A Return To Convertibility

Making the Dollar ‘as Good as Gold’

L.A. Times 10/30/79

The events of the past several weeks have served to make interest rates, reserve requirements and money supply targets of cocktail talk at all proper meeting places. What appears to be missing, however, is any serious discussion of a word understood by virtually everyone: gold. In my view, any successful solution to the monetary crises occurring at ever-more frequent intervals must include a reestablishing of dollar convertibility. Historically, convertibility of a currency has been into gold.

Within the last decade, the price of gold has been as low as $35 per ounce. In recent weeks, the price of that same ounce of gold has gone as high as $440. As of today’s reading each ounce sells for about $375. Even discarding overall price increases, the appreciation of gold has been sensational. In the last 10 months alone, the dollar price of gold has risen well over 50%.

The underlying production and consumption characteristics of gold have basically remained the same. The gold market itself is a by-stander, absorbing the reverberations of a fundamental economic “malaise,” especially in the United States. Along with a handful of other indicators, such as the stock market, the price of gold is a measure of the health of an economy. The prognosis is not good.

In his book, The Golden Constant, UC Berkeley Prof. Roy Jastrom documents the stabilizing nature of a gold standard, a monetary system in which a nation’s currency is officially convertible into gold at a predetermined price. When maintained on a gold standard, price indexes show a “retrieval phenomenon.” This means that when monies are convertible into gold, prices are bounded: if prices rise, for any reason, they will later fall back into line.

This is why, under the gold standard in the United Kingdom, the price level was the same in 1718 as it was in 1930, as well as in various intervening years. Incredible as it may seem today, there was no generalized inflation over the entire 200-plus years. That period, save for brief interludes, saw the pound sterling convertible into gold.

Recent research by USC’s James Turney has further documented the financial characteristics of the gold market. Turney has found that the price of gold is inversely related to the foreign exchange value of the dollar. Thus, a dollar decline in comparison with other currencies is closely related to increases in the dollar price of gold. Moreover, this inverse relationship is not proportional. On average, when the dollar falls by, say, 1%, against a weighted average of other currencies, the price of gold rises 2%.

Gold is the first refuge of the cautious. As an investment item, gold and gold stocks have some admirable characteristics. The returns on gold due to price fluctuations don’t appear to be related to returns on common stocks. As often as not, when stock prices fall, gold prices rise. Thus, including gold in an investment portfolio reduces the risk of that portfolio. In addition, the returns on gold are often better than those on stocks. From the end of March of 1968 until October 3 of this year, the increase in the price of gold was almost ten-fold.

More interesting than the investment implications of gold as an asset, though, are its inflation-hedging qualities. In the United Kingdom, for example, while gold kept three-quarters of its purchasing power between 1933 and 1976, the purchasing power of the pound sterling fell to less than one-fourteenth of its 1933 level.

Intuitively, the close association between gold price fluctuations and inflations makes a lot sense for gold has many qualities that make it an ideal money substitute. Gold is also a truly international commodity, with a long tradition of stability.

More important than these, however, is the fact that governments cannot print or otherwise create gold. The absolute quantity of gold and its value are outside the purview of monetary authorities and their purely political decisions.

Tying a currency to a gold standard has the same effect on inflation that putting a governor on a car engine has on speeding. Fuel is restricted. From 1957-1967, the inflation averaged 1.7% annually (based on the consumer price index). In March of 1968, a two-tier gold market was instituted. Officially, the price of gold remained at $35 per ounce. But in effect, the dollar became inconvertible. In the next three years, inflation escalated to an average annual rate of 4.9%.

In August of 1971, the gold standard was scrapped in the United States. Not even foreign governments could convert their dollars to gold. Inflation from 1971 through mid-1979 has risen to an average annual rate of 7.5%. Figures for the latest periods show that inflation has broken the double-digit barrier, and the price of gold has broken all records.

If done correctly, a return to gold convertibility could be effected with little disruption in the financial and real markets. The most serious problem is how to determine the appropriate price of gold once the dollar is convertible. At present, the price is in excess of $350 per ounce. If the government were to reestablish convertibility at this price an enormous inflation would follow as other prices rose to reacquire parity to gold.

The basic point is that the price of gold has been bid up to such heights because inflation is expected to continue at even higher rates. If prices were known to be stable over horizons both near and distant, there would be a dramatic shift out of gold into dollars. In a free market this change in anticipations would result in a sharp reduction in the current price of gold.

The first step of an intended return to convertibility would be to announce it. A period of transition and a specific date for the reestablishment of convertibility should be set. During this transition period the monetary authorities should take an austere posture and sell a large portion of the government’s gold holdings. Whatever the market price of gold at the pre-specified date, that would be the price the monetary authorities would choose as the price of conversion. Therefore, the price of all commodities would not be forced to adjust to the price of gold. The price of gold would do the adjusting.

Intervention to maintain dollar convertibility once the price is established is a critical feature of any gold exchange standard. Fortunately the annals of monetary authorities, both here and abroad, are replete with workable examples. Perhaps the single most successful episode was conducted by the British from the beginning of the 18th century to the beginning of the 20th century. The method then was simply to adjust the U.K. money supply to maintain gold’s pre-determined price. If there were upward pressure on the price of gold, the U.K. monetary authorities would reduce the money supply until the pressure abated.  Likewise, if downward pressure developed they would increase the number of pounds outstanding. It worked, and worked well.

Wouldn’t it be nice if our economy were restored to being “sound as a dollar,” and the dollar as “good as gold”?