Price stability and commodities
19 December 2006
Over the fold is a price chart that I made a few years ago. In it I have charted the US dollar price of gold (shown in red) and of oil (shown in blue) with both prices normalised so that in both instances the price is 100 unit in the base year (1955). They are shown on a log scale so that relative volatility during different eras is more easily compared.
Observations, notes and comments:-
i) The gold standard years in the 1950s and 1960s are clearly shown by the flat gold price.
ii) During the gold standard years oil prices were extremely stable.
iii) The gold standard years were characterised by stable consumer prices (much like the last decade has been).
iv) The gold standard years were characterised by stable commodity and currency prices (unlike the last decade).
v) When the gold standard was terminated in 1971 it is clear that the rise in the gold price led the rise in the oil price.
vi) In terms of gold the price of oil closed at the same level that it started. They remain roughly on par with eachother.
26 January 2007 at 12:15 am
Hi Terje, nice blog. I’m finally thinking ‘Tay-a’ when I see it on the page now
Very interested to see this graph. Gold and oil are fascinating topics, there’s something so… fundamental to them.
26 January 2007 at 9:48 am
Fatfingers,
Thanks for getting my name straight.
The major point of this thread was to point out that we are currently enjoying a claytons form of price stability. In other words the type of price stability you have when you’re not having price stability. We have stable consumer prices but we don’t have stable currency prices or stable commodity prices.
The point is not that prices should be regulated but rather that some monetary systems deliver greater stability than other monetary systems. A lot of the noise we see today in financial, currency and commodity markets is due to monetary error and uncertainty rather than just mere fundamentals.
Regards,
Terje.
4 April 2007 at 10:11 pm
Terje,
Is there any other reason behind the price stability of gold and oil? Do deregulated markets not lead to greater commodity speculation? Were there price controls or regulatory systems regarding the trade of these commodities? Didn’t OPEC start messing with the oil supply around the 1970s and this be more responsible for price fluctuations than fiat money?
5 April 2007 at 10:49 am
Brendan,
These are excellant questions. A few quick answers with some more detail depending on what you most want to focus on.
Firstly commodity markets are global and whilst changes in domestic regulation may effect some producers and some consumers they are not likely to change international dynamics significantly on a daily, weekly or monthly basis. Global shifts in policy simply don’t happen that often although they do happen occasionally (eg Kyoto or ending Brenton Woods). And the sudden change in oil volatility does not correlate with a sudden increase in policy volatility.
With regards to OPEC it is worth noting that even though volatility has increase the oil price relative to gold has barely changed at all. And the upswing in gold preceded the upswing in oil prices. And the public pronouncements by OPEC at the time stated quite clearly that they were raising prices in US dollar terms because the US dollar was losing value. They were responding to a monetary price phenomena not driving it. Of course the US then enacted domestic price controls and got the shortages that price controls cause and the myth of a global oil scarcity was born. However nations such as Germany and Japan had no oil shortages because they did not impose price controls. Most telling is that gold prices rose sooner and quicker and there is no gold cartel in the world.
The oil price chart illustrates my point the nicest but we also see sudden increases in volatility in all manner of commodity prices at precisely the moment when Brenton Woods is terminated. And of course with nations shifting to alternate monetary policies we see the disappearance of currency price stability and the emergance of floating exchange rates. Not that anything really floated in a policy sence they just all started fixing to numereous divergent alternate targets. Australia continued to fix to the US dollar for more than a decade but ultimately even we ceased to trust uncle sam and went our own way. Of course the pre WWI gold standard was not as subject to a political fracturing from the centre which is why it endured for more that two centuries instead of two decades. However US production also did not dominate global production in those earlier periods in the way it has done during the most recent century.
Regards,
Terje.
11 April 2007 at 2:54 am
Terje,
I can see the correlation, but this leads me to other questions. If OPEC cut production to raise the price in US dollars, was the US dollar over valued under the gold standard? Did the value of gold in US dollars increase before oil because of this over valuing once US price controls for gold were removed (I’m assuming here that setting the US dollar at US$35 = 1 ounce of gold is a price control on gold as well as a gold standard)? Could oil have tracked the gold price because it was considered as gold equivalent?
On an aside, how does a gold standard deal with instances where currency demand growth exceeds gold extraction and/or exchange growth. Would you advocate a basket of commodities to overcome the risk of this?
Would a gold standard merely be a subsidy for the gold mining industry? Would gold backed currency still be subject to gold speculation up until to the point it becomes widely used?
11 April 2007 at 9:11 am
I am not sure what you mean when you ask if the US dollar was over valued during Brenton Woods. It’s value was set by the market. All that the monetary authorities did was adjust the supply. So the value of one dollar was 1/35th of an oz of gold. To say this was an over valuation would assume that there is some objective measure of value beyond the market place. As such I would say that there was no over valuation and the subsequent price change reflected a change in the dollar supply policy.
Under a gold standard any growth in demand for currency will tend to increase the value of currency (deflation). If currency is worth more then less of it is required to conduct business. However typically within a gold standard any such shift is more typically accomodated by an inflow of gold from abroad and an increase in extraction via mining and a shift in purpose from jewellery etc to monetary. Any significant restraint on the admission of new gold into the monetary sphere only really prevails at the level of the global economy and as that is the only known closed economy the dynamics are somewhat different. In any case we have hundreds of years experience with gold standards and they have almost never caused extremes of inflation or deflation. From 1800 to 1900 in Britian constraits in the supply of new gold caused deflation at about 1% per annum with consumer prices halving over that century. And in the dark ages widespread death by plague did leave gold supplies in excess of production and prices did rise significantly, although it just meant supplies came from abroad and gold left the region until things normalised. None of these monetary affects were negative in consequence.
Keynes proposed a global currency called the Bancor. The ECU was a later varient on the theme although the Bancor was to be linked to a basket of commodities whilst the ECU was not. I think the Bancor would have been workable in economic terms but politically it would have had some of the same problems as the Brenton Woods gold standard which is an over reliance on centralised agents of management in the system.
I don’t believe that a gold standard is a subsidy to gold miners. It does fix the nominal price of their produce but their input nominal input costs (labour, land, capital) will still fluctuate based on alternate use value. If gold production is inflationary (ie too much new gold) then input costs will rise and margins will squeeze marginal gold producers until they go bust and exit the industry. The beauty of a commodity standard is that it self regulates in this way. If it costs you 98 grams of gold (in wages etc) to extract 100 grams of gold then any general increase in nominal input costs is going to put you out of business. There is no subsidy because there is no net transfer of resourses.
Every price is subject to speculation and always will be. I’m not sure what your last question is really saying. And you use of the word “backed” is also misplaced because nowhere have I implied that any currency need be backed by gold. The mechanism for fixing the exchange rate with gold can be achieved in essentially the same way as interest rates are currently fixed. That is to say open market operations modify the base currency supply to achieve a target price. So for instance the RBA may buy and sell Australian dollar on the open market to keep it priced between 39 and 41 milligrams of gold. When they sell dollars they procure gold or foreign exchange or bonds. And when they buy dollars they discard gold or foreign exchange or bonds. The speculators can do as they like but they can’t out gun the central bank because they don’t own a printing press. To be sure the central bank needs financial assets in it’s tool box (including possibly gold) but it does not have to back the currency with gold.
11 April 2007 at 5:28 pm
So your gold standard is not gold backed? I couldn’t go down to the RBA and demand my ounces of gold? If it is not backed by some asset, how is this different from fiat money?
How do you keep the value of a currency within a band of values without buying gold (or some other asset) to increase money supply or selling to decrease money supply?
How does a central bank get these financial assets in it’s tool box? Don’t these assets by default have to equal the value of issued currency? Or am I missing something?
Where does private banking fit into this gold standard with respect to private currency?
Sorry for all the questions.
11 April 2007 at 9:48 pm
My prefered gold standard is not what I have on offer here. I’m talking here about gold standards in general. My preference would be for no national currency and no central bank whilst the gold standard that I have outlined is a fiat gold standard. The currency under the standard I have outlined is not a promise so it is fiat. It is just a managment approach that fixes the value of that fiat currency (rather than targeting interest rates and a consumer basket). The point is that we can have a gold standard with superior results to what our current monetary system offers with very little technical effort and very little sacrifice.
However lets be clear about this. If open market operations are conducted so as to hold the value of the dollar between 39 and 41 milligrams of gold then at any time you could go to the market place and swap your dollars for gold at a price very close to 40 milligrams. It may not be a formal backing but it does give you the freedom to turn in your dollars. And when lots of people decide to turn in their dollars it does necessitate the RBA draining dollar liquidity. Such a scheme is not a promise forever that the dollar in your hand would be worth 40 milligrams of gold but given the ability of governments to break a promises as redily as they change a policy the net effect of either commitment is nearly as secure to the end user.
You do need to buy and sell some asset to change the base money supply. This is what open market operation are. It is just that the asset traded doesn’t have to be gold even if the price target is gold. You can buy and sell Yen whilst targeting the exchange rate with gold. What you trade and what you target don’t have to be the same thing.
At this point in what I have outlined it doesn’t. To move to private currency (a good thing) you would subsequently need to do the following:-
1. Repeal the Bank Notes act of 1910.
2. Define the Australian Dollar to mean 40 milligrams of gold for the purposes of legal contracts, tax laws etc.
3. Direct the RBA to only issue new currency if the value of the legal tender notes hits a higher target of say 43 milligrams. (ie given step one the banks could fill the void an meet the demand for more currency with private promisory notes, gold storage certificates payable to the bearer and the like) all of which could operate as currency (exactly as they did prior to 1910).
There all good questions.
11 April 2007 at 11:11 pm
So would you see this fiat gold standard as a step towards a hard currency commodity standard where every issued form of currency is backed by exchangeable commodity by a multitude of private banks with government taxation and liabilities met by payment with a equally commodity backed government central bank issued currency?
Money supply would be dictated by the market, with currency issuing banks costs and profit derived from seigniorage (as well as their other banking functions). E-currencies would probably have little seigniorage except for perhaps storage costs, since physical notes of exchange would not exist.
12 April 2007 at 11:17 am
I see a fiat gold standard as a worthy reform in it’s own right regardless of whether you take the additionals steps. It would achieve most of the benefits of a truely private system with few technical risks or difficulties. It would be an easier sell because if it fails to work you can easily exit the scheme. If you get the fix price correct it wouldn’t fail but not everybody is as confident about this as me so an easy exit is a good selling point. The easy exit is of course also a weakness but if you need to win over cautious half hearted reformers then it’s got a lot of merit.
If you did reform all the way to a fully private system then I do not expect that private currencies (ie bank issued gold denominated promisory notes) would necessarily be 100% backed by gold. In most instances they may be backed primarily by financial assets. Some would be 100% backed by gold but a lot probably wouldn’t.
Today the Perth Mint issues gold certificates (bits of paper) backed 100% by gold. However these are non-transferable so they don’t operate as a currency in any way. Repeal the Bank Notes act of 1910 and I fully expect we would see high grade, privately issued, transferable, hard gold backed currency along these lines. However in a free system I don’t think they would ever dominate. Gold denominated promisory notes would still typically only entail fractional reserves just as demand deposits do today.
Ultimately I think that such a system would be good. The most important thing is to have a stable “unit of account” and the quality of the actual medium in circulation is of far less concern. Gold is a fantastic unit of account but paper and credit is a better medium of exchange. A gold standard of pretty much any form gives you the best of both.
30 August 2007 at 1:57 pm
Just a question about inflation. It says on the reserve banks website that the reason for having a small positive amount of inflation is to allow things that can’t fall in value by their nature, for example wages, to actually fall in value. The reason you would want that to happen is to encourage efficiency. My understanding of what that means is that you have to work harder next year to get a pay rise but because of inflation it’s really the same amount as you got this year thus you are working more efficiently.
Under the system your proposing here (can I call it exchange rate targeting?) would we still need a small amount of positive inflation, ie. the 2-3% that the RBA targets, but it would just manifest as the price of the dollar in terms of gold increasing?
3 September 2007 at 10:56 am
Historically when gold was targeted during the 1800s the end result was slighly deflationary at about a rate of 1% per annum on average across the century. Although there were periods when inflation hit 2-3% during the Californian and Australian gold rushes.
In a system with flexible wage laws or where real wages are rising over time it does not matter overly if we endur a minor deflation or a minor inflation although the latter does perhaps provide for an easier job of selling any downward real wage price adjustment.
One real reason that the RBA must favour inflation is that with an interest rate targeting mechanism you can’t escape a deflation of any signficance. For instance if you end up with deflation of 5% (due to a supply or demand shock) then a nominal interest rate of 0% may in real terms (ie +5%) represent too tight a setting to move prices out of the downward spiral. And nominal interest rates can’t be lowered below 0% in practice. Of course the RBA could (and should) in that circumstance abandon interest rates as a targeting mechanism and undertake quantitative easing but it compromises the approach. Japan actually got stuck with deflation for more than a decade through the 1990s before it’s monetary authority switched from interest rate targeting (stuck at 0%) to quantitiative easing. At which point they got accused of trying to weaken the Yen (which of course was precisely the point).
If you are going to stick with interest rate targeting then you are essentially commited to ongoing inflation. There is no such nominal zero boundary problem with commodity price targeting. If you were targeting a dollar price at 40 milligrams of gold and the outcome was deflationary then you could revise your target to 35 milligrams of gold (ie make the dollar worth less). Of course the point of a gold standard is that it offers a stable reference for value and such adjustments are in practice generally unwarranted.
30 June 2008 at 5:51 am
do you have any explanation for why in your graph the price of oil is relatively flat when gold is fluctuating, and vice versa – the price of gold is fairly flat when oil is fluctuating madly?
ps. isn’t it Bretton Woods not Brenton?