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nonzerosum (87.16)

The Gold Equivalence Provision

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November 14, 2010 – Comments (9)

Now that the president of the World Bank, Robert Zoellick, is talking about variations for a global gold standard, I thought I’d throw one out.  It is the Gold Equivalence Provision (GEP) and is designed to constrain reckless government spending but still allow prudent monetary policy (if you don’t think that’s an oxymoron).  I think it should have the legal strength of a constitutional amendment and it should cover all forms of government debt.

Under GEP, the holder of the debt has an option to collect principal and interest in gold ounce equivalents based on the price of gold at the time the bond was issued.  Note: this is very different from the gold standard because the price of gold is set by free markets.  Here's how it works:  Suppose a government agency issues a 10 year $10,000 bond with a 10% coupon on a day when NYMEX gold closes at $1,000.  The holder of the bond would normally receive $1,000 interest per year and then the lump sum principal of $10,000 after 10 years.  In terms of Gold Equivalence, the holder is being paid out interest of 1 ounce of gold every year, and then the principal of 10 ounces after 10 years.  The Gold Equivalence Provision (GEP) would kick in at any time that gold rises above the closing price of gold when the bond was issued (i.e. $10,000 in this example).  In that scenario, the holder would get paid out the current market value of the equivalent gold ounces.  If the gold price drops then the bond works in the normal way.

For example, suppose after 1 year the price of gold is $1,200.  Since this is higher than $1,000 gold price at issuance it means that the GEP kicks in.  The holder gets paid out $1,200 instead of the usual $1,000 in interest.  Suppose after year 2 the gold price drops to $900.  Well then the GEP does not apply and the holder gets paid the regular $1,000 in interest.  Principal payments work the same way.  If after 10 years gold is trading at $1,500 an ounce then the holder gets $15,000 in principal instead of $10,000.

Why gold?
All the usual gold-bug and sentimental reasons plus these two:
- Because it’s useless.  No, seriously. The gold price has limited industrial or economic repercussions.  If the price of gold rises or falls suddenly it doesn't affect farmers or motorists like the price of soy beans or oil would.  So it is the perfect market proxy for inflation expectations or financial discontent.
- Because it’s large market cap makes it hard to manipulate for any extended period of time.  You need massive, global discontent/inflation expectations to move the price.

What would GEP do?

The GEP would impose a market based constraint on government spending.  If the markets feel that spending is unsustainable, the gold price will rise and the government will be constrained.  Or at the very least, bond holders would be made whole.  This is more flexible than the usual balanced budget amendments (which always have "war" and other loopholes anyway) because productive debt financed projects would not be penalized.  If the market thinks that, say, Interstate freeway construction is good for the economy, then gold prices would stay tame. Naturally, many of the gold standard deficiencies apply too.  If someone figures out a way to make gold from sea water then the whole mechanism will collapse.

How is this different from TIPS or currency hedging?
TIPS are subject to the government run CPI number (talk about a fox in the henhouse!). All major modern currencies are fiat based (or worse), and so they don't offer much protection in today's environment of beggar thy neighbor competitive devaluations. 

Summary
I think the GEP provides the same government spending constraints that gold standard supporters yearn for.  But it does this in a more flexible manner by allowing "good" borrowing, and without eliminating modern monetary policy tools and without setting an arbitrary, government imposed price control on gold.  That’s why I think it is better than the gold standard and it can win the support of both Austrian and Keynesian economists.

9 Comments – Post Your Own

#1) On November 14, 2010 at 7:51 PM, dbjella (< 20) wrote:

Why would a Keynesian economist got for GEP?

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#2) On November 14, 2010 at 8:17 PM, nonzerosum (87.16) wrote:

And vice versa on the "useless" aspect.  A commodity like corn can suffer weather induced shortages and you don't want those affecting the GEP payments.

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#3) On November 14, 2010 at 8:20 PM, nonzerosum (87.16) wrote:

#1: Because you can still have monetary policy and the govt can still borrow during recessions for productive infrastructure projects.  So you can still implement Keynesian stimulus. 

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#4) On November 14, 2010 at 8:20 PM, dbjella (< 20) wrote:

got = go

Sorry 

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#5) On November 14, 2010 at 8:56 PM, MegaEurope (< 20) wrote:

Instead of GEP, you could call them GIPS - Gold Inflation-Protected Securities.  The US converting all its debt to gold-indexed bonds is extremely unlikely, but I could seem them as a specialty bond type alongside TIPS.

Of course, considering TIPS now have a negative yield, GIPS would have an even larger negative yield.

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#6) On November 14, 2010 at 11:10 PM, ikkyu2 (99.23) wrote:

This is a neat idea.  I don't see how we get there from here, though.  Seems like adopting this, even piecemeal, would be very disruptive.

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#7) On November 15, 2010 at 9:54 AM, nonzerosum (87.16) wrote:

#5 "gold indexed debt" - a much more concise term.  Thanks - could have saved myself some writing :-).

#5 & #6.  Agreed, its unlikely.  But less disruptive than a gold standard. 

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#8) On November 15, 2010 at 10:59 AM, outoffocus (23.17) wrote:

Good idea.  After a bad enough currency crisis we might end up adopting something like this.

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#9) On November 15, 2010 at 12:17 PM, ChrisGraley (29.65) wrote:

Boy It sure would be entertaining !

JP Morgan would have a huge incentive to drive the price down, but at the same time the hedge funds would have a huge incentive to drive it up.. Since we would only be talking about the price on some specific date, I'm thinking that the hedge funds would win though.

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