THE BEAR'S LAIR Sliding back towards a gold standard
By Martin Hutchinson
Gold broke through US$1,200 per ounce last week on rumors that the People's
Bank of China might increase the percentage of gold in its reserves. The
dollar, the euro, sterling and the yen all have good reasons to weaken, yet in
our current global fiat money system, they have nothing to weaken against.
Global foreign exchange reserves are at record highs, but there is nothing
solid for central banks to buy. This all raises the interesting question: are
we seeing the beginning of the end of the fiat money floating exchange rate
system that has prevailed since 1973? And could something closer to a gold
standard replace it?
At the extreme, it is very unlikely that in the near future we will go back to
a full gold standard. We're unlikely in five years time to be
wandering round with gold sovereigns or double eagles clanking in our pockets.
Pity. However, it's quite possible for us to move some considerable distance
towards a gold standard without actually getting to the final destination, and
there are increasing signs that the world is heading in that direction.
The explosion in global liquidity in the past decade has had an effect on
global central bank reserves, which increased 414% between 1998 and the second
quarter of 2009 to $6.8 trillion, an annual rate of increase of 14.5%. This is
more than three times the rate of increase of nominal gross world product (GWP)
of 4.6%. Put another way, central bank reserves increased from 4.2% of GWP to
11.1% during the 10 years 1998-2008.
The world therefore has been flooded with liquidity; former Federal Reserve
Alan Greenspan, his successor, Ben Bernanke, and to a lesser extent their
counterparts in the European Central Bank, the Bank of England, the Bank of
Japan and the People's Bank of China, have a lot to answer for. Effectively,
they have by their own actions flooded the globe with paper money and made
ordinary currency and short-term securities increasingly undesirable assets. It
is thus not surprising that private-sector investors and even central banks
themselves are looking for something better. India's purchase in October of 200
tonnes of International Monetary Fund (IMF) gold, at a then value of $6.7
billion, was not a fluke.
The central bank search for an alternative to paper money holdings naturally
leads them in the direction of gold. Gold has very few uses, so theoretically
could lose its value almost completely if the world's markets decided that
holding gold was no more sensible than collecting old tram tickets. However, in
practice, even in the disinflationary and economically ebullient 1980s and
1990s, the gold price dropped only to around $250 an ounce, a price equivalent
to its extraction cost from the most efficient gold mining operations. (That
cost is now around $400 per ounce.) After all, if investors had decided the
stuff was of no interest, there's 50 years supply of it just lying around, so
there would have been no need to produce any more, and no floor from mining
costs on the gold price. In that case, gold would probably have dropped to
around the $50 per ounce at which it becomes a plausible substitute for other
metals in industrial uses.
So the world has bench-tested the Keynesian theory that gold is a barbarous
relic and found it wanting. Even in the 1990s, a time of peace and apparent
disinflationary prosperity, investors - including central banks - wanted to
keep a certain portion of their reserves in gold. Ideologically driven
decisions, such as then UK Chancellor of the Exchequer Gordon Brown's sale of
half Britain's gold reserves in 1999-2002, quickly came back to haunt the
fanatic, as inflation-free prosperity dissolved and the normal world of
economic toil and monetary sloppiness returned.
There are three ways in which the world could move towards a gold standard
without actually getting there. First, the world's central banks, particularly
the ones like China and Japan with the biggest reserve pools, could increase
the percentage of their reserves kept in gold. According to IMF data, that
percentage declined from 13.9% to 9.8% during the great increase in central
bank reserves from 1998 to 2008 even though the gold price more than trebled
during that period.
A return to even the modest 1998 percentage of gold reserves would result in
gold purchases of $324 billion, surely enough to shift the gold market a fair
whack. A return to a still modest ratio of gold holdings of 20% of reserves,
which prevailed as recently as 1994, would result in central bank gold
purchases of $867 billion, about eight years' mine supply at current prices,
and more than 15% of all the gold now in existence.
Second, the world's monetary authorities could start targeting the gold price
as part of their monetary management, aiming to keep it within a certain range,
thereby preventing excessive monetary expansion and dampening excessive
exchange rate fluctuations. A "hard money" Federal Reserve chairman, for
example, worried about the value of the dollar, could seek to keep the gold
price between $900 and $1,000. He would sell gold from Fort Knox when, as now,
the price was above that range, but would maintain a stated commitment to
buying gold if and when the dollar had strengthened sufficiently that the price
fell below $900.
Such a policy would have the advantage that it would not result directly in
manipulating the value of other currencies through central bank purchases or
sales, thus minimizing the chances of protectionist retaliation. That's an
especially valuable advantage when, as at present, the world is in a difficult
and lengthy recession. Of course, as the United States sold gold from Fort
Knox, the dollar might still decline against other currencies even as it rose
against gold.
Finally, the world's politicians could decide that unlimited money creation was
a thoroughly bad thing, and impose restrictions upon their monetary
authorities, attempting to move monetary creation to the kind of automatic,
limited mechanism that a gold standard naturally imposes. As the United States
moves into its 16th year of Greenspan/Bernanke sloppiness since the monetary
relaxation began in February 1995, we hard-money types have come to think
nostalgically, not of the gold standard period, which almost nobody now
remembers, but of the period of monetary stringency, sound economy and
inflation reduction under Fed chairman Paul Volcker and president Ronald
Reagan, in the early 1980s.
Since even Volcker (now aged 82) will not live forever, it is necessary to
Volckerize the Fed by some artificial statutory means, so whatever expansionary
Princeton economics professor a deluded president may appoint to chair the
institution, it is forced to follow a sound monetary policy. The best form of
such a restriction would be to mandate that the Fed must keep the two-year
average of the rates of growth of the M2, MZM and M3 monetary aggregates
between 2% and 4% annually.
The average of several aggregates would be used to minimize the distortions
from one aggregate or another wandering off in a funny direction through
technological change. (For example MZM - the total amount of money available in
an economy - increased exceptionally slowly compared to other aggregates during
the 1970sm and M2, the narrower aggregate Greenspan occasionally glanced at,
rose exceptionally slowly compared to other broad aggregates in 1995-2006.)
That would prevent inflation from taking hold, while being sufficiently
flexible to allow for technology-driven fluctuations in price levels and
sufficiently expansionary to permit normal economic growth without deflation.
Such a program would mimic the gold standard, in which the increase in money
supply depended on the rate of discovery of new gold, which fluctuated only
slowly except with major gold discoveries such as California in 1849 and the
Yukon in 1896-97. However, since the world's gold supply increases by less than
2% annually, an official gold standard may be thought somewhat deflationary -
as well as giving apoplexy to the unfortunately numerous Keynesian economists
who infest academia, officialdom and the media. A "Volcker Standard", if
sufficiently constitutionally embedded that short-termist politicians could not
override it, would give the same advantages as a gold standard, without the
dangers of deflation or Keynesian heart failure.
In three ways therefore, official gold purchases, gold price currency
targeting, and a quasi-gold Volcker Standard, we are likely to approach a gold
standard ever closer in the years to come. Inflationists and official opinion
will sneer at the possibility. However the markets are already making it
inevitable, fueled as they are by the excessive global money creation of the
last 15 years, and the money supply explosion since September 2008.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-2009 David W Tice & Associates.)
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