Wednesday, April 20, 2016

A 21st century gold standard

Imagine waking up in the morning and checking the hockey scores, news, the weather, and how much the central bank has adjusted the gold content of the dollar overnight. This is what a 21st century gold standard would look like.

Central banks that have operated old fashioned gold standards don't modify the gold price. Rather, they maintain a gold window through which they redeem a constant amount of central bank notes and deposits with gold, say $1200 per ounce of gold, or equivalently $1 with 0.36 grains. And that price stays fixed forever.

Because gold is a volatile commodity, linking a nation's unit of account to it can be hazardous. When a mine unexpectedly shuts down in some remote part of the world, the necessary price adjustments to accommodate the sudden shortage must be born by all those economies that use a gold-based unit of account in the form of deflation. Alternatively, if a new technology for mining gold is discovered, the reduction in the real price of gold is felt by gold-based economies via inflation.

Here's a modern fix that still includes gold. Rather than redeeming dollar bills and deposits with a permanently fixed quantity of gold, a central bank redeems dollars with whatever amount of gold approximates a fixed basket of consumer goods. This means that your dollar might be exchangeable for 0.34 grains one day at the gold window, or 0.41 the next. Regardless, it will always purchase the same consumer basket.

Under a variable gold dollar scheme the shuttering of a large gold mine won't have any effect on the general price level. As the price of gold begins to skyrocket, consumer prices--the reciprocal of a gold-linked dollar--will start to plummet. The central bank offsets this shock by simply redefining the dollar to contain less gold grains than before. With each grain in the dollar more valuable but the dollar containing fewer grains of the yellow metal, the dollar's intrinsic value remains constant. This shelters the general price level from deflation.

This was Irving Fisher's 1911 compensated dollar plan  (see chapter 13 of the Purchasing Power of Money), the idea being to 'compensate' for changes in gold's purchasing power by modifying the gold content of the dollar. A 1% increase in consumer prices was to be counterbalanced by a ~1% increase in the number of gold grains the dollar, and vice versa. Fisher referred to this fluctuating definition as the 'virtual dollar':

From A Compensated Dollar, 1913

Fisher acknowledged that 'embarrassing' speculation was one of the faults of the system. Say the government's consumer price report is to be published tomorrow and everyone knows ahead of time that the number will show that prices are rising too slow. And therefore, the public expects that the central bank will have to increase its gold buying price tomorrow, or, put differently, devalue the virtual dollar so it is worth fewer ounces of gold. As such, everyone will rush to exchange dollars for gold at the gold window ahead of the announcement and sell back the gold tomorrow at the higher price. The central bank becomes a patsy.

Fisher's suggested fix  was to introduce transaction costs, namely by setting a wide difference between the price at which the central bank bought and sold gold. This would make it too expensive buy gold one day and sell it the next. This wasn't a perfect fix because if the price of gold had to be adjusted by a large margin the next day in order to keep prices even, say because a financial crisis had hit, then even with transaction costs it would still be profitable to game the system.

A more modern fix would be to adjust the gold content of the virtual dollar in real-time in order to remove the window of opportunity for profitable speculation. Given that consumer prices are not reported in real-time, how can the central bank arrive at the proper real-time gold price? David Glasner once suggested targeting the expectation. Rather than aiming at an inflation target, the central bank targets a real-time market-based indicator of inflation expectations, say the TIPS spread. So if inflation expectations rise above a target of 2% for a few moments, a central bank algorithm rapidly reduces its gold buying price until expectations fall back to target. Conversely, if expectations suddenly dip below target, over the next few seconds the algorithm will quickly ratchet down the content of gold in the dollar to whatever quantity is sufficient to restore the target (i.e. it increases the price of gold).

Gold purists will complain that this is a gold standard in name only. And they wouldn't be entirely wrong. Instead of defining the dollar in terms of gold, a compensated dollar scheme could just as well define it as a varying quantity of S&P 500 ETF units, euros, 10-year Treasury bonds, or any other asset. No matter what instrument is being used, the principles of the system would be the same.

A compensated dollar scheme isn't just a historical curiosity; it may have some relevance in our current low-interest rate environment. Lars Christensen and Nick Rowe have pointed out that one advantage of Fisher's plan is that it isn't plagued by the zero lower bound problem. Our current system depends on an interest rate as its main tool for controlling prices. But once the interest rate that a central bank pays on deposits has fallen below 0%, the public begins to convert all negative-yielding deposits into 0% yielding cash. At this point, any further attempt to fight a deflation with rate cuts is not possible. The central banker's ability to regulate the purchasing power of money has broken down.*

Under a Fisher scheme the tool that is used to control purchasing power is the price of gold, or the gold content of the virtual dollar, not an interest rate. And since the price of gold can rise or fall forever (or alternatively, a dollars gold content can always grow or fall), the scheme never loses its potency.

Ok, that is not entirely correct. In the same way that our modern system can be crippled under a certain set of circumstances (negative rates and a run into cash), a Fisherian compensated dollar plan had its own Achilles heel. If gold coins circulate along with paper money and deposits, then every time the central bank reduces the gold content of the virtual dollar in order to offset deflation it will have to simultaneously call in and remint every coin in circulation in order to keep the gold content of the coinage in line with notes and deposits. This series of recoinages would be a hugely inconvenient and expensive.

If the central bank puts off the necessary recoinage, a compensated dollar scheme can get downright dangerous. Say that consumer prices are falling too fast (i.e. the dollar is getting too valuable) such that the central banker has to compensate by reducing the gold content of the virtual dollar from 0.36 grains to 0.18 grains (I only choose such a large drop because it is convenient to do the math). Put differently, it needs to double the gold price to $2800/oz from $1400. Since the central bank chooses to avoid a recoinage, circulating gold coins still contain 0.36 grains.

The public will start to engage in an arbitrage trade at the expense of the central bank that goes like this: melt down a coin with 0.36 grains and bring the gold bullion to the central bank to have it minted into two coins, each with 0.36 grains (remember, the central bank promises to turn 0.18 grains into a dollar, whether that be a dollar bill, a dollar deposit, or a dollar coin, and vice versa). Next, melt down those two coins and take the resulting 0.72 grains to the mint to be turned into four coins. An individual now owns 1.44 grains, each coin with 0.36 grains. Wash and repeat. To combat this gaming of the system the government will declare the melting-down of  coin illegal, but preventing people from running garage-based smelters would be pretty much impossible. The inevitable conclusion is that the public increases their stash of gold exponentially until the central bank goes bankrupt.

This means that a central bank on a compensated dollar that issues gold coins along with notes/deposits will never be able to fight off a deflation. After all, if it follows its rule and reduces the gold content of the virtual dollar below the coin lower bound, or the number of grains of gold in coin, the central bank implodes. This is the same sort of deflationary impotence that a modern rate-setting central bank faces in the context of the zero lower bound to interest rates.

In our modern system, one way to get rid of the zero lower bound is to ban cash, or at least stop printing it. Likewise, in Fisher's system, getting rid of gold coins (or at least closing the mint and letting existing coin stay in circulation) would remove the coin lower bound and restore the potency of a central bank. Fisher himself was amenable to the idea of removing coins altogether. In today's world, the drawbacks of a compensated dollar plan are less salient as gold coins have by-and-large given way to notes and small base metal tokens.

In addition to evading the lower bound problem, a compensated dollar plan would also be better than a string of perpetually useless quantitative easing programs. The problem with quantitative easing is that commitments to purchase, while substantial in size, are not made at any particular price, and therefore private investors can easily trade against the purchases and nullify their effect. The result is that the market price of assets purchased will be pretty much the same whether QE is implemented or not. Engaging in QE is sort of like trying to change the direction of the wind by waving a flag, or, as Miles Kimball once said, moving the economy with a giant fan. A compensated dollar plan directly modifies the price of gold, or, alternatively, the gold content of the dollar, and therefore has an immediate and unambiguous effect on purchasing power. If central bankers adopted Fisher's plan, no one would ever accuse them of powerlessness again.

*Technically, interest rates need never lose their potency if Miles Kimball's crawling peg plan is adopted. See here.


  1. I've seen many people criticize the old gold standard and only recently learned about this new take, though you note that the compensated dollar was proposed a century ago. The redemption into actual gold seems very clunky. If we had redemption into securities, the banks would need a large inventory of them and accounts denominated in this alternative unit. The ideal case would be an alternative unit that banks could issue directly, without keeping an inventory.

    1. Actually, the first time it popped up was in the early 1800s. Fisher rediscovered it.

      The actual item defining the dollar can be anything, doesn't have to be gold. But it should be of low storage, easily transportable, and fairly common.

    2. Settlement in terms of futures contracts is probably a nice way of reducing costs, especially since we do so much electronic banking nowadays and rarely visit bank branches. The futures contracts proposed by Shiller are nice as money because they are infinitely-lived and thus fungible. John Cochrane used similar thinking to propose perpetual US debt as money.

  2. It isn't gold that is the "volatile commodity". Gold is the constant, it is the dollar that is the volatile commodity. The price of gold (measured in dollars) is the reciprocal of the value of the dollar: a stronger dollar (because of higher nominal interest rates or declining inflation) means a lower price of gold; and vice versa for a weaker dollar.

    1. If the CPI is falling and the price of gold is rising, is the dollar getting strong or weaker?

      If you look at a chart of gold and compare it to the US Treasury bill, you'll see that gold is far more volatile. Right? That's because commodities like gold tend to move a lot, whereas government issued assets like Treasury debt don't. And Federal Reserve debt is essentially the same as Treasury debt.

  3. Great post! For the last few years, I've thought the compensated gold standard is the most elegant means of carrying out monetary policy since coming across it in Glasner's book.

    However, I'm perplexed why Glasner makes no mention of the idea anymore, despite his own previous endorsement. Sumner also dismisses out of hand any proposal to include gold as a tool of monetary policy, even though he called Earl Thompson's plan (virtually identical to, and the primary influence on, Glasner's proposal), the "perfect" monetary policy in an old post. What gives, any thoughts?

    I'd add two more reasons I support the compensated gold dollar plan. First, just including the word "gold" makes the plan (in essence, a form of NGDP targeting) a much easier sell to US Republicans. Something makes them feel uneasy about the Fed being able to create money "out of thin air." Even though adjusting the gold content is in some sense the same thing, reviving the concept of physical redemption would reassure them psychologically. Branding matters--just call it "The 21st Century Gold Standard."

    The other benefit I see is that it puts a check on the US Federal Government's ability to extinguish public debt. Correct me if I'm wrong, but under the current system, what is there to stop the US govt (assuming for argument's sake that the Fed and the Fed govt act in concert) from just using OMOs to buy up all of its debt obligations should the Debt/GDP ratio get too high? Under the compensated dollar plan, the Federal govt could potentially lower the gold content to next-to-nothing and inflate away its debt, but this would have the serious repercussion of causing hyperinflation. At any rate, I feel it's better to sever any link between monetary policy and the level of govt debt.

    As you write, directly controlling the gold content would seem to have much more of an immediate bite than wishy-washy steps like managing expectations, asset purchases, QE, or even negative interest rates. Price level too low? Boom--Fed reduces gold content until it's not. Simple.

    Do you see any (theoretical) drawbacks to the Fisher/Glasner plan?

    1. Hi John,

      I'm not sure why Glasner and Sumner don't talk about the compensated dollar more, especially because--as you say--Glasner wrote about it in his book. Sumner seems more concerned with the target, NGDP, rather than the instrument, at least on his blog. Having said that, Lars Christensen often blogs about the compensated dollar. See here:

      You're right that the mention of gold will make it more attractive to Republicans than something like Miles Kimball's crawling peg. At the same time, it will make it less attractive to those with a visceral dislike of gold. Gold attracts strong emotions, both positive and negative.

      A compensated dollar plan is probably an easier sell to a nation that already pegs to the U.S. dollar or euro, say like Denmark. Instead of defining the krone as a fixed amount of euros, the Danes would create a compensated krone that contains a varying number of euros. It would be easier to use the euro than gold as the linchpin of the plan since the euro is already in use, and it avoids all the philosophical baggage of gold.

      You ask about drawbacks. I wrote about two of them, the coin lower bound and destabilizing speculation. To discover more criticisms, it would be a good idea to explore the monetary policy literature in the 1910s and 1920s, since all the big shot economists contributed their thoughts on Fisher's idea. There was a rebirth of these ideas in the 1980s and early 90s (the "New Monetary Economics" it was called) where they would have debated these sorts of ideas. Sumner, Woolsey, Glasner, Cowen, and Selgin/White were all involved in the debate.

  4. just call it "The 21st Century Gold Standard."

    Oh duh, that's the title of your post, lol! But I've made the re-branding point before on Sumner's blog.

  5. This seems like an overly complicated way to achieve the desired goal.

    If you want to give the Fed proper control over interest rates, just give it the power to act as a market maker and peg the price of Treasury bonds.

    If you want to have an effective interest rate of -10%, have the Fed put up a standing offer of 1.10x the sticker price on *all* Treasury bills. Sure, the Fed would take a loss, but from the point of view of the government as a whole the result would be essentially neutral due to devaluation of the government's debt.

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    2. * Technically that should be 1.11x face value, and would only apply to Treasury bills due 1 year from now.

      Similarly, if the market thinks 1.11x is too low, you can let the Fed write its own Treasury bonds and sell them at that price.

    3. Of course, like helicopter money, this is essentially just another kind of backdoor fiscal policy; developing better fiscal policy would clearly be a better solution.

    4. Hi Dimitri,

      "This seems like an overly complicated way to achieve the desired goal... If you want to give the Fed proper control over interest rates, just give it the power to act as a market maker and peg the price of Treasury bonds."

      What your describing *is* the compensated dollar plan. While Fisher's basic idea was to vary the gold content of the dollar (ie. set the price of gold), there is no reason why the instrument has to be gold. You could, as you say, define the content of the dollar as a varying quantity of treasury bills, ie. set a T-bill price. Or why not the S&P 500?

      But choosing gold (or the S&P 500) has an advantage over Treasury debt, there is no zero lower bound problem. If you peg the price of government debt such that it yields a negative amount, people will flee into 0% yielding cash.

    5. But won't you just get people fleeing into 0% yielding gold instead?

    6. I don't follow your question. You mean, if the central bank pegs government debt such that it yields a negative amount, will people flee into 0% yielding gold?

  6. I'm confused. In effect, it says that the CB commits to fixing the value of its currency to a basket of real goods while floating its value vs. gold, even if the market for gold is strictly controlled. That is not a gold standard, it is a CPI standard with an artificially high but meaningless price of gold.

    Is the policy tool a wedge between the market price for gold and whatever government announces every morning? Whre would the price of gold in dollars be determined? Would that not create a black market for gold? Sounds like Venezuela to me.

    Would gold (also) be legal tender? Would that not effectively create two currencies (with floating exchange rates)?

    1. Hi Olivier,

      As you say, it's not really a gold standard. Its a "CPI standard" that uses the price of gold as its tool.

      Just like a regular exchange rate peg, there would be no difference between the market price of gold and the price set by the central bank. If the central bank offers to buy and sell gold at, say, $1800, and the market price is still at $1700, then arbitrageurs will buy gold at $1700 and bring it to the central bank for $1800 worth of deposits, until the gap has closed. It would happen very quickly.

      Gold would not be legal tender, existing coins and notes would be legal tender. That would avoid the coin lower bound problem I described (of which floating is one of the solutions, albeit a clunky one).

    2. Hi JP
      I can relate to all of that except the tool part. The CB does not control the price of gold, nor does it make any commitment to parse it, so how can the price of gold be said to be its tool? How is the price of gold any different from the price of rice or massages in this system?

    3. Under a compensated dollar plan the central banks *does* control the price of gold. But it's easier to think of what it is doing in reverse, that it, setting the gold content of the dollar. It sets the dollar's gold content by offering to provide one dollar to anyone who brings a certain amount of gold to the gold window, say 0.35 grains. The next day it may decide to reduce the gold content of the dollar by offering one dollar for just 0.3 grains. We can agree that the central bank has unlimited control over the dollar's gold content, right?

      In reverse, we can also say that the central bank is setting the price of gold at $1455. Because if the central bank is setting the gold content of the dollar at 0.3 grains, and there are 437 grains in an ounce, then it is buying gold ounces at $1455.

    4. We can agree that the central bank has unlimited control over the dollar's gold content, right?

      I seem to be the only one who doesn't agree, so I've probably missed something. But no, I think if the CB commits to keeping the gold content of the dollar such that its market value equals the value of a predefined consumer basket, it has no control whatsoever over the price of gold and thus over the dollar's gold content. The gold content only becomes freely determinable if it gives up the link to the basket. Any sugestion otherwise means you're constructing an over determined system.
      Venezuela announces the dollar content of the bolivar (I believe it's called). The market in dollars is everything but free for Venezuelans and there are no hickups in dollar mining in the US, yet the local market arbitrages that annoncement to oblivion.

    5. Let's back up in time. Take a gold coin standard. The king is responsible for issuing coins but regularly manipulates the quantity of grains in the coinage in a way to profit the royal family. He notices that when he reduces the number of grains in coins, the price of the consumer price basket rises, and when grains are added, it falls. He realizes that instead of managing the standard for his own advantage, he can target a stable price basket by making appropriate modifications the gold content of coins.

      And what applies to coins applies just as well to a modern central bank that issues banknotes and deposits.

    6. I agree with that. But you said: the central bank has unlimited control over the dollar's gold content.

      That's the opposite of what you say above. As soon as you commit to the basket, you lose the dollar's gold content as something you can actively manipulate (use as a tool, control). You have to change it according to the movements of relative prices between gold and the basket. As soon as you have to do something, you lose control.

    7. You are right Oliver. He is making the central bank completely passive, indeed replacing it with a rule in order to stabilize the price level. We know that countries that peg their currency lose independent monetary policy, and here the peg to consumer basket likewise results in loss of tool for macroeconomic stabilization.

    8. "You have to change it according to the movements of relative prices between gold and the basket"

      Ah, I see what you mean. Yes, if the central bank wants to hit the target it has chosen for itself then it has to settle on the proper gold content. It can't just choose any number of grains, and therefore it gives up any say it might have had in determining the dollar's gold content. Sort of like a modern interest rate-setting central bank in that can only select the level of interest on reserves that allows it to hit its inflation target. But gold content (like interest rate on reserves) is still the central bank's tool, or its policy instrument. That's what it has to move to hit its target.

    9. Bingo!
      And I think I now see how that can be used as a tool. It's the promise to redeem, say 1$ for 1 basket of goods worth of gold that ties the $ to the goods.

    10. The tool I think is to adjust the peg to a new price for the consumer basket. Some central banks do this where there is an official exchange rate, but the peg is adjusted now and then to pursue a goal of macroeconomic stabilization.

  7. I like to think of this as a compensation scheme that pays arbitrageurs to collect widely-dispersed information about movements in the price level, and then profit by coming to the gold window for trades. The central bank limits this expense by quickly adjusting the price of gold to bring it back into equilibrium. It's a bit like retailers collecting information about market prices for their goods by offering price-match, and then adjusting their own prices to remain competitive.

    Now that we have companies like Premise and projects like BPP, it might be more economical to simply buy price information from them in real-time and then find suitable ways to adjust the dollar. I personally like the idea of making compensating payments into dollar-denominated accounts overnight, but this method assumes FTPL and predicts that these compensating payments will stabilize the purchasing power of dollar deposits.

    1. "I like to think of this as a compensation scheme that pays arbitrageurs to collect widely-dispersed information about movements in the price level, and then profit by coming to the gold window for trades."

      That's a good analogy. Although its tough to arbitrage the consumer price basket. How do you store services?

      "...but this method assumes FTPL and predicts that these compensating payments will stabilize the purchasing power of dollar deposits."

      I don't follow you here.

    2. With the arbitrage trade I was commenting specifically about the gold window. You are right: there is no arbitrage trade for the consumer price basket. But instead of relying on arbitrage, dollar holders could be compensated for daily changes in value by having compensation adjustments to their inflation-protected accounts overnight. I was thinking before that if these payments came from the government, then their effect on government debt would stabilize the price level via FTPL. But on second thought, perhaps this effect is working in the wrong direction. I'm not sure how the math works out on this: perhaps price level stabilization requires someone other than government to bear fiscal risk.

  8. Very interesting.

    I think/hope I understand most of this, but have some observations using an example:

    Suppose the system starts in “equilibrium”. A CPI basket is defined such that a quantity of gold worth $ 100 according to the prevailing price set by the CB buys a defined CPI basket @ $ 100.

    Suppose a gold supply contraction shock hits the market.

    And suppose the CPI basket subsequently deflates to an observed price of $ 98.

    Because the CPI has deflated, the CB according to the compensated dollar formula reduces the gold content of money proportionately, which means it increases the price of gold. So the CB sets the price of that same assumed quantity of gold at $ 102.

    The market assesses that. If the market thinks CPI deflation will continue, then it thinks the next CB reset for gold will be even higher than $ 102. So there will be a rush to buy gold now at $ 102. That will result in a flow of gold into the private sector, increasing the quantity of gold available, undoing at least some of the initial gold supply shock. That in turn will reduce deflation expectations and move the “equilibrium” price of gold closer to $ 102 than was initially thought, gradually increasing the private sector supply of gold while reducing its demand at the official price of $ 102.

    Suppose that results in a new equilibrium, with no more deflation or inflation.

    That means the (official) gold price is at a new permanently high level.

    So the compensated dollar policy has worked.

    But the price level has still changed. Deflation has been realized.


    a) The usual fixed rate gold standard sets the value of gold in terms of money, and the value of money in terms of gold. It fixes the gold price indefinitely. The hope is that the CPI neither inflates nor deflates, given the expected arbitrage of a fixed gold price versus the prices of other commodity inputs to the CPI.

    b) The compensated dollar system also sets the value of gold in terms of money, and therefore the value of money in terms of gold. But it floats the gold price as a near-continuous function of the CPI money price level. This is still a type of gold standard for the value of money, but the standard is a formula that is a function of a money price for something other than gold – the CPI basket. That formula contrasts with a non-formulaic fixed price for gold arbitrarily set by the CB for an indefinite period of time under a fixed gold standard. The desired/intended effect is roughly the same in both cases. The hope is that the CPI in future neither inflates nor deflates.

    c) I don’t think I quite agree with this, if I understand it:

    “The central bank offsets this shock by simply redefining the dollar to contain less gold grains than before. With each grain in the dollar more valuable but the dollar containing fewer grains of the yellow metal, the dollar's intrinsic value remains constant. This shelters the general price level from deflation.”

    My understanding is that the general price level is constant and sheltered from deflation in the sense of the gold price of the CPI basket, when measured at the precise time of each gold price reset. But I don’t think that means the general price level in terms of money is sheltered from deflation. Each gold price reset adjusts for realized deflation in terms of resetting the gold price of the CPI basket. But that doesn’t undo the price level deflation in terms of money that has just occurred or that has accumulated over time. I think, if the system is effective, that the money price level may be expected to follow a random walk of sorts, with expected but not actual price stability over time.


    1. ...

      d) I think the compensated dollar system is similar to a fixed rate gold standard in that same sense – that there is no reason to anticipate perfect stability in the CPI money price level. That stability is more a wish than a rational expectation. The best that can be hoped is that CPI price level volatility will be more muted than in a free floating market system – the same as is the hope for the operation of a fixed rate gold standard.

      e) The “problem” of speculation in some form is unavoidable. Speculation in this system will always be present as a function of the periodic discrete adjustment of the gold price by the central bank. It is not just the next price setting that is subject to speculation, but the expectation for the path of all future price settings. And there is no reason to expect that realized inflation will match expected inflation, or that a system using an expectations pricing formula (e.g. futures) will result in perfect actual price stability.

      f) It seems to me that speculation is in fact necessary in order to make the compensated dollar system work. The gold flow between the monetary authority and the private sector is an important aspect of the functioning of the system, just as it is in the fixed rate system. It can provide a degree of quantity rebalancing following a supply shock. If a conversion option exists, there will be speculation and a resulting gold flow. If there is no conversion option, the idea of the CB setting a floating rate price for gold becomes meaningless. An accommodating gold flow is what makes this work to the degree that it does.

      g) As a result, there is risk involved with CB gold reserve management, just as there is under a fixed rate gold standard. The risk is that the CB runs out of gold to sell in a deflation environment. The CB can’t manage its way out of a shortage of privately held gold under the compensated dollar plan unless it resets the price of gold higher and higher. The resetting of the gold price according to CPI deflation becomes a protracted process with the gold price ratcheting up gradually for the duration of the deflation. There is no freedom to reset the gold price higher all at once, as there would be in a “one-time” devaluation under a fixed rate standard that faces similar pressure. So a run on gold may happen if expectations for future deflation are pronounced. And it may require an eventual supply adjustment that is not forthcoming quickly enough as current deflation materializes. Adjustment is delayed in that sense. Therefore, the speculative value of gold will take into account the full expected future for deflation – not just the current time period and the deflation measured between gold price resets. Thus, the formula may artificially hold down the price of gold for a period, causing a run. All that said, the run on gold increases the private sector supply so long as the CB has the reserves to withstand it, which itself should act to reduce deflation expectations.


    2. ...

      h) I think the compensated dollar standard can be viewed as the logical near-limit of a fixed rate gold standard, with respect to contingencies of revaluation or devaluation as a result of the imperfections in eliminating realized inflation or deflation. For example, a CPI that continues to deflate will result in the equivalent of a sequence of “mini-devaluations”, with each corresponding reset of the gold price according to the CPI-dependent dollar compensation formula. The compensated dollar standard becomes an accelerated version of the case of a CB that periodically is forced to devalue from an existing fixed rate standard because of the accumulation of deflation pressures and its decision (based on judgement rather than formula) to react by devaluing the currency.

      i) The imperfection of the compensated dollar system in terms of its effectiveness in eliminating realized inflation or deflation is one of degree, when compared to the fixed rate gold standard. In both cases, the degree of imperfection depends on underlying forces driving the real relative values of gold and money, including gold flows in and out of the private sector.

    3. Hi JKH,

      "That means the (official) gold price is at a new permanently high level. So the compensated dollar policy has worked. But the price level has still changed. Deflation has been realized. "

      I'm not 100% sure, but I think the example you use is designed to draw out a similar problem as Kevin Dowd's criticism of the compensated dollar. See Dowd's "The Compensated Dollar Revisited," specifically the section called 'Difficulties from fixing the price of the redemption medium.'

      Basically, if the central bank changes the gold content of the dollar in order to keep the price index at 100, that may have real effects on things like mining activity and gold's use in the arts. If it fails to compensate for these secondary effects, then we might get the sort of end state you envision, where the gold price adjustments have failed to keep the price index constant.

      But I could be wrong.

    4. Thanks JP for that very clear explanation. If I may add, there is a similar side effect if we offer redemption in the form of securities. In this case the bank client is shifting from risk-free to greater holdings of risky assets. But in this case the side-effect is not undesirable or unpredictable, it is exactly why the bank client wants make the asset purchase.

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  10. The compensated dollar plan is not worth reviving. It's based on the wrong-headed notion that movements of the ill defined "price level" are per se undesirable. This was and remains an egregious error of theory.

    It also is a bizarre trick, in which we all pretend gold plays some role in system, but really, it doesn't.