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Musing on a Gold Standard

Paul van Eeden
May 30. 2006

What would the gold price be if we could replace all the existing notes and coins in the world with gold?

Not such a long time ago paper receipts for gold in storage were used as currency, and people would trade these receipts because it was more convenient than carrying around a lot of gold. Over time, those who held the gold and issued the receipts noticed that physical gold was seldom claimed even thought the receipts changed hands several times. The temptation to issue more receipts than the gold in storage became too large to resist, and fractional banking was invented. This allowed the issuers to charge interest and increase the amount of currency in circulation.

The scheme would work as long as everyone did not claim his or her gold at the same time. Those issuers (or later, banks) who egregiously abused the system suffered from bank-runs, in which receipt holders claimed their gold. Since there was not enough gold to cover all the outstanding receipts, only the first folks through the door would get any gold.

The system was based on the faith the public had in the gold receipts, with all issuers not being equal. The Federal Reserve Bank was therefore created to regulate the system and stand ready to bail out any bank that could not meet its obligations. Fractional banking was allowed to continue subject to additional regulation and scrutiny, but the system is still based purely on the faith and confidence that people have in pieces of paper.

Many hardcore believers in the gold standard feel that fractional banking has to be demolished. I personally never liked the idea of fractional banking, but I also don't think the population at large is ready to do without it. And, even if fractional banking were eliminated and a pure gold standard recreated, the temptation to issue receipts in excess of gold on deposit would just exert itself again.

So instead of the most conservative extreme of a gold standard without the ability of debt creation, let's consider what would happen if we accepted fractional banking, but just took away governments' right to seigniorage.

If we add together all the currency in circulation (notes and coins) in the US, Japan, China, Britain, Canada, Russia, Australia and the European Union, converted to US dollars for simplicity, we arrive at $2.6 trillion. These countries represent roughly 80% of the world's GDP so by extrapolation we can estimate that all the currency in circulation in the world today is approximately $3.25 trillion.

Total historical gold production is about 5 billion ounces and most of it is still around. If all the gold in the world were converted to money to replace existing notes and coins, it would imply a gold price of $650 an ounce.

Back in the 1940s the United States alone held about one third of all the gold in the world and two thirds of the official reserves (gold held by governments). At the time, governments held approximately 50% of all the gold. If we assume that only half the gold in the world could be converted into money then it would imply a gold price of $1,300 an ounce.

Another model I have used to estimate the fair value of gold is based on relative inflation rates. According to that model (see, the gold price should be around $900 an ounce. I found it interesting that both these calculations came up with gold price values in the range of $1,000 an ounce, which is intuitively more acceptable than some of the deflationist models that predict gold at $300 an ounce or alarmist predictions of $8,000 to $10,000 an ounce. While either extreme is a possibility, I do not consider either one to have a very high probability. On the other hand, I believe there is a high probability of seeing gold at around $1,000 an ounce in the not-too-distant future.

Gold is currently less than that because the US dollar is over-valued on foreign exchange markets. A rise in the gold price from $600 to $900 an ounce purely due to weakness in the dollar would imply that the dollar lost 30% to 35%. Such a decline in the US dollar does not have to be uniform against all currencies, and I doubt that it would be; the dollar will probably fall most against the Chinese Renminbi, the Japanese Yen and other Southeast Asian currencies.

A newcomer to the ranks of The Dollar Bears is the Organization for Economic Co-operation and Development (OECD). The OECD was quoted in Forbes last week as saying the dollar had to fall by 35% to 50% in order to balance the US current account gap. I don't know how they came up with those figures, but they correspond incredibly well to my own expectation of how much the dollar should decline.

I still maintain that we are not currently in a gold bull market but that the gold price is merely adjusting to monetary inflation and foreign exchange rates. We might well enter into a gold bull market if the decline in the US dollar precipitates a crisis, but we are not there yet.

Paul van Eeden

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