Gold and Reserve Currency Status

Posted by Charles Kahn on Oct 11, 2009

Filed Under (Finance)

A week when the price of gold is at record highs would hardly seem to be the time to argue against gold as an individual investment or as a currency backing. So that’s just what I’ll do.

A year when other countries have been talking up the possibility of replacing the dollar as the world’s reserve currency with something else–another currency, maybe, or a basket of currencies–would hardly seem the time to be complacent about the perceived weakness of the dollar. And again, that’s just what I’ll be.

Actually my argument against gold as an individual investment is simply that there’s no reason to include gold in an investment portfolio in any greater proportions than any other commodity, and no reason to include commodities in any greater amount than warranted by the basic arguments for diversification. Commodities, including gold, are useful as a component of a portfolio as a hedge against financial crises; so are US Treasuries. Commodities, including gold, are useful as a hedge against inflation; so are common stocks. Is gold useful as a hedge against meltdown of the world economic order?–Certainly not if held as financial claims, and probably not if held as bars under the bed: hardtack and distilled water will end up more valuable. As for speculation on future directions of the price of gold–your guess is as good as mine, and I wish you the best of luck.

Largely the same people who would rather hold gold than cash would also rather make cash more gold-like. Partly the belief is that re-tying the dollar to gold is the only effective way to make it “stronger” and that making it stronger is a good thing.

But had the dollar been tied to gold over the recent run-up, that would have been a very bad thing. During the past past year, the run up in gold prices has nearly 20%, and inflation has been minuscule. If dollars had been priced by gold, then there would either have been a massive deflation, or there would have been serious dislocations, as prices of goods and services in the US economy became way-too-high, and businesses struggled to adjust.

I’ve heard it argued that the US should strengthen the dollar to protect its position as the world’s reserve currency. The Chinese, for example, would like to be able to use some other currency than the dollar as a basis for world trading, and have been attempting to make their own currency more acceptable as a reserve for their trading partners. Imagine the effect if they were to peg the yuan to gold–wouldn’t everybody flock to this stronger currency, to the detriment of the US economy?

Well, probably not. I don’t claim to understand the psychology of international currency dealers and speculators, but I do know that they’ll be concerned by the stability of the promise: a country that goes on the gold standard can go off it as well–and the same people that flock to the currency at the initial announcement will run away from it whenever there is a sign that the government cannot commit to continue the peg. We’ve seen such swings in sentiment for currencies pegged to the dollar; they’d be even more dramatic when pegged to a fluctuating commodity price. As a result it seems to me that smart money will still hedge with a basket of currencies, just as they do now.

What about the more moderate version of this argument, that the US should strengthen the dollar in less drastic ways to keep its reserve currency status secure? It’s probably true that prospects of further depreciation of the dollar discourage some holders of dollars, and tightening US monetary policy would make the dollar more attractive as a reserve (although the mechanism through which this happens is actually pretty murky).

But why would the US want to continue to be the reserve currency country in the first place? There are two reasons why the dollar’s ceasing to be the reserve currency would be bad:

1. Loss of seignorage. Because payment assets are useful, others are willing to hold them even if they don’t generate as high a return. That’s how kings made money minting money. It would be expensive for the US to lose this seignorage, but by no means devastating for the US economy.

2. Loss of status as unit of account. Lots of transactions are denominated in dollars even if the payment is actually accomplished in yen or euros. In ancient times when it was expensive to hire scribes to multiply and divide for you, there would be lots benefit from having other people make their pricing decisions based on the unit of account you used for your own day-to-day operations. With electronic calculators, this is now trivial. There is still a little bit of risk reduction provided by the decision by others to use the unit of account most convenient for you. But again, the disappearance of this advantage wouldn’t be devastating.

So the reserve currency role is a nice perk. But if the only way to keep it is to use monetary policy to keep the currency strong, even when the domestic economic situation demands loose monetary policy then that it way too high a price to pay. When inflation is low and unemployment is high, monetary policy should be easy, even if it’s detrimental to our reserve currency status.

2 Responses to “Gold and Reserve Currency Status”

  • jerry l. carson says:

    as usual charlie your points and comments are enlightening. obviously you are much more educated in this area than i am. but in the spirit of this new open blog at my alma mater–which i find very exciting–i will offer my layman thoughts.

    your conclusion that if our economic situation demands easy monetary policy then be damned the risk to our reserve currency status is to me too simplistic.

    i think that you would agree that having the dollar as the reserve currency is quite beneficial as long as the price to maintain it doesn’t become unbearable or counterproductive–which i think was the reasonong behind your conclusion.

    so what is that “price”?

    well to me in very layman terms it is far beyond our monetary policy. it incorporates a host of decisions, charateristics, culture, leadership, standards, competiton, innovation, etc, etc.. to be the best and be the reserve currency of the world you have to be at the top of your game in a myriad of areas.

    since it is a financial arena, to me as a layman, it really comes down to basic finance 101. keep a strong income statement and a powerful balance sheet.

    how do we do that as a nation? well that is all those items above. in my layman opinion we must have a culture that inspires education, high aspiration, innovation moral values and discipline. we must have a free, open capitalistic system with low taxation and regulation. we must have a government with outstanding leadership that serves the good of the nation as a whole.

    ok–so that is so much patriotic blather. let’s get down to basics–finance 101.

    to maintain a strong income statement we must obviously over a long period strive to keep a reasonably balanced current account. in a free trade global economy we should concentrate on maximizing our technology, innovation and productivity to produce the highest margin goods and services. the free market forces will source the lower margin items. maintaining a low taxation and regulatory friendly business environment will not only hep that endeauvor but will also attract foriegn capital.

    to establish a powerful balance sheet we need a government that concentrates on keeping a budgetary balance between taxation and spending. since a low taxation environment is crucial for a strong income statement it is essential that spending is limited to high return investments, critical defense, and needed social safety net programs.

    do these things and the world’s confidence in our economy, leadership and financial discipline will preserve our reserve currency status.

    obviously we currently have strayed from this scenario. if we don’t have the moral fortitude, the financial discipline and enlightened leadership then the world will seek another alternative. what that might be is up for grabs, will require a lot of creativity and may have to entail sacrifices. whether it is another currency, a basket of them or some involvement of gold remains to be seen. the ultimate answer is something that inspires the confidence and stability of the world–what the dollar represented in the past.

    jerry l. carson
    bs management and economics
    1962

  • Charles Kahn says:

    Hi Jerry–welcome to our blog, and thank you for your careful and considered comments. You have correctly called me out on stating my case too glibly: policies are always about tradeoffs, and while the case for loose monetary policy is good right now, there will come a point in the future where the “price” of continuing to keep monetary policy loose will become too high.

    Macroeconomic policy in general has several goals: sometimes these goals are conflicting and sometimes they are complementary. Focusing on monetary policy, there are four important considerations: general economic activity (unemployment); inflation; stability of financial system; and attractiveness of currency to foreign holders. In normal times the most important consideration is inflation: the Fed’s primary job is to keep inflation rates low and (even more important) stable. In normal times if the fed focuses on this goal, the effects are beneficial for the other considerations as well: it aids in financial stability and keeps the currency a desirable international reserve. (Virtually no economists believe any more that the Fed can use monetary policy to keep unemployment artificially low on a long-term basis; instead stable and low inflation rates are now believed to be the best way to ensure high long-term employment as well).

    But we have just been through a situation where the financial system has suffered a massive shock, which has in turn caused a sudden, sharp increase in unemployment. In this circumstance, a loose monetary policy is justified as promoting financial stability, and thereby helping to promote employment. With the inflationary risks minimal, and the current dislocation serious, I believe the price in reduced international confidence (if it indeed occurs), is fully justified.

    Over the longer haul, as economic activity picks up, loose monetary will no longer be justified. Eventually there will be a point where the price for continuing further loose monetary policy will become too high–primarily in terms of inflation, but also in collateral damange to our international standing. It is the job of the Fed to monitor the situation carefully, and to rein in the money supply as the economy approaches this point. This will not be an easy task, but it is an extremely important one, and it involves weighing the considerations you noted.