THE GOLD RUSH: ARE WE SEEING THE END OF PAPER MONEY?

MY VIEW 17 – ECONOMICS MATTERS
By W.A. Wijewardena
THE GOLD RUSH: ARE WE SEEING THE END OF PAPER MONEY?
A Gold Rush of a different type
The headlines of wire services cried last week: “Gold is at its historical peak”. The event was that gold prices in the international markets had crossed the seemingly impossible peak of US $ 1500 per fine ounce of the metal.
However, a similar cry-out was made when its price crossed $ 1400 level, $ 1300 level and $ 1200 level too in the recent few months. It was a story of gold rising to a historical peak day in and day out. That appeared to be a journey which gold started mildly in 1999 and sharply about 3 years ago with the intention of never going back. In all probability, it seemed that it would be a one way journey for the precious metal which had sparked so many wars among and within nations and caused so much of anguish and pain to humans throughout history.
A similar increase in gold prices took place in early 1980s just before and during the Mexican financial crisis. The US dollar which was the uncontested reserve asset at that time came under pressure and the global interest rates started to rise in the presence of the rising inflationary trends. The London Inter-Bank Offered Rate or LIBOR, the standard interest rate indicator in the global markets, rose to its peak level of 20 percent during this period.
A War between the US Dollar and Gold
The current gold rush is similar to the experience which the world had during that period in some respects and dissimilar to it in some other respects. In the current period, the world has just managed to avert a global financial crisis, but there is a prolonged economic stagnation in the major industrial nations. In the midst of a high global excess liquidity, interest rates are at their historical lows with the six month LIBOR falling to a level of even less than one percent. Inflation rates in major industrial nations as well as the developing world have been historically low, but have started to move up again along with economic recovery. The sudden political turmoil in the Middle East and North Africa and the tsunami disaster and ensuing nuclear crisis in Japan have pushed the confidence about the global economy to its lowest levels. The US dollar has started to fall against all major currencies, recording an eighteen percent fall against its major rival, Euro, since June, 2010.
It, therefore, appears to be a war between the US dollar and gold and in this war, gold appears to have gained the upper hand.
Historical Set up: the Gold Standard Era
Before the advent of paper money and even during the first phase of paper money‟s ascendancy to the status of the main medium of exchange, gold played a key role in adding value to paper money and enforcing discipline in its production. This was done under a system known as the Gold Standard.
Under this system, a country expresses the value of its paper currency in terms of gold and has to keep a gold stock equivalent to the value of paper money issued. Gold is acquired either through mining or through international trade where the country would have exported more of goods than it would have imported from other countries. When the

gold stock goes up, it permits the country to issue more paper money notes to its people. If, however, the gold stock declines, then the country has to withdraw an equivalent value of paper money from circulation. Thus, the gold standard prevented the countries from issuing paper money excessively at its own discretion. Ironically, this was the main reason for world nations to abandon the gold standard in late 1920s because it was perceived as a fetter in their eagerness to issue paper money in large volumes and boost economic growth.
Accordingly, with this discipline no more, the world nations began to over produce paper money through their central banks thereby causing inflation and reducing the real value of paper money they had issued to their public.
The Gold Exchange Standard of the Breton Woods Era
When the IMF and the World Bank were set up under the Breton Woods agreement in 1944, an attempt was made to introduce gold again to protect the value of currencies issued by independent nations. Since there was no gold standard any more to back the value of currencies, the world nations had the problem of accepting each other‟s currencies in settlement of international transactions. To overcome this problem, it was suggested that one country should be designated the world‟s central banker nation and that country should allow free convertibility of its currency to gold.
Given the supremacy which the US had acquired over the world‟s economic and political affairs at the end of the World War II, it was naturally the uncontested candidate to become the world‟s central banker nation. Accordingly, the US government agreed to convert the US dollar to gold at the rate of $ 35 per fine ounce of gold at any time. Thus, if a world nation has $ 35 US dollars, it could buy one fine ounce of gold from the US Treasury; similarly, if a world nation has one fine ounce of gold, it could sell that gold for $ 35 to the US Treasury. Since the US dollar was freely convertible to gold, the world nations did not have any problem of accumulating dollar balances.
According to this system, dollar was convertible to gold and through dollars, other currencies too were convertible to gold. This system was known as Gold Exchange Standard.
US’s free ride on dollars
When a country becomes a central banker nation, like a national central bank, it stands to profit from issuing currency which the economists call earning „seigniorage‟. Suppose, for example the US government issues a one dollar note. It does not cost the US government one dollar to issue that note, but only a fraction of it. But the US government, by using that dollar bill, is able to buy a basket of goods worth of one dollar from another country. Its promise to the country which agrees to accept that one dollar bill in exchange of a good from that country is that one day, should that country choose to buy goods from the US, a dollar‟s worth of an output is available from the US.
Thus, the US immediately enjoys a better life and the other country accumulates dollars backed by a promise. Since there are other nations in the world which are willing to accept dollars from that country for selling their goods, that dollar never returns to the US and it does not have to honour its promise.
This has led to bad behaviour and indiscipline in the issue of dollars by the US in accord with its promise to function as the world‟s central banker nation.
According to US statistics published by the website www.seekingalpha.com , the US has never been serious about its role as the world‟s central banker nation. In 1944

itself, in which the Breton Woods agreement came into force, the US had issued $ 39 per fine ounce of gold it had held in its reserves, though it promised to convert dollars at the rate of $ 35 per fine ounce of gold. Thus, if all the people holding dollars wanted to have their dollars converted to gold simultaneously, the US Treasury did not have enough gold to satisfy them all.
The situation became more alarming since then. By 1961, it was $ 64.97 per fine ounce, by 1963, $ 81.42 and by 1968, $ 135.01 and by 1971, $ 198.82. This was like creating multiple deposits and credit by a commercial bank based on a given amount of bank reserves.
Consequently, by 1971, had all those dollars demanded immediate convertibility to gold, the US Treasury could have met only one fifth of such demand. When the open market price of gold went up to $ 70 per fine ounce of gold and arbitrageurs started to raid on the US gold reserves and the US Treasury could no longer meet the demand, in August, 1971, the US abandoned the Gold Exchange Standard unilaterally.
This possibility had been long warned by John Exter, founding Governor of the Central Bank of Sri Lanka, on account of the profligate money printing by the US Federal Reserve System. In a private discussion in 1962 with Paul Samuelson, Nobel Laureate in economics, Exter is reported to have remarked “Paul, it is very simple. The Fed is printing too many dollars and they flow out of the country into foreign central banks who demand gold”. Two other Nobel Laureates, Friedrich A Hayek and Milton Friedman, too made unkind statements about the US Federal Reserve System‟s irresponsible money printing policy. Hayek advocated that the money supply monopoly should be taken away from governments and handed over to the private sector in a path breaking publication titled „Denationalisation of Money Supply‟ in 1975. Friedman was much more militant in his approach: he declared that if he were given a choice that he would ‘padlock the Federal Reserve Bank and take a helicopter ride to the Atlantic Ocean to drop the keys to the Ocean’ meaning that the world would be better off if the Federal Reserve System is permanently closed.
The US Profligacy continues since 1971
Even after the end of the Gold Exchange Standard, the US dollar continued to function as the world‟s major reserve currency not by agreement but by popular demand. Though there was no official obligation on the part of the US authorities, for the well and smooth functioning of the global economy, the US administration was expected to produce dollars within limits and maintain its value over time. But this was the least which the US did since then.
From 1971 to 2009, the total of dollar reserve money created by the Federal Reserve System went up from around les than $ 100 billion to $ 800 billion. It is pertinent to note that commercial banks are able to create multiple deposits and credit by using this reserve money and therefore its stock growth is highly inflationary. This is witnessed by the sharp increase in the US Consumer Price Index by 435 percent during this period.
Naturally, the dollar holders should get alarmed and nervous because the value of a dollar in 1971 has fallen even less than one US cent in 2009.
With the financial crisis of 2007-9 and the ensuing economic recession that forced the US Administration to throw generous economic stimulus packages, the US dollar printing was much faster than what John Exter witnessed in 1960s. Between end 2009 and March 2011, the reserve money base in the US increased sharply from $ 800 billion

to $ 2200 billion, another historical record by the US. Consequently, the US has now issued $ 3813 per fine ounce of gold it is holding in its reserves. As a result, the dollar has now lost completely its free convertibility to gold.
This has so far not contributed to the US inflation in a big way. Its CPI has increased only by 4.6 percent between end 2009 and March, 2011. But, inflation is yet to come and the world nations have correctly felt the heat of the oncoming US inflation.
The results are obvious. World‟s central banks are now increasingly converting their dollar balances to gold, thereby raising the price of gold on one hand and reducing the market value of the dollar on the other.
This is why the gold prices exceeded the $ 1500 mark in April and dollar fell by 18 percent against Euro during the last ten months.
The Way out
It, therefore, appears that a massive restructuring programme has to be undertaken by the US in order to give confidence to markets and the world nations which have relied on the dollar in the past.
Since the current gold prices are at $ 1500 level, the US has issued dollars more than two and a half times the value of gold in the market. To maintain parity, either the US has to cut down its money supply by two and a half times so that its issued dollars would be equal to $ 1500 per fine ounce of gold it is holding in its reserves or the free market price of gold should rise to $ 3800 level per fine ounce.
The first option is a near impossibility given the long time frame of 12 years which President Barack Obama has given to cut his budget deficit by $ 4 trillion and the disagreement with the Republicans about the appropriate course of action which the US has to take in achieving that goal. Obama wants the wealthy Americans to bear the full burden so that the deficit will be trimmed by raising tax revenue rather than expenditure cuts. The Republicans want him to go for deeper expenditure cuts rather than imposing additional tax burdens on the citizens.
Both appear to be insincere in their approaches and eyeing for the Presidential election that is scheduled for November 2012. To win the election, Obama seem to be placating low income Americans who are more numerous in terms of votes. Republicans, on the other hand, seem to be wooing the rich Americans for raising funds for the election campaign. While there is logic behind the strategies of both parties, it does not do well for the US dollar or the nations that have relied on the dollar to keep their excess foreign exchange reserves. A country like China which has put in more than a one third of its $ 3 trillion foreign exchange reserves in to Dollar assets stands to lose the most.
Hence, the world nations have become anxious, nervous and alarmed. They naturally tend to over-react because it is they who have already lost and who stand to lose in the future. Gold is, therefore, being increasingly used as a hedge against the dollar with the outcome which the world has already witnessed: dollar falling and gold rising in the world markets.
Return to Gold Standard?
Many have now suggested that the world should return to the gold standard once again.
Even the President of the World Bank, Robert B Zoellick, a former US Treasury Official, in an article published in the London‟s Financial Times in November 2010, declared, calling for a more cooperative monetary system to increase confidence and

boost economic growth, that world leaders should reconsider reintroducing a gold standard to protect the emerging leading currencies, namely, dollar, euro, sterling pound, yen and the Chinese Yuan (available at: http://www.guardian.co.uk/business/2010/nov/08/world-bank-new-gold-standard) His attempt has been to protect the use of paper money because its production involves less cost and it is more convenient to handle.
Gold prices may rise, but gold is not an alternative to paper money. The use of gold as money involves a series of cumbersome and costly economic activities, namely, mining, refining, appraising, transporting, storing, safekeeping and handling. These are all costly activities. Paper money does not involve such high costs. Hence, as suggested by Zoellick, the world may be better off by imposing discipline on abusers of paper money production through a system of returning to the gold standard and developing a cluster of reserve currencies so that the world does not have to rely on one currency.
Hence, at least for the next decade, we do not see the end of paper money in the world.
(W.A Wijewardena can be contacted on waw1949@gmail.com)