The resource costs of a gold standard

by on January 3, 2014 at 2:46 am in Economics | Permalink

This is one of those topics which bugs me.

I’m not happy with counting the stock of “monetary gold” as the “resource costs of a gold standard,” as did Milton Friedman.  We also hold stocks of oil, copper, and other commodities — how about books in libraries? — and no one considers inventories of those commodities as costs per se.  For one thing, holding monetary gold in vaults still involves an option to convert into commodity uses and it may in essence serve as a useful commodity inventory for gold.  Another way to put the point is that a properly capitalized bank can simply hold its gold in dental offices — or in wedding rings — if need be.  How about if they hold their assets in the form of securities (T-Bills?) which can be, if needed, traded for gold mining stocks?

Is there a systematic market failure when it comes to locating inventories too close to major shipping centers?  I don’t see why.  But that’s arguably the same question as the one about the resource costs of a gold standard.

Or consider the Hotelling resource pricing rule, namely that a resource price should rise at the nominal rate of interest, with various adjustments for costs and changing costs and risk tossed in.  Let’s say there is a gold standard and gold is also the medium of account.  The price of gold rising at the nominal rate of interest thus means the general price level is falling at the nominal rate of interest.  During the times of the classical gold standard, expected price inflation was roughly zero, but nominal interest rates were higher than zero.  Either prices weren’t falling fast enough or nominal interest rates were too high or some mix of both.  Say prices weren’t falling enough.  Well, that is violating the Hotelling rule but in fact gold production is then falling short of an optimum, not exceeding it.  Alternatively, you could toss in a liquidity rate of return on holding gold inventories and maybe then things would be just right.

A way to put this point more generally is that pricing some contracts in terms of a commodity does not itself create violations of the Hotelling rule.  You might think that the liquidity premium on gold has to create an inefficiency, perhaps because social and private returns to liquidity differ.  But do they, in the case of base money?  Or isn’t the social return to liquidity arguably higher, if you see bankruptcy costs and benefits from thick capitalization using the liquid asset?  In any case, the marginal liquidity return on money gold has to equal the marginal liquidity return on “commodity gold inventories” and then I am back to not being so sure there is a significant externality wedge.

It is unlikely that a final “all things considered” view will have the quantity of gold mined and held be just right.  Yet as a first cut answer, postulating zero real resource costs for a gold standard is more reasonable than it might at first appear.

By the way, for macroeconomic reasons I’ve never favored a gold standard, but the resource cost argument has long seemed to me weak.  All things considered, we might not end up digging up enough gold (liquidity) and that is the real worry we should hold.

Ray Lopez January 3, 2014 at 3:21 am

This is an incredible post by TC! It forces you to think like a chessplayer to get to what is bugging TC. I will have to Google some of the terms of art, but does this mean TC is now a gold bug? LOL he has lost his mind, but gained RESPECT (now there’s a topical topic for MR readers) from a bunch of gold bug kooks like me!

Yes we can revert to a gold standard, especially if we all agree, as the experiment with Japan over the last 20 years, and as the ongoing _failure_ of Abenomics over the last year show, that inflating the money supply does not really solve any long-term problems (or even short term problems–does anybody think liquidity was the cause of the Crash of 2007 and that increased liquidity solved anything–as opposed to a government bailout, which arguably did stop or slow down the 2008 panic? No, liquidity does not solve anything). Prices are not sticky in the long run. A gold standard would give confidence to people to invest and not worry about having to index everything and hedge inflation. And it would possibly make government borrowing harder, which, unless you are a diehard Ricardo-Lucas Equivalence fan, government borrowing as opposed to a spend-as-you-go scheme cannot be a good thing… now onto Wikipedia to read about the Hotelling rule.

Ray Lopez January 3, 2014 at 3:31 am

OK it’s Barro-Ricardo equivalence (sorry) and the Hotelling rule is simply the well known first-order differential equation used in biology etc (and verified in nature) that the rate of change of something often depends on the something itself times a constant (usually a fixed constant but can vary with time as well). A sound rule that is found in nature and electronics and easy to solve as an exponential function with a time constant, typically the solution is logistic (S-shaped curve).

I’ll leave it to the commentators to see what the wider significance of TC’s post is.

prior_approval January 3, 2014 at 3:38 am

It’s a rallying cry for free silver. Only a GMU Econ professor would be so bold, though one needs a bit of historical knowledge of American monetary issues to understand that the issue of gold’s quantity being a restraint is anything but new.

prior_approval January 3, 2014 at 3:31 am

‘and no one considers inventories of those commodities as costs per se’

The organization formerly named the Charles Koch Foundation may disagree –

‘The SPR is a response to the oil embargo imposed by the Organization of Arab Petroleum Exporting Countries after the 1973 Arab-Israeli War. It comprises five underground storage facilities, hollowed out from salt domes, located in Texas and Louisiana. By 2005, the SPR’s capacity reached its current level of 727 million barrels. At present, 706.8 million barrels are stored in the SPR. That’s over twice the size of private crude oil inventories. To put SPR’s size into perspective, its current storage would cover about 71 days of U.S. crude oil imports or 47 days of total U.S. crude oil consumption.

The SPR’s drawdown capacity is 4.3 million barrels per day. That rate is slightly greater than the combined daily crude oil exports from Iran and Kuwait. In short, the SPR is huge.

Not being faced with capital carrying charges and never wanting to be caught short, government officials, like proud pack rats, want to just sit on this mother of all commodity hoards. They argue that the SPR represents an insurance policy for national emergencies. But without a specified release rule, just what is the insurance policy written for?

What should be done with the hoard of crude oil in the SPR? It’s time to remove the SPR’s “fill” and “release” rules from the grip of politics. Market-based release rules would transform the SPR into an oil bank. It would provide the country with a huge precautionary inventory of oil, generate revenue to defray some of the government’s stockpiling costs, smooth out crude oil price fluctuations, and push down spot prices relative to prices for oil to be delivered in the future. It would also force the government to “buy-low” (when crude oil is plentiful) and “sell-high” (when crude is scarce).’ http://www.cato.org/publications/commentary/greenback-commodity-prices-0 (The third result at google for ‘spr commodity cost’)

‘All things considered, we might not end up digging up enough gold (liquidity) and that is the real worry we should hold.’

Free silver! ( http://en.wikipedia.org/wiki/Free_silver )

Mark Thorson January 3, 2014 at 6:13 pm

Sell it off! With the U.S. soon to become a net exporter of oil, why the heck do we need an SPR? We don’t have a Strategic Coal Reserve, for the obvious reason that with 26% of the world’s recoverable coal (by far the largest of any nation) we not going to suffer a coal embargo unless we’re the ones doing it.

david January 3, 2014 at 3:34 am

The bitcoin subtext is so tangible you can taste it.

prior_approval January 3, 2014 at 3:40 am

OK, then, free Bitcoin!

No need to remain mired in the past.

Rahul January 3, 2014 at 3:43 am

Does the stock of monetary gold respond nimbly to demand variations of commodity gold uses the same way as stocks of oil & other commodities respond to oil demand?

Steve Sailer January 3, 2014 at 5:48 am

In the past, the quantity of gold produced did not respond smoothly to demand. It tended to either slow down as existing mines played out, or spike due to spectacular new discoveries. For example, William Jennings Bryan’s “Cross of Gold” campaign for bimetallism in 1896 was a response to the deflation caused by a stagnating supply of gold, which meant that debtor farmers in Kansas had to repay New York creditors with dollars that kept going up in value.

Fortunately, the 1898 Yukon gold rush poured a lot of new gold into the system, which eased social pressures.

But discoveries of new gold fields were pretty random then. Whether gold mining techniques have advanced like oil and natural gas have is a question I can’t answer. (Of course, just six years ago it didn’t seem like oil production was terribly responsive to demand, either.)

mulp January 3, 2014 at 11:26 am

Gold production is purely a matter of capital investment as new sources of gold are well known and abundant, but the price of gold is extremely responsive to both supply and to speculation, so the willingness to invest in productive capital reflects the faith in capitalism, or lack of faith in capitalism, the gold price signals.

A high gold price indicates a low faith in capitalism – those buying gold see no future in capitalism, capitalism being the belief that building more and moe productive capital will provide a fair rate of return. Instead, looking at the economy, a potential investor sees building wind generators or coal power plants as money losing because no one will be able to pay for the electric power you produce, so he instead buys gold in the hopes that gold will retain more of its value==price than a power plant will, or all other productive capital assets will because the incomes of workers is expected to sink an that will sink demand for all production, thus reducing returns on power plants and factories, thus destroying their value.

But when buying gold, the last thing you want is investment in gold production capital which will increase the supply and drive down the price of gold to its marginal cost of less than $800 per ounce. New production takes a decade and billion dollar commitments for capitalist gold production. However, pillage and plunder by individuals is rampant these days, stealing the gold, and killing and maiming others along the way, mostly through mercury poisoning.

prior_approval January 3, 2014 at 6:03 am

Sailer, being a quite American commenter (the idea that half of Germany is ‘ethnic Catholic’ seems to have escaped him when talking about old and new U.S. immigration patterns), could probably benefit from a slightly more global view – ‘Bryan, the eloquent champion of the cause, gave the famous “Cross of Gold” speech at the National Democratic Convention on July 9, 1896 asserting that “The gold standard has slain tens of thousands.” He referred to “a struggle between ‘the idle holders of idle capital’ and ‘the struggling masses, who produce the wealth and pay the taxes of the country;’ and, my friends, the question we are to decide is: Upon which side will the Democratic party fight?” At the peroration, he said “You shall not press down upon the brow of labor this crown of thorns, you shall not crucify mankind upon a cross of gold.” However, his presidential campaign was ultimately unsuccessful; this can be partially attributed to the discovery of the cyanide process by which gold could be extracted from low grade ore. This process and the discoveries of large gold deposits in South Africa (Witwatersrand Gold Rush of 1887 – with large-scale production starting in 1898) and the Klondike Gold Rush (1896) increased the world gold supply and the subsequent increase in money supply that free coinage of silver was supposed to bring.’ http://en.wikipedia.org/wiki/Bimetallism

The Yukon gold rush pales in comparison to what happened in South Africa – ‘The Witwatersrand Gold Rush was a gold rush in 1886 that led to the establishment of Johannesburg, South Africa. It was part of the Mineral Revolution.

There had always been rumours of a modern-day “El Dorado” in the folklore of the native tribes that roamed the plains of the South African highveld and in that of the gold miners who had come from all over the world to seek out their fortunes on the alluvial mines of Barberton and Pilgrim’s Rest, in what is now known as the province of Mpumalanga.

But it was not until 1886 that the massive wealth of the Witwatersrand would be uncovered. Scientific studies have pointed to the fact that the “Golden Arc” which stretches from Johannesburg to Welkom was once a massive inland lake, and that silt and gold deposits from alluvial gold settled in the area to form the gold-rich deposits that South Africa is famous for.’ http://en.wikipedia.org/wiki/Witwatersrand_Gold_Rush

Vaidas January 3, 2014 at 7:23 am

If this post was called “Why bitcoin isn’t evil”, it would get more hits.

CPV January 3, 2014 at 8:13 am

Think of an economy with no paper currency – only gold. then there will be a positive cost of borrowing gold (the lease rate, also payable in gold), which is equivalent to interest rates on any other currency. This positive cost of borrowing means that today’s gold is worth more than tomorrow’s gold, just like positive interest rates imply in any other currency.

The forward price of gold in terms of any other currency (like USD) will trade at the interest rate differential between that currency and the gold lease rate. F = S *(1+ IR- GL)*t

The forward price is just the hedgeable price, not necessarily an expected realized future price.

The resource cost I guess in this context would be the price of financing the inventory in USD net of leasing the gold out on the market. I’m not sure the gold lease market is large enough to support that much leasing.

Hotelling’s rule is widely discredited.

CPV January 3, 2014 at 8:19 am

I guess a more interesting question is if you expect the gold backed USD interest rates to equal the gold lease rate. I suppose that depends on exactly how the backing mechanism works,a s well as relative demands for scrip vs the commodity, which have different utilizations, and the ease of convertibility.

Nick Rowe January 3, 2014 at 8:42 am

Imagine a world where people get utility from wearing gold as jewelry. U(G,…) where G is the physical quantity of gold (not the value) of gold worn. And there is diminishing marginal utility of wearing gold jewelry. If they use that gold jewelry as a money, their inventory of gold would fluctuate over time as they bought and sold goods. Jensen’s inequality says their expected (average) utility would be lower, than if they used paper money instead.

Nick Rowe January 3, 2014 at 10:21 am

But to criticise my own comment, if people rented all their jewelry from the banks, and used paper money convertible into gold to buy and sell things, there would be no resource cost. Unless banks needed to hold inventories of gold that couldn’t be worn as jewelry.

George Selgin January 3, 2014 at 11:44 am

The argument also assumes that “paper money” (meaning irredeemable fiat money) is a perfect substitute for gold-standard money. In that special case adopting it means doing away with all monetary (including hedge) demand for gold.

In actual fact fiat money has proven to be an imperfect substitute for gold-standard money, especially w.r.t. it’s long-run rate of return. In consequence the demand for what we might call pseudo-monetary gold (bullion, Maple Leafs, Kruggerands, etc.) has tended to more than make up for the reduced demand for monetary gold in the strict sense of the term. Hence gold’s high, though also highly variable, real price, since the early 1970s.

The irony of all the usual resource cost arguments against a gold standard is that in practice such a standard did in fact tend, unlike modern fiat monies, to minimize gold resource opportunity costs, by generally relying upon redeemable paper and deposit-balance media that were in fact relatively close gold substitutes (though redeemable paper notes were less reliable substitutes for gold when these were issued by central banks that might suspend payment with impunity.) Friedman’s famous resource cost estimate assumed, quite unrealistically, a 100% gold coin standard, that is, one with no fractionally-backed redeemable substitutes to reduce the real demand for monetary gold, while also assuming that fiat paper would itself be a perfect substitute for gold-based money. He later acknowledged the error of the latter assumption. For a critique of Friedman’s argument, I recommend Larry White’s chapter on this topic, in his Theory of Monetary Institutions.

mulp January 3, 2014 at 11:05 am

“We also hold stocks of oil, copper, and other commodities — how about books in libraries? — and no one considers inventories of those commodities as costs per se.”

Anyone holding reserves of oil, copper, etc consider that a burden, a cost, and in the past decades have drastically cut the sizes of the reserves to cut costs. The objective increasingly is zero reserves with the raw materials delivered just prior to use.

More important, no one ever considers the idle stocks of raw materials as a means of storing corporate wealth.

And what library sees stocking 1000 copies of “Average is Over” to be better than stocking 100 copies, as better than just one copy on the shelf and maybe a Kindle and iPad copy?

Ron Paul is saying that tons of gold locked in underground vaults are superior to just one copy of “Average is Over” and that a 1000 copies would be a 1000 times worse that seeing a book as a store of wealth relative to gold locked in a vault out of sight and touch.

Given Ron Paul wants the gold locked underground, it seems to me the best gold reserves are those still buried undisturbed underground. We know that that the Brazilian mountain of copper holds tons of gold, so leaving it unmined would serve as a gold reserve of a size that scientists and engineers can estimate to a high certainty which will require zero cost to establish as a reserve buried underground, and zero cost to protect from thieves.

Of course, far larger reserves of gold are stored in the oceans; while the percentage is extremely small, the vastness of the oceans means the gold in the oceans dwarf all the gold mined and accumulated in thousands years of gold worship.

Jon Teets January 3, 2014 at 1:55 pm

Let’s say in 2030 Planetary Resources identifies an asteroid in near earth orbit it turns out that they will have no choice but to discard about 3 olympic swimming pools worth of gold, “produced” as a byproduct of mining for the materials they actually need for furthering their space exploitation agenda. (If it makes you more comfortable, they put as much of the gold to use as they could whilst building their robotic spaceships, miners, etc.)

Should this gold affect the price on Earth?

Consider that:

1) The gold was mined
2) It is in a secure location
3) Ownership is easy to transfer, by fiat, say

mulp January 3, 2014 at 7:09 pm

How about if FDR or Nixon declared the gold in the oceans in territorial US waters as part of the US Treasury or Fed holding? The global total is 20 million tons, so the amount within a 200 mile limit, especially around Hawaii should come close to a million tons, five times the total of all the gold mined by humans.

Transfer of gold reserves between nations could be handled by staking claims on parts of the oceans and then ceding the claim to the creditor nation.

Dick King January 3, 2014 at 3:43 pm

Over the period of time during which the major commodity use of silver [photographic film] decreased tremendously, did the relative price of silver and gold change much?

-dk

Michael January 3, 2014 at 7:16 pm

The resource cost argument SHOULD seem weak–that’s one of the last of many many good reasons not to have a gold standard. And it’s rarely invoked–why bring it up when so many better arguments against the gold standard are readily available?

Anthony Alfidi January 4, 2014 at 12:43 am

Extracting non-renewable resources implies that costs will rise gradually, then perhaps exponentially, as the depletion point nears. We see this in oil and gas shale after production falls of the statistical cliff. This would theoretically cause the marginal net revenue from said commodity’s sale to also rise dramatically, assuming demand remains price inelastic. Expanding the definition of “resources” to include those that are theoretically recyclable (wedding rings) or extractable (dissolved gold in the oceans) becomes a semantic game if there is insufficient non-renewable energy to undertake those activities. Hotelling rule, meet Hubbert’s peak.

Andre Mouton January 4, 2014 at 9:16 am

Weren’t people hoarding gold long before it became a political institution? It seems unfair to blame the gold standard for a resource cost that predates it. Postdates it, as well: gold production nearly doubled over the last 30 years, with no gold standard in sight.

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