Some Gold Standard Technical
January 8, 2012
I've been having some discussions with a friend about technical
operating mechanisms for a gold standard system. What would be best?
In some of my recent writing for Forbes.com, I've made the point
that a "gold standard system" is actually a rather broad and vague
term. It means a policy of maintaining a currency's value equivalent
to gold, at some parity ratio. However, within that context can be a
great many variations on exactly how it gets done.
Our discussions are regarding redeemability of gold bullion, and the
use of open market operations using bonds. These are both ways to
manage the base money supply, by buying and selling assets. When you
buy an asset, the asset (gold bullion, bonds, or perhaps something
else) is paid for by creating money "out of thin air." This money
appears in the seller's bank account, but it is not debited from an
existing account. When you sell an asset, the money received in
payment disappears, thus shrinking the monetary base.
Let's assume that you have a policy of gold redeemability. In other
words, the monetary authority is willing to sell gold, and take base
money in return, at a certain price. This might be the parity price,
or it might be a percent or two away, creating a "trading band"
around the parity price. When the monetary authority sells gold in
this fashion, the money received disappears, and thus the base money
supply shrinks. You can also have a gold standard system without
gold redeemability -- one that uses non-gold assets such as bonds
exclusively -- but this has been rare historically.
Let's say you have a conventional currency board, that links one
currency with another. Country A has a currency board that links its
currency to the euro at a rate of 5:1. Thus, A$5 per €1. There is
base money of A$500 million, and the currency board authority holds
€100 million. The currency board authority is willing to either buy
or sell A$ in any quantity, in trade for euros, at A$5 per euro. Or,
maybe there is a little trading band or bid/asked spread, so the
currency board authority will buy A$5 at €0.98 and sell A$5 at
€1.02. When the currency board authority sells A$, it does this by
creating new A$ "out of thin air," and taking euros in return. Thus,
the amount of A$ in existence (A$ base money) increases, and the
reserve holdings of euros increase. When the currency board
authority buys A$, and gives euros in return, these A$ disappear
from existence, and the reserve holdings of euros decrease.
The currency board authority rarely holds an actual €100 million of
euro base money -- literal bundles of banknotes, or a reserve
deposit at the ECB. Typically, the currency board authority might
hold a little euro base money, perhaps €10 million (10% of reserve
assets), and the rest of the reserve asset holdings will be in the
form of euro-denominated German government bonds.
The currency board authority can also adjust its reserve holdings.
For example, if it feels that it has too much non-interest-bearing
euro base money, it can use the euros to purchase a bond asset, such
as euro-denominated German Treasury bonds. If it feels that it
doesn't have enough euro base money, it can sell some German
Treasury bonds and receive euro base money in payment. These actions
don't change the monetary base.
It looks something like this:
Note that both buys and sells in this system, which create changes
in A$ base money, arise wholly from someone approaching the currency
board authority (the "private market participant"), to buy or sell
A$ at the prices indicated. The currency board authority does not
instigate any buys or sells on its own. Thus, the currency board
system is wholly automatic, with no discretionary element, even on a
The quantities in this example are rather large. Normally, the
changes as a percentage of assets would be quite modest. Also, most
foreign exchange transactions (buying/selling A$ and euros) would be
between two private market participants. The CBA's contribution
would be if there were more buyers than sellers, or more sellers
than buyers, at the indicated parity price.
This system, a "currency board" system, links one currency with
another currency. We can use the same mechanisms to link a currency
to gold. In this case, the gold standard authority (GSA) is willing
to buy or sell gold at, let's say, A$1000. Of course there could be
a little buy/sell spread of a couple percent as described earlier.
For now, let's assume that the GSA's reserve asset is gold bullion
exclusively, or a "100% bullion reserve" system. Note below that I'm
using "thousands of gold oz." and "millions of A$", so there's the
1000:1 ratio right there. It looks like this:
The terminology "buys A$100m, pays 100,000 oz." is a little odd, but
the transaction is exactly the same as our euro currency board
example. When I say that they "pay 100,000 oz.," I mean that they
actually deliver 100,000 of physical gold bullion to the GSA, and
receive A$100m in return.
This kind of "100% reserve" system basically did not exist in the
last three hundred years. The Gold Standard Authority (in practice
commercial banks, and later central banks) typically held most of
their reserve in the form of government bonds, or perhaps
high-quality corporate bonds. However, unlike our euro currency
board example, where we use foreign government bonds (German
Treasury bonds), they could use domestic government or high-quality
corporate bonds. (In practice, many used foreign government bonds in
a gold-linked currency, such as British Consol bonds. This works
The domestic government bonds are denominated in A$, and since the
A$ is linked to gold, the domestic government bonds are linked to
gold too. Thus, if the central bank wants to reduce its bullion
holdings and increase its interest-bearing bond holdings, it would
sell the bullion on the open market for A$, and then use the
proceeds of the sale to purchase domestic government bonds (or
foreign government bonds, same thing). It would look something like
In fact, gold standard systems such as those of the Bank of England,
or those operated by hundreds of private commercial banks in the
U.S., worked along these lines. Do you see why I say that a gold
standard system is like a "currency board linked to gold"? Pretty
obvious, don't you think.
We didn't even get to the topic at hand today. Maybe next time.