Fool’s gold standard: Financial Express 11th November 2010

There is a distinct feeling of déjà vu with Robert Zoellick broaching the idea of returning to the gold standard. The concern emanating from the current global monetary disorder is quite palpable, especially after the US has gone in for quantitative easing, round two (QE2). Curiously, the financial crisis has led to a new generation of policy stances beginning with Basel-III, QE2 and now possibly GS-2, which makes the shadows longer than the subjects. What are we talking of?

Today almost everyone is questioning the basis of having the dollar as the reserve currency as it has violated the tenets of an ideal ‘anchor’ that should support the global monetary system. The US has been quite brash, burdening the other nations with the onus of adjustment, which has prompted possible policy responses that, in turn, are being frowned upon by the West.

Robert Zoellick, in an op-ed article in FT, has made a reference to bringing in more currencies for better monetary cooperation and, as a corollary, suggested that along with the dollar, euro, renminbi, pound and yen, we could bring in gold. Gold could be used to assess market expectations for inflation, deflation and future currency values.

It may be recollected that after WW2, currencies were linked to the dollar, which had its value fixed to gold at $35/ounce. This did not work as the US walked out of this in 1971, which led to BW-II (Bretton Woods). Now, Zoellick has suggested that we could consider going back to such an anchor as gold is today viewed as good as currency. In fact, it is held as a substitute for the dollar and there is an inverse relation between the two—when the dollar drops, the price of gold goes up, as investors move from the dollar to gold. Will this work?

The value of the dollar has slid by 13%, helping US exports but troubling its partners. QE2 only exacerbates the situation as other nations have to adjust to tackling these inflows. Quite clearly, one country’s problems cannot be allowed to become major hindrances for the rest of the world. In fact, today currencies are vulnerable to the whims of governments, which are being driven by inward-looking policies, so much so that monetary policy has become politicised. It is for this reason that there is this talk of currencies being linked once again to gold.

The problem with this approach is that one cannot link the entire monetary system of the world to a metal that has a limited and fixed supply. Countries would lose control over domestic policy in times of crisis. If expanding money supply was strictly linked to the quantity of gold held by governments, Keynesian reflation would be ruled out, thus leading to a chaotic situation. Also, making gold the reserve currency would lead to large-scale hoarding of the metal, which, in turn, would lead to considerable volatility in the monetary conditions across the world. In fact, there is divided opinion over the speculative nature of gold wherein trading in paper gold through the derivative market influences the current price, which is driven by investors (read speculators). The reserve currency cannot have its price driven by this class.

India, for one, would be in a peculiar situation where it is the largest consumer of gold (20% share), which also gets hoarded automatically in the form of jewellery. Linking such hoarded gold to policy would be a mammoth task. Therefore, making gold the reserve currency may not really be tenable for central banks across the world.

Can gold really anchor expectations of inflation or deflation or currency movements? The answer is a shoulder shrug as linking currencies with gold will actually restrict policy flexibility. The biggest problem for a reformed gold standard would be the mismatch between the value of official gold holdings and the size of the monetary system. In 2008, the values of the two were $1,300 billion and $61,000 billion, respectively. Such a peg can be destabilising for any currency if others failed to sustain domestic monetary and financial stability, leading to dramatic flows of gold between currencies that are better managed, thus changing their relative values.

However, the fundamental issue remains that we need to have a system in which countries should not be able to manipulate their currency or money supply to the detriment of other nations. The SDR is a solution but can gold be a part of this basket? The fact that there is perfect correlation with the dollar, would actually make the mathematics convoluted and hence the idea may be brushed aside as being a theoretical novelty, which does not have practical applicability in a world that has become more complex than it was in 1945. We have moved on.