The current ‘fiat money’ or paper money monetary system has been in existence since the 1940s, in place of the ‘gold standard’ which failed miserably during the Great Depression of the 1930s. The gold standard is partly blamed because it prevented the authorities to expand the money supply quick enough to revive the economic activity in times of crisis.
Thus this has led to the creation of the Bretton Woods system in July 1944. Under the Bretton Words system, central banks of countries other than the United States are allowed to fixed their exchange rate to the dollar. They are allowed to buy and sell their currencies in exchange for dollars so as to maintain a fixed rate of its currency to the dollar. It did survive until 1971, where inflation and trade deficit is undermining the value of the dollar.
Finally, the world abandoned the fixing of their currency to the dollar and adopted the ‘managed float’ system. By adopting the ‘managed float’ system, central banks still intervened in currency fluctuations to prevent sharp changes but only within a trading range. Up till now most countries are still using this managed float monetary system.
The not-so Golden days
During its heydays of the gold standard, in the 19th and early 20th century, depression and bank panic were common. After adopting the paper money monetary system since the 1940s there has not been a single depression till now and resulted in most mainstream economist rejecting the gold standard.
An argument by those who are pro gold standard appears that governments are irresponsible by printing money to pay its bills and hence create inflation in goods and assets. Furthermore they argued that under the gold standard, the total money supply will be fixed and the market will adjust itself to achieve equilibrium amidst any imbalances.
However, mainstream economist agreed that the current monetary system allows governments to manipulate the money supply so as to fight recession or unemployment. For the last six decades there is not a single country experienced a depression. During the 1987 stock market crash in the U.S, the Federal Reserve after witnessing the 10 years of depression during the 1930s decided to expand the money supply tremendously. The result, there is not only there is no depression but the economy experienced a remarkable boom during the 80s.
The reversion of an economy back to gold standards does pose its problems. In a gold standard economy, it will be using gold coins instead of notes and coins. There are problems like the need to carry large amounts of metals during purchases such as weekly grocery purchases. Furthermore, imagine what sort of denomination a person need to carry, if you are buying small portions of meats and vegetable Security is also a problem, you can’t just leave your gold coins lying around and also the need to protect it from thieves.
From the 1870s to 1914, it is known as the era of Gilded Age where most countries operated under a full gold standard. One US$ was define as 23.22 grains of gold while One British pound was define as 113grains of gold. Basically a country’s money supply is determined by the amount of gold reserves it has. In other words, the world operated under a single unified monetary system. Such a system do have its problem, say when the US have large trade deficits with UK, it has to pay the deficits in gold. When people found out that the US is paying the UK with gold for its deficits, they will get panic because gold is leaving the country. As a result there are often banks runs because people will be lining up to withdraw their gold before it ran out. Thus bank panics were a common thing during the Gilded Age.
More cons than pros
One of the strongest arguments by the Gold Bugs for the return to gold standard is that it will prevent irresponsible governments from printing money in order to increase its money supply to pay its debts. An excellent case study is Argentina during 1999 – 2002. After printing too much money Argentina is suffering from the effects of hyperinflation. Eventually the Argentine government resorted to fixing its peso to the dollar. This may not be an optimal strategy but nevertheless better than what they have been doing previously. So, in Argentina’s case, it doesn’t need to return to the gold standard to solve its problems.
Another reason for the gold standard is that it provides a stable exchange rate for nations that participate in international trade. Exchange rate will not fluctuate as with the current fiat money system whereby exchange rates fluctuate daily. However this appear to be a weak reason because there are now plenty of treasury products like currency options and forward contracts to provide hedging facilities for international trades. Traders can buy forward contracts for USD/MYR, say for the next 90 day at a fixed exchange rate, so that in 3 months time, they will still receive the same exchange rate at the time of execution, no matter how much the US $ fluctuates.
Say the world decided to return to Gold standard. There is another enormous challenge gold standard defenders had to face is ‘what kind of gold standard’ are they going to adopt? Will it be a monetary system whereby it will be 100 % back by gold or one that is partially back by gold which in the end will also lead to fractional banking system and eventually lead to bank runs.
If it is 100% back by gold then how much physical gold will be needed for all nations on earth to fully back their currency. According to the World Gold Council so far there are 170,000 tons of gold mined. With current gold price at US 1850, the total value of gold works out to be about US 9.5 trillion. As we know, in the US alone, its money supply already stands at US 10.2 trillion, which means all the gold mined so far is not enough to back the US$ by 100%. How about the rest of the world? How many more tons of physical gold are needed to back all the currencies of the world and most importantly, where are all the physical gold going to come from?
To give you a glimpse of how payments for deficits are made during the Gilded Age. If Britain imports more than it exports to the US, then automatically this will create a balance of payment deficits. There are 2 options the British can pay the Americans. One is to convert the pounds to dollar and the other will be to convert the pounds to gold and do a Trans Atlantic shipment to America. If the British were to choose option 1 then their demand for will create a rise in the value of the dollar, in the foreign exchange market. The second option will be to convert the pound to gold and ship it to America. So just imagine the predicament of doing international trade when we revered back to the Gold Standard.
On the myth about central banks around the world buying gold, and how it will help keep gold prices sustained and eventually head for the moon, is just a fairy tale. If you look at the World Gold Council’s Dec,2010 chart for Gold/Forex reserves, you will notice that the biggest holder of gold/forex are the Eurozone countries and US.
Country Gold/Forex Tonnes
Portugal 81.1 % 421
Greece 78.1 % 111
USA 74.7 % 8133
Germany 71.7 % 3401
Italy 71.4 % 2451
France 66.1 % 2435
India 8.1 % 614
Japan 3.0 % 765
China 1.7 % 1054
Malaysia 1.5 % 36
South Korea 0.2 % 14
Not so simple trading strategies
You also notice that Asian countries, have the lowest Gold/Forex ratio even though China, India and Japan have one of the largest tonnage of gold in its reserve. So the argument that central bank’s gold buying in the open market will go on forever is rather naïve. Since they have the money, wouldn’t it be better to short gold in the futures market like CME which will eventually bring down the price and take physical delivery of the metals? What makes you think that the central banks will keep on buying gold in the open market which will continuously push the price up? Will they be so stupid to forever buy expensive gold in the open market instead of taking delivery of cheaper gold in the futures market?
Asian Central Banks gold buying are more of playing catch up rather than anything else. China’s buying into IMF’s gold is more politically motivated than economic. China have long wanted to have more say in the IMF and by buying its gold and increase its reserve in the IMF, it will eventually get to increase its influence on IMF’s day to day operations and decision making.
The final and most important point of all is, whether the ultra gold defenders ever wondered what will happen to the world if the DOLLAR COLLAPSES TODAY? What sort of scenarios are we going to face when this actually happens?
Should the dollar collapse
The following is a potential outcome if the dollar collapses today. Picture yourself in the scenario, if you are heading towards a super market for your weekly shopping, you will be shocked to see hundreds of people queuing behind the counters and most of the shelves are empty. On your way home you decided to fill up your tank in your neighborhood petrol station. When you reach the station and when you insert you credit card into the reader, there will be a ‘Call your bank’ instruction flashing in the screen. Thinking this is the card problem, you insert another card into the reader and the same message appears. So, you are wondering ‘What the hell is happening’, and soon you are heading for home.
Later in the night when the US market opens you will see the following headlines:
DOW Plunge 1200 points
Nasdaq Down 10%
S & P down 8%
Gold up another $300 to $3850
USD/EUR down 15% to 0.65
Dow, Nasdaq and S&P futures all limit down and trading suspended indefinitely. The internet is crawling and rumors abound about bank holidays, riots, widespread looting, declaration of martial law, gang fights, rapes ,robbery, ATMs not working and petrol stations being empty.
When you turn on to CNBC, this is what Jim Rogers will be reporting. This is what the financial crisis looks like when the dollar collapse, and if you are not prepared, you will be wiped out. About the same time, another news anchor reporting about empty shelves in supermarkets and ATM machines. This is total PANIC. While on the other news channel, CNN is seen busy reporting about fund managers and stock brokers jumping off high rise buildings. While on Bloomberg, Timothy Geithner, trying his best to calm down the situation, saying that ‘everything is under control and there is no reason to be panic and the situation will be back to normal in the next few days’. At the same time, someone twittered saying that police are putting up road blocks all over the country and curfew might be imposed the next morning.
Well, this is what actually going to be played out scene by scene as if we are watching a horror movie should the dollar collapse. Our governments have no contingency plans to deal with such a situation. There will be chaos and panic everywhere.
Can Gold be a safe haven when it is priced in USD?
One thing really intrigue me is that, a lot of gold bugs and gold standard defenders calling for the return of gold standard monetary system and also at the same time calling for the collapse of fiat currency. There is an irony behind this statement. Say, if everyone buys gold and this will push the price of gold up, say triple of what it is trading now, at $1850 to $5550 per ounce.
What good is it if the dollar collapsed, and looses 90% of its value at the same time? Instead of the current exchange rate of 3 MYR to 1 US, it will be 1 MYR to US 3. So, for an ounce of gold valued at $1850 with an exchange rate of 3 MYR to 1 US, we will be receiving MYR 5550.00 ($1850 x 3 MYR). But now after the debasement of the US $, for an ounce of gold we are only getting MYR 1850 (US 5500/3) even though the price of gold triples. In other words you are worse off.
Sometimes, the financial world works in a funny way which I find it difficult to comprehend. How can gold be a safe haven investment when the US $ collapse, since gold is priced in dollars ?
Anyway back to reality, there are reports that FEMA are preparing its member for possible future social unrest and counter terrorism threats. Many empty detention cells are being built all over the country in secret locations to prepare for the big day. It is also widely known that there many palatial homes being built in isolated islands in the Pacific Islands and Caribbean islands as well. These homes are equipped with helipads and are guarded by armed personnel. So who are those people who own these homes. They are the elites of the society, the rich and powerful families and if there are any threats or even any signs of trouble, you bet they are the first to get out of the country and head for their retiring nest overseas. The global seed vault in Svalbard, Norway is not built without any reasons.
Lately, I have been seeing a rush of activities towards gold buying. Gold is now the preferred topic of discussion , both in parties and market place. People are all talking about gold investments and are selling their stocks to convert to gold. It appears that there are a lot of people buying gold without knowing the reason why are they buying. This is DANGEROUS because when people start buying something without any reason other than speculation, then this is one of the prerequisite for the setup of a bubble.
Talk is cheap
Talk is cheap and easy when people don’t understand the complexities and inner workings of different economic models. It is easy to demand the authorities to stop printing money and reinstate the Gold Standard economy. Have they ever thought what effect will it have on the world economy when all central banks in the world stop their printing press? The world economy will come to a grinding halt and eventually it will reach a standstill. What implications will it have on nations when there is no international trade and economic activity?
Ad hoc implementation of a new economic model will cause more chaos and mayhem than helping to solve its problems. It has to go through the boom and bust cycles before it can be fine tuned to be a better economic model. As demonstrated in the past, a truly centrally planned economy like China will not work because of its inefficiency to allocate limited resources to different sectors of the economy and hence wastage. That is why China under Deng Xiao Ping, incorporates some free market policies like the development of the Shenzhen Free Trade Zone into its economy, which resulted in a boom in the Chinese economy.
Similarly, a truly free market economy like those in the Western Countries, will not work without government intervention because it creates excessive and dislocation of resources in the economy. Expansionary and contractionary monetary and fiscal policies are economic tools available to governments to fine tune the economy.
Governments will embark on an expansionary monetary and fiscal policy during bad times, so as to increase the level of economic activity. So by increasing the nations money supply (M1+M2+M3) through money printing or via the permanent open market operations in the bond market (POMO), the government hope that there will be more money going around in the economy and hence create economic activity and also jobs.
The faster the velocity of money moves in the economy, the bigger the impact it will have on the economy. And during boom times like now in China, the Chinese government embark on a contractionary monetary policy through multiple hike in the interest rates and also through an increase in the SRR (statutory reserve ratio) and SDR (statutory deposit ratio) ratios in the banking industry ,so as to keep the economy from overheating and hence create a ‘soft landing’ in its economy.
As Warren Buffet famously summaries it, “Gold has no utility other than looking shiny and pretty. Gold demand equals fear demand and when people becomes more afraid than you in a year or two, then you will make money but if they are less afraid, then you will lose money. Gold by itself doesn’t produce anything and is a bad investment in the long run”
- Malaysia Chronicle
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