19 May 2010

Goldbug Wind Tunnel

Gold 21 Comments

OK kids, I am working on something for the layperson, and I want to give some suggestions for reform. I have given the caveats that political “fixes” are always messy, and that all we know for sure is that returning money and banking to the private sector is the ultimate goal and solution.

Having said all that, of course I can’t help myself and make a proposal. Let me know what you guys think would happen in the financial markets in the following scenario:

In order to give a concrete example of how such a policy could work, suppose that Bernanke called a press conference and announced the following (keeping in mind that the officially reported U.S. gold reserves in December 2009 was a little over 8,000 tons) :

“Effective immediately, the Federal Reserve will begin a program of gold accumulation, purchasing 100 tons per month, until total official reserves equal 15,000 tons. Every quarter we will allow outside auditors to inspect our vaults and verify our holdings. Furthermore, in exactly twelve months we will begin selling gold at a price of $2,000 per ounce to any party, whether foreign central bank or private individual. This offer will remain a permanent feature of Federal Reserve policy, and the gold redemption price will remain fixed.”

21 Responses to “Goldbug Wind Tunnel”

  1. Lequita says:

    Hell would freeze over

  2. Jacob Hedegaard says:

    The 8,000 tons would be revised 😉

  3. Coury says:

    Haha! From $35 to $2000.

    There would be a huge chance for arbitrage perhaps: by the time the Fed would be ready to sell gold at $2,000, the real market price would probably be much higher. It would last for maybe a couple months, then the treasury would have to bailout the Fed haha!

    God, this scenario is just plain impossible on so many grounds. Bernanke would be assassinated. Would the ECB approve, would China approve? The former seems easy to answer, the latter… good question.

    Of course we wouldn’t be able to afford fighting all those who hate “our freedom” (durr-da-durr), so the evil leprechauns will easily acquire nuclear weapons and soon after the whole world will be blown to bits. Gold Dollar = Worldwide Nuclear Destruction!


  4. hrg says:

    I can see them buying it, but I don’t see them selling it. Nonetheless, what would happen is, if financial markets find the Fed credible, the price of gold would immediately rise to $2k an ounce.

    • bobmurphy says:

      Why? (I’m not challenging you, I want to hear your explanation.) The Fed isn’t promising to pay $2k for gold, they are promising to sell gold at $2k to any takers.

      • Mike M. says:

        I think that the implication is that $2k / ounce is the upper limit of the price of gold. The fed would be free to keep less dollars in circulation (and therefore a lower price / ounce) … but it’s tying their hands at the upper limit. The price should only move upwards at whatever the supply – demand curve indicates for the extra 100 tons per month. Perhaps offset by renewed credibility in the dollar.

        Ironically, I think that it’s only if the market DOESN’T find the fed credible that the price of gold will hit $2k immediately.

        It’s a one-way currency board. I don’t know that it’s ever been tried. But two way price fixes on exchange rates have worked for periods of time (think Argentina between crises).

        Of course, none of this takes into account what the euro denominated price of gold would be, which at this rate, may well approach infinity.

  5. Ash Navabi says:

    This looks very complicated. My knee-jerk guess is that everyone buy as much gold as the can right at the beginning of the announcement, since they know the price will be going up steadily regardless in the next 12 months. Then, near the time of the Fed’s announced sell-point, everyone would start shorting the crap out of it.

    • bobmurphy says:

      The gold price would go up because of the Fed’s buying, but on the other hand if investors actually believed the new peg, then the dollar would presumably strengthen. So that would be downward pressure on all dollar prices, including gold.

      I think this would allow the Fed to print more dollars so long as the spot price were under $2k, but then as it got close they would have to ease back.

      BTW my basic idea was to allow the Fed to lock-in a dollar/gold peg without forcing massive price deflation elsewhere. So if the Fed just locked in the current price–while engaging in massive gold buying to build up its reserves and bolster credibility–then it would actually require huge CPI drops to get the relative prices right.

      • Ash Navabi says:

        I’m not following you on why the dollar would strengthen. I’m presuming the Fed is printing money to buy gold–is that correct? Wouldn’t that cause the dollar to sink, and all other dollar prices would rise? So, then not only would the real price of gold increase due to the shift in demand, but the nominal price would increase faster since it’s new money being used to buy the metal. So I’m not convinced that the Fed, using new money to buy an asset, is doing anything worthwhile to its credibility.

        Unless, of course, it’s using its replacing its current fiat reserves with actual reserves… but then ‘everyone knows’ that it’s going to be selling the gold after a while anyway… so I’m not at all convinced of any changes in creditability.

        Unless I’m missing something major here.

        • bobmurphy says:

          Suppose Bernanke announced, “Starting in 12 months, we are never printing another dollar. From that point forward, the supply of dollars will be fixed.”

          Can you see why that would strengthen the dollar?

          So similar thing here. So long as they believed the peg, investors would know that the Fed could only increase the supply of dollars very slowly (starting in 12 months). It’s true, the Fed initially could just print new dollars to buy gold, but the moment the market price exceeded $2,000, they would have to rein back the dollars, as I explained in a previous comment.

          Maybe $2k is too high, but I wanted to leave room for the increased demand. In other words, if the Fed just locked in the current price of gold, and sold off MBS and government bonds to swap out for gold holdings, then the tremendous strengthening of the dollar would force every other dollar price (besides gold) to fall probably by more than 30% before restoring equilibrium. I would choose that outcome rather than our current mess, but I think there’s no reason to force a price deflation for purely monetary reasons. It would be like Great Britain going back on gold at the pre-world war I parity, rather than just admitting they had printed a bunch of paper pounds in the interim.

  6. Lucas M. Engelhardt says:


    Just to make sure I’m getting this right: the Fed is going to be continuously buying 100 tons of gold per month (as long as they have low enough gold holdings – meaning, less than 15,000 tons), and will be willing to sell it at $2000/oz. to whomever wants to buy it.

    My impression is that the price would rise to about $2000 an ounce reasonably quickly, and then stay there.

    An interesting thing to me is the impact on the money supply. As long as gold is under $2000 an ounce, the money supply would grow as the Fed purchases gold but no one buys the Fed’s gold – but it would grow more slowly the lower the price of gold is. (Of course, until the Fed’s vaults are full.) If gold would be over $2000 an ounce, the money supply would shrink as the Fed sells a lot of gold at $2000 an ounce, but only buys back a small portion of that at a somewhat higher price. Until, of course, the Fed’s vaults are empty and they can only sell the gold that they just purchased. At that point, it seems that the money supply would grow as the Fed has to buy gold at a higher price and sell exactly that much gold at a lower price.

    Of course, I might be getting the mechanics messed up.

    • bobmurphy says:

      You’ve got the arrangement correct, but keep in mind the Fed can shrink the supply of dollars by selling off other assets, not just its gold holdings. So if two months before the peg kicks in, the spot price of gold is $2,500, then the Fed would have to tighten up pronto. If it didn’t get the price down below $2,000 before the peg kicked in, then arbitrageurs would quickly empty out the Fed’s vaults.

      • Mike M. says:

        But it’s not a peg, right? It’s only an upper limit. They have full flexibility to create / destroy dollars until they reach $2k / ounce.

        • bobmurphy says:

          Right a “peg” usually carries the notion that the government will enforce it on both ends.

  7. NOTAL says:

    I would think that the price of gold in dollars would jump immediately based upon the anticipated new demand from the Fed, maybe up to $2000, but probably not much higher. I don’t know how big the gold market is, and how far the price would be driven up by the Fed’s demanding of 100 tonnes per month. If the price went any higher than $2000, all buyers besides the Fed would be incentivised to put off buying for the six years until the Fed started selling, and they could get any gold they needed for $2000.

    Pegging currencies do metal generally strengthen the currency, but if the peg is at a devalued level (1/2000 oz. Au, vs. current level at 1/1200 oz Au) it would also promise inflation to that level before stabilizing. 1/1200 to 1/2000 over 6 years would be something like 9% inflation per year. The anticipated inflation might drive up prices right away, and thus weigh most of the inflation toward the first years, before leveling off at the new price level.

    Does my reasoning make sense?

    • bobmurphy says:

      Your reasoning makes sense, but the peg kicks in in 12 months, not 6 years.

  8. RG says:

    I must make a few more assumptions before answering. First, all world fiat currencies would remain stable between the announcment and the Fed sale. Second all world currency pegs would remain at the same levels. Third, no major gold discoveries or increase in gold manufacturing levels would occurr. I believe the market gold price would increase logrhithmically to $2000 up to the instant when the Fed began selling gold at $2000 at which time the market price would be $2000. The Fed would have 9200 tons at that point. That’s when things would get interesting. I believe, the 9200 tons would be purchased in nearly the next instant following the beginning of the sale. After that instant we would be at the precipice of the destruction of all current world governmenst or complete global totalitarianism.

  9. RG says:

    It proposes the ultimate showdown of fiat currency vs. market currency and by extension freedom vs. totalitarianism.

  10. Alasdair Macleod says:

    The price of gold would immediately rise to $2,000 less the interest-time value. It would then hold there only as long as the market accepts the proposition.

    I see some assumptions that have to be made:
    1. That they actually have 8,000 tonnes, and are prepared to accept an independant audit. The history here is not good.
    2. That they can acquire sufficient gold. I can see them getting 1,000 tonnes perhaps quite easily, but much more than that I doubt.
    3. That total gold at the Fed at $2,000 is sufficient to stabilise the $. Given the $s outstanding this is a big assumption.
    4. I assume that this won’t operate as a gold standard, otherwise the next economic downturn will see a flood of dollars presented for redemption. And without it operating as a proper gold standard, my guess is that the Fed would get a lot of flak for enriching the nasty gold bugs to no end.
    5. This will create huge problems for other central banks, who have leased gold out from $250 upwards.
    6. Lastly, it would bankrupt bullion banks, who run a fractional reserve system with unallocated accounts.
    Hope this helps.

  11. Alasdair Macleod says:

    Oh,, and the short position on Comex is about 750 tonnes.

  12. RG says:

    I believe that’s a bit shortsighted, Alas. The US government has just announced plans to rid itself of that pesky gold it believes is nearly worthless – at least as money. When they then have no gold (assume also that all other historical hard currencies are included) and are dependent on enforcing their fiat currency with absolutely no backing besides arms, I believe the US dollar and government will either collapse or be enforced with the full extent of the empire’s military might.