Today, we present a guest post written by Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy School of Government, and formerly a member of the White House Council of Economic Advisers. A shorter version appeared in Project Syndicate.
The price of gold reached an all-time record high of $2,000 per ounce this month. Mainstream economic thinking has treated gold as a side-show since the world went off the gold standard. Nevertheless, the recent spiking in the price signals some important trends. It is not merely “sound and fury signifying nothing,” as sometimes seems true of financial markets.
There are three ready explanations for the historic increase in the price of gold: (i) monetary policy, (ii) risk, and (iii) a spreading desire for an alternative to the dollar as a safe haven. Each of these explanations contains some truth.
(i) Easy money.
The first reason for the high dollar price of gold is that the Fed has eased US monetary policy very strongly since the onset of the coronavirus recession in March of this year. True, gold had already begun to climb in 2019. But the Fed had already begun to cut interest rates in 2019.
Gold’s role as a hedge against inflation has for centuries been one of the major motives for holding it. One might observe that there is little sign of inflation today. But inflation in goods markets is not the only sign of easy money. Other signals include low real interest rates, a depreciated dollar, and high stock prices – not to mention the size of the Fed’s balance sheet. Each of these signals currently confirms the aggressive loosening of US monetary policy. A low real interest rate is often associated with a high real price of gold, in theory and empirically. After all, the long-time argument against holding the yellow metal, that it doesn’t pay interest, is less persuasive at a time when other assets are not paying much interest either.
The last decade confirms the correlation. In 2011-12, during the Fed’s second and third rounds of quantitative easing (QE), the gold price was almost as high as it is now. It fell to $1,200 an ounce during the “taper tantrum” that followed Fed Chairman Ben Bernanke’s May 2013 announcement of plans for the coming end of QE, which eventually brought a sequence of interest rate increases during 2016-18. Then, as noted, gold began its current sharp ascent in early 2019, when the Fed ended its period of monetary tightening.
Another age-old motive for holding gold is as a hedge against economic and financial risk (especially the risk of catastrophe). Although the price of gold is highly variable, its movements tend to have relatively low correlation with the price of the market basket of securities. It thus offers investors an opportunity to diversify risk. For obvious reasons, risk perceptions have been elevated since February, according to policy uncertainty indices and the VIX (the so-called “fear index”). Gold is historically one of several safe-haven assets to which risk-averse investors flee in times of uncertainty.
(iii) Diversification away from dollars
The dollar has long been the leading safe-haven currency. (The Japanese yen and Swiss franc are other safe-haven currencies.) This is one aspect of its unchallenged status as the number one international currency. But many investors around the world are becoming increasingly eager to diversify their holdings away from dollars. A new element is the extent to which the US President has sought to weaponize the dollar, using – or abusing – the exorbitant privilege of the dollar’s status, for example, to extra-territorially enforce unilateral US sanctions against Iran. Russia, China, and even Europe have thereby been motivated to find a payments mechanism that is not dependent on the dollar.
Another plausible factor is international loss of confidence in the general competence of US governance and the implied consequences for the American economy. The most egregious example is the perception that White House mismanagement underlies the US status as #1 victim of Covid-19 globally, in terms of the number of cases and number of deaths.
The decline of the dollar’s pre-eminence as #1 among international currencies has been prematurely declared many times before. It hasn’t happened, because there is no obvious challenger. The #2 international currency, the euro, still lags far behind the dollar in measures of international use (though the new prospects of a large-scale public Eurobond market brings the currency one step closer). Meanwhile the renminbi, heralded as a challenger to the dollar not long ago, has only made it to 5th, 7th or 8th place in the rankings, depending on the criterion used.
Gold is not a currency, but it is a rival for the dollar as an international reserve asset held by central banks and as a perceived safe-haven asset in the portfolios of investors. So, it has benefited from the international desire to diversify away from dollars.
For whatever combination of reasons, the dollar has depreciated against the euro and most other major currencies since April, which in itself partly explains the increase in the dollar price of gold. That is, gold has not appreciated as strongly when measured in terms of the euro or other currencies.
Gold’s role in the international monetary system
The sensitivity of gold to monetary policy might offer a small kernel of truth supporting the relatively small group of economic commentators who want to bring gold back out of retirement and return it to a central role in the global monetary system. Let us call them “gold bugs.” (This term is also used to describe investors who expect the price to rise, which at the moment includes more speculators who jump on the bandwagon of appreciation than those whose motivation is an ideological wish to return to the gold standard.)
The hey-day of the international gold standard, the period when most major currencies were convertible into gold, ended in 1914 with the advent of World War I. But the metal continued to play an important role as anchor to the international monetary system until August 1971, when President Richard Nixon surprised the world by abruptly ending international convertibility of the dollar into gold. Over the 1970s decade of rapid US monetary expansion, gold’s price rose 16-fold [from $41/oz. to $668/oz.], reaching in January 1980 a level that in real terms slightly exceeded the current price and by that criterion remains the record.
It is true that the three vertiginous ascents of the price of gold — in the 1970s, 2008-11, and 2019-20 — each reflected easy monetary policy. It is also true that monetary expansion was excessive in the first case, the 1970s, resulting in run-away inflation (13% in 1980). Thus, the gold bugs could argue that a rule “the central bank should reduce the rate of money growth when the price of gold is rising” might have produced a better outcome in the 1970s. But it would have produced much worse outcomes in both the 2008-11 and 2020 episodes, when monetary stimulus was entirely appropriate since the unemployment rate was very high (surpassing 8 % in 2009-11 and 10 % currently), while inflation remained very low.
The gold standard is of more than antiquarian interest. In January, Donald Trump officially nominated Judy Shelton to be one of the seven Governors on the US Federal Reserve Board. The Senate Banking Committee voted on July 21 to approve her (along party lines). The Senate leadership might choose to bring Shelton up for a final vote as early as the return from recess in September.
Judy Shelton made her reputation as a died-in the-wool proponent of the gold standard. One might almost have admired the integrity of her ideological consistency. She seemed different from Stephen Moore, the last candidate whom Donald Trump suggested for the Federal Reserve vacancy. Moore had said several times that he supported a return to gold, but then denied it. Shelton, by contrast, has built her career on this position. Her views go beyond nostalgia for the good old days. “Let’s go back to the gold standard,” she wrote in February 2009. She made it clear that she meant to abolish the alternative (the fiat-money dollar) as legal tender.
There are two big problems here. One is that a return to a gold-based monetary system would be a terrible idea. Even if low and stable inflation were the only objective, the gold standard did not deliver that. During 1873-1896, the general price level fell 53% in US and 45% in the United Kingdom due to a dearth of new gold deposit discoveries, which came to an end only with the Klondike gold rush.
Moreover, the economy does better when the central bank, in addition to the goal of price stability, also pursues financial stability and acts to stabilize income and employment as well. Monetary stimulus was the right answer in 2008-12, when unemployment was 9% and inflation was low. Conversely, monetary tightening was appropriate in 2016-18 when unemployment fell below 5 %, even below 4%. Had the Fed followed what the gold market was saying, it would have tightened monetary policy in 2010, prolonging the period of high unemployment, and loosened policy in 2018. The wrong answer both times.
Stimulus was again the right answer when the coronavirus recession hit in March of this year. Gold would have gotten that one wrong too. The recent $2,000 price would tell a true believer that the Fed should tighten aggressively, by more than 270 basis points according to one estimate.
The second problem is that Shelton has recently even failed the test of ideological consistency. As soon as the prospect of appointment to high office arose, she abandoned a lifetime philosophy in order say what Trump wanted to hear. What he wanted to hear, after he occupied the White House (not before), is that the Fed should loosen, even faster than it has. Shelton has dutifully adopted Trump’s position, $2,000 gold or no $2,000 gold. The switch fits into a general swing from a Republican campaign for tighter monetary policy when Barack Obama was in office, to agitation since 2017 to open the floodgates of liquidity.
If Shelton were to take a seat on the Fed Board, her vote would probably be determined neither by the price of gold nor what is good for the economy. Almost certainly, if the Democratic candidate wins the election in November (and is allowed to take office), she would suddenly remember the discipline of gold and rediscover the urgent need to tighten money – even if the economy were still very weak at that time (perhaps as the result of a second dip in the recession). On the other hand, if Trump remains in the White House, she will probably vote to double down on the current monetary stimulus, even if inflation starts to become a problem.
We have become accustomed to toadyism and cronyism in this Administration, from the Justice Department to the Post Office. But the Fed has been blessedly free from it until now. The Senate should not approve this nomination.
This post written by Jeffrey Frankel.