Currency Wars_ The Making of the Next Global Crisis - James Rickards [127]
Taking the above factors into account produces some startling results. Without suggesting that there is any particular “right” level, the following implied gold prices result when using the factors indicated:
In order to impose discipline on whatever regime was chosen, a free market in gold could be allowed to exist side by side with the official price. The central bank could then be required to conduct open market operations to maintain the market price at or near the official price.
Assume that the coverage ratio chosen is the one used in the United States in the 1930s, when the Fed was required to hold gold reserves equal to 40 percent of the base money supply. Using April 2011 data, that standard would cause the price of gold to be set at $3,337 per ounce. The Fed could establish a narrow band around that price of, say, 2.5 percent up or down. This means that if the market price fell 2.5 percent, to $3,254 per ounce, the Fed would be required to enter the market and buy gold until the price stabilized closer to $3,337 per ounce. Conversely, if the price rose 2.5 percent, to $3,420 per ounce, the Fed would have to enter the market as a seller until the price reverted to the $3,337 per ounce level. The Fed could maintain its freedom to adjust the money supply or to raise and lower interest rates as it saw fit, provided the coverage ratio was maintained and the free market price of gold remained stable at or near the official price.
The final issue to be considered is the degree of flexibility that should be permitted to central bankers to deviate from strict coverage ratios in cases of economic emergency. There are times, albeit rare, when a true liquidity crisis or deflationary spiral emerges and rapid money creation in excess of the money-gold coverage ratio might be desirable. This exceptional capacity would directly address the issue pertaining to gold claimed by Bernanke in his studies of monetary policy in the Great Depression. This is an extremely difficult political issue because it boils down to a question of trust between central banks and the citizens they ostensibly serve. The history of central banking in general has been one of broken promises when it comes to the convertibility of money into gold, while the history of central banking in the United States in particular has been one of promoting banking interests at the expense of the general interest. Given this history and the adversarial relationship between central banks and citizens, how can the requisite trust be engendered?
Two of the essential elements to creating confidence in a new gold-backed system have already been mentioned: a strong legal regime and mandatory open-market operations to stabilize prices. With those pillars in place, we can consider the circumstances under which the Fed could be allowed to create paper money and exceed the coverage ratio ceiling.
One approach would be to let the Fed exceed the ceiling on its own initiative with a public announcement. Presumably the Fed would do so only in extreme circumstances, such as a deflationary contraction of the kind England experienced in the 1920s. In these circumstances, the open market operations would constitute a kind of democratic referendum on the Fed’s decision. If the market concurred with the Fed’s judgment on deflation, then there should be no run on gold—in fact, the Fed might have to be a buyer of gold to maintain the price. Conversely, if the market questioned the Fed’s judgment, then a rush to redeem paper for gold might result, which would be a powerful signal to the Fed that it needed to return to the original money-gold ratio. Based on what behavioral economists and sociologists have observed about the “wisdom of crowds” as reflected in market prices, this would seem to be a more reliable guide than relying on the narrow judgment of a few lawyers and economists gathered in the Fed’s high-ceilinged boardroom.
A variation of this approach would be to allow the Fed to exceed the gold