Myth 3: The Volatility of the Price of a Gold Since 1971 Shows that Gold Would be an Unstable Monetary Standard

Eichengreen (2012, p 128) writes of “gold's inherent price volatility” making it unsuitable to “provide a basis  for  international  commercial and financial transactions  on a  twenty-first-century  scale.”

Ezra Klein (2012) declares that “The problems with the gold standard are legion, but the most obvious is that our currency fluctuates with the global price of gold as opposed to the needs of our economy.” It is not entirely clear what “our currency fluctuates with the global price of gold” means in this declaration.  If it means that for a country that is part of an international gold standard the purchasing power of domestic currency moves with the world purchasing power of gold, it is true, but if fails to identify a problem.  The world purchasing power of gold was better-behaved under the classical international gold standard than the purchasing power of fiat money has been since 1971.  If it means to invoke the volatility of the real or dollar price of gold since gold was fully demonetized in 1971, it identifies a problem, but it is a problem experienced under a fiat standard and not under a gold standard.  Today demonetized gold varies rises and falls in price as savers and investors rush into and out of gold as a hedge against fiat money inflation.

The respected economist and blogger James D. Hamilton makes an argument that is less ambiguous, but puzzling nonetheless.  Hamilton (2012) charts how much the average dollar wage would have varied if initially fixed in ounces of gold but paid in the dollar equivalent as the price of gold varied between January 2000 and July 2012.  He observes that “if the real value of gold had changed as much as it has since then, the dollar wage that an average worker received would need to have fallen from $13.75/hour in 2000 to $3.45/hour in 2012.”  Of what possible significance is such a calculation?  It is relevant only if the behavior of the real value (purchasing power) of gold is independent of the monetary regime.  Such a calculation would therefore be relevant to a proposal that a small open economy (say The Bahamas) should by itself adopt the gold standard today.  That would indeed be a bad idea. That is why thoughtful advocates of the gold standard specify that it should again be an international standard.  Hamilton’s calculation is completely irrelevant to that case.  A Lucas critique applies: observations drawn from a world of fiat regimes are not informative about the behavior of the purchasing power of money under an international gold standard.

Hamilton anticipates such an objection and has a reply ready:  “To which the gold advocates respond with the claim that if the U.S. had been on a gold standard since 2000, then the huge change in the real value of gold that we observed over the last decade never would have happened in the first place.  The first strange thing about this claim is its supposition that events and policies within the U.S. are the most important determinants of the real value of gold. According to the World Gold Council, North America accounts for only 8% of global demand.” Again, this is irrelevant to the evaluation of an international gold standard.  By the way, Hamilton’s 8% figure is North America’s share of global purchases of new gold jewelry, a flow measure, rather than its share of the stock transactions demand to hold monetary gold, which under an international gold standard would presumably be closer to North America’s 30% share of world output.

The purchasing power of money was clearly more stable under the classical international gold standard (1879-1914) than it has been under fiat money standards since 1971.  In a blog entry a few days after the one just quoted, Hamilton recognizes this fact: “It is true that the biggest concern I have about going back on a gold standard today – that it would tie the monetary unit of account to an object whose real value can be quite volatile – was not the core problem associated with the system of the 19th century.”  He then continues:  “But the fact that this wasn't the core problem with the gold standard in the nineteenth century does not mean that it wouldn't be a big problem if we tried to go back to the system in the twenty-first century.”

Why think that instability of purchasing power might be a big problem in a present-day international gold standard?  Hamilton attributes “recent movements in the real value of gold” to “the surge in income from the emerging economies rather than U.S. monetary policy,” citing data showing global gold jewelry sales up strongly in 2010 over 2009, led by large increases in sales to India, Hong Kong, and mainland China.  It is reasonable to suppose that demand for gold jewelry rises with income.  But real income in India and China is rising fairly steadily.  It makes little sense to attribute volatility in the real price of gold demand to steadily rising income.

Hamilton’s inference of a trend from two data points, however, is not a careful reading of the data source he cites.  Even if we focus exclusively on 2010 over 2009, only a small fraction of the extraordinary increase of 69% in gold jewelry sales to India can possibly be attributed to India’s real income growth, which was just 10% that year according to the IMF.  The income-elasticity of demand for gold jewelry is not plausibly 6.9.  The text of the article containing the data (Holmes 2011) provides a clue to the lion’s share of that year’s increase:  “Historically savvy gold buyers, India’s influx of buying implies an expectation that gold prices still have much higher to go. The WGC [World Gold Council] says that ‘Indian consumers appeared almost universally to expect that the local gold price was likely to continue rising.’” That is, Indians did not buy so much gold jewelry in 2010 just for ornamentation but also as an investment or inflation hedge.  Likewise, “many in China’s middle class are looking to gold as a means for long-term savings and a possible hedge against inflation.”

If we look at additional years of the data, we see that global gold jewelry sales in 2010 were down from the levels of 2007 or 2008, which is hardly consistent with the hypothesis that gold demand is rising mainly due to rising emerging-economy income.  If we look at the entire 2004-2010 range of sales data for gold in all forms, we see as much or more volatility in “investment” sales of gold (bars, coins, medallions, exchange-traded funds) as in jewelry sales.  Absent fiat inflation hedging, there is little cause for concern about the volatility of demand for gold or gold’s real price.

The well respected economist and blogger Tyler Cowen (2011) also expresses concern about volatility in the real price of gold:

Why put your economy at the mercy of these essentially random forces?  I believe the 19th century was a relatively good time to have had a gold standard, but the last twenty years, with their rising commodity prices, would have been an especially bad time.  When it comes to the next twenty years, who knows?

In a later blog entry, Cowen (2012) adds, “I think a gold standard today would be much worse than the 19th century gold standard, in part because commodity prices are currently more volatile and may be for some time.”

Cowen does not consider that the current volatility of several commodity price series, most importantly that of gold, is endogenous to our fiat money standard.  Inflation-hedging demand is volatile because in the world’s current unanchored fiat monetary systems inflation expectations are volatile.  Inflation-hedging involves other commodities in addition to gold and silver.

The answer to Cowen’s first question – why put your economy at the mercy of “essentially random” supply and demand shocks for gold? – is that, to judge by the historical evidence, it creates less volatility than the alternative of putting your economy at the mercy of a central bank’s monetary policy committee.   Monetary supply and demand shocks under fiat money systems have been worse.  Under the classical gold standard changes in the growth rate of the base money stock were relatively small (Rockoff 1982), perhaps surprisingly small to those who haven’t looked at the numbers.  The largest supply shock, the California gold rush, caused a cumulative world price level rise of 26 percent (as measured by the UK RPI) stretched over eighteen years (1849 - 1867), which works out to an inflation rate of only 1.3 percent per annum. As Cowen recognizes, gold discoveries the size of California’s are hardly likely today.

Barry Eichengreen (2011) also worries that volatility in the demand for gold would persist even in an international gold standard:

There could be violent fluctuations in the price of gold were it to again become the principal means of payment and store of value, since the demand for it might change dramatically, whether owing to shifts in the state of confidence or general economic conditions. Alternatively, if the price of gold were fixed by law, as under gold standards past, its purchasing power (that is, the general price level) would fluctuate violently.

We can ignore the odd suggestion in Eichengreen’s first sentence that we can imagine a separation of monetary functions such that gold serves as the commonly  accepted medium of exchange but a unit of something else (what?) serves as the unit of account, giving one ounce of monetary gold a fluctuating price.  In every historically known system where gold or gold-redeemable claims were the principal means of payment, a specified amount of gold also defined the pricing unit.  Let us focus on the claim that under a gold standard, due to dramatic shifts in the demand for gold, “its purchasing power (that is the general price level) would fluctuate violently.”  Surely Eichengreen knows the historical evidence on whether violent fluctuations in the purchasing power of gold – meaning, more violent than those in the purchasing power of fiat money since 1971 – characterized the classical gold standard.  They did not.

There is a good reason why the demand for monetary gold did not change dramatically under the classical gold standard.  As Robert Barro (1982, p. 105) noted thirty years ago, the classical gold standard better constrained inflation, thereby better pinned down inflationary expectations, and thereby better stabilized the demand to hold money relative to income (or stated inversely, it better stabilized velocity), than the fiat money system that followed it.  He explained:

Since the move in 1971 toward flexible exchange rates and the complete divorce of United States monetary management from the objective of a pegged gold price, it is clear that the nominal anchor for the monetary system—weak as it was earlier [under Bretton Woods]—is now entirely absent. Future monetary growth and long-run inflation appear now to depend entirely on the year-to-year “discretion” of the monetary authority, that is, the Federal Reserve. Not surprisingly, inflationary expectations and their reflection in nominal interest rates and hence in short-run inflation rates have all become more volatile.

Volatility of inflation and volatility of inflation expectations did diminish during the “Great Moderation” after the 1980s, but since 2006 they have returned.  In the 14 years between August 1991 and August 2005 the annual US CPI inflation rate (year-over-year, observed monthly) stayed between 1 percent and 4 percent, a band of just three percentage points.  Between July 2008 to July 2009 the year-over-year inflation rate went from a high of 5.5 percent to a low of minus 2.0 percent, a swing of 7.5 percentage points in a single year.  It has since risen as high as 3.9 percent.


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