The recent outperformance of precious metals, combined with budget problems in the United States and parts of Europe, has prompted some to speculate that gold or silver will become the next international reserve currency following the dollar.
The argument in favor of the switch is backed in the United States by tea partiers and individuals concerned with budget deficits and the Federal Reserve's program of Quantitative Easing. The Los Angeles Times has written a piece chronicling the rising clamor for a return to the gold standard, including a program in Utah to accept minted silver and gold coins as legal tender and a failed Montana measure to require distributor-paid tobacco taxes be collected in gold.
As an individual investor, the recent resurgence of precious metal popularity and their strong relative returns, combined with an economic environment of high uncertainty, no doubt makes precious metals look attractive. A 5-10% or more portfolio allocation in precious metals through vehicles like the SPDR Gold Trust (NYSEARCA:GLD) or the iShares Silver Trust (NYSEARCA:SLV) seems reasonable ... or as some financial pundits would claim, downright prudent.
In response, here are my four reasons a return to a gold or silver standard in the United States is downright near-impossible.
1. The Great Depression
While still debated by economists, it is believed that one of the major reasons for the Great Depression's severity and length was a combination of the initial fiscal hawkishness of the Hoover administration and the inability and/or unwillingness of the Federal Reserve to increase the monetary supply.
The rigidity of the monetary supply was largely due to the gold standard in place at the time, and research by economists (including Ben Bernanke, now the Federal Reserve chairman) has suggested that a good predictor of the length of a depression occurring in an individual country was how quickly it removed itself from a gold or silver standard.
The events of the Great Depression have created an academic environment almost exclusively against a return to a precious metals backed currency, and thus any national political advances towards a return to a precious metals standard would face considerable headwinds from the academic community.
2. The Fate of the Liberty Dollar
The Liberty Dollar was an alternative currency backed by gold and silver started in 1998 by Bernard von NotHaus. While at one point being utilized by over 250,000 people, the currency was shut down in 2009 largely using US code 486, that except by law no one may distribute gold, silver or other metals as currency.
Mr. von NotHaus faces 15 years in jail and $250,000 in fines, showing that the federal government is very serious about competition with the dollar in the United States. As Ben Bernanke was a famed scholar of the Great Depression prior to becoming the chairman of the Federal Reserve, it is additionally unlikely the federal government will change its perspective on precious metals as an alternate currency any time soon.
With the precedent of the Liberty Dollar, the rise of a third-party gold or silver backed currency would face considerable headwinds from regulators.
3. Eventually Rising Interest Rates
With exceptionally low interest rates and unprecedented fiscal stimulus and quantitative easing, investors concerned about future inflation might have either looked to Treasury Inflation Protected Securities (TIPS) or commodities. Since five- and 10-year TIPS recently traded with real yields of 0.52% and 0.68%, respectively, and are backed by the federal government, whose profligacy was the cause for concern in the first place, it's understandable that over the short- to intermediate-term money found its way in to precious metals.
However, as realized inflation continues to come in below estimates set by commodity price movements and more in line with inflation as predicted by the difference in yield between Treasuries and TIPS of equal terms, commodities may face downward selling pressure.
Moreover -- as the Federal Reserve begins to raise interest rates in the future -- if precious metals continue to trade sideways, investors will likely begin to switch to higher yielding assets like bonds or equities. This may cause a feedback loop where lower prices lead to additional selling.
4. Logistical Impracticalities of Precious Metals
In addition to the theoretical and historical arguments against a re-adoption of a new gold or silver standard, there are practical reasons why such a practice would be inconceivable today. The logistical case against precious metals consists of the following:
a. Monetary supply would be in the hands of miners, as the introduction of new money would be dependent on the discovery of more silver or gold in a 100%-backed system. This would allow central bankers and politicians no levers to pull in a financial or economic crisis to increase the monetary supply to fight off deflation
b. The physical size of the markets for precious metals would mean that the value of silver and gold would need to increase many times over to cover the notional value of the USD and all other fiat currencies.
c. A gold or silver currency would still require a central holder to issue certificates of deposit or promissory notes of the metal; thus currency holders would still be susceptible to counterparty risk in bankruptcy or economic shock.
d. The value of gold and silver is still measured in dollars, and as long as their returns are benchmarked to other assets based upon dollars, the system is no where near leaving fiat currencies.
As many precious metal bulls will attest, the run up in silver and gold has been largely due to investment demand. Unfortunately, investment demand can be fickle and there is no industrial-backed reason why gold or silver should trade higher than they do currently.
Although precious metals-based currencies worked well to create a transparent base of value before the Internet, in today's globalized economy and interconnected financial system, a currency backed by fixed commodities is unneccessary. In light of this and the facts laid out above, investors would be highly encouraged to give pause when allocating a portion of their portfolios to precious metals.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.