Gold may move centre stage again in years to come

Piet Coetzer

Robert Zoellick, the president of the World Bank, has called on bickering Group of 20 nations to bring gold back into the global monetary system as an anchor to guide currency movements. His call came amid mounting – and globally widespread – evidence of moves away from the ailing United States dollar as the world’s central currency of settlement. At this stage, however, there is no sign of a silver bullet to fix what seems to be a broken global currency system.

Ahead of a recent G20 summit in Seoul, Zoellick said an updated gold standard could help retool the world economy at a time of serious tensions over currencies and US monetary policy.

He said the world needed a new regime to succeed the “Bretton Woods II” system of floating currencies, which has been in place since the fixed-rate currency system linked to gold broke down in 1971.

The new system “is likely to need to involve the dollar, the euro, the yen, the pound and a renminbi (Chinese yuan) that moves toward internationalisation and then an open capital account”, Zoellick wrote in an article in the Financial Times.

Recently, Jeremy Warner wrote under the heading, “The age of the dollar is drawing to a close” in the Telegraph that “currency competition is the only way to fix the world economy.

“Right from the start of the financial crisis, it was apparent that one of the long-term casualties would be the mighty dollar, and with it, very possibly, American economic hegemony.

“The process would take time – possibly a decade or more – but the starting gun has been fired,” Warner added.

Currency war

While the possibility of a currency war between the US and China has taken centre stage in an unfolding global scene of currency turmoil, there is mounting evidence that – even in the developed world – countries are beginning to take up positions to protect themselves against the possible disappearance of the US dollar as the currency of last resort.

The announcement by the US Federal Reserve (Fed) of a second round of so-called quantitative easing (QE2) may not only have increased the risk of a global currency war, but it is also likely to increase the global move away from dollar hegemony.

While it seems obvious that the global currency system needs a much weaker dollar to bring its economy back into kilter and avoid slow ruin, the rest of the world cannot easily handle the consequences of such a wrenching adjustment. Many countries feel obliged to take steps to protect their own currencies.

In anticipation of this move by the Fed, a number of countries and groupings of countries began moves to protect themselves against the impact of QE2.

According to a recent report by Michael Hudson on the Information Clearinghouse website, the BRIC countries (Brazil, Russia, India and China) are simply creating their own parallel system.

In September, China supported a Russian proposal to start direct trading between the yuan and the rouble, while a similar deal was brokered with Brazil.

Early in October, Chinese Premier Wen Jiabao reached an agreement with Turkey, an American ally in the Middle East region,  to use its own currencies in a drive to triple the trade between the countries to $50 billion over the next five years.

“We are forming an economic strategic partnership. In all of our relations, we have agreed to use the lira and the yuan,” Turkish Prime Minister Recep Tayyip Erdoğan said at the time.

However, it is apparently not only China, the other BRIC countries or the wider family of developing nations that feel the need to prepare for a post dollar-dominated world.

Ambrose Evans-Pritchard of the Telegraph recently reported that he “heard French Finance Minister Christine Lagarde say in person at a meeting in Italy that France would use its G20 presidency to push for an alternative to the dollar. She specifically cited the ‘Bancor’ – the idea floated by [John Maynard] Keynes in the 1940s for a commodity currency priced off a basket of metals”.

Tim Duy, as reported by Information Clearinghouse, said that “if the Federal Reserve is committed to QE, there is no way for the rest of the world to stop the flow of dollars that is already emanating from the US. Yet, much of the world does not want to accept the inevitable and there appears to be no agreement on what comes next.

“Call me pessimistic, but right now I don’t see how this situation gets anything but more ugly.”

Evans-Pritchard’s assessment is that “this is a dangerous moment for the world and may backfire against the US itself.

“We are already starting to see the same sort of rush into oil and resources that played such havoc in mid-2008 and may have been a key trigger for the Great Recession. There is a risk that this commodity shock will hit before QE stimulus filters through”.

Moves back to gold

The Financial Times in June this year reported that as a sign of a move away from the dollar – after two decades as net sellers of gold, central banks have become net buyers.

It is unlikely to happen overnight, however.

A survey of central bank officials has found that 50% of them did not think the dollar would be the world’s reserve currency by 2035. Among the predicted replacements were Asian currencies and the euro, but by far the majority favoured gold.

But it is not only gold that attracts attention, as global investors are seeking safer havens for value than the dollar – not all of them without even considerable risks attached.

In early November, the Telegraph reported from London that the British Financial Services Authority “has been warned that new commodities funds being launched by investment banks pose a danger to the metal markets and are a bad deal for investors.

“Several metal traders and experts have written to the City watchdog, claiming that the licensing of the so-called physically backed exchange-traded funds (ETFs)... may amount to approving the next financial bubble.

“Traders’ concerns are based on the ETFs model that will require the investments to be backed by physical metals such as copper, lead, aluminum and nickel, rather than paper assets offered by futures contracts,” it added.

“They claim that the success of existing physical ETFs, particularly gold, will not translate to other metals. Metals experts warn that investors will face expensive shipping, storage and disposal costs that are likely to take the lion’s share of the investment gains.”

Judged on the reactions in the comments section at the end of this article, the international financial system is still suffering from a credibility crisis in the wake of the financial crisis that began in 2007.

Referring to the banks planning these ETFs, one respondent writes: “These are the same guys that have been responsible for the price suppression and manipulation of PMs (protected money investments) for years now, so why would anyone trust them with this kind of investment? It’s very simple: if you want to invest in gold or silver, buy physical and store it.”

In another Telegraph article immediately after the Fed’s announcement of QE2, Evans-Pritchard wrote: “ The Fed’s QE2 risks are accelerating the demise of the dollar-based currency system, perhaps leading to an unstable tripod with the euro and yuan, or a hybrid gold standard, or a multi-metal Bancor along lines proposed by John Maynard Keynes in the 1940s.”

How smooth a transition?

Few observers and commentators seem to think that the transition away from the dollar will be a smooth and orderly one, and assess that it could take as long as a decade or two for a new system to come into place.

John Hathaway, managing director of Tocqueville Asset Management in New York, wrote in an article published in early November in Business Report under the headline, “Global monetary system on the brink of collapse”: “The prospects for an orderly unwinding of the extreme posture of global monetary policy are zero. Central bankers in the US and Europe are huddling upon the most precarious perch in the history of monetary affairs.

“These alleged guardians of monetary stability have simply created the incinerator for paper money. We are past the point of no return. Quantitative easing may well become a way of life.”

Some of the reactions are even alarmist. Brian Hicks wrote on the Energy & Capital website the day after the QE2 announcement: “Yesterday, we put the last nail in the lid of the dollar’s coffin. It took five minutes, the ink from a pen... And just like that, the world’s primary reserve marched to the gallows.

“Conservative estimates claim this latest printing session will cost our dollar at least another 20%... The move will soon have a nation in panic, as the price of everything, from groceries to gas, skyrockets with inflation.

“But to a smart investor, it’s also guaranteed to send gold prices into the stratosphere.

“Physical gold as well as gold ETFs holders are already salivating and loading up as much as they can,” he added.

The Zoellick plan

The suggestions aimed at a new gold standard, made by Zoellick, are apparently aimed at finding a transitional mechanism to a new international currency system, which is as stable as possible.

He said the world needed a new regime to succeed the “Bretton Woods II” system of floating currencies, which has been in place since the fixed-rate currency system linked to gold broke down in 1971.

“The system should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values.

“Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today,” Zoellick added.

The original Bretton Woods agreement laid out a US-led framework for stability in the world financial system after World War 2, with the dollar pegged to gold and controls in place to limit the flow of capital.

The gold standard is believed to help guard against inflation, but does not allow for the flexible monetary policy that many economists believe is essential in counteracting economic shocks.

It was abandoned by US President Richard Nixon in 1971, as the dollar’s value plummeted relative to gold.

Zoellick acknowledged that forging a new monetary agreement to govern the world economy would take time, two years after the West’s worst financial crisis since the 1930s. “But we need to begin,” he wrote.

No silver bullet

But gold on its own may not be the silver bullet that some commentators would want one to believe.

On the website The Motley Fool (www.fool.com) in early November, Alex Dumortier analysed the risk that investors are taking by paying more than $1 300 for an ounce of gold.

He came to the conclusion: “In fact, gold appears to have eked out a small positive real return over time.

“Using data from the World Gold Council and precious metal dealer, I was able to construct a series of inflation-adjusted gold prices going back to 1851, according to which gold generated a historical average return of 0.7% per annum.

“However, even that small positive real return is a bit of a mirage resulting from the powerful gold rally we’ve witnessed.

“Indeed, as recently as 2005, gold’s average real return over 154 years was zero, period,” Dumortier wrote.

This would seem to indicate that there are two sides to the gold coin.

Over a prolonged period of more than a century and a half, gold has proven itself as an excellent preserver of value but, as a vehicle to generate real profit, it is less attractive.

If you have the stomach for short- to medium-term speculation, it is, of course, a different story.

Right from the start of the financial crisis, it was apparent that one of the long-term casualties would be the mighty dollar.