A note on the viability of an "indirectly convertible" gold standard.

I. Introduction

A recent set of papers by Dowd [1; 3], and Schnadt and Whittaker [5] examined the feasibility of an indirectly convertible gold standard. Schnadt and Whittaker (S-W) argued that Dowd was mistaken in asserting that a gold standard could be operational without direct convertibility. Dowd [3] responded that the problems discussed by S-W could be avoided by linking indirect convertibility to a futures targeting approach. This paper will demonstrate that the S-W critique is inappropriate to the system proposed by Dowd. The critique by S-W is not relevant to a system based on a commodity traded in centralized, auction-style markets. And in his rejoinder Dowd conceded too much by arguing that futures targeting could overcome the objections raised by S-W.

The paradox of indirect convertibility is briefly explained in section II. In section III I use both theoretical arguments and historical evidence to demonstrate that the objections raised by S-W are not applicable to a gold standard. Section IV includes a discussion of what type of media of account are not suitable for a monetary system featuring indirect convertibility.

II. The Paradox of Indirect Convertibility

Dowd [3] discusses the paradox of indirect convertibility by using an example where $1 notes are convertible into an amount of silver sufficient to purchase a specified quantity of gold. In his example, if the price of the defined unit of gold rose to $1.20, then banks would pay out 20% more silver than previously for each currency note. This would immediately reduce the market price of silver by a proportionate amount, however, unless the price of gold immediately fell to $1, the bank would be required to again increase the amount of silver paid out to redeemers of each currency note. This would result in a collapse in both the currency stock and the price of silver.

Dowd then argues that for this paradox to occur, the price of gold would have to be "relatively slow" in returning to par. While Dowd takes no position on the issue of whether gold prices are sticky, S-W state that adjustments in the price of gold "presumably take time to occur." Yet S-W offer no theoretical model or empirical evidence to justify this assertion. The next section will provide evidence that gold prices are not so inflexible as to render ineffective a system of indirect convertibility into gold.

III. Gold Markets: Past and Present

Gold is currently traded in highly efficient commodity exchanges in a number of major financial centers. The price of gold in these exchanges often fluctuates by relatively large amounts over extremely short periods of time. Nor is this volatility a recent phenomenon. During 1933, monetary policy pronouncements by the Roosevelt administration often caused rapid changes in the price of gold.

If gold prices reacted slowly to monetary policy then implausibly profitable arbitrage opportunities would be available. For instance, suppose it took a full month for gold prices to react to changes in the currency stock. Now assume that, under a system of indirect convertibility, the price of the specified unit of gold temporarily fell from (its par value of) one dollar to 80 cents. Also assume that the (monthly) nominal interest rate is 1/2 per cent. In the absence of an implausibly large risk premium, the expected return from holding gold should not greatly exceed the nominal interest rate. If so, then the price of gold would immediately rise to at least 99.5 cents, even before there was any change in the money supply.

The preceding example suggests that financial market arbitrage would prevent large deviations between the market price of gold and its par value. Alternatively, this example shows that gold prices must be highly flexible in order for organized commodity markets to operate efficiently. Nevertheless, it could be argued that the previous example does not eliminate the possibility of very small deviations between the market price of gold and its par value. There are, however, other reasons to believe in the feasibility of making a currency indirectly convertible into gold.

At various times in history, countries have employed systems whereby their currencies were indirectly convertible into gold. In most cases, the country's currency was made directly convertible into the currency of a gold-backed currency, and thus indirectly convertible into gold itself. For instance, under the Bretton Woods system, the dollar served as the international reserve currency. A similar form of indirect convertibility occurred for some countries under the pre-war gold exchange standard.

It might be argued that these examples do not directly address the paradox discussed by S-W and Dowd, since the rate of exchange between the medium of redemption (the dollar) and gold was fixed whereas in the examples used by S-W and Dowd the MOR/gold rate of exchange was not fixed. Yet it is difficult to see how this difference could have any important implications. For instance, suppose that under the gold exchange standard the Bank of England chose to change its policy of making the pound convertible into $4.86 (U.S.) to a policy of making the pound convertible into enough Canadian dollars (a floating currency) to buy $4.86. Investors could convert this system of convertibility into the gold exchange standard by simply utilizing three-way arbitrage. The time path of the pound/dollar exchange rate (and thus the pound/gold exchange rate) would be identical in either case.

The pre-war gold standard provides other evidence against the hypothesis that indirect convertibility into gold would be less feasible than direct convertibility into gold. S-W suggest that changes in the stock of currency are one of the mechanisms that would help to eliminate deviations of the market price of gold from its par value. In contrast, under direct convertibility an incipient fall in the price of gold would result in both an increase in the stock of currency and an increase in the issuing bank's demand for gold. Both processes would tend to raise the price of gold back up to its par value. Is the additional demand-for-gold mechanism under direct convertibility necessary for gold prices to remain at par? Although the S-W hypothesis suggests an affirmative answer to this question, the historical record suggests that the demand-for-gold mechanism was not essential.

Under the pre-war gold standard, many small countries such as Danzig and Estonia were able to maintain a fixed exchange rate (into gold) for extended periods of time. How would the Bank of Estonia have responded to a sudden 10 percent increase in the velocity of circulation that threatened to increase the kroon (Estonian currency) price of gold by 10 percent? Clearly the standard procedure would be to sell gold and buy kroons in order to maintain the exchange rate at its par value. This would result in a significant decrease in the world-wide supply of kroons, but only a trivial decrease in the world-wide demand for monetary gold. In this case, changes in the monetary gold stock could not have had a significant effect on the kroon/gold exchange rate. The other mechanism, the change in the currency stock, is of course the mechanism that is allegedly insufficient to assure indirect convertibility into gold.

In practice, movements in the price of gold would often precede changes in the currency stock. If investors had confidence that the central bank would take the necessary steps (i.e., adjust the money supply) in order to bring the price of gold back to par in the near future, then they would engage in stabilizing speculation. Intertemporal arbitrage would preclude the existence of a substantial gap between the market price of gold and its par value.

IV. Other Media of Account

In an earlier paper, Schnadt and Whittaker [4] argued that indirect convertibility would not work if the medium of account was linked to a (relatively comprehensive) defined basket of goods. Given the findings of the previous section, it would be interesting to examine the issue of exactly what type of good or goods can form the basis of what S-W term a "variable commodity standard".

S-W [4, 214] emphasized the fact that the "prices of goods are independently determined by supply and demand in decentralized markets". They also noted that this would prevent variations in the redemption rate of currency from instantaneously correcting the price of the defined basket. There are actually two related problems associated with baskets of goods traded in decentralized markets. The prices of many of the goods may be "sticky," i.e., slow to respond to changes in the money supply. Furthermore, there may be a lag between changes in the price of the defined basket, and the recognition of that change. For instance, there is a recognition lag of approximately one month for the Consumer Price Index in the U.S.

In the real world some prices are flexible and other prices are sticky. The feasibility of index convertibility (direct or indirect) would hinge on whether the proportion of goods with flexible prices is sufficient to offset any fluctuations in the proportion of the index that is composed of sticky prices. Obviously there is an asymmetry in the sense that there is no theoretical limit to how high the price of flexible goods prices can rise, whereas these prices cannot fall below zero. Thus it is conceivable that no amount of monetary contraction would be sufficient to offset a sharp rise in the nominal prices of goods with relatively inflexible prices. (We are not assuming that "inflexible" prices never change, but rather that they respond relatively slowly to monetary shocks. Nevertheless, a large rise in the inflexible portion of the price index, in the absence of any increase in the flexible portion of the price index, would seem rather unlikely.)

In practice, the recognition lag is likely to be a much more serious problem for index convertibility. Even many goods with flexible prices (such as real estate) are traded in decentralized markets and thus the prices are reported with a significant lag. S-W [4] showed that the paradox of indirect convertibility is applicable to this situation. Dowd [2] and Sumner [6] showed how index futures targeting could overcome the recognition lag and Woolsey [7] showed how this approach could be combined with indirect convertibility.

V. Concluding Remarks

A recent paper by Schnadt and Whittaker [5] argued that indirect convertibility into gold is not feasible, and Dowd [3] responded that the futures targeting of price indices could overcome the problems raised by S-W. Both papers failed to notice that gold meets the key criteria for media of account in a system of indirect convertibility: Gold is traded in centralized markets and gold prices are highly flexible.

S-W appear to have inappropriately transferred their earlier (valid) criticism of systems utilizing baskets of goods traded in decentralized markets to the much more feasible system utilizing gold as a medium of account. Dowd appears to have looked forward to the more difficult issues raised by index futures convertibility, and failed to recognize that his proposal for indirect convertibility into gold did not require further refinements.

Both Schnadt and Whittaker, and Dowd, have adequately addressed many of the issues raised by indirect convertibility. Future discussions of this issue need to more carefully address the impact of price stickiness and/or the recognition lag.

Scott Sumner Bentley College Waltham, Massachusetts 

References

1. Dowd, Kevin, "Financial Instability in a 'Directly Convertible' Gold Standard." Southern Economic Journal, January 1991, 719-26.

2. -----. "A Proposal to Eliminate Inflation." Unpublished Manuscript, University of Nottingham, 1992.

3. -----, "The Viability of an 'Indirectly Convertible' Gold Standard: Reply." Southern Economic Journal, October 1993, 501-504.

4. Schnadt, Norbert and John Whittaker, "Inflation-Proof Currency? The Feasibility of Variable Commodity Standards." Journal of Money, Credit and Banking, May 1993, 214-21.

5. -----, "The Viability of an 'Indirectly Convertible' Gold Standard: Comment." Southern Economic Journal, October 1993, 495-500.

6. Sumner, Scott, "Using Futures Instrument Prices to Target Nominal Income." Bulletin of Economic Research, April 1989, 157-62.

7. Woolsey, William W., "The Search for Macroeconomic Stability: Comment on Sumner." Cato Journal, Fall 1992, 475-86.