Bretton Woods II: The Folly of Large Gold Reserves
November 19, 2007
I’ve said over and over that a central bank (or other currency manager, such as a private bank) need hold no gold at all to operate a gold standard. What they must do is add and subtract base money appropriately to maintain the value of their currency at its gold peg. This is the same operation as a proper currency board today.
This really irks some people, who have become comfortable with the idea that a large “backing” or “reserve” of gold means “greater safety.” This is really just superstition among people who don’t understand how the mechanisms work, akin to the large bank vault with huge heavy door on prominent display at many retail bank branches, which is supposed to give the impression that your money is “safe” inside the safe. This is nonsense, of course — a bank deposit is merely a loan to a bank, and the bank then goes and does what it pleases with your money, such as making bridge loans to troubled SIVs.
Last week, we looked at the Bretton Woods period, in which the US maintaned the dollar’s peg to gold while other countries pegged to the dollar. However, the dollar’s peg with gold came into constant conflict with the urge to manipulate interest rates and the economy in general, and in practice the proper currency-board-like adjustment of base money was rarely practiced. Instead, the Fed and the government attempted to bully the dollar/gold market into place with large, mostly sterilized (no effect on base money) sales of gold bullion, in addition to some other Fed tactics including higher interest rate targets. This ultimately failed.
The way in which Bretton Woods failed — by apparently “running out of gold” — drove many to conclude that the problem was, obviously, not enough gold! This is completely backwards. The problem was that they didn’t know what to do except selling gold, which was really just a stopgap. That’s why I focus incessantly on the technical mechanisms of managing base money as a way to manage currency value, while the gold reserve itself is all-but-irrelevant.
If anything, the Bretton Woods period serves as a good example of the idea that it doesn’t really matter how much gold you have, as long as you know how to properly manage a currency through base money adjustment. At the beginning of Bretton Woods in 1944, the United States started with a mammoth amount of gold. In 1942, the US government/Fed held 78% of all the gold held by all governments/central banks in the world, and 52% of all the aboveground gold in all of existence! This figure was and will probably never be topped by any government, anywhere, at any time. In 1942, the US goverment held a whopping 630 million ounces of gold. For comparison, the Bank of England, in 1910 — the very height of the “classical gold standard,” and after the pound had been the world’s premier international currency for over 200 years — held 7.2m ounces, or about 1/87th as much gold. This was a mere 4% of the total gold held by central banks, and approximately 1.2% of all the gold in the world. The BoE’s gold reserves didn’t decline, either. In 1860, when London was the center of the financial universe, the BoE held 2.5m oz. Obviously, the BoE knew what it was doing.
So, I’ll say it again: the currency manager that knows what it is doing (BoE of 1900) needs virtually no gold at all. The currency manager that doesn’t know what it is doing (Fed/Treasury of 1965) will eventually find that no amount of gold can correct their fundamental ignorance.
Despite beginning with US reserve holdings of the maximum extent imaginable, the system failed in a relatively brief 27 years. Obviously, this was not a problem of “not enough gold,” but rather, a lack of understanding of how to operate a gold standard system. Even when the Bretton Woods system was abandoned in 1971, the US government still held about 15% of all the gold in the world, or 291m oz., which was 40 times more than the BoE had when the pound was the world’s premier gold-linked currency.
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A reader asked for a review of base money adjustment systems. “Base money” is the technical term for money. There are other “forms of money” but these are really forms of credit, so base money is the only “money” that is actual money. Base money today is about 90% coins and bills, and 10% bank reserves, held electronically at the central bank. The Fed, or other currency manager, is only capable of adjusting the base money supply. Increasing the base money supply (aka “printing money”) is done through the purchase of an asset, typically a government bond. The Fed buys a bond, in the regular market, and pays for its purchase with newly-created money, in the form of bank reserves. These bank reserves are exchangeable on demand with paper currency, and vice versa. To reduce the amount of base money, the Fed sells an asset, typically a government bond, on the regular market. The proceeds from the sale disappear, which reduces the amount of base money (again typically bank reserves). In this way, the currency manager can “run the printing presses” both forward and in reverse, to virtually any extent necessary.