Hamish McRae: Why the soaring gold price should set alarm bells ringing

Economic Life
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It is a squawk of alarm – but is it alarm about the threat of inflation in general, or about the long-term value of the dollar? The gold price is at a new record in dollar terms. But it is not at a peak in other currencies, particularly the euro. Nor it is at a peak in real terms, that is to say after being adjusted for inflation, for in the early 1980s it was roughly twice the present level. Take the gold issue first, the dollar's plight second.

There is no need to go into the "barbarous relic" aspects of gold, to pick Keynes' phrase, or indeed the mystical part that it plays in human psychology. We use the word so often to convey a sense of excellence – a "gold medal", a "gold standard" or a "golden opportunity" – that to assert that the metal has no intrinsic value is pointless.

At times of trouble people turn to gold. That is why the present surge in the gold price is troubling. There is a huge trust deficit. Governments around the world are borrowing more than they have ever done in peacetime, and savers are profoundly suspicious that they will seek to inflate away the real value of their borrowings. The fact that part of this debt is being bought by the central banks, most notably in Britain, rather than coming from genuine savers alarms people even more. The inevitable progression of the present monetary easing programme ends in inflation. The issue is what the authorities will do about that once it happens.

The central issue is that governments are resorting to wartime financing measures to finance the consequences of a peacetime policy failure. Inflation has almost always followed periods of wartime finance, though it is usually suppressed for a while by rationing and other means. Savers reasonably ask: why should this time be any different?

As a result, two things are happening. One is the rise in the price of gold, the other the differentiation being made by investors between currencies where they feel, rightly or wrongly, that there will be a solid commitment to contain inflation and those where the commitment will be less sure.

Until the spring of this year, the two moved pretty much in synch. There was a flight into the dollar, which was perceived rightly or wrongly as a safe currency. And there was a flight into gold. Since then, as you can see, the two have diverged. The peak gold price in euro terms was actually in February/March. Rightly or wrongly the euro is now seen as a safer bet than the dollar.

However, it is important to get the gold price into perspective. In itself it does not matter. Gold is unlike other commodities, most especially oil, in that a rise in the gold price does not feed through into inflation elsewhere. It is not a raw material as such, or rather it has limited industrial uses. A rise in the oil price might check the global recovery; a rise in the gold price won't.

What it does do, though, is signal alarm. The last time that gold was in high fashion was in 1980, when inflation and interest rates in most of the developed world were in double digits. It shot to a peak of around $850 an ounce. That would be about $2,300 in today's money, according to Capital Economics, which supplied the charts.

Still, the price did not stay there for long. It slumped back to $500 before trading in the $600-$700 range for most of the rest of the year. The reason was an awareness that governments around the world were gradually recovering control of inflation, or at least had made a start on that policy objective.

You may recall that this was the first year of the Thatcher government in the UK and Ronald Reagan won the presidential election in November 1980. Eventually the world will recover fiscal discipline, just as it then recovered monetary discipline. Interest rates will rise (just started in Australia) so the carrying cost of holding gold will climb and when that happens the gold price will fall back.

So what might this mean for the dollar, and indeed sterling? I don't think one should get too hung up about short-term swings in confidence about different currencies. All our experience shows that they eventually revert somewhere towards their purchasing power parity, though they may remain out of line for a long time. Arguably the dollar has been artificially strong for several years, as it suited Japan and China (and some other Asian countries) to hold down their own currencies and build up large dollar balances. Being a reserve currency does convey advantages, at least in the medium-term, and the US has found it easier to borrow abroad as a consequence of the dollar's reserve status.

There has been a lot of stuff in the past week about the dollar eventually losing its reserve currency status and about oil being quoted in a basket of currencies. The big point here is that a gradual diversification away from the dollar is already happening, and a further shift is inevitable, but that does require other countries making their currencies available to be held in central bank reserves. China does not seem too keen on that.

What a commodity is quoted in is irrelevant. Oil happens to be quoted in dollars because the US remains the world's largest oil trader. When Chinese imports of oil pass those of the US, expect it to be quoted in renminbi. The US can slow the pace of the movement away from the dollar by following responsible policies, or it can increase the pace by doing the reverse. But it cannot change the big picture.

In all this, sterling is a footnote. The Governor of the Bank of England, Mervyn King, is trying hard to talk down the pound. All you need to know to make a turn is to wait until you know he is making a speech and buy some other currencies ahead of it. But the more serious criticism of the Bank is that it has been complicit in allowing the Government to run up a deficit that looks like being somewhere around 14 per cent of GDP. That is even worse than the US. Had the Bank not had its present quantitative easing programme in place, gilt yields would be at least half a percentage point higher.

This is now quite fragile. Were there not going to be a change of government – and a more responsible fiscal policy – in six months' time we might well be facing a really serious run on the pound and a forced change in Bank policy.

We are not alone in this danger. I fear the US may face an irrationally serious run on the dollar at some stage during the winter. Indeed that is really what, in its disorganised and incoherent way, the gold market is trying to tell us. Savers worldwide don't trust the dollar. Why on earth else might they choose to stick their cash in gold?