Hamish McRae: Is it time to return to the gold standard?

Wednesday 10 November 2010 01:00

Gold is making a comeback. Keynes called it a "barbarous relic" but actually its allure is deeply embedded in our early civilisation, as King Midas discovered to his cost. And of course the draw is as powerful now as ever: Olympians win gold medals, wedding rings are made of gold – and poor old Gordon Brown gets stick for selling off our gold reserves at a knock-down price.

However, while the gold price, at least in dollar terms, is at an all-time high, and while the central banks of China and the rest of the emerging world are stashing away the stuff, there is something ludicrous about imparting such special worth to something that is inherently worthless. Or at least it is if all you do is dig it up, refine it, and stick it back underground in a bank vault. Real wealth is the ingenuity and productive power of human beings, forces that generate a flow of income, not gold.

So it should come as something of a shock to hear Robert Zoellick, president of the World Bank no less, write earlier this week that the world should move back to some sort of gold standard, arguing that markets were now using gold as an alternative monetary asset. The markets were suitably encouraged and marked gold up another $15 an ounce.

But actually I don't think he is right. Money has several functions: a denominator of value, a medium of exchange and a store of wealth. Gold is only being used for the last of these, the store of value. Goods and services are not priced in gold, nor is gold used to facilitate trade. And even as a store of value, gold is still relatively unimportant in world terms. The global stock of equities and bonds is far more valuable. Add in property, and the relative importance of gold shrinks even more.

What is happening, though, is rising distrust of paper money, and for good reason. With the US Federal Reserve creating hundreds of billions of dollars out of thin air and the US government spending four dollars for every three it raises in taxes, it is hardly surprising that the rest of the world should distrust the dollar. And the dollar is the world's principal reserve currency. It is a long way from there to saying that the we need to bring back gold into the world's currency system.

To see why, a little history. During the 19th century the world was on a gold standard and that period saw a huge leap forward in wealth and trade. But it was very much a managed system, managed by the Bank of England, for the amount of gold that had to underpin the growing world economy rose much more slowly than trade and output. Price levels tended to decline, or at least did until there was some new gold rush in California or wherever. The system worked, largely because of the dominance of the UK in world trade and investment, but gold was a harsh discipline.

The Gold Standard collapsed with the First World War, was temporarily and unsatisfactorily recreated in the inter-war period, and was finally replaced after the Second World War with the gold exchange standard, approved at the Bretton Woods conference in 1944.

Under the Bretton Woods system the two reserve currencies, the dollar and the pound, were notionally convertible into gold at a fixed price. Other currencies were fixed, within narrow boundaries, too. That bought a quarter century of calm as Europe recovered and world trade resumed. But there was what you might call a design fault.

The system only worked because of the dominance of the dollar in world trade (sterling was a sideshow and its role was undermined by two devaluations). But to get more dollars into the pool to finance world trade, the US had to run a current account deficit, and that undermined confidence in the dollar. The system collapsed in 1973, and we moved to floating exchange rates.

That, notwithstanding the fact that the Chinese yuan is pegged to the dollar and the creation of the euro, remains the system of today. But it was a painful transition. In the 1970s and 1980s we had the greatest worldwide inflation we have ever known – far worse than the inflation that followed the discovery of gold and silver in the Americas in the 16th and 17th centuries. Gold shot up because people feared that money would become worthless.

The painful clawing back of monetary discipline took 20 years and the fear now is that the central banks have forgotten the lessons they learnt then. Since they managed to create a huge housing bubble in most countries and have not been nearly as contrite as they should be about their failure, we are probably right to distrust them now.

But that is not to call for a return to gold. There are really two ways forward. Either the world patches up the present system by making sure that all countries play fair. That means deficit and surplus countries alike adjusting their policies to correct their imbalances. It means the US stopping printing money and it means China allowing its currency to appreciate. It means cutting trade restrictions and permitting reasonably free capital movements. It means a world of better co-operation and more self-discipline.

Or we go the other way. We will have some external discipline, in which gold will surely play some role, and in which the freedom of countries to run their own monetary policies will disappear. Maybe that is the way it will go, a system designed at a new Bretton Woods-style conference but dominated by what will have become the world's largest economy, China.

Maybe. But I would not wish for it. Better, surely, to patch up what we have got: a system that has enabled the greatest sustained burst of prosperity that the world has ever known.


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