Tag Archives: price stability

Should we Restore the Gold Standard?

This blog post is a guest post on BullionStar's Blog by the renowned blogger JP Koning who will be writing about monetary economics, central banking and gold. BullionStar does not endorse or oppose the opinions presented but encourage a healthy debate. 

Would it make sense to rebuild an international gold standard like the one we had in the late 1800s? Larry White says the idea has merit, David Glasner believes it isn't worth the risk. Over the years I've followed the back-and-forth between these two blogging economists, each of whom has done an admirable job defending their respective side for and against the gold standard. Let's look at one or two of the most important themes running through the White v Glasner debate.

Like a ruler measures distances, a nation's monetary standard serves as a measuring stick for the value of goods and services. People need to be able to set sticker prices with the unit, calculate profit and loss, negotiate labour contracts, and establish the terms of long-term debts using it. If the measuring stick is faulty, then all these important tasks becomes unnecessarily difficult.

Gold as Unit of Account

Since 1971 our measuring stick has been irredeemable paper currency, or a fiat money standard. Central banks try to ensure that, within the confines of their nation, the general level of domestic consumer prices stays constant, or at least rises at a constant rate of around 2-3%. And while the first decade of the fiat standard was a disaster characterized by high and rising inflation, central bankers in developed nations have generally managed to keep inflation on track for the last thirty or so years.

To re-establish gold as the measuring stick, each nation's unit of account—say the $ or ¥ or £—would have to be redefined as a certain fixed number of ounces of gold. Banknotes and central bank deposits, which are currently inconvertible, would be made convertible into an appropriate amount of gold. It is important that all nations return to the gold standard rather than just one, because one of the big advantages of an international gold standard is that with all currencies pegged to gold, it is much simpler for citizens of one nation to make calculations using another nation's unit. And this makes cross-border trade and investment easier to engage in.


Should banknotes and electronic fiat currency once again be made convertible into gold?

In Favour of the Gold Standard: Larry White

How well have the two standards served as measuring sticks? As the chart below illustrates, year-to-year changes in U.S. consumer prices were quite variable during the classical gold standard era, rising some years and falling the next. The source for this chart is from this paper that White has coauthored with George Selgin and William Lastrapes. The classical gold standard from which the authors draws their data lasted from 1880—when the majority of the world's major nations defined their currency in terms of the gold—to 1914 when the gold standard was dismantled on the eve of World War I. Data shows that the fiat standard that has been in place since 1971 demonstrates more predictable year-to-year price changes. Citizens of developed nations are pretty safe assuming that next year, domestic prices will rise by 2-3%.

Quarterly US inflation rate, 1875 to 2010

However, it is over longer periods of time that gold outperforms as a measuring stick. In the chart below, the authors show that the quarterly price level during the gold standard tended to deviate much less from its six-year average rate than during the fiat era. Because the general level of prices was more predictable under a gold standard, this provided those who needed to construct long-term debt contracts with a degree of certainty about where prices might be in ten or twenty years that is lacking under a fiat standard. White points out that this may be why 100-year bonds were common in the 1800s, but not so much now.

6-year rolling standard deviations of the U.S. quarterly price level

According to White, the main reason for the long-term stability of gold is the tendency for higher prices to encourage gold miners to increase the supply of metal, thus tamping down on the price, and conversely lower prices to encourage them to reduce production, thus buoying prices. In other words, prices under a gold standard were mean reverting. This mean reversion was generated "impersonally", or automatically, by the market, a superior sort of stability compared to that generated by a fiat standard, which depends on the skills and wherewithal of technocrats employed by the central bank.

Against the Gold Standard: David Glasner

David Glasner is skeptical about the gold standard because he doesn't agree that it mean-reverts fast enough. All of the gold ounces that have ever been mined continue to exist in vaults or under mattresses or around necks. Compared to this extant gold stock, the flow of new gold production is tiny. So if there is an increase in people's demand for gold, it is unlikely that new flows will be able to satisfy it, at least not for some period of time. Likewise, reduced gold production on the part of gold miners won't be able to vacuum up enough of the slack should people suddenly want less of the stuff. In either case, the price of gold will have accommodate shifts in demand by rising or falling quite a bit.

One thing that most monetary economists agree on is that fluctuations in the value of the item used as the standard—gold or fiat money—should not interfere with the "real" economy, say by causing unemployment or gluts of unsold goods. While many prices in an economy are incredibly flexible, like the price of stocks or gold or bitcoin, there are also many prices that are sticky, in particular labour. Under a gold standard, if there is a sudden increase in the demand to hoard gold, then there will be pressure on price of gold to rise. The rise in the gold price means that the general level of prices must fall. Goods and services, after all, are priced in terms of gold-backed notes. But with wages and many other prices locked in place, the response on the part of employers will be to adjust by announcing mass layoffs. Rather than cutting the sticker prices of goods, retailers will suffer though gluts of unsold inventory. This is a recession.

Glasner's favorite example of this occurred during the late 1920s. After WWI had ended, most nations attempted to restore the pre-war gold standard with banknotes once again being redeemable with fixed amounts of gold. But then the Bank of France, France's central bank, began to buy up huge quantities of gold in 1926, driving the gold price up. The U.S. Federal Reserve was unwilling to counterbalance what was viewed as insane purchases by the Bank of France, the result being the worst recession on record, the Great Depression.

What Type of Gold Standard?

Given that various commodity standards have been in place for centuries, why did it take till 1929 for a massive monetary mistake to finally occur? White blames this on large government actors, specifically central banks. In the initial international gold standard that ran from 1880-1914, nations such as Canada, Australia, and the U.S. didn't have central banks. Commercial banks in these nations chose to link their privately-issued banknotes to gold, the goal of these competing banks being to to earn profit rather than enact social policies. So earlier versions of the gold standard functioned far more naturally, without the meddling of large actors who refused to abide by the typical rules of a gold standard. It is for this reasons that White prefers that any return to the gold standard be packaged with an end to central banks, thus precluding episodes like the Great Depression from occurring.

David Glasner remains skeptical. According to Glasner, even the classical gold standard that ran from 1880 to 1914 required management, the Bank of England leaning in such a way as to counterbalance large demands for gold from other central banks and thus preventing anything like the Great Depression from occurring. And even if central banks were to be dismantled under a 21st century version of the gold standard so as to preclude an "insane" Bank of France scenario, there remains the problem of "panic buying" of gold by the public—and the resulting gold-driven recession this would cause.

So Where does that Leave us?

As I hope you can see by a quick exploration of the debate between Larry White and David Glasner, restoration of the gold standard is a complicated issue. I'd encourage readers who are interested to dive a bit deeper into the subject by reading David's posts here and Larry's here.

As for myself, White's work on the 1880-1914 gold standard has been helpful in removing many of the preconceptions I had of the gold standard, no doubt passed off to me by commentators who were never very familiar with the actual data. Nevertheless, I tend to agree with Glasner that under a global gold standard (with no central banks) a sudden spike in the public's demand for gold would impose large costs on the global economy. With citizens of the globe being so connected through the internet and free capital markets, these sorts of episodes might be more common nowadays than they were in the 1800s. I'm not sure the benefits of a gold standard, including exchange rate stability, make up for this risk. Given that Western central banks have done a fairly decent job of keeping inflation under control for the last thirty or so years, I'll give them the benefit of the doubt... for now.

Hyperinflation in Zimbabwe – It’s back, but maybe not for long

When a nation adopts a foreign currency it will typically face significant hurdles when it tries to rid itself of that currency, or de-dollarize. But Zimbabwe’s autocratic ruler Robert Mugabe has appeared to have done the impossible. After dollarizing ten years ago, over the course of the last year or two he and his cronies have managed to throw off the U.S. dollar and re-introduce a Zimbabwean replacement.

We can see evidence of this new currency in Zimbabwe's stock market. Below I've charted the country's main equity index, the Zimbabwe Industrial Index, going back to 2011. What an incredible rise over the last year, right? Beware; these returns have nothing to do with real economic growth. Zimbabwean equities have switched from being claim on an a stream of cash flows denominated in U.S. dollars to a stream denominated in Zimbabwe's new currency. Because investors expect inflation of the new currency to drive up future cash flows, they have responded by bidding stock prices up. In real terms (i.e. U.S. dollar terms), stock prices are probably flat–and may have even declined.

Dollarization and de-dollarization

Let's back up a bit. For those countries that mismanage their currency, the penalty box has typically been some form of dollarization. The citizens of a nation grow so tired of the hyperinflating currency that they opt for an alternative, whether that is euros, dollars, or some other medium of exchange.

Dollarization is usually only partial, the mismanaged currency continuing to circulate–albeit to a lesser extent–in conjunction with a stable alternative. Zimbabwe is unique in being one of the few countries to fully dollarize. By late 2008 the hyperinflation of the Zimbabwe dollar had become such a burden that Zimbabweans–without the permission of the Mugabe regime–threw their local currency notes into the gutters and adopted the U.S. dollar as their sole medium of exchange and unit of account.

Zimbabwe 100 trillion notes and gold bullion
Do you prefer to own 200 trillion dollars or do you prefer to own gold?

In 2016-17, the reverse has happened. Before I go into how the new Zimbabwean currency was introduced, it should be emphasized how difficult it is to replace an existing currency with a new one. Currency usage is locked in place by tradition and broad acceptance. Even when a national currency is doing very poorly, any single individual will be loath to be the first to desert it for a more stable alternative. Money is only useful when many people are using it, and since any new money lacks a base of users, it faces the paradox that it cannot ever get jumpstarted. In the case of modern Zimbabwe, the communal benefits of using the U.S. dollar as the "language of trade" are significant, so any alternative should have faced a huge hurdle in gaining acceptance.

The birth of Zimbabwe’s new currency

That the new Zimbabwean currency managed to make it past this hurdle is a testament to the powerful combination of subterfuge, brute force, and good old Gresham's law that overpowered the staying power of the U.S. dollar. What follows are the steps that led to this switch.

After the 2008 dollarization rendered it useless, the Reserve Bank of Zimbabwe (RBZ) sneakily got back into the money printing game in 2012 or 2013. Creating a new national currency from scratch would have been politically impossible; the population was still furious with its leaders' previous monetary mistakes. So instead the central bank began issuing a U.S. look-alike. Domestic banks had the option–and later were required–to open U.S. dollar accounts at the RBZ. These accounts weren't available to the public but could be used between banks to settle domestic payments flows. At first, the RBZ's U.S. dollar deposits were as good as the real thing. Banks could easily convert them into U.S. paper currency.

As time passed, Robert Mugabe's government drew down on the RBZ's resources in order to fund a massive spending campaign. This depletion of the RBZ's hard currency reserves eventually forced it to renege on its promise to commercial banks to redeem in dollars. Regular Zimbabweans only got their first sign of trouble in early 2016. Since commercial banks could no longer rely on the RBZ to convert its U.S. deposits into real U.S. cash, the banks had no choice but to pass their inability to get cash on to their customers. The ability of the public to withdraw cash from U.S. dollar accounts was steadily cut back until they could only take out $50 per day, leading to massive lineups at banks across the nation. With the convertibility promise having been betrayed, dollars held in the banking system ceased to be equivalent to U.S. dollars. They began to trade at a 5-20% discount to genuine U.S. cash in the black market.

In November 2016 the RBZ introduced the bond note, its first issue of paper money since the old Zimbabwe dollar had expired worthless in 2008. (For more details, read my post on the topic here). As in the case of the accounts at the central bank, bond notes were supposed to be redeemable on demand into U.S. dollars. But this redemption promise proved to be a sham–and bond notes quickly began to trade at a discount to U.S. paper money.

Gresham’s law makes an appearance in Zimbabwe

Having duped the population into accepting RBZ-issued dollar notes and deposits, the government proceeded to declare its new currency legal tender. This meant that any creditor who had lent out U.S. dollars was obligated by law to accept payment in bond notes at par. At the same time, the authorities required retailers to treat all payments media as equivalents–they could neither discount the inferior currency nor accept the superior currency at a premium, the penalty being seven years in jail.

Which gets us to Gresham's law. A rule going back to medieval times, Gresham's law tells us that when a government dictates the exchange rate between different types of money, the 'good', or undervalued money will be chased out by the 'bad', or overvalued money.

To see how Gresham's law has played out in Zimbabwe, consider a Zimbabwean street hawker who prior to 2016 had been selling oranges for $1 per bag. The new Zimbabwean currency is introduced. Because this new currency is inferior to the U.S. dollar, the street hawker continues to charge $1 per bag for those paying with genuine dollars but requires everyone paying with new currency to pay an extra 50 cents, or $1.50. With this new dual-pricing scheme, some customers will continue to pay with U.S. dollars, others will pay with bond notes. Both types of money circulate together.

Zimbabwe 100 trillion dollar notes with bread, eggs and milk
In 2008, on the first day of issuance, a 100 trillion dollar note reportedly could buy 3 eggs in Zimbabwe but only 1 egg the day after

When the government announces that all currencies must be treated as equals, the street hawker can no longer charge an extra 50 cents to those paying with Zimbabwean currency. To meet the letter of the law, he sets his price at a flat $1.50 per bag of oranges, irrespective of the type of currency used. However, this undervalues the U.S. dollar. After all, $1.50 in U.S. cash should be capable of buying a bag-and-half of oranges, not just one bag. The result is that none of the street hawker's customers will ever pay with U.S. dollars, preferring to hoard them and proffer Zimbabwean currency as payment instead.

This parable of the street seller has occurred all over Zimbabwe over the last twelve months. Thanks to the government's edict that all currencies be treated as equals, U.S. dollars have been driven entirely from circulation. No one wants to use them because they are undervalued. As a result, bank money and bond notes have become the main media of exchange in Zimbabwe. Zimbabwe has dedollarized.

Hyperinflation 2.0

Prices are on the rise. I used the stock market as an illustration of this in my introduction. Consumer goods have been slower to adjust, but earlier this month Equity Axis–a local financial research firm–reported that the prices of basic goods have gone up by between 50- 100% over the past eight weeks. On the streets, illegal currency traders will buy $1 worth of bank money for just 54 cents in genuine cash, according to recent reports.

Comparing the price of bitcoin in Zimbabwe against its international price also gives some clues into how far the new currency has tumbled. Last week bitcoin traded at $13,185 on the Golix, a Zimbabwean bitcoin exchange, but only $7190 on U.S. exchanges. We need to take the price of $13,185 with a grain of salt, because Golix is a very illiquid exchange. In any case, the ratio between the two bitcoin prices implies that a Zimbabwean bank dollar is only worth 54 cents in genuine U.S. dollars ($13185/7190), confirming the unofficial street price in the previous paragraph. Put differently, in just one year Zimbabwe's new currency has lost almost half its value.

Economist Steve Hanke, who helps maintain the Hanke-Krus World Inflation Table, has used interlisted stocks on the Harare and London stock exchanges to infer that Zimbabwe’s inflation rate has soared to 77%. (I described this technique in more detail here). When inflation exceeds 50% per month and lasts for at least thirty consecutive days it qualifies as hyperinflation, which means that Zimbabwe’s current currency collapse will be added to the Hanke-Krus table.

Going forward…

Given that Mugabe and his cronies have already shown a penchant for destroying currencies, as long as they are in power it seems unlikely that the current inflation will stop. As I was writing this post, however, the situation in Zimbabwe has dramatically changed. On November 14, the army announced that it had placed Mugabe under house arrest. We don’t know if he will be permanently removed from power or if the situation is just a temporary one. If a new government can be established, and the international community mobilized to support it, it is possible that the collapse in the new currency will be halted, perhaps even reversing back to par. For instance, a large enough IMF loan might allow the RBZ to uphold its original promise to convert bond notes and deposits into genuine dollars on a 1:1 basis.

The market may already be pricing in an improvement in the odds of the Zimbabwean currency being stabilized. Over the two days the Zimbabwe Industrial Index has plunged by over 100 points or 20%, as the chart at top illustrates. This correction may be partly due to operating uncertainties faced by listed firms given the lack of visibility surrounding future leadership. But the largest chunk of the decline is surely a pure monetary phenomenon. Since all stock prices are quoted in Zimbabwean money, a massive increase in the purchasing power of money will cause stock prices to fall.

Many outside the country have no doubt been anxiously watching Zimbabwe's monetary experiment, especially in Europe. In the same way that Zimbabwe was part of the U.S. dollar-zone, most European nations are part of the Eurozone, in some cases reluctantly so. Zimbabwe offers these nations a blueprint for quickly exiting the monetary union. That may be one reason why the President of the European Central Bank, Mario Draghi, was so quick to shoot down Estonia's recently mooted state-backed cryptocurrency, the Estcoin. By nipping it off at the bud, he ensured he wouldn't have a home-grown bond note problem.

This blog post is the first in a series of guest posts on BullionStar's Blog  by the renowned blogger JP Koning who will be writing about monetary economics, central banking and gold .