Gold Standard Technical Operating
Discussions 3: Discretion Vs. Automaticity
January 29, 2012
Now, at last, we come to the topic which prompted this rather
interesting discussion of technical operating mechanisms.
Gold Standard Technical Operating Discussions 2: More Variations
2012: Some Gold Standand Technical Operating Discussions
For some reason, I seem to become inspired at the beginning of the
year. I'll start on some innocuous topic, and it turns out to be
something quite important.
30, 2011: Italy With the Gold Standard 1861-1914
23, 2011: The Gold Standard in Britain 1778-1844
9, 2011: The "Money Supply" With a Gold Standard 2: 1880-1970
2, 2011: The "Money Supply" With a Gold Standard
23, 2008: How Banks Work 7: the Lender of Last Resort
March 16, 2008: How Banks Work 6: Liquidy Crises and Bank Runs
March 9, 2008: How Banks Work 5: Selling Loans
24, 2008: How Banks Work 4: Banks and the Economy
17, 2008: How Banks Work 3: More Elephant Poop
February 10, 2008: How Banks Work 2: Shitting Like an Elephant
February 3, 2008: How Banks Work
The topic is the role of discretion vs. automaticity in the daily
operations of a gold standard system.
We began our discussions with a typical currency board arrangement.
(Actually, I think even currency boards don't hold very much base
money, but probably use a demand deposit or maybe short-term debt of
a foreign government.) A typical currency board is wholly automatic
as regards to adjustments of base money supply. Every action is
prompted by private market participants ("PMPs") wishing to buy or
sell with the currency board authority.
However, the currency board does have some discretion regarding the
composition of its reserve holdings. We examined how that could
You can set up a gold standard system in this way too. Our first two
gold standard examples were of this type. Their actions to reduce or
increase the base money supply were prompted entirely by PMPs
wishing to trade with the gold standard authority.
Historically, there were no doubt systems of this type in use
somewhere, during the past two centuries. However, the core systems
-- Britain, the U.S., Germany and so forth -- were generally of the
hybrid type. This was the last type we looked at, in which the gold
standard authority has an automatic-type mechanism in the form of
bullion redeemability, and also a discretionary mechanism in the
form of open market operations in high-quality debt, typically
domestic government bonds. We saw that you could also develop a
system that uses open-market operations in bonds entirely, and does
not have a redeemability element, but set up a system of automatic
rules of operation. I don't know of any example of this
historically, but it certainly could be done.
The hybrid systems in use historically typically used open market
operations, on a discretionary basis, as the first and preferred
avenue of adjusting the monetary base. The practical reasons for
this are obvious enough: they tended to hold most of their reserves
in the form of debt, instead of bullion, because this would maximize
seinorage income. A ratio of around 80% debt:20% bullion was common.
Second, it is quite a lot easier to buy and sell debt than to
transport bullion, which has higher transaction costs.
Thus, a typical system would have bullion "buy/sell" points, whether
official or the natural result of the transaction costs of bullion,
let's say around 2% on either side of the parity ratio. In other
words, if the official parity was $1000:one troy oz, then people
would go to the central bank to buy bullion (redeem banknotes) at a
market price of $1020/oz., and sell bullion (trade for banknotes)
around $980, perhaps. In other words, when the market price was
$1020/oz., you could bring $1000 to the central bank and get an
ounce of gold in return, thus generating a $20 profit, minus
However, the gold standard authority ("GSA") would often act to
adjust the monetary base, through unsterilized purchases and sales
of bonds, before the value of the currency reached these "bullion
points." If the market price was $1005, in other words, it took a
little more than $1000 to buy and ounce of gold and therefore the
value of the currency was a little low, the GSA would sell some of
its bond holdings, thus reducing the monetary base and supporting
the value of the currency. It would drift back toward its $1000/oz.
parity, ideally never reaching the $1020 bullion redemption point.
Or, if the market didn't move back toward its parity, the GSA would
sell more bonds, reducing the monetary base further. If that still
didn't work, then the unsterilized redemption into bullion would act
as yet another means to reduce the monetary base.
The timing and size of these open market operations in bonds were
left to the discretion of the GSA and its operators. Over time, they
probably developed a natural feel for appropriate timing and size.
That's the idea, anyway.
However, this presents some complications. It relies upon a certain
level of mastery of the GSA operators. Unfortunately, as we have
seen, sometimes these people have no idea what they are doing. They
might do exactly the wrong thing, buying when they should be
selling, or selling when they should be buying! Instead of improving
upon an automatic system of redeemability, now we are instead
undermining it. This happened in the late 1960s in the U.S.
Also, any open market operation, in bonds or bullion, changes the
monetary base and thus would probably change the reserves of banks.
(The exception would be if banknotes were redeemed.) This would have
some effect on the market for overnight bank loans, which is
actually not that big a deal -- there are many ways of funding other
than overnight loans. We have way too much fixation on this today.
However, the discretion to make open market operations leads
naturally to the discretion to manage short-term interest rates. In
the 1920s, the Fed began to do this. As it was managing the gold
standard system, it could also, concurrently, subtly manage the
short-term bank loan market. This was nothing like what we have
today, but you can see how the seeds were planted.
I'm a bit of a traditionalist. There are a few good reasons for
this, but in general I think there is way too high of a priority
placed on "originality" or "innovation" today. I use quotes because
often these ideas are not very original or innovative. There are a
lot of reasons for this excessive focus on novelty. It is, for
example, a Heroic Materialist theme. We are ardent believers in
"newer and better." We just assume that the iPhone 4 is better than
the flip-phones of five years ago, and we emphasize the same kind of
"innovation" in all spheres, whether it is appropriate or not. This
then relates to the academic world, where careers are built upon the
impression of intellectual leadership. Ambitious professor types
feel that they can more easily obtain tenure by inventing some
newfangled notion, even if total nonsense as it often is, rather
than just saying: the old way worked well, so why not just use that?
I'm much more practical, and would rather go with a way that works
than have to sift through the dozens of bonehead propositions that
people come up with these days.
Thus, when asked how to design a gold standard system for today, I
tend toward the kind of hybrid system that worked in the U.S. and
Britain for several successful decades and even centuries.
However, I admit that this has certain drawbacks, as I have outlined
above. This might be a time for some improvements, namely a wholly
automatic system in which there is no discretion.
Of course, there is always discretion in how the automatic system is
set up. Also, there will always be a "manual override," either de facto or de jure. But, maybe the
day-to-day operations of the system should not be left to anyone's
supposedly good judgement, because we all know how rare that is.
So, let's think of some wholly automatic systems. We've already
outlined two. One is the bullion-redeemability-only system. There
are no open market operations in debt, except in the role of the
"lender of last resort" which is really a sort of overlay system.
The monetary base is adjusted entirely through unsterilized sales
and purchases of gold bullion, initiated by PMPs wishing to transact
with the GSA.
Within this system, the GSA then has the option of deciding how much
of its reserve to hold in either gold or gold-linked bonds. It can
adjust this as necessary, through transactions that do not change
the monetary base, as we saw in our previous items in this series.
We also looked earlier at various ways to set up a wholly automatic
system that used only open-market operations, and did not have
bullion redeemability. For example, you could say that if the market
price is 1% away from the parity price, then the GSA would increase
or decrease the monetary base by 0.5% via open market operations,
per day. If the currency is 1% or more below its parity value for
four days, the GSA would reduce the monetary base by selling bonds
by 0.5% each day, for a total of 2.0%. Over a month, about 23
working days, you would reduce the monetary base by 11.5%, which is
quite a lot actually.
You could add a laddered sequence of activity. If the parity price
deviated by 2% or more, then the GSA would adjust the monetary base
by an additional 1.0%, per day, for a total of 1.5%. This would add
up to 7.5% over the course of a week, which is a lot.
There we have two wholly automatic systems. Now, we could develop
some hybrid systems, that have both automatic elements in them.
In a hybrid system, the basic question is how the two elements would
work together. Would the first avenue of action be an open market
bond operation? Or gold redeemability? Or would we like them to
Let's look at examples of all three.
In our first example, we will have open market operations in bonds
as our first means of operation. This corresponds to the
U.S./British example, but with an automatic rather than
discretionary system. So, let's say we have our 0.5% base money
adjustment triggered by a 1% or more deviation from parity, per day,
and then gold redeemability (or monetization) at a 2.0% deviation
In our second example, gold redeemability is the first means of
operation. We could make a rule that gold redeemability shall be the
normal course of operations, but if gold reserves fall below 10%, or
if gold transactions (either redemptions or monetizations) amount to
more than 2% of total base money in a week, then additional open
market operations in bonds will be added at a rate of 1% per day.
In our third example, we could have both operate simultaneously. For
example, for every $1 million of gold that is either redeemed or
monetized ("monetized" means gold is sold to the GSA at the parity
price), we will match with another $1 million of open-market bond
operations. Or, you could do it in proportion. If gold reserves are
20% of total reserves, then each gold transaction will be matched
with an automatically-triggered open market bond transaction of four
times the size. This would maintain the reserve ratio at a stable
You could develop a number of other variations as well.
All in all, I tend to think that some sort of wholly-automatic
hybrid system involving both gold redeemability and open market bond
operations would be best. However, people need to learn how to do
this before they can design, establish, and maintain such a system.
It's not really that hard, but we are starting from a very
rudimentary level of understanding today.