- Gold is a monetary alarm signal, and a useful indicator for US dollar liquidity
- While everyone loves criticizing the Fed, Janet Yellen did a reasonably good job
- Even with Yellen, the Fed's historical track record remains poor
Criticizing the US Federal Reserve for weakening the value of the US dollar is almost every financial spectator’s favorite past time. The fact that the US dollar has lost more than 95% of its purchasing power since 1913 (the year the Fed was established) relative to gold is a well-known fact. Given the loss of purchasing power over time, many believe that the Fed has failed in its mandate to maintain ‘price stability’. As my former college professor Reuven Brenner writes, the true purpose of gold remains widely misunderstood.
At one extreme, some believe that gold has no purpose (this is the ‘barbarous relic’ argument). Given the limited availability of gold means that it is unsuitable to serve as money. The argument is that the world is far too large and complex to be weighed down by a ‘limiting’ monetary anchor based on a physical commodity. At the other extreme, some believe that the purpose of gold is to ensure that all money is always fully backed by gold reserves. This camp argues for abolishing fractional-reserve banking entirely.
Gold’s real purpose is to hedge monetary mistakes
Neither perspective is particularly helpful. Unrestrained growth in lending has led to many issues including frequent booms and busts, volatility in foreign exchange and interest rates, and high levels of debt. The need for individuals and businesses to manage this volatility has led to an outsized financial and legal sector in most developed countries.
On the other hand, requiring all bank credit to be backed by gold would lead to an unnecessary slowdown in economic growth. Since historical times, goldsmiths have discovered that they can lend out more gold than they maintained in their vaults. As long as customers avoided redeeming their gold at the same time, goldsmiths could earn fees from both maintaining deposits and from interest payments on loans. The British Museum best describes the history of the goldsmith trade in the UK. The difference between a goldsmith and a modern bank is the risk of bankruptcy. In the event of a bank run, goldsmiths faced a real risk of bankruptcy. Today (even after the 2007-2008 recession), banks assume that governments will ultimately bail them out in the event of a catastrophe. Unlike goldsmiths, modern bankers have no skin in the game.
According to Brenner, the real purpose for gold is to act as an indicator for US dollar liquidity. According to this perspective, gold acts like an alarm. When US dollars are too easily available (as measured by real interest rates), gold prices shoot up in response. Conversely when monetary conditions are too tight, gold prices fall.
When the Fed fails to do its job, gold prices react accordingly
Looking at historical gold prices, the precious metal has served its alarm function well. Gold prices rallied sharply between 2002 and 2007 as the US Federal Reserve failed to manage excessive US dollar liquidity. Specifically, it lost control of the rapidly growing international Eurodollar market and the US mortgage sector. While domestic measures of inflation (such as headline CPI and Core PCE) suggested limited reason for caution, gold prices foreshadowed the coming catastrophe. This is shown below:
Despite low inflation, gold correctly anticipated the 2007-2008 financial crisis
Following the financial crisis, gold resumed strengthening as Ben Bernanke advocated for (excessively) easy monetary policies. While the initial rounds of quantitative easing look justified (based on gold prices at the time), subsequent measures to ease monetary policy (QE2 and QE3) were probably unnecessary. Instead of catalyzing growth, Bernanke instead started a global currency war as the European Central Bank and the Bank of Japan soon followed with their own monetary easing programs. This is shown below:
Too loose! QE2 and QE3 went too far
Gold’s judgement on Yellen: mostly right
Looking at gold prices over Janet Yellen’s term, prices have mostly traded in a range between $1,150 and $1,350. This leads to the uncomfortable conclusion that sometimes, the Fed gets monetary policy mostly right. This is visually highlighted below:
No alarm signals looking at gold prices
As can be seen above, gold prices have not strengthened excessively during Yellen’s term as Fed Chair. While gold initially shot up after her inauguration (rising above $1,380), Yellen has done a better job of maintaining the value of the dollar relative to her predecessor. In fact, gold weakness in 2015 suggests that the Fed’s policies were probably too tight given the growth and inflation outlook at the time.
All in all
Gold prices show that Yellen did a good job in delivering an appropriate monetary policy during her tenure. While this is good news, the bad news is that the Federal Reserve has done a bad job of maintaining the purchasing power of the US dollar for most of its history. While easy monetary policies provide a short-term boost to growth (in the form of higher exports and increased lending activity), longer term costs including subsequent credit defaults and excessive volatility in financial markets are seldom addressed.