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Wednesday, April 1, 2009
Metal myth

It’s an old chestnut, the question of whether the world should return to the gold standard. This would require all notes, coins and bank cash deposits to be matched by an equal amount of the precious metal held in central bank reserves. The issue was raised yet again as recently as March in a paper presented by Eustace Davie of the Free Market Foundation (see accompanying story).

It does have some respected proponents, for example, in no less a person than the former chairman of the US Federal Reserve Board, Alan Greenspan. As far back as 1966 he published an essay entitled, "Gold and Economic Freedom", in which he described supporters of fiat currencies as "welfare statists" hell-bent on using monetary printing presses to finance deficit spending.
Instead he argued for a return to a proper gold standard. Curiously, when he in fact became chairman of the Federal Reserve Board in 1986, he also became head of the biggest printer of fiat money in the world.
In the accompanying article Davie suggests that the South African Reserve Bank should purchase a further R30 billion of gold for its reserves so that the rand would be fully backed by the metal. He goes on to explain that SA should consider establishing an independent Currency Board that utilises gold to back the rand. It would be compelled to maintain exact holdings of the metal at a fixed weight per rand to cover notes and coins in issue.
  So we asked several economists in South Africa if they thought it was a good idea. But they all said ‘no’. Here’s why.
One bank economist said it was “a bit off the wall.” Even if it were adopted by every economy in the world (a basic pre-requisite of the idea), as a single solution it could never address all the world’s problems, and might cause more trouble than it was worth.
“Economic and monetary mechanisms are so intricately connected globally these days that there is no single problem, and therefore no single solution. Even economic theory has been turned on its head. “For example, take money supply. An increase in money supply used to cause higher inflation. That simply does not happen anymore.”
Says another economist, “There are far more interesting things to write about; the subject of a gold standard is a bit of a relic.” But he did agree that printing money was going to lead to serious problems of its own and would need to be addressed at some stage.
Kevin Lings, economist at Stanlib, also gives the thumbs down. For one thing there isn’t enough gold in the world for the purpose (see our other article). “It would be very impractical,” he comments, “and would have unintended consequences. For example, it would divert a huge amount of resources into mining for gold.”
Indeed, how could you blame entrepreneurs from closing their coal mining, platinum mining, or iron ore excavation businesses, for example, and going off in search of gold at, say, $10 000/oz? Skills, capital and resources would disappear from current industry overnight. “You would very quickly find yourself with a commodity inflation crisis,” he suggests.
The loss of an important shock absorber is a second reason against gold. “Currency exchange rates are an essential buffer for all economies,” Mr Lings points out. “With a gold standard there would be no buffer, so any shocks would simply wash through an economy and destroy its local production. With a small open economy like South Africa’s this would be particularly serious. Instead, I would rather have a devaluing currency absorbing any global economic shocks, as at least it would lift the competitiveness of the country’s exports and maintain rather than destroy local production.”
Gold might have had its day for another reason: its volatility. In real terms the value of the metal has been more volatile than the world’s leading currencies, so should be lower down on the list as a reserve candidate. For example, remember it rose to US850/oz in January 1980 from $227 just a year before? A year later it sank quite a bit further before recovering to $477.50 the end of 1987. But it plunged again to as low as $289.80 the end of 1997, then to $255.60 July 1999; before picking up speed again, touching $725.00 mid-2007 and recently peaked at $989.00 on 20th February 2009. In such a volatile environment how could central banks keep their reserves on track, let alone have faith in the metal?
Another point is that you need a maximum amount of flexibility to handle an economic crisis. With a gold standard one’s hands would be tied. You can’t, for example, print money to get out of a crisis. Observes another leading economist, “The gold standard removes the ability of individual countries to allow exchange rates to absorb external shocks.
“In the case of South Africa, for example, if commodity prices fall the rand would remain fixed under a gold standard, which would make it very painful for the economy. By the same token if commodities rose sharply it would potentially be highly inflationary.
“Monetary policy would be thrown out the window, the currency would not adapt, and you would have an economic crisis on your hands. On the other hand, free floating exchange rates are an important part of monetary policy, which is why economies can absorb financial shocks, and why, for example, you can have an increase in the money supply without an increase in the rate of inflation. “
It is true that US money supply is expanding at record levels: up from $1 392 billion in August 2008 to $1 567 billion the end of January 2009, for example (for the M1 measure, notes in circulation and demand deposits) – that’s unprecedented, at an almost 25% annual seasonally adjusted increase. The broader M2 (which adds all bank deposits to the picture) saw a “massive increase” from $7,68 trillion to $8,22 trillion over the same period. Now that’s not good, but the alternative under a gold standard would be disastrous.
“The response by the United States is not the problem,” Lings points out; “it is responding to the problem that the world is experiencing.” In a sense what the US government is doing – essentially printing money – is the lesser of the two evils.
He explains that the funding for the US bailout is coming from two main sources: internally, from the government itself, especially the pension funds; and externally, from the likes of China that continues to turn its export earnings into US government bonds. He points out that, despite the crisis, the US dollar remains a trusted haven of assets, continuing to attract 70% of the world’s savings.
One bank commentator observed that as a backing for the worlds’ currency reserves maybe the US dollar is also becoming a bit of a relic. “The currency is relying on huge capital investments from overseas to support its trade deficits. This has been going on for years. But there must come a time when there are no assets left in the United States that overseas investors want to buy. And, bear in mind economies, such as China, will at some stage want to liquidate some US investments to support growth in their own economy.” As it is they have refused to fund an IMF bailout. Perhaps it’s no coincidence the Chinese are also calling for a new reserve currency.
Ian de Lange of Seed Investments says that governments are working at full speed on plans to get increased spending and borrowing plans passed. They are scared witless of deflation getting a grip on the world pointing out that the 1930 depression “was possibly exacerbated by a contraction in the money supply. In those times the government authorities were unable to reflate their economies; which is precisely what everyone is now trying to avoid.”
As far back as 2002 when there was concern of deflation Ben Bernanke made a speech to the National Economics Club, entitled “Deflation – Making Sure It Doesn’t Happen Here”. He said
“The U.S. government has a technology called a printing press that allows it to produce as many US dollars as it wishes at essentially no cost.
“By increasing the number of US dollars in circulation, or even by credibly threatening to do so, the government can reduce the value of the dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”
Says De Lange, central banks are now firing up their printing presses in order to increase the volume of money in circulation and so drive up prices of real assets, relative to the currency – i.e. devalue their currencies.
“For sure it’s a very dangerous game. Over the years the debt driven US economy required more and more debt to drive up growth. Again in order to stop the decline in the economy and then to sustain an element of growth, the printing presses will have to work harder and harder.
“Recently the US Secretary General, Tim Geithner unveiled a more detailed plan that will see the US government buying so called toxic debt assets from banks, looking to spend up to $1 trillion. It will do this via appointed private asset managers, essentially gearing up their efforts to buy riskier debt from banks.”
So, what do they hope to achieve?
• They are looking to keep interest rates low;
• Banks need to get rid of their unmarketable assets – high risk loans – to strengthen their balance sheets and allow them to concentrate on normal lending operations;
• The US is looking to weaken the relative strength of the US dollar;
• They want to stop the nominal prices of real assets, especially houses but also shares, from a continual downward slide;

Economists believe the gold standard, by preventing the printing of money, delayed recovery from the depression of the 1930s, and caused deflation, which in turn stunted economic activity (why buy today when if you can hold off and buy the same thing tomorrow for less?).
Of course, right now, because of the indisciplines of the past, governments are using some unorthodox, some would say, ill-disciplined policies to deal with the current global economic crisis. Whatever the arguments for or against a gold standard, one thing is clear: financial discipline will have to be restored. The more money they print today, the more future generations will have to pay back through a higher debt build up and higher interest rates. By Nigel Benetton

Copyright © Insurance Times and Investments® Vol:22.4 1st April, 2009
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