[Jeffrey Frankel] Dark heart of gold as an international reserve asset

The price of gold reached an all-time high of $2,000 per ounce in early August. And while mainstream economists have treated gold as a sideshow since the world abandoned the gold standard in 1971, this recent price spike is a significant signal.

Three explanations for the elevated gold price -- related to US monetary policy, risk and investors’ growing desire for a safe-haven alternative to the dollar -- have been offered. Each contains some truth.

The US Federal Reserve has eased monetary policy aggressively since the onset of the coronavirus recession in March. True, there currently is little sign of inflation -- for centuries a major motive for holding gold. But rising goods prices are not the only sign of easy money. Today’s low real interest rates, depreciated dollar and high stock prices -- not to mention the size of the Fed’s balance sheet -- all reflect the Fed’s accommodative monetary-policy stance.

A low real interest rate is often associated with a high real price of gold, both in theory and empirically. After all, the longtime argument that gold doesn’t pay interest is less persuasive when other assets are also yielding scant returns.

The last decade confirms the correlation. The gold price was almost as high as it is now in 2011-12, during the Fed’s second and third rounds of quantitative easing. It then fell to $1,200 per ounce during the “taper tantrum” that followed then-Fed Chair Ben Bernanke’s May 2013 announcement of plans to end quantitative easing.

Another age-old reason to invest in gold is to hedge against risk, because the gold price, although highly variable, tends to correlate relatively weakly with prices of other securities. For obvious reasons, risk perceptions have been elevated since February, as reflected in policy uncertainty indices and the Volatility Index, aka the “fear index.” Gold is typically one of several safe-haven assets to which risk-averse investors flee.

Although the dollar has long been the world’s leading safe-haven currency, the increasing eagerness of many investors’ to diversify their holdings partly reflects US President Donald Trump’s weaponization of the greenback, using -- or abusing -- its status as the leading international reserve currency to enforce unilateral US sanctions extraterritorially. Another likely factor is widespread loss of confidence in the competence of US governance, with the most egregious example being Trump’s mismanagement of the COVID-19 pandemic.

The end of the dollar’s preeminence has been prematurely declared many times, and no obvious challenger has yet emerged. The world’s second most important currency, the euro, lags far behind the dollar in measures of international use. Meanwhile, the Chinese yuan, heralded as a potential challenger not long ago, is only fifth, seventh, or eighth in the rankings, depending on the criterion used.

Gold is not a currency, but it rivals the dollar as an international reserve asset and has benefited from the desire for diversification. Moreover, the dollar’s depreciation since April against the euro and most other major currencies itself partly explains the increase in the dollar price of gold.

The heyday of the international gold standard (under which most leading currencies were convertible into gold) ended in 1914, with the advent of World War I. But the arrangement continued to play an important role until August 1971, when US President Richard Nixon surprised the world by abruptly ending the dollar’s convertibility into gold.

Today, however, the gold standard is of more than antiquarian interest. In January, Trump nominated Judy Shelton -- who made her reputation as a dyed-in-the-wool proponent of the gold standard -- to be one of the seven governors on the Federal Reserve Board. The Senate Banking Committee voted to approve her, along party lines, on July 21, and her appointment could come up for a final vote as early as September.

Shelton’s views go beyond nostalgia. “Let’s go back to the gold standard,” she wrote in February 2009. She favors abolishing the fiat dollar as legal tender.

But returning to a gold-based monetary system is a terrible idea. Even if low and stable inflation were the only objective, the gold standard did not deliver that. Between 1873 and 1896, for example, the general price level fell by 53 percent in the US and by 45 percent in the United Kingdom, owing to a dearth of new gold discoveries, which ended only with the 1896 Klondike gold rush.

Moreover, economies do better when central banks, in addition to seeking price stability, pursue financial stability and act to stabilize income and employment. The Fed’s monetary stimulus in 2008-12, when unemployment reached 9 percent, was the right policy. Conversely, tightening was appropriate in 2016-18, when US unemployment fell below 4 percent.

Had the Fed instead followed the gold market, it would have tightened monetary policy in 2010, prolonging the period of high unemployment, and loosened policy in 2018. Stimulus was again the right decision when the coronavirus recession hit -- but true believers in gold would take the recent record price as a sign that the Fed should tighten policy aggressively.

Then there is Shelton’s ideological inconsistency. As soon as the prospect of attaining high office arose, she contradicted her long-standing philosophy in order to say what Trump wanted to hear -- namely, that the Fed should loosen monetary policy even faster.

Were Shelton to join the Fed board, neither the price of gold nor what is good for the economy would likely determine her vote. Should Democratic presidential nominee Joe Biden win in November, she would almost certainly reconnect with gold and rediscover the urgent need to tighten policy -- even if the economy is still very weak. But if Trump is reelected, she will probably vote to double down on the current monetary stimulus, even if inflation revives.

We have become accustomed to toadyism and cronyism under Trump, from the Justice Department to the US Postal Service. Until now, the Fed has been blessedly free of these scourges -- but perhaps not for much longer.


Jeffrey Frankel
Jeffrey Frankel is professor of capital formation and growth at Harvard University. -- Ed.

(Project Syndicate)