Gold, Reserve Currencies and Global Trade

Imaging that you wake up in the morning and you hear about an unbelievable cataclysmic event that has occurred overnight. As you struggle to clear the fog from your head you think you heard on the clock radio that due to some mysterious cosmic event everything is now exactly half the size it was yesterday.

What a crazy thing you might say to yourself. But how would you convince yourself that this extraordinary occurrence is true or false? You look around and you notice that everything appears the same as before. Then it hits you that if everything is half the size, including yourself, you might be unable to tell the difference. Think about it a little more and you wonder if by 'everything' that really does include everything or just some fraction of the world or cosmos.

You vaguely recall from high school science that if you halve linear dimensions then volume, and therefore mass, will decline by the cube. So you jump onto the bathroom scale and see that it gives the same reading as before. It would seem that whatever occurred with the foundations of physical laws the springs and levers in the scale also seem to be responding in a proportionate manner. You might then consider looking at the sun or moon to see if they've changed, but then you remember that even if you are smaller that if these heavenly bodies are still the same size and at the same distance they would also have the same appearance. Of course there may follow catastrophic astronomical events if their mass stayed the same while that of the Earth decreased, but, well, it all gets very complicated very quickly. All you know is (if it's really true) that there must be something detectable to scientists or they would not know that this peculiar event had occurred and it would not have made the morning's news.

Now imagine instead a slightly (but just slightly) more believable news story. Instead of a change in physical laws, imagine that overnight the Governor of the Bank of Canada announced that effectively immediately the loonie is worth exactly half its previous value. At first you're shocked, but then you notice that little has actually changed. The money in your pocket and bank account are unchanged, and price of goods and services are, at least at first, either unchanged or randomly altered due to general confusion among the public. The intrinsic value of things and labour is no different, so perhaps this makes sense. Or perhaps not, as we will see.

When you are lost at sea and the sky is cloudy you search for a reference point to position yourself. It is the same with currencies (and the laws of physics): you can only make sense of the new value of the loonie by comparing it to something else. What else, after all, could the Bank of Canada have meant except that the loonie is half its previous value in comparison to some reference. For several decades now the world has most often used the US dollar at a reference point. Before then it was gold. Once we left the gold standard -- opting for floating currencies -- the size and resilience of the US economy made that choice only natural. We are now witnessing what happens when their economy becomes unhinged. Pushing the earlier analogies a bit further, this is like discovering that the spit of land you've spied is itself floating freely on the sea's surface, leaving you feeling lost once more.

In the case of the hypothetical devaluation of the loonie, the existence of the US dollar serves us well as a reference since our economies are so inextricably linked and the US economy is so much larger. Declaring, by fiat, that the loonie is now worth US$0.50 is insupportable unless we at the same moment sever all financial and trade ties to the US. If we don't, there will be a rush of capital across the border and abrupt shifts in business relationships that would seek a new equilibrium point, one that (if we ignore the disaster such a rapid change would entail) will restore the loonie to its previous level.

However if the US and Canada jointly halved their respective currencies the impact would be slower if even more monumental, with the loonie getting tossed around like a leaf in the wind as the world comes to terms with the change. The US Federal Reserve is pursuing a policy very much like this at the moment, and many currencies, not just ours, are getting tossed around.

Bank of England Governor Mervyn King said ...“There needs to be a genuine recognition that there is a collective interest in the path along which the current-account imbalances unwind,” King said. “Unless we recognize that, then we will face a situation where more and more countries will resort to policy instruments that will be damaging to everyone.”

 If they persist we will likely see increased momentum to remove the US dollar as a common reserve currency in favour of, most likely, a basket of other currencies. Interestingly this is not too unlike the policy China follows in setting the value of the yuan, which they do not allow to float freely. Other, usually small countries, have tied their currencies in this manner to the US dollar, except in China's case there are some serious impacts on global competitiveness and trade. This makes the currency dispute between the US and China of such global import, and why it is getting so much attention at the present G-20 meeting.

“We will never seek to weaken our currency as a tool to gain competitive advantage and to grow the economy,” Treasury Secretary Timothy Geithner told CNBC in response to Mr. Greenspan's commentary
...
Mr. Geithner had proposed resolving the currency dispute by setting limits on current account balances, which measure trade-and-investment flows.

Ahead of the crisis, the U.S.'s current-account deficit swelled as households consumed imports with borrowed money, ...

Mr. Geithner's bid for current-account targets fell flat amid the anger over the Fed's monetary policy.

Here we see a reference to debt, much of which is being purchased by China. They are obviously interested in maintaining the value of their investment in the US economy, which would suffer is either the US dollar is devalued or, equivalently, the yuan is raised. China isn't budging so the US is initiating a sort of currency war.

Other countries are not willing to sit on the sidelines while this dispute unfolds, perhaps in a manner that will disrupt the functioning of the global economy. Since we live in a world where all national economies are so intricately tied together that currency volatility can quite easily disrupt international business patterns and send all of us into a deep recession: currency stability is needed to allow business investment, today, to proceed by removing the risk of value destruction, tomorrow.

A likely mechanism to replace the reserve currency model might be a basket of major currencies with some type of common asset base to make it workable. Although gold is being brought forward once more as a possible asset base, this is unlikely.

World Bank's Robert Zoellick, says he didn't propose a full return to a gold standard. His objective, he said, was to point out that the gold price is sending a message that the policy fundamentals within the G20 are rotten.

However, gold is not really a suitable standard in the present ear since it no more stable in value than any other commodity; that is, gold does not have any intrinsice value, just scarcity and and short-term appeal to those searching for hedges against currency devaluation and economic disruption. Here's Zoellick again:

The point on gold, and this is the golden elephant in the room, whether people recognize it or not, it is being used as an alternative monetary asset. So I'm not saying return to the gold standard as a control of money stock. But what I'm saying is the price of gold has been telling people is that there is a lack of confidence in some of the fundamental growth policies. So gold in that sense is a reference point, it's an indicator. Now people might wish it wasn't so. But I'm describing the facts as they see it and saying to policymakers: "You have to recognize what this says about the fundamentals of the policy you are pursuing." [You can't achieve confidence with] exchange rates and rebalancing alone.... You want to get the private sector back engaged. The time of government fiscal expansion and programs has run its course.

His viewpoint seems perfectly sensible. Gold, in fact, only has the value that we ascribe to it. The combination of scarcity and demand make it a risking asset class, but one that could reverse tomorrow. Its price is just as volatile as the currencies to which some would seek to tie themselves. Gold isn't even a very liquid asset, for a variety of practical and legal reasons, and for the majority of people it is merely an abstraction underlying the variety of financial instruments that derive from real stores of the metal.

Whether currencies or metals, investing in either is nothing more than betting on human belief systems, and what those beliefs are likely to be in the future. We should leave betting to the poker table and manage the global economy more deterministically. Like it or not, depending on one's political outlook or financial interests, some measure of coordinated monetary policy is necessary to keep our economies, jobs and trade reliably functional.

The US has less than 5% of the planet's population, but it no longer has 30% of the global economic activity. As more populous countries like China and India, not to mention Brazil, Indonesia and many more, continue to rapidly grow their economies and, of course, the well-being of their peoples, it is a question of when not if the US will lose it position as the world's leading economic engine. As Brazilian Finance Minister Guido Mantega said this week:

“The U.S. economy used to reign absolute, it was the strongest economy in the world and stood out from the others,” Mantega told reporters. “Today that is no longer the case.”

The faltering of that engine over the past two years only brings that time closer. As they become one among several dominant economic giants it is only sensible to move away from the US dollar as a reserve currency.

It's replacement will not be gold. Gold's price will continue to move up and down as currency volatility continues, and that volatility is enough to drive investor interest. I don't believe there is anything to be gained in thinking that the gold standard will return, ever.