Bernanke Rejects Gold Standard

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

By Marc Chandler

NEW YORK ( BBH FX Strategy) -- In yesterday's lecture, Federal Reserve chairman rejected the idea that a return to a gold standard is desirable or practical. His pointed remarks come as Republican presidential candidate Ron Paul has fanned ideas in some quarters of the benefits of the discipline of a gold standard. Previously the outgoing World Bank head Robert Zoellick had also advocated a return to a gold standard. In addition, there have been press reports suggesting that some central banks have recently stepped up their purchases of gold for monetary (reserve) purposes.

Bernanke's objections were essentially four-fold. First, a gold standard prevents adjusting policy in response to shifting economic conditions. No matter how high unemployment rose, for example, under the strict adherence to a gold standard, monetary policy tools could not be used.

Second, by participating in a gold standard, countries would be more vulnerable to developments in other countries. It would increase the transmission mechanism, leaving countries more sensitive to developments of other participants.

Third, Bernanke cited the challenge of credibility. Participants have to convince investors that they will sacrifice all domestic goals for the sake of maintaining the gold standard. This seems hardly politically feasible under representative governments. If there is any doubt whatsoever, there would be speculative attacks. Bernanke noted that the gold standard did not prevent frequent financial crises/panics.

Fourth, Bernanke acknowledged that a gold standard did promote price stability over the very long run. However, he noted that over the medium run, it sometimes caused periods of inflation and deflation. He cited the second half of the 19th century when a shortage of gold reduced U.S. money supply and fueled deflation.

Bernanke warned that the gold standard often produced pro-cyclical impulses. During periods of strong growth, money supply would increase and interest rates would fall, which is exactly the opposite of modern central banking and the withdrawal of the proverbial punchbowl just as the party gets going.

Bernanke cited practical difficulties as well. Essentially he argued there is simply not enough gold. Consider that at the end of last week, the press reported that several central banks had taken advantage of the drop in price to step up their gold purchases. Some 4 tons to 6 tons of gold were said to have been purchased (through the BIS). The "street value" is around $250 million-$300 million. This is a mere pittance by nearly any metric.

After unilaterally severing the link between gold and the dollar in August 1971, as "friendly" countries like France and the U.K. insisted on exchanging their Treasuries for gold, the U.S. retained the most monetary gold, with about 8,100 tons. This is more than the second largest holder, Germany, with about 3,400 tons.

As of the end of last year, China had the sixth largest, if one were to include the IMF in the rankings. China's gold holdings were a little more than 1,000 tons (street value ~$62.5 billion). Recall China has more than $3.2 trillion in reserves. If it were to double its gold holdings, would that really amount to a meaningful diversification of its reserves away from dollars?

Global currency reserves are valued at about $10.2 trillion. Central banks' monetary gold holdings are roughly 31,000 tons. The value of that gold is about $2 trillion. Simple back-of-the-envelop calculations suggest that it would require a 4-fold increase in the price of gold in order to bring the value of monetary gold to the value of the currency reserves.

As a thought experiment, we can ask what price of gold is needed to back not only U.S. money supply (given that the last gold link was unilaterally broken) but also, say, the eurozone's and Japan's money supply. It appears it would take at least a 10-fold increase in gold prices. Less than that would risk triggering a depression and deflation.

The U.S. and many European countries' gold holdings account for around 3/4 of their total reserves (currencies plus gold). The BRICs' holdings are considerably lower. China's gold holdings account for less than 2% of its reserves. Russia and India's gold holdings account for about 10% of their reserves. Brazil holds practically no monetary gold.

The fact that the possibility of a return to a gold standard is so remote does not mean that countries will abandon gold purchases. Central banks were net sellers of gold between 1990 and 2010. This year will likely be the third year of net purchases.

However, the amounts of money seem so modest compared with the currency reserves that diversification away from paper money (dollars?) does not seem a very satisfying explanation. Status/prestige of rising powers seem to be a more compelling explanation than moving to any sort of efficient frontier of portfolio diversification.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.