Is gold the answer?

The more countries start to think about gold as an index, the more the authorities will try to keep price from rising.

The sovereign debt crisis, unsustainable budget deficits and economic recession in the major reserve currency areas — the United States and Europe — have revived discussions on a return to gold. The gold standard broke down at the time of World War I. The Bretton Woods arrangement, put in place after World War II, pegged the dollar to gold at $35 per ounce. In the wake of persistent stagflation, the United States unilaterally delinked the dollar from gold and moved to the present fiat currency system in 1971. From around $1,400 an ounce at the beginning of this year, gold prices shot up to over $1,900 last week. This spectacular rise suggests high demand, not just from investors hedging against inflation and currency crisis, but also some worried central banks like the Bank of Korea and the Reserve Bank of India. Inflation in the United States and Europe is low, as are interest rates. Over the past decade, the annual increase in inflation of 2.4 per cent fell way behind the annual increase of 21 per cent in the price of gold. So what is it that buyers are hedging against? Either they expect inflation to resurge or gold is almost acting as a currency. Barring some exceptions, gold prices tend to move in the opposite direction of interest rates.

Those arguing for a return to gold believe this fiat is inefficient like all government interventions. The root cause of the crisis is the power to create money. The gold standard takes this power away, as the supply of money is limited by the quantity of gold available. As opposed to the system of fiat currency, the gold standard is stable and non-inflationary. A fixed exchange rate between countries also ensures stability of international trade flows. However, the supply of gold may not be enough. Demand rather than supply influences the price of gold. New discoveries make supply erratic. It also gives monopoly power to countries endowed with gold mines. Disabling money creation restricts the policy choices available for curing recession. This was an important factor in the Great Depression of the 1930s. There is a deflationary bias, which benefits creditors or savers. Debtors lose as the real value of their debt rises. They are forced to lower spending to service debts. Creditors may not necessarily spend the wealth they gain. Aggregate spending falls, leading to mass unemployment.

Congressman Ron Paul, businessman Steve Forbes, former US Federal Reserve chairman Alan Greenspan and economist Robert Barro have been supporting some role for gold in order to have a self-governing mechanism against printing too much money which eventually chases too few goods. In 2001, former Malaysian Prime Minister Mahathir Muhammad proposed an Islamic gold dinar to reduce the dependence of Muslim countries on the dollar as a reserve currency for trade among themselves. The country issuing a reserve currency is in an advantageous position in buying goods and services and contracting debt. The share of gold in foreign exchange reserves is being increased, but gold denominated international trade is a distant dream. The fact of the matter is that 61 per cent of global foreign exchange reserves are held in dollars and another 27 per cent in euros. As predicted by economist Robert Mundell of Columbia University in 1997: “I do not think that we will see the time when either of those two great economic powers, the United States and the European Union, will ever again fix their respective currencies to gold as they have in the past. The more countries start to think about gold as an index, as a warning signal of inflation, the more the monetary authority will try to keep the price of gold from rising.”

Published in The Express Tribune, August 26^th,  2011.