Economics on Trial THE FREEMAN SEPTEMBER 1998

A Golden Comeback, Part I
by Mark Skousen

"A more timeless measure is needed; gold fits the bill perfectly."
--MARK MOBIUS

When speaking of the Midas metal, I'm reminded of Mark Twain's refrain, "The reports of my death are greatly exaggerated." After years of central-bank selling and a bear market in precious metals, the Financial Times recently declared the "Death of Gold." But is it dead?

Following the Asian financial crisis last year, Mark Mobius, the famed Templeton manager of emerging markets, advocated the creation of a new regional currency, the asian, convertible to gold, including the issuance of Asian gold coins. "All their M1 money supply and foreign reserves would be converted into asians at the current price of gold. Henceforth asians would be issued only upon deposits of gold or foreign-currency equivalents of gold." Mobius castigated the central banks of Southeast Asia for recklessly depreciating their currencies. As a result, "many businesses and banks throughout the region have become bankrupt, billions of dollars have been lost, and economic development has been threatened." Why gold? "Because gold has always been a store of value in Asia and is respected as the last resort in times of crisis. Asia's history is strewn with fallen currencies. ... The beauty of gold is that it limits a country's ability to spend to the amount it can earn in addition to its gold holdings."

Not Just Another Commodity

Recent studies give support to Mobius's new monetary proposal. According to these studies, gold has three unique features: First, gold provides a stable numeraire for the world's monetary system, one that closely matches the "monetarist rule." Second, gold has had an amazing capacity to maintain its purchasing power throughout history, what the late Roy Jastram called "The Golden Constant." And third, the yellow metal has a curious ability to predict future inflation and interest rates.

Let's start with gold as a stable monetary system. With most commodities, such as wheat or oil, the "carryover" stocks vary significantly with annual production. Not so with gold. Historical data confirm that the aggregate gold stockpile held by individuals and central banks always increases and never declines.2 Moreover, the annual increase in the world gold stock typically varies between 1.5 and 3 percent, and seldom exceeds 3 percent. In short, the gradual increase in the stock of gold closely resembles the "monetary rule" cherished by Milton Friedman and the monetarists, where the money stock rises at a steady rate (see Chart I).

Compare the stability of the gold supply with the annual changes in the paper money supply held by central banks. As Chart II indicates, the G-7 money-supply index rose as much as 17 percent in the early 1970s and as little as 3 percent in the 1990s. (Why has monetary growth slowed even under a fiat money standard? The financial markets, especially the bondholders, have demanded fiscal restraint of their governments.) Moreover, the central banks' monetary policies were far more volatile than the gold supply. On a worldwide basis, gold proved to be more stable and less inflationary than a fiat money system.

Critics agree that gold is inherently a "hard" currency, but complain that new gold production can't keep up with economic growth. In other words, gold is too much of a hard currency. As noted the world gold stock rises at a miserly annual growth rate of less than 3 percent and oftentimes under 2 percent, while 70% GDP growth usually exceeds 3 or 4 percent and sometimes 7 or 8 percent in developing nations. The result? Price deflation is inevitable under a pure gold standard. My response: Critics are right that gold-supply growth is not likely to keep up with real GDP growth. Only during major gold discoveries, such as in California and Australia in the 1850s or South Africa in the 1890s, did world gold supplies grow faster than 4 percent a year.3

Prices Must Be Flexible

Consequently, an economy working under a pure gold standard will suffer gradual deflation; the price level will probably decline 1 to 3 percent a year, depending on gold production and economic growth. But price deflation isn't such a bad thing as long as it is gradual and not excessive. There have been periods of strong economic growth accompanying a general price deflation, such as the 1890s, 1920s, and 1950s. But price and wage flexibility is essential to make it work.

Next month. Update on Jastram's study The Golden Constant, and gold's amazing ability to maintain its purchasing power over the past 400 years.

1. Mark Mobius, "Asia Needs a Single Currency," Wall Street Journal, February 19, 1998,p. A22.
2. See the chart on page 84 of my Economics of a Pure Gold Standard, 3rd ed. (1997), available from FEE. Note how the world monetary stock of gold never has declined between 1810 and 1933.
3. Ibid., p X6.