Limited Convertibility: Something New For A 21st Century Gold Standard

(This item originally appeared at on March 8, 2017.)

The idea of a “gold standard” monetary system is pretty simple — the currency’s value is fixed to gold. This is really no different than the dozens of “euro standards” and “dollar standards” already in use today. The IMF says that about two-thirds of all governments, worldwide, already use some kind of fixed-value system. The only real difference is the “standard of value.”

However, once you move beyond the basic idea, sometimes the details can get complicated. One thing that the U.S. gold standard advocates have been going back-and-forth on for a long time is the principle of “convertibility” — the legal obligation of the currency issuer to trade its currency for gold bullion, at the official price.

It is not necessary to have convertibility to have a gold standard system. A currency manager (central bank) can maintain the value of its currency at a gold parity without this feature. Originally proposed by David Ricardo in 1817 (if not earlier), this idea is sometimes known today as a “gold price rule.” There are a few examples in history, such as the U.S. dollar 1968-1970 or Italy in the latter 19th century. You could still “convert” your currency to gold at any private-sector gold dealer. I talk about the details of this in Gold: the Monetary Polaris.

However, even Ricardo insisted that direct gold convertibility is a political necessity to maintain the reliability of the system. Today, many insist on the unlimited conversion that central banks commonly offered in the pre-1914 “Classical gold standard” era.

One problem with this is that there has been a tendency for the demand for money worldwide to expand a little faster than the aboveground supply of gold. Major central bank balance sheets today total about $17.6 trillion. Today, there are about 6.0 billion ounces of aboveground gold, worth about $7.2 trillion at $1,200/oz. As you can see, it would be difficult for the world’s central banks to have the 30%-ish bullion coverage ratios common in the pre-1914 era. Today, central banks hold about 20% of the world’s aboveground gold, which seems like a nice ratio. It is also the same ratio as in 1910.

It’s true that central bank balance sheets have radically expanded from where they were a decade ago (about $6 trillion). And, things like eliminating “cash” (banknotes) could reduce them considerably. But, it would be nice not to be dependent upon such things. In the end, gold is just a standard of value. As Ricardo argued two centuries ago, you don’t have to pile it up in vaults. It would probably work even better, as a standard of value, if most of the gold in the world traded freely, among private hands.

Traditionally, before 1930, central banks have offered unlimited bullion conversion. In practice, this was not a problem. However, any central bank might justifiably feel nervous about making such a commitment when gold reserves are perhaps 5%-10% of base money liabilities. At the end of 2016, the United States had official gold holdings of 261 million oz., worth $313 billion at $1200/oz., against Federal Reserve base money liabilities of $3,531 billion – a reserve ratio of 9.5%.

One solution is to allow limited conversion. If the Federal Reserve agreed to sell up to one million ounces of gold at $1,200/oz. per day (worth $1.2 billion), and this maximum was reached every day, it would take 261 working days, or a little more than a calendar year, for the reserve to be completely depleted. This would give the Federal Reserve more than enough time to respond to the problem of sagging dollar value via measures such as open market operations (selling government bonds and reducing the monetary base) in whatever size was necessary to achieve the goal. At the same time, speculators would be reluctant to pay more than $1,200/oz. on the open market, preferring perhaps to wait a day and get their bullion at the parity price from the Federal Reserve. With proper management, the value of the dollar could rise at some point slightly above its $1,200/oz. parity, at which point the Federal Reserve would experience bullion inflows.

Especially since 2011, various “paper gold” markets including the U.S. Comex futures exchange and the London Bullion Market Association, have exerted enough influence upon gold prices that such prices apparently do not reflect actual supply and demand conditions for bullion itself. This prompted several efforts, the most prominent of which was the Shanghai Gold Exchange, to provide a mechanism for gold pricing that reflected large-scale and liquid trade in actual bullion for immediate delivery.

Certainly a market for actual gold bullion, as opposed to gold-flavored derivatives that can be created or extinguished at will, is a necessity for gold to best serve its role as a standard of value. One advantage of including gold conversion by central banks is that central banks themselves in effect act as bullion dealers, in multi-billion dollar size. Bullion in large quantity could be bought or sold with central banks themselves, in the process illustrating the relationship of currency value to bullion itself without the influence of any external “paper gold” pricing mechanism.

There are other methods one could use. The Bretton Woods system was based on the idea of linking the U.S. dollar to gold, and other currencies to the U.S. dollar. This is another method that would not require most central banks to hold gold at all. However, in the past it has tended to make the system too dependent on the good behavior of the managers of the “reserve currency.”

This is the time to rethink a lot of our post-WWII institutions. Among them is our present — although historically quite aberrant — fixation on central bank funny-money manipulation as the solution to all conceivable problems. But, if we are going to have something different in the future, we need to construct it in our minds, in all of its specific and functional details, so that we will know what to do when it comes time to act.