Sliding Back Towards A Gold Standard

By Martin Hutchinson, Prudent Bear

Gold broke through $1,200 per ounce this 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 last 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 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; Alan Greenspan and Ben Bernanke and to a lesser extent their counterparts in the ECB, 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 tons of 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.

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