The Return of the Gold Standard

Nov 26, 2010

Does it surprise you how a term/concept suddenly becomes a buzzword? You hear someone mention something and then you keep hearing others talk about it, you start finding it in your newspapers, and you start seeing it on television - almost like a forest fire, isn't it? I work in an Asset Management Company, am constantly surrounded by financial professionals, and like keeping myself updated with daily news reports, and the one term that keeps stalking me around these days is - Quantitative Easing - the currency wars initiated by it, the existing strain in international economic co-operation, and concerns raised over the existing unsatisfactory exchange rate systems.

The more I follow the buzz, the more I learn about various policy proposals that have been called for - implementation of capital controls, tightening of current account balances, and most recently a return to the gold standard.

Finally, someone rises to the occasion and says - "Enough!"
Robert Zoellick, President of the World Bank, has called for a re-negotiation of the global monetary order and more importantly, the introduction of a new gold standard - not a very pleasant thought for central bankers and policy makers. After all, a gold standard would prevent governments from using inflation tax to aid artificial prosperity, socialist programs and finance military expeditions.

However, a gold-backed currency provides hope for a more rational world monetary order.

Zoellick is visualising a system (which he calls Bretton Woods II) comprising of major currencies - the Dollar, the Pound, the Euro, the Yen and the Yuan - where gold would be an international reference point for market expectations, inflation, deflation and future currency values. "Practical and feasible, not radical," is what Zoellick feels of the return of the currency link to gold.

Indeed, there is a strong need to depoliticize money.

It is common knowledge that unlike paper currencies, gold cannot be printed at will. Hence, there is a strong belief that governments would not be able to manipulate money if it is linked to a hard asset like gold.

In the evolution of our monetary system itself lies its degradation, the primary culprits being politicians prone to spending beyond their means (deficit spending).

The original Bretton Woods system which functioned between 1945 and 1971, involved fixed but adjustable exchange rates. This arrangement was supervised by the International Monetary Fund and had safeguards against de-stabilizing capital flows across national borders.

During the first major crisis with hard money, the government devalued paper money and raised the value of gold. However, Franklin Roosevelt, 32nd President of the United States of America, went on to suspend convertibility for citizens. International convertibility and the gold standard remained until the next crisis when the government could no longer afford the standard and so de-linked the dollar permanently.

Without gold and silver standards to keep prices stable, capital lost its respect.

Under a fiat regime, the US and other governments have built up unsustainable debts. Debt has grown faster than GDP. Gross misallocations of capital have occurred. Sure, society has prospered and standards of living have improved, but there also is an increasing number of people lagging behind and falling into poverty. The living standards in the US are rapidly deteriorating and have been since 1970. The cost of living has risen faster than wages. One in every seven Americans lives in poverty while more than 40 million receive food stamps. That is up 58.5% in just the last three years. Not quite a perfect world, eh?

So is there hope? Well, actually there is...

Charles Kadlec's (of the Economic Advisory Board of the American Principles Project) article in the Wall Street Journal said, "guaranteeing a stable value for the dollar by restoring dollar-gold convertibility would be the surest way for the Federal Reserve to achieve its dual mandate of maximum employment and price stability."

He went on to say, "From 1947 through 1967, the year before the US began to weasel out of its commitment to dollar-gold convertibility, unemployment averaged only 4.7% and never rose above 7%," which happily produced not only low unemployment, but that "low unemployment and high growth coincided with low inflation" along with low interest rates, as exemplified by AAA-rated corporate bonds averaging less than 4%, and which "never rose above 6%."

In our present situation, there is simply too much debt in the system. We are looking at a vicious circle where you have to use debt to purchase more debt so that you can repay your original debt. A serious issue with intent here!

Hence, the logical ending point of this bull market is a new currency regime with gold having a significant role to play in it. A new monetary system which will go a long way towards fixing today's monetary problems.

Gold - Tomorrow's money?

Do you see the signs? Investors and foreign central banks re-monetizing gold as they move their savings out of the dollar.

It could soon be accepted as a pseudo legal equivalent to a non-federal reserve note. The International Currency Exchange (ICE), known to acknowledge that, "Gold bullion will be permitted for initial margin only and will be accepted by the clearing house by electronic transfer in increments of 1 troy ounce, and will be priced daily using the London Gold Fixing Price in US Dollars," will gladly treat your gold equivalent to money.

Is it practically possible?

You may like to know this... If gold were to be used as money then what would be the likely adjustment in its price? The likely estimate of money is $60,000bn. The approximate store of gold in the world is about 5bn ounces (best of estimates). Even if we were to exaggerate total gold to include the unaccountable production and assume that all the gold ever into existence totals 10bn ounces. And if all the paper money in the world were replaced with gold, then the price of gold would soar to about $6,000 an ounce.

Yes, very much at least in today's time. The probability of gold being money today is much higher than in previous years due to technology available that can facilitate transferability of gold without any physical movement. Even ownership has become much simple, similar to holding money in the bank. The monetary gold could remain locked in vaults and the ownership linked to the quantity of gold with denominations as low as a fraction of a gram. The transactions can be effected electronically.

Gold Exchange Traded Funds (ETFs) serve as a real example in operation. The gold is stored in vaults with the investors owning units linked to gold and transactions between owners are effected electronically. Gold ETFs are available in denominations as low as ½ gram. The success of ETFs shows that such model is viable.

The Ironic Truth

Any monetary standard, including gold, unless depoliticized would be far from ideal because of government tendency to find enough excuses to change the rules. At present there is a lack of political will to take such an extreme path of rationality.

The reality is that the current sizes of the government's future obligations (the unfunded liabilities like social security, pensions, medical care, payments to bondholders, etc.) are completely and blatantly incompatible with sound money.

There would also be problems of defining what a true gold standard would be at this juncture. Even if some clarity is arrived at, it is likely that holders of gold would derive huge windfalls.

On this note, I stay in wait of tomorrow's headlines, who knows, they may announce - THE RETURN OF THE GOLD STANDARD!