Currency Wars: Why The United States Cannot Return To A Gold Standard

The book Currency Wars by James G. Rickards (Penguin, 2011) quickly became a bestseller not only in goldbug circles. One of the main theses presented by Rickards is that the United States ought to return to a Gold Standard.

Have you ever wondered whether this would be possible? The answer is No. But why not? The reason we give might strike you as rather unexpected, but it leads you right into the question of what will be the future international monetary system. The answer is that it is the existence of the Euro that prevents the United States from returning to a gold standard.

The Euro zone is set up in such a way that it values gold at its free market price. Since the Euro zone is a major global trade hub, they are in fact in a strong position to block any attempt by the United States at returning to a gold standard. They can rather force the US to value gold at its free market price, too. Any attempt at linking the US dollar to a fixed weight of gold is futile in the long run because this would eventually lead to an under-valuation of gold in US$ and thereby irreversibly drain gold reserves from the United States. In the present article, we explain these ideas in greater detail.

1. Gold Standard

In order to understand the question of returning to a gold standard, we first need to understand how gold can be valued in terms of a currency. Let us therefore summarize the main results of Sections 5 to 9 of our article The Many Values of Gold.

In the following, it does not matter much whether the proposed gold standard is modelled after the Gold Coin Standard that existed in the United States until 1922, after the Gold Exchange Standard that lasted until 1933 or after the system that used to be in place between 1933 and 1971, including the Bretton Woods period, in which only foreigners or only foreign central banks and governments were allowed to redeem US dollars for gold while domestically in the United States, private gold ownership was illegal.

In each of these flavours of what is commonly called a Gold Standard, there existed credit money with deposits, loans, account balances and bank notes. This credit money circulated as currency and was generally accepted as a form of payment, for example, in the form of cash, i.e. tangible bank notes, or in the form of cheques. Today, it would be accepted as payment in the form of electronic account-to-account balance transfers, too.

In addition to the use of such credit money as currency, some institution, either the local banks, the central bank, or a government department, kept a gold reserve in stock and promised to exchange one unit of currency for a certain fixed weight of gold. In other words, all of the circulating currency, including the credit money created by the banking system, was denominated in a weight of gold. Before 1933, gold coins freely circulated along with various forms of credit money. Between 1933 and 1968, although private gold ownership was illegal in the United States, foreigners could still redeem US dollars for gold bullion. Between 1968 and 1971, redemption was possible only for foreign central banks and governments, but not for foreign private entities.

During each of these periods, the banking system was able to create credit, i.e. the total volume of currency units in circulation was variable, but the amount of gold held in reserve, was almost fixed or even declined substantially. As long as one currency unit could still be exchanged for a fixed weight of gold, both credit money and physical gold traded at the same price. Both are very different things though:

• Physical gold is a tangible asset, free of counterparty risk if in your possession, and it forms an excellent long-term store of value. The globally available quantity changes very little.
• Credit money, in contrast, is a contract and does involve counterparty risk. Its volume keeps changing, depending on the credit creation in the banking system, for example, depending on GDP, on the variations in economic activity, and on the prevalent debt level.

Let us assume that at some point in time, the value of the currency unit agrees precisely with the intrinsic value of the corresponding weight of gold. The parameters of the new gold standard that we are designing, are therefore fine-tuned in the optimum way. Rickards proposes to determine this value and then to return to the gold standard at this fixed exchange rate between credit money and gold. He mentions backing one US$ by 1/7000 of an ounce of gold as a good guess for this initial value.

Once this new gold standard has been established, GDP, economic conditions and debt levels change. The banking system creates new credit, some existing credit is paid back, defaulted on or is bailed out. The total volume of currency units in circulation which includes both the circulating gold coins (if there are any) and the circulating credit money, therefore keeps changing. This means that over time, the currency unit might be worth either less or more than the intrinsic value of the weight of gold to which it is linked.

In the former case, it would be profitable to redeem credit money for gold and hoard the gold because as part of the currency, it can be acquired at a discount to its intrinsic value. This can be seen as a variant of Gresham’s Law. In the latter case, it would be profitable to purchase gold bullion in the free market and to deposit it with the central bank in exchange for credit money because its value as currency is higher than its intrinsic value.

Firstly, let us recall which one was the prevalent situation in the history of the gold standard. How often have you seen people purchase gold bullion in the free market, take it to the central bank and deposit it there for newly issued bank notes? Never? At least not in a century? This is no surprise because the banking system typically creates additional credit over time – this is their job after all. When the total volume of credit expands, the real value of the currency unit is devalued, and so the currency unit will eventually be worth less than the intrinsic value of the weight of gold to which it is linked. Periods of shrinking credit volume, in contrast, have been the exception and have typically been brief. So we have to accept the fact that, historically, the currency unit was often cheaper than the corresponding weight of gold would have been, had it not been linked to the currency.

Secondly, one can nevertheless still argue that just the option of redeeming credit money for gold inspires confidence in the credit money, enough confidence in order to avert a run on the physical gold. In other words, one might acknowledge that the banking system creates credit over time while the amount of gold is fixed or changes little, and that the redemption of all credit for gold would eventually be impossible to guarantee. But one may still argue that just by allowing redemption at the margin, i.e. in not too large quantities at any time, one might be able to protect the currency from a loss of confidence.

The question we wish to answer is whether this is possible for the United States as of 2012, i.e. whether they can succeed in backing the US dollar with a fixed weight of gold per unit of credit money, even if this would undervalue gold in terms of the currency unit during some periods in the future. The answer will be a clear ‘No‘ as long as there exists a major competing currency which values gold at its free market price: the Euro (€). The existence of the Euro will eventually force the United States to value gold at its free market price, too, and to let the price of gold in US dollars float freely. The mechanism by which this is enforced is a kind of arbitrage using international trade. But let us first consider the question of whether a new gold standard is necessary in order to inspire confidence in the US dollar and what the United States can possibly gain from this step.

2. Confidence from ‘Gold Backing’

One primary argument for the gold backing proposed by Rickards is confidence. As long as the banks, the Federal Reserve or the United States Government guarantee that one US$ can be redeemed for a fixed weight of gold, say 1/7000 of an ounce as suggested by Rickards, no market participant should need to fear holding US dollars for the long run.

This backing of the US dollar with gold ought to be reflected in the Balance Sheet of the Federal Reserve System. As of 8 February 2012, this balance sheet looks roughly as follows.

Simplified Balance Sheet of the Federal Reserve System (billions of US$):

Assets		Liabilities
Gold Certificates	11	Cash in Circulation	1037
Foreign Exchange Reserves	5	Reserve Balances	1634
Financial Assets	2915	Other Liabilities	205
		Contributed Capital	55

We see that the official gold reserve of the United States is owned by the government which gave the Federal Reserve gold certificates that value gold at US$ 42.22 per ounce. The official gold reserve of the United States of 8130 tonnes whose current market value is about US$ 450bn (as of 17 February 2012, using the London pm fixing of US$ 1723 per ounce) appears on the balance sheet for a paltry US$ 11bn.

Now we assume that the United States Government hands the actual gold to the Federal Reserve in exchange for the gold certificates. Then the Federal Reserve revalues the gold to US$ 7000.00 per ounce which produces a huge revaluation windfall that they keep on their own balance sheet as an additional Capital Reserve. The hypothetical new balance sheet of the Federal Reserve System then reads as follows:

Hypothetical Balance Sheet of the Federal Reserve System (billions of US$):

Assets		Liabilities
Gold Bullion	1830	Cash in Circulation	1037
Foreign Exchange Reserves	5	Reserve Balances	1634
Financial Assets	2915	Other Liabilities	205
		Capital Reserve	1819
		Contributed Capital	55

We see that the gold reserve is now valued at US$ 1830bn. This would be more than sufficient in order to redeem the entire cash in circulation, presently US$ 1037bn, and it would in fact cover about two thirds of the entire monetary base of US$ 2671bn (cash in circulation plus reserve balances). Certainly this balance sheet inspires more confidence in the US dollar than the first one above.

Rickards advertises the return to the gold standard in particular with the claim that the first country that makes this step, would gain a considerable international advantage through the gain in confidence in its currency.

The problem with this statement is that the advantage of the first adopter is no longer available. The first step was made as early as 1999, and it was done by somebody else: by the Euro (€). It was just accomplished in a fashion slightly more sophisticated than just a plain old-fashioned backing of the currency with gold at a fixed exchange rate: The Eurosystem of Central Banks, i.e. the European Central Bank (ECB) together with the National Central Banks of the member countries of the Euro zone, account for their gold reserve at the current market price of gold in €.

As of 10 February 2012, the Consolidated Balance Sheet of the Eurosystem looks roughly as follows:

Simplified Balance Sheet of the Eurosystem (billions of €):

Assets		Liabilities
Gold	423	Cash in Circulation	870
Foreign Exchange Reserves	245	Reserve Balances	812
Financial Assets	1987	Other Liabilities	498
		Capital Reserve	394
		Contributed Capital	82

We see that it is the actual gold and not some gold certificates that appear on the balance sheet. Furthermore, the gold is valued not at some artificial historical value such as US$ 42.22 per ounce, but rather at the current market price. In fact, the gold held by the Eurosystem has always been marked to market since the introduction of the Euro in 1999. On the above balance sheet, the 10826 tonnes held by the Eurosystem are valued at € 1217 per ounce for a total of € 423bn. They are marked to market at the end of each quarter, and these figures correspond to the price of gold as of 30 December 2011. Finally, the increase in the price of gold since 1999 has already produced a healthy Capital Reserve (which can be found in the Revaluation Accounts on the liabilities side, item 11, of the consolidated balance sheet of the Eurosystem).

If we assume the United States revalue their gold to US$ 7000 per ounce as sketched above and that these US$ 7000 indeed agree with the free market price of gold, we arrive at a price of € 5310 per ounce using the exchange rate of US$ 1.3173 for € 1.00 (as of 14 February 2012). The hypothetical new balance sheet of the Eurosystem then reads as follows:

Hypothetical Balance Sheet of the Eurosystem (billions of €):

Assets		Liabilities
Gold	1848	Currency in Circulation	870
Foreign Exchange Reserves	245	Reserve Balances	812
Financial Assets	1987	Other Liabilities	498
		Capital Reserve	1819
		Contributed Capital	82

The gold reserve of the Eurosystem would now be worth € 1848bn, more than covering the € 870bn of cash in circulation and even the monetary base of € 1682bn.

From these balance sheets, we can see that there is no advantage of early adoption that could be captured by the United States. The Euro zone has already anticipated this step, and the Euro enjoys an even more robust gold backing. In fact, all else being equal, the comparative advantage of the € over the US$ increases with an increasing price of gold.

Let us finally clarify who would back what in this scenario:

• In the United States, according to Rickards’ proposal, the government or the Federal Reserve guarantees that one US$ can always be redeemed for 1/7000 of an ounce of gold. The key to this guarantee is that the government pays out the gold even if there is no private participant in the market who is willing to sell her or his gold for this price. Even if the free market values gold higher than US$ 7000 per ounce at some point in the future, the United States Government is still required to redeem one US$ for 1/7000 ounces of gold (this is the point of having a gold standard after all). How clever is that?
• In the Euro zone, in contrast, the Eurosystem values gold at its market price. When someone is uncomfortable holding Euros for the long run, she or he can therefore simply purchase gold in the private market. From the point of view of the individual saver or investor, this achieves precisely the same result, namely exchanging Euros for gold at the stated price, but it does so without running down the official gold reserve. How smart is this?

Once more in different words:

• If there is trouble with the confidence in the US dollar, the official gold price of US$ 7000 per ounce remains unchanged, but the United States start losing their gold reserve.
• If there is trouble with the confidence in the Euro, the price of gold in Euros rises while the gold reserve of the Eurosystem is unchanged.

Let us contrast the two philosophies as follows:

• In Rickards’ proposal, the United States claim that one US$ is as good as 1/7000 ounces of gold. Even if others in the market do not agree and value gold higher than that, the United States Government must still continue to allow redemptions at the fixed exchange rate of 1/7000 ounces per US$, drawing down the gold reserve in the process if necessary.
• The ECB simply lets the market discover how good the Euro is in terms of gold. Since the ECB has no intention of interfering with this market judgement, any gold that is purchased, can be purchased from the private market equally well, leaving the gold reserve of the Eurosystem intact in the long run.

And finally, yet another aspect:

• In Rickards proposal, the US dollar claims to be as good as gold and is advertised as a long term store of value. The United States Government or the Federal Reserve commit to draw down their gold reserve in order to deliver on this promise.
• Since the ECB has never claimed that the Euro were as good as gold, they need not redeem any Euros for gold. If somebody purchases gold with their Euros, these Euros continue to circulate. The Euro is explicitly advertised as a transactional currency, but not as a store of value. Gold is the store of value. This is Free Gold, the separation of the store of value from the medium of exchange, i.e. from the credit money that forms the transactional currency (also see Section 7 of The Many Values of Gold and FOFOA’s The Long Road to Freegold).

We could also ponder the political implications of these opposing choices: long-term sustainability; big government versus small government; regulated market versus free market; and so on. But in the present article, let us focus on the viability of Rickards’ proposal in the near term.

The only requirement for the ECB policy to work is the existence of a liquid private market for gold in Euros. As of February 2012, such a market does not exist. Gold is rather traded in US$ in the London market where it is linked to bank credit denominated in ounces (unallocated accounts), and its US$ price is almost certainly substantially below the intrinsic value of physical gold (also see Section 8 of The Many Values of Gold; FOFOA’s The View: A Classic Bank Run; and our joint Via Email). So the present mark-to-market valuation of the gold reserve of the Eurosystem can be viewed as a temporary placeholder: for now, they insert the current London price of gold in US$, converted to € using the current exchange rate; but once a liquid market for physical gold in € becomes available, this is the value that belongs on their balance sheet. We will come back to this point in Section 4 blow when we discuss possible Gold Open Market Operations by the ECB.

Let us finally remark that the price of US$ 7000 per ounce as proposed by Rickards merely serves as an example and that none of our arguments depends on this precise figure.

The material presented in this section was inspired by Rickards’ book and by contrasting it with FOFOA’s point of view. See, for example, Euro Gold, Party Like It’s MTM Time, Reference Point Gold Update 1 and Reference Point Revolution. Finally, we have seen that the Federal Reserve does not hold any gold, but that the U.S. gold reserve rather belongs to the Treasury Department. Please refer to this remark in Central Bank Gold Leasing for the political implications.

3. Currency War and Trade War

Let us now think about what happens if the United States take their new Gold Standard seriously and actually keep the official gold price fixed come hell or high water. Since returning to the gold standard includes the commitment to settle international trade balances in gold, the key question is whether a fixed official gold price (for example the US$ 7000 per ounce as suggested by Rickards) is compatible with international markets in which trade balances are settled in physical gold.

The problem is that as soon as the free market price of gold diverges from the official US price of gold, the new gold standard as proposed by Rickards becomes unsustainable in the long run. If the system does not break because of internal tensions (perhaps he would again make gold ownership illegal in the United States), it will certainly break because of external trade imbalances.

In order to illustrate this effect, let us assume that the official US gold price and the free market price in Euros diverge considerably. We estimate that the US$ and the € presently have purchasing power parity at an exchange rate of US$ 1.20 per € 1.00. As a very rough simplification, let us say that one hour of labour costs € 30.00 in the Euro zone and, at parity, it costs the same amount in the United States: US$ 36.00. Also at parity, the official US gold price of US$ 7000 per ounce corresponds to € 5833 per ounce. Let us further assume the free market price of gold in the Euro zone differs substantially: € 8750 per ounce.

Firstly, there is the obvious arbitrage: The smart money in the Euro zone can simply take € 5833, exchange them for US$ 7000 in the foreign exchange market, go straight to the Federal Reserve and redeem this sum for one ounce of gold which is immediately shipped back to Europe. There is therefore a continuous flow of gold from the United States to Europe unless the currency exchange rate adjusts to $US 0.80 per € 1.00. This is the exchange rate at which the official US price of gold of US$ 7000 per ounce agrees with the European free market price of € 8750 per ounce.

Although this adjustment of the exchange rate indeed eliminates the arbitrage opportunity, it does not stop the outflow of gold from the United States to Europe. The problem is that the currency exchange rate now deviates from the purchasing power parity of US$ 1.20 per € 1.00. At the no-gold-arbitrage exchange rate of US$ 0.80 per € 1.00, one hour of European labour can be offered in the United States for US$ 24.00 whereas American labour still costs US$ 36.00 per hour. The United States therefore run an increasing trade deficit compared with the Euro zone. Under the proposed gold standard, the Europeans who initially receive US$ for their exports, can immediately cash in and redeem their US$ for gold.

The flow of gold from the United States to Europe therefore persists regardless of the currency exchange rate. If it is not a consequence of direct price arbitrage, then it follows from an imbalance of the trade accounts. In either case, physical gold reserves are drained from the United States, and the United States would have to make a choice between accepting the increased instability of their banking system or starting to liquidate credit in order to adapt to the shrinking reserve base.

If you remember the 1960s, then all this might sound familiar. This is no surprise. During that time, the official US gold price at which the United States redeemed US dollars for gold internationally, was lower than the free market price of gold abroad (private gold ownership inside the United States was illegal). Since at that time, basically all currency exchange rates with respect to the US dollar were fixed, what happened was a combination of the two effects described above: (1) gold price arbitrage between the official and the free market price; and (2) US dollar redemptions for gold by foreign governments and central banks who cashed in their trade surpluses with the United States.

The United States and their Western European allies had tried to suppress the arbitrage with the London Gold Pool starting on 1 November 1961. This operation was, however, not sustainable in the long run. On 14 March 1968, the London Gold Pool collapsed, and the London gold market remained closed for two weeks at the request of the United States. On 18 March 1968, Congress officially revoked the gold backing of the US dollar. From this date on, the US dollar was redeemable for gold only by foreign governments and central banks, but not by foreign private entities. Finally, on 15 August 1971, US dollar gold convertibility was suspended even for foreign governments and central banks.

We see that the arrangement that is now proposed by Rickards, basically used to exist during the Bretton Woods period. In the late 1950s, the credit volume in US dollars was already growing so quickly that the official US gold price and the free market price of gold outside the United States started to diverge. Although the Western European allies helped to stabilize the gold standard, it inevitably failed because of the arbitrage and the trade imbalances sketched above. If a gold standard of this type is established again while a major trade block openly advertises a free market price of gold, it would probably collapse even sooner than it did in the 1960s.

In 1971, the United States chose to terminate the gold convertibility of the US dollar rather than to revalue gold in US dollars. We refer to FOFOA’s It’s the Flow, Stupid for the reasoning that lead to this decision. Finally, please see his Once Upon A Time for more details on the London Gold Pool.

4. Gold Open Market Operations

In the new gold standard proposed by Rickards, the gold operations by the local banks, the Federal Reserve or by the United States Government are essentially automatic. As soon as someone presents them with a US$, be it a coin, a tangible bank note or some electronic account-to-account transfer, they are required to redeem it for a fixed weight of gold, for example, 1/7000 of an ounce. Conversely, if someone presents them with one ounce of gold bullion, she or he would be entitled to a credit of US$ 7000 – perhaps up to some transaction fee.

The ECB, however, which does not guarantee a redemption of the Euro for a fixed weight of gold, can engage in various types of Gold Open Market Operations.

Firstly, in absence of a liquid market for physical gold in Euros, the ECB can act as a market maker and, say, bid for a fixed weight of gold at € 8745 per ounce and offer to sell a fixed weight at € 8755. If they bid for and offer more than 10 tonnes each at any time, they are able to make a liquid market for physical gold in Euros, a market in which other central banks can trade the quantities that typically arise in the settlement of international trade balances. As soon as it turns out that there is more weight of gold sold than it is bought (or vice versa), the ECB adjusts the bid and offer prices accordingly. This amounts to assisting the price discovery for large quantities of physical gold while the reserve of the Eurosystem remains essentially unchanged.

Let us stress that as of February 2012, there exists no liquid private market for physical gold in € in which bid and offer would be quoted for tranches of 10 tonnes or more at any time. In fact, this is apparently not even possible in the London market in which gold is traded in US$:

James G. Rickards, Currency Wars, page 26:
In ordinary gold trading, a large bloc trade of as little as ten tons would have to be arranged in utmost secrecy in order not to send the market price through the roof […]

Secondly, the ECB can manage a dirty float of the gold price in order to smooth fluctuations in the currency exchange rates, in order to influence the domestic price level, or even in order to affect the competitiveness of goods and services from the Euro zone in the international market. If they expand the monetary base and purchase gold in the private market, they lower the exchange rate of the Euro relative to gold, creating domestic consumer price inflation and rendering exports more competitive and imports more expensive. Conversely, if they sell a part of their gold reserve and cancel the base money they receive, they raise the exchange rate of the Euro relative to gold, reducing consumer price inflation and rendering exports less competitive and imports cheaper.

In particular, if things ever turned hostile, for example because not only a book author but also some government officials started talking about ‘confiscating’ the gold owned by foreign countries, the dirty float could be used in order to terminate Rickards’ experiment with the new gold standard in the United States at any time, simply by expanding the monetary base in € and purchasing physical gold in the open market. This operation is always possible because it relies only on the ability to expand the € money supply, but does not require any existing official gold reserve. In fact, any major currency area or trade block who exports enough goods and services for which there exists a global demand, can make this move. So far, none of them has.

FOA also commented on the possibility of the U.S. returning to a fix exchange rate gold standard, just as Rickards suggests in his book. Please see the four comments by FOA starting with this one in our article Central Bank Gold Leasing.

5. How is this different from what we have today?

In the previous sections, we have illustrated that returning to a gold standard does not achieve anything that cannot already be obtained by the policies that the Euro zone has already adopted. On the other hand, most people agree that the global financial system is seriously under-capitalized and that many governments of the Western World are over-indebted and therefore in serious difficulties. So which step is missing that actually does solve some of the problems?

This step is the other part of Rickards’ proposal, namely to revalue gold upwards by a substantial factor. This would do little damage to the real economy (as opposed to, for example, increasing the price of oil by such a factor), but it would work magic in terms of recapitalising the financial system and restoring the confidence in the major currencies. It should be clear from Sections 2 and 3 above that it is the high price of gold in terms of US$ or € that inspires confidence in these currencies rather than the question of whether the currency unit is redeemable for a fixed weight of gold. (There is one caveat though: as long as the US gold reserve is owned by the highly indebted government rather than by the Federal Reserve, it will never inspire the full possible confidence.) The appropriate question to ask is therefore not why is the US$ not backed by gold, but rather why is the current price of gold in US$ so low?

We do have a free private market for gold in US$, the London market, don’t we? So why does this private market not value gold substantially higher if this is a key part of the solution? Why would it need Rickards in a US government position in order to do so?

The answer to this question has a technical and a political component. The technical answer, we think, is the observation that in the London market, the price of physical gold (allocated gold) and the price of bank credit in ounces (unallocated gold) agree as long as allocation is still possible at the margin. Only a run on the physical gold in the banks would allow the revaluation of gold to Rickards’ price target or beyond. For more details, we refer to Sections 5 to 8 of The Many Values of Gold; to our How Credit Suppresses The Gold Price; to FOFOA’s The View: A Classic Bank Run; and to our joint Via Email.

Apart from the fact that the London gold market commingles physical gold and bank credit denominated in ounces, there are further indications that the London gold market is not the liquid market for physical gold that would be required. Let us repeat:

James G. Rickards, Currency Wars, page 26:
In ordinary gold trading, a large bloc trade of as little as ten tons would have to be arranged in utmost secrecy in order not to send the market price through the roof […]

Although some central banks have recently been buyers of gold (we do not even know whether they bought it through the private London market, by the way), this is a clear indication that the market is too small in order to settle international trade balances in physical gold. That would require multiple transactions of the order of 10 tonnes of physical gold every week at today’s price or smaller amounts at a substantially higher price.

The political component of the answer is that the United States, at least from the early 1980s until 1999, have generally preferred a strong US dollar relative to gold. Some quotations in Section 6 below come back to this question.

Let us summarize what is the key point of Rickards’ proposal to return to a gold standard at a substantially higher price of gold in US dollars. It is not the idea of the gold standard that the currency unit would be backed by a fixed weight of gold. This would not be sustainable in the long run, and it would eventually fail for the same reasons for which the London Gold Pool failed. It is rather the revaluation of gold in US dollar terms that inspires confidence and that addresses many of the present issues such as recapitalizing the banking system.

We finally refer to FOFOA’s How is that Different From Freegold for another response to a very similar question.

6. Another and Friend Of Another (FOA) on the US dollar, oil, gold and the Euro

Now that we have understood the question of whether a return to a gold backed US dollar is possible and that we have seen the special position occupied by the Euro, we are ready for a first glimpse of the actual historical developments: why the United States went off the gold backing in the first place and why the Europeans have countered the American control of the gold price with the introduction of their own currency.

The following are excerpts of the postings by Another and FOA in the discussion forums of Kitco and Centennial Precious Metals between 1997 and 2001.

Firstly, in 1971, the United States terminated the gold convertibility of the US dollar (rather than devaluing it with respect to gold) in order to raise the US dollar price of oil and thereby to reduce their dependence on oil from the Middle East. For more details, we refer to FOFOA’s It’s the Flow, Stupid.

7/19/98 ANOTHER (THOUGHTS!)

[…]
The Middle East nations, in particular, have shown their reserves to be much greater than ever thought possible. These “new/ larger” reserves have come to be known about, only in the last eight years. It was the “possible existence” of this oil that created much fear in the American Capitol, prior to the 1970s. In that time, it was known that the Western economy was growing on low priced energy. This growth would soon consume all “local / domestic” reserves that, in turn, would bring much dependence on low cost Middle East oil. The reserves in this region were, and now even more so, are the lowest cost to produce in the world. As all oil was sold in dollars, and US$s were then, still somewhat attached to gold, the ME producers had “no need” to raise prices! The political forces in the West needed much higher oil prices to “stimulate exploration” to avoid the “strategic problem” of “all oil supply from one region”. Make no mistake, there is enough oil reserves in the ME to supply “all world” for “many grandchildren”! It was in this time that the events created by the “politics of dollar currency”, allowed the decision to remove the gold backing from the US$. This move, broke the “gold bond to oil”, and created a need for more dollars per barrel of ME oil. The oil producers, as expected, did create “Beirut Resolution titled XXI. 122”! [VtC: It was Beirut XXV.140 which followed Caracas XXI.122]

Partial reprint from report by others:

Shortly after the gold window was closed in August 1971, OPEC called an emergency meeting with U.S. and other nations’ finance ministers in Beirut. The result of the meeting was the Beirut Resolution titled XXI. 122. It called for adjustments to OPEC’s crude oil pricing whenever the dollar had been devalued. The resolution called for OPEC’s price adjustments to be triggered whether or not dollar devaluation was caused by government action or by market forces. If the dollar lost purchasing power, OPEC could raise its prices.

[…] this was the beginning of a move by dollar advocates to raise this commodity price by inflating the “world reserve currency”. As an “also”, the ME was shown to be and caused to be “unstable” for dependence for oil production.
[…]

Date: Sat Apr 04 1998 19:55
ANOTHER (THOUGHTS!) ID#60253:

[…]
But, in the same time frame, all central banks did sell gold to all persons, even the US. All treasuries held gold and dollars as reserves. To what end did the world financial system gain with the dollar off gold backing, and then allowed to “dirty float” against all currencies? Would the world not have been better off to find gold revalued to, say $300 and then begin a “dirty float”? Noone would have lost, and the inflation would have , at best, not have been worse!

Truly, I tell the reason for this action. The US oil companies knew that the cheap reserves were found. The governments knew this also. The only low cost oil reserves in the world at this time were in the Middle East, and their cost to find and produce was very low. It was known, that, in time, ALL oil would come from this land. As much higher US dollar prices were needed to allow exploration and production of other reserves, worldwide. But, how to get crude prices, up, when the Gulf States were OK to pump and produce in exchange for “gold backed dollars”? I will not name the gentlemen that brought this thinking to the surface in that era, but it was discussed. It was known that oil liked gold. It was known that “local oil” would be used up without higher prices. What if, the US dollar was taken off the gold standard, and gold was managed “upward” to say, $208 per ounce? The dynamics of the market would force oil to rise and allow for much needed capital to search for the higher priced oil that was known to exist! The producers would find shelter in gold even as the price of oil was increased in terms of a now “non gold dollar”! Price inflation would rise, but gold and oil would also increase. The dollar would continue to be used as the only payment for oil, and in doing so replace gold as the backing for this “reserve currency”. All would be fair.

The war in 1973 and the Iran problem did make markets “overshoot”, but all did work to the correct end. The result was “a needed higher price for a commodity that was, as reserves, in much over supply by the wrong countries”! It was known that the public would never have accepted this “proposition” as fair. To this end, we have come.

And it is from this end, that the gold markets are managed for today!
[…]

Then, in the early 1980s, the US dollar faced huge problems from price inflation and the high oil price. The London gold market was developed and expanded in order to manage the gold price in US$ down and thereby induce the oil producers to lower their price in US$.

Date: Sun Oct 05 1997 21:29
ANOTHER ( THOUGHTS! ) ID#60253:

[…]
It was once said that “gold and oil can never flow in the same direction”.
[…]
It is the movement of gold in the hidden background that has kept oil at these low prices. Not military might, not a strong US dollar, not political pressure, no it was real gold. In very large amounts. Oil is the only commodity in the world that was large enough for gold to hide in.
[…]
the question was asked, “how could LBMA do so many gold deals and not impact the price”. That’s because oil is being partially used to pay for gold!
[…]
People wondered how the physical gold market could be “cornered” when it’s currency price wasn’t rising and no shortages were showing up? The CBs were becoming the primary suppliers by replacing openly held gold with CB certificates. This action has helped keep gold flowing during a time that trading would have locked up.
[…]
The Western governments needed to keep the price of gold down so it could flow where they needed it to flow. The key to free up gold was simple. The Western public will not hold an asset that going nowhere, at least in currency terms. ( if one can only see value in paper currency terms then one cannot see value at all ) The problem for the CBs was that the third world has kept the gold market “bought up” by working thru South Africa! To avoid a spiking oil price the CBs first freed up the publics gold thru the issuance of various types of “paper future gold”. As that selling dried up they did the only thing they could, become primary suppliers! And here we are today. In the early 1990s oil went to $30++ for reasons we all know. What isn’t known is that it’s price didn’t drop that much. You see the trading medium changed. Oil went from $30++ to $19 + X amount of gold! Today it costs $19 + XXX amount of gold! Yes, gold has gone up and oil has stayed the same in most eyes.
[…]

6/4/98 ANOTHER (THOUGHTS!)

[…]
Because the Central Bank loans and sales offered “credibility” to any outstanding “short gold paper”, a large derivatives market was built around this “gold trading arena”. The CBs, along with the Bank For International Settlements (BIS), wanted gold to fall into the low to mid $300 range as this made the dollar (US$) strong in gold. It also made much of the “old” gold paper “good for delivery” as the Bullion Banks could supply the physical by purchasing on the “outside market” at lower prices! Had many of the early paper buyers (year or so ago) called for delivery, there be no supply as the physical market was spoken for. A falling dollar gold price made good on past paper deals as existing private supply was made free. In this light, I think few do truly understand how much trading in done in the world “gold trading arena” by LBMA! To understand this, is to know, “the CBs could never supply it! To think that gold is not wanted or not traded or “is a dead asset”, it does become the foolish thought, yes?
[…]

Date: Sat Jan 17 1998 20:45
ANOTHER (THOUGHTS!) ID#60253:

[…]
Enter the world of “paper gold”.

Yes, gold just like currencies has been “digitized”. If you brought gasoline, made from oil sold under $20/bl, you are part of this system! For just as the “digital currencies” are created for trading only, paper gold was created for the trade of oil. In a very broad sense, it was created as an “extra” or “kicker” to allow the purchase of small amounts of cheap gold in return for a full supply of oil. In reality, this gold paper represents the future production of gold ( from the ground ) to balance the reserves of oil ( also in the ground ) . The huge amount of “paper gold” traded and outstanding today is now in excess of all the gold in existence above ground! In essence, it is of the same value as the currencies, “the thoughts of nations, blowing in the wind”. The Central Banks gave value to this paper by selling and lending some of their gold stocks. But, as economies became hooked on cheap oil, and demanded more of the same, these same CBs had no choice but to use fractional reserve gold lending” to pump the gold market.
[…]

5/26/98 ANOTHER (THOUGHTS!)

[…]
I say, a travel to London will offer much education, as the “city” trades more gold than exists!
[…]

On the question of backing the Euro with gold or using a flexible gold reserve that is marked to market:

6/14/98 ANOTHER (THOUGHTS!)

[…]
Your question of Euro gold backing? The Euro will not be backed or fixed in gold. It will, as Michael Kosares (USAGOLD) notes, be the first “modern currency” to hold true “exchange reserves” in gold. It is important to understand that “exchange reserves” of gold are much more powerful a tool for currency defense than gold backing! In this system, gold must be traded in a “public physical market”, in that currency, Euros! As such, the Euro can “devalue gold” (Euro price of gold falls) thereby making it strong in gold! In today’s world, this will happen as a “strong Euro physical market” displaces and defaults ” the old dollar settlement paper gold market”! The dollar will become”weak in gold”!
[…]

8/10/98 Friend of ANOTHER

[…]
This group, made up of much of Europe and the Middle East, is not looking for a return to the old Gold Standard, but perhaps something far better. They do not see any advantage in holding the currency bonds of one country, as a reserve asset of future payment, over holding physical gold as a reserve asset in full payment. The fact that the debt reserve asset pays interest is little more than a joke in these banking circles. Any paper currency, the dollar included, can fall in exchange value against your local currency far more than the interest received! In today’s paper markets, the only true value in exchange reserves, held by a government as currency backing, is found in it’s effectiveness for defending the local currency from falling against other currencies. In other words, use the reserves to buy your countries money. But, this is a self defeating action as sooner or later the reserves are used up! This fact is not lost on many, many countries around the world, as they watch their currencies plunge, lacking reserves as defense. Ask them how important the factor of earning interest on reserves is under these conditions.

On the other hand, buying gold on the open market, using your local currency, works as a far different dynamic from selling foreign bond\reserves. This action takes physical gold off the market, and in doing so increases it’s value in dollar terms. Gold is and always has been the chief competitor with the dollar for exchange reserve status. The advantage here comes from the fact that governments do not run out of local currencies to use in buying gold, as opposed to selling foreign currency reserves to buy the local currency on the open market. Of course, the local price of gold goes sky high, however, in this action you are seen as taking in reserves, not selling them off.
[…]
Basically, this is the direction the Euro group is taking us. This concept was born with little regard for the economic health of Europe. In the future, any countries money or economy can totally fail and the world currency operation will continue. What is being built is a new currency system, built on a world market price for gold.
[…]
The Euro will not replace gold, it will evolve into a gold transactional currency. It will also price Euro gold very high, perhaps $6,000 in current dollar terms buying power.
[…]

On the question of whether the United States can return to a gold backed US dollar:

5/3/98 ANOTHER (THOUGHTS!)

[…]
Mr. Kosares, Your friend thinks much of this gold owned by the USA. It could be used to back the dollar up to 25%, no? Many come to this thinking and hold a secure thought, that as last resort, this gold will save the day! I think, many persons never gained the understanding that the American gold is kept by the “Treasury”, not the maker of your money, “The Federal Reserve”. It is there for good reason, as the present world currency system is not a function of American law! If the US were to place gold in the hands of the US/CB as reserves for the dollar, the BIS could claim it! It is, as a point of contention and of no real use. I think not a war would come of this claim, if it should happen! As the world currencies are now, a “new dollar” would be needed if gold were used as reserves! The present dollar would then, truly be as “paper for the wall”!

The urgent drive to create a new “reserve currency” began in the early 80s, after the last small “gold war”. The road to making this new Euro did never include gold in large amounts, until the last few years! Even one year ago, the news would say, 5% or less. Today, we speak of a much greater amount! This is interesting, yes? The BIS did “hatch” this deal in a very late fashion! The future of the Euro was found to be “weak”, as the Middle East oil imports onto the continent would continue in dollars! This was so from the dollar being made strong in gold. Gold priced in dollars at near production cost, offered a “no switch currency” position, for oil. This position has been unstable for the last year, and the alternative of a switch to gold was in progress! You have read my “Thoughts” before. Now the BIS does offer to “change the rules of engagement”, a real reserve currency is offered!

Few do grasp what is happening and why! They think the holding of gold reserves by the Euro is of a little point, as to what good are gold reserves? One cannot use gold as Marks or Yen to intervene in currency market to support the Euro. My friend, the BIS has played the, as you say, “big poker hand”! The holding of large reserves by the ECB and the withholding of sales from the market will not only bring the end of the London paper gold market, it will, thru a high USD gold price, “make the dollar weak in gold”!
[…]

On the question of who else can force gold back into the international monetary system:

Date: Sat Jan 17 1998 20:45
ANOTHER (THOUGHTS!) ID#60253:

[…]
There is one oil state that no one will play for a fool. The CBs will sell all of their gold or the nations will nationalize all mines and operate them at a loss. One way or another, most of the paper gold market will be honored. Why? Because oil will bid for gold if they do not! We are not talking about an oil embargo or rising oil prices. Indeed, oil will become very cheap for those that can supply physical gold. This deal will not require the agreement of all oil states. Only one can start this, the others will gladly follow.

A large oil producer, with plenty of reserves and unused capacity, can say: We now value gold at $10, $20 or $30,000/oz.. That is the rate we will use to sell oil. We will go to “full” production and offer at $10.00us/bl.. Pay us in physical gold and USD ( or EUROs ) as a 50% mix to the above rate to equal $10/bl..

It would be a deal like none other! Oil, worldwide, would drop to $10.00/bl and every economy would do very well, IF they had gold. All gold would immediately be arbitraged to the above prices thereby creating a “world oil currency” large enough to handle oil. This creating of a new “specialized currency” will be the result of the first “commodity corner” that ever succeeded!

On the introduction of the Euro and its role in breaking the price lock on gold in US$.

7/19/98 ANOTHER (THOUGHTS!)

[…]
[VtC: The following refers to the termination of the gold convertibility of the US dollar in 1971 in order to raise the US dollar price of oil] Not all nations agreed with this move. The French and Germans did not, and by 1980, Europe was working with the BIS to implement a new “reserve currency”. They did long for a “money” that would resolve “Beirut XXI” and allow for the purchase of low cost reserves, not the high US$ cost “world oil supply”, of perceived strategic importance to America alone.

The “new Euro” did take much longer to create, and the Gulf War did create a crisis of payment for oil. In this time, early 1990s, the currency of gold was brought “into use” as a “temporary” partial payment until the Euro could be presented. A paper gold market, of sufficient size, was created, that as such, it could hide discount payments to a few producers for oil. Today, if these claims on paper were converted into bids for physical, it would take all of the “tradable gold” in existence! It was this “leverage” that forced the Euro makers into gold. Gold backing for the Euro would not be enough! Only “exchange reserves of gold” would allow oil priced in Euros. We move to this end today. Tomorrow will see ME oil in good supply for a new trading block of nations.
[…]

6/4/98 ANOTHER (THOUGHTS!)

[…]
Today, a new currency is formed. It offers a way to break the dollar valuation of gold without the total destruction of worldwide currency markets and economies. In time, oil producers can offer their low cost reserves at true valuations, that support industry and commerce in exchange for a revaluing of real money, gold, in a real currency, Euros!

And finally on the revaluation of gold and its effects.

Date: Sat Apr 25 1998 22:55
ANOTHER (THOUGHTS!) ID#60253:

When the US government does not take in enough taxes to meet expenses, it sells treasury debt to make up the difference. When no one bids for this debt at an “acceptable” interest rate, the Federal Reserve bank buys the debt, outright! It gives printed cash to Washington and then, “holds the new treasury debt ( bond ) as backing for the issued cash!

Everyone understands the implications of this. Or do they? In reality, when the US government needs money, it doesn’t sell debt! It “TRANSFERS” the obligation of it’s citizens to pay future real production ( taxes ) as a “backing” for it’s newly printed currency! As this process has been going on for decades, it has built up a debt of “real production payments” that it’s citizens can never pay. Further, as the world reserve, this currency is held thru proxy “by every single person on this planet” that uses paper to trade anything!

It is true, that in times past when a currency is inflated ( over printed ) to a point of only 10% real gold backing, the government could revalue gold 90% [VtC: 900%] upward and the currency was 100% backed again! A terrible blow to the holders of this paper, but at least the money system survived! Today, the worlds currency, the US$, by default, would require a gold price of many, many thousands to back it without using it’s citizens as collateral! The only problem with this is the US gold stock is so small, that even at $10,000/oz, a large deflation would be necessary to decrease the outstanding US currency to this gold backing level!

Now, consider the Euro. It will have much real gold backing from the beginning. Even at 10% to 30%, the Euro will be the equivalent of a 100% gold backed dollar, when the world comes off the dollar standard! The selling of old dollar reserves, alone will reprice gold in US$ terms of at least $6,000/oz! It’s present interbank reserve value.
[…]

Date: Sat Apr 04 1998 20:42
ANOTHER (THOUGHTS!) ID#60253:

[…]
When the battle to keep gold from devaluing oil ( in direct gold for oil terms ) is lost, the dollar will find “no problem” with $30,000 gold, as it will be seen as a “benefit for all” and “why did noone see this sooner”?
[…]

Update (24 February 2012)

FOFOA reported that his reader Aquilus had asked Rickards whether he really wanted to peg the USD to gold or whether it would not be better to let it float. Aquilus reported to FOFOA:

Aquilus: The more interesting part is that I had been trying to get him to give me a straight answer on the notion (from his book) that once gold is revalued to “the right price” the Fed would then step in and defend that price (in a narrow range). He had been avoiding a straight answer for months, but I finally got one yesterday while he was signing the book – in a short one on one conversation.

When I asked him how he could seriously believe that a fixed price could be defended when dollars continue to be issued and credit created, and how that would be different from the old London Gold Pool, he smiled and said, “no, no, you see, the defended price would indeed have to change every year or else it would not work.”

So, basically, he’s still somewhere in the “we can semi-control” the price with this Fed-defense of an adjustable price, as far as I can tell.

Blondie commented on FOFOAs blog:

Back in September I had an email exchange with Jim Rickards about his “peg to gold” proposition, which I reproduce here in full as it seems pertinent to the above post:

Blondie (to Jim): I have listened with interest to your interviews on KWN, and have a query with regards to your comments from your most recent broadcast

[KWN transcript start]
Jim Rickards: This is what the currency wars are all about – not everybody can devalue against everybody else, you have these sequential or partial devaluations of one currency against the other, but somebody has to be the strong guy, somebody has to be the currency that’s going up so all the others can go down, and this kind of brings us back to gold, Eric, because gold is the one thing in the world that everybody can depreciate against.

Eric King: Then given everything you’ve said Jim, what are the implications for gold?

Jim Rickards: Well the implications for gold is, gold has the unique role, because since its not a liability, (I think its the ultimate form of money because its not issued by any government) when I say that all the currencies cannot depreciate against all the other currencies, that’s true, but they can all depreciate against gold.

You know as gold is the one thing that allows every currency in the world, every paper currency, to depreciate against it, and that’s how kinda everybody wins the currency war at once, and of course the big winner is gold.

But in order to do that, you need some kind of gold standard, you need an international monetary conference, you need an agreed peg to gold, and then we can reset all the currency values against each other in ways that reflect the relative terms of trade and existing surpluses and deficits in the global trading system, and yet not have the currency wars because basically gold would have won the currency wars because it’s the one thing that everybody can depreciate against at once. It’s exactly what happened in the 1930s, it’s exactly what happened in the 1970s, and my view is it will happen again – in fact it’s in the process of happening – but nobody really wants to talk about it.

[KWN transcript end]

You make perfect sense (I have been of the same opinion for a couple of years now too), but can you please explain the reasoning behind your statement that “…you need an agreed peg to gold…”? It seems to me that the process you are describing of essentially the need to devalue fiat and repeg gold much higher is just like the raising of the debt ceiling: kicking the can but not solving the problem.

Why the need for a peg?

Why not let the market decide the relative exchange rates of currencies and gold? Pressure is thus equalized by the system constantly, eliminating the problems which arise due to the undervaluation of gold which are culminating periodically (every 40 years) in systemic crisis?

The market is the arbiter with regard to currency values, relative terms of trade and existing surpluses and deficits in the global trading system, and if gold were not intentionally undervalued this function would be performed, naturally and automatically.

You have a rare talent (and platform) for explaining the situation and your reasoning as to how it will be resolved, but on this issue of the peg to gold you supply no reasoning… are we just to accept that central planners know best?

Jim Rickards: It’s easy to do a peg using market forces. The key is open market operations. If you (as a central bank) are a willing seller and buyer at the peg price, the market will quickly tell you if your price is too high (by selling) or too low (by buying) gold from you. You then adjust your monetary policy accordingly to equilibrate at the peg price. So, in this case, the peg is not anti-market, in fact it relies upon the market as a price signal to dictate monetary policy (versus arbitrary rule).

Blondie: So if, for example, the market tells you (as a central bank) that your peg is too low (by buying your gold stock), you would engage in a deflationary monetary policy to increase the value of your currency, until such time as the buying ceased?

Or vice versa if your peg was too high.

Jim Rickards: Right. The point is, market forces are always in use to send signals about monetary policy.

Blondie: Could you (as a central bank) not more easily engage in open market operations in which you let the price of your gold stock float, altering your bid or offer accordingly until the equilibrium level was found? No discussing monetary policy, implementing it, waiting for the market’s judgement as to whether or not you have gone far enough, too far etc.

Such a float provides an instant, dynamic establishment of the equilibrium price in accord with market forces, whereas the peg seems a slow and cumbersome method of arriving at the same destination, so slow in fact that I question what is to stop the run on underpriced gold form exhausting all stocks before appropriate monetary policy has been enacted? The market would need more than jawboning to be convinced that the Fed for example was seriously going to embark on deflationary policy to defend their peg. Deflationary monetary policy would have massive repercussions in the debt markets. The market has also seen before (twice) that the US is not above defaulting instead upon its gold obligations.

The peg does however create the impression that the CB’s currency is valuing gold, whereas the float clearly demonstrates gold valuing the currency.

Is there some other unmentioned advantage to a peg as opposed to a float that I am not aware of?

Jim Rickards: It’s difficult for companies to plan capital investment if they have no idea what the value of money will be in the future. A fixed rate helps there planning.

I left the discussion there, as there seemed no point in continuing further. Jim clearly had no counter-argument of merit with which to defend his “peg to gold” proposition, and no intention of conceding; I can only assume he has his own reasons for promoting it, as he is clearly capable of grasping the vast superiority of Freegold to his completely unworkable peg (as demonstrated by Victor’s example above).

I did think he had shown his colors more clearly in the same interview on KWN when he stated that any monetary remedy involving gold was for him a PlanB, and that PlanA was, as far as he was concerned, the continuing reign of King Dollar.

Also see the subsequent discussion on FOFOAs block starting with this comment.

Comments

If you have comments, suggestions or corrections concerning this article, please comment here (comments are moderated, and it may take a while until I have time to check for new comments). For the general discussion on the role of gold in the monetary system, please go to the comments section at FOFOA’s and so we do not fragment the discussion.

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