike
our euro currency board example, where we use foreign government bonds
(German Treasury bonds), they could use domestic government or high-quality
corporate bonds. (In practice, many used foreign government bonds in a
gold-linked currency, such as British Consol bonds.
This works fine too.)
The domestic government bonds are denominated in A$, and since the A$ is
linked to gold, the domestic government bonds are linked to gold too. Thus,
if the central bank wants to reduce its bullion holdings and increase its
interest-bearing bond holdings, it would sell the bullion on the open market
for A$, and then use the proceeds of the sale to purchase domestic government
bonds (or foreign government bonds, same thing). It
would look something like this:
In fact, gold standard systems such as those of the
Bank of England, or those operated by hundreds of private commercial banks in
the U.S., worked along these lines. Do you see why I say that a gold standard
system is like a "currency board linked to gold"? Pretty obvious,
don't you think.
We didn't even get to the topic at hand today. Maybe
next time.
Nathan Lewis
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