The London Gold Pool I and II (and a David Frum-bashing contest!
November 11, 2007
This week, we have a David Frum-bashing contest! Sort of like dwarf-tossing I suppose.
A reader sent in a piece by David Frum in the National Review Online. Here it is:
David Frum’s gold-bashing article
This is fairly typical stuff. By now, if you’ve read my book and this website, you should be able to dismantle these arguments without much difficulty. Give it a try. On at least one but possibly multiple points, explain exactly why Frum is mistaken, and what the proper answer/solution is. Send your answer to me at nathan@newworldeconomics.com. I don’t care if you “agree” with me or not. I want to see if you can do what I can do. I’ll put some of the answers on the website in the future, with additional comments of my own.
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I often use the Bretton Woods period (1944-1971) as a good example of an operating gold standard. During this time, the dollar was pegged at $35/oz. of gold, which was actually a holdover since the dollar was originally pegged to that level in 1933-1934. People who don’t understand the gold standard very well can nevertheless see that it operated pretty well during that period. Indeed, that period was a kind of Golden Age for the US and the world as a whole. Europe and Japan were booming, and actually the emerging markets were doing quite well also. Caracas, Venezuela, for example, was quite a wealthy and happening place to be in those days.
However, the Bretton Woods period was flawed from the beginning. The idea of government manipulation of the economy, in practice through central bank manipulation of money and credit, was very popular at the time, and indeed college textbooks such as those written by Paul Samuelson (a vastly overrated economist) regularly championed the idea of a steady rate of “background inflation” to maintain a healthy economy. Thus, pretty much from the beginning, the urge to fiddle with currencies and the gold standard peg at $35/oz. came into conflict. In some countries this conflict was more overt, and indeed Britain and France devalued their currencies a number of times in the 1944-1971 period. The U.S. itself started off rather inauspiciously, as the Treasury put pressure on the Fed to keep short-term interest rates low in the late 1940s and early 1950s. This resulted in a sagging dollar value vs. gold during that period.
You can see that, after the Bretton Woods agreement in 1944, there was a period of time up until 1954 when the dollar was actually rather far from its promised $35/oz. value. This was resolved in an Accord between the Fed and Treasury in 1951, and we can see that after 1951 the dollar moves back toward its $35/oz. peg.
At the beginning of Bretton Woods, the US held most of the government-owned gold in the world.
This holding didn’t change much in the early 1950s, but beginning in 1958 or so, we see the U.S.’s holdings drop fairly precipitously. Under Bretton Woods, U.S. entities were forbidden from owning gold (since 1933), but Europeans (in practice European central banks) could exchange their dollar bills for gold at the London market. That’s one reason the London market remains the world’s primary bullion trading market today. From about 1958 to 1970, European central banks dumped their excess dollars on the U.S. and took gold in return, resulting in expanding gold holdings in the Rest of the World (plus a little more from mining etc.).
The reason gold was flowing out of the US was that the supply of dollars was in excess of its demand. The proper solution was to reduce the supply of dollars (“base money”) via the bond-selling operation we have discussed before. If the US had done that, the gold outflows would have stopped. Indeed, we saw a couple weeks ago that Friedrich Hayek recommended exactly this (as did Ludwig Von Mises in the late 1940s-early 1950s period).
However, it appears that at that time, nobody in power really understood this process — the process by which a proper gold standard operates. They thought it was just a matter of “selling gold at $35/oz.” No no no. If you just sell gold, but do not adjust base money properly, you just end up selling all your gold. During the 1950s and 1960s, this is exactly what the US government did. Indeed, then as today, it appears that the Fed didn’t really have an official operating mechanism to adjust base money properly. It was already stuck in the “interest rate manipulation” format, which was an outgrowth of 1930s Keynesianism. At any time, the Fed could have adjusted base money supply, but instead it was focused on “changing interest rates.” The problem with this is that there is no direct connection between a central bank’s interest rate target and the currency value. Thus, even if the Fed was cognizant of the gold-outflow problem and what it meant, in their eyes there was nothing they could do. Eventually, the Fed did do something, as it raised rates to 10% in late 1969. And, actually, this seems to have worked, but the policy of high interest rates turned out to be very destructive.
Soon after the gold outflows began around 1958, something called the London Gold Pool was established. In brief, the London Gold Pool was an attempt by the US to have the European central banks withdraw less gold than they would have otherwise, slowing the outflow. They agreed to keep the market value of dollars at “$35/oz.” through a sort of central bank cartel. There’s a bit more info on this period here:
Lessons from the London Gold Pool
In 1968, the European members of the LGP were fed up with this nonsense. They were willing to allow the US some time to get its act together, and properly manage the base money supply so that the dollar’s value would return to its $35/oz. peg. However, the U.S. government itself didn’t show much interest. In 1968, the U.S. introduced Special Drawing Rights, which were touted as a kind of “paper gold.” Instead of taking dollars and giving gold in return, the U.S. government would take dollars and give you — Special Drawing Rights! The SDRs were a currency basket, which meant that they consisted of dollars and currencies linked to the dollar. In other words, the SDR was essentially dollars. Beginning in 1968 we see that the gold outflows largely come to a halt, because the U.S. was no longer offering gold in exchange for dollars. Also as a result, we see in 1968 that the dollar blips from $35/oz. to about $40/oz. (not really all that far from $35/oz.), as the LGP cartel dissolves. This is the point at which Bill Martin at the Fed starts to get serious about supporting the dollar’s value, but he does so via a “high interest rate target” rather than direct base money adjustment. After he was replaced in January 1970, the dollar’s value began to fall again. The Europeans were not real happy with this SDR crap. They bided their time until 1971, when it was apparent (see Hayek’s comments) that the U.S. didn’t give a hoot about the gold standard, and was well on the road to inflation. In July-August of 1971, Britain and France said, to paraphrase, forget about this SDR garbage, give us some gold for our crap dollars! In response, Richard Nixon officially ended the policy of dollar/gold convertibility on August 15, 1971, which we now take as the official end of the Bretton Woods period.
The point of all this is that the entire Bretton Woods period was polluted by Keynesian central bank manipulation, and a general lack of awareness of the proper mechanisms of operating a gold standard, which is adjusting the supply of base money — not selling gold, and not “raising interest rates.” The U.S. government did both of those things during Bretton Woods, and they didn’t work.
All of this brings us to the London Gold Pool II, which is the present-day central bank cartel to try to keep the dollar’s value from falling too much against gold. The best place for info about LGP II is www.gata.org and www.lemetropolecafe.com. For our purposes, we can consider LGP II to be operative during the 2000-present period although some people date its influence before that. Like LGP I and the other nonsense that was going on in the 1960s, I am not too critical of the purpose of the program. After all, the purpose of LGP I was to keep the dollar pegged to gold at $35/oz., which is what they were supposed to be doing, even if they attempted to do it in a stupid way that didn’t work.
LGP II was set up during the period when Alan Greenspan was head of the Fed. Greenspan was always something of a gold guy, as we saw a few weeks ago:
However, Greenspan didn’t really know how to operate his gold standard. This is what he wrote in 1981.
The only seeming solution is for the US to create a fiscal and monetary environment which in effect makes the dollar as good as gold, i.e. stabilizes the general price level and by inference the dollar price of bullion gold itself. Then a modest reserve of bullion coin could reduce the remaining narrow gold price fluctuations effectively to zero, allowing any changes in gold supply and demand to be absorbed in fluctuations in the Treasury’s inventory.
What the above suggests is that a necessary condition of returning to a gold standard is the financial environment which the gold standard itself is presumed to create. But, if we restore financial stability, what purpose is then served by a return to a gold standard?
There is no mechanism for a gold standard here. The dollar value just happens to float in the neighborhood of stability vs. gold due to the general “financial environment.” Then, the Treasury bullies the gold market into place by sterilized sales of bullion. (This probably explains in part Greenspan’s annoying deficit-hawk streak, as he wanted to maintain a proper “financial environment.”)
Which is sort of how Bretton Woods operated.
Today, LGP II is trying to keep the dollar’s value from collapsing vs. gold. However, they are doing it in the same way as the US and LGP I tried to do it in the 1960s — with sterilized sales of bullion. (“Sterilized” means that there is no corresponding change in dollar base money to go along with the sale of bullion. Thus, base money remains effectively unchanged.) Just as was the case in the 1960s, the plan isn’t working. The dollar is losing value, and they’re running out of gold. Just as was the case in 1971, they don’t want to “raise interest rates” — in their eyes the only Fed option — because the economy would implode. The proper solution, then and now, is not to sell bullion, and not to “raise rates”, but to adjust base money directly.
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The Europeans are starting to get angry with the wayward Americans, another very Bretton Woods sort of situation. The Europeans know that, as the dollar falls, it will be difficult for them to avoid following the dollar lower, due to the forex/trade consequences. Already, inflation is too high, which the euro is too high vs. the dollar (but not too high vs. gold). France’s president Nicolas Sarkozy warned last week that “monetary disorder risked turning into economic war.” Many other governments have reached the point where they can no longer easily tolerate the forex/trade effects of the sinking dollar. Many have begun to apply capital controls to keep their currencies from rising.
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I’m hearing that the funds in the Wanta accounts are finally being transferred to the U.S. Treasury. This might allow them to support the Treasury bond market, in the face of selling by other central banks.
