14 March 2008

Mediocratic money

Why has the price of gold been rising? (Chart 1). Is it the weakness of the US Dollar? (Chart 2). But it has been going up in euros too (Chart 3). Is it inflation? But reported consumer price increases, and future expectations thereof, are barely above 2% per annum (Chart 4: UK inflation projection).

Gold is thought to mirror excess liquidity in the global monetary system. Excess liquidity is loosely defined as actual money supply minus estimated money demand. At a time when so many central banks are lowering rates and flooding the system with money, this generous supply is [according to enthusiasts for gold] failing to be matched by a commensurate demand for the uses of money in consumption or investment.
Certainly the US Federal Reserve seems to have lost credibility as regards its supposed hawkishness. It now appears it will do whatever it takes to rescue the flagging US economy. So much for the theory that the effect of having an ex-academic at the helm would be in the direction of excessive pedantry or prudence.

A recent Citibank report, from which the above quote is taken, has a different explanation of why gold has been rising, which seems persuasive.
We could, in fact, be in an era not unlike the early 1970s when the foundations of the Bretton Woods exchange-rate regime finally fractured. There are some eerie similarities between then and now. Japan and Western European countries were rapidly building up their foreign reserves by financing US trade deficits. Although the amounts of international reserves were smaller then, the surge was as spectacular as anything we have seen in recent years from China or the oil-producing Gulf States. Also, at that time the US economy’s monetary policy was “super-easy,” an appellation that has been used by some to describe the Fed’s current stance in the face of still-sticky inflation.
Orthodox economics tends to scorn comparisons between Bretton Woods and now: its confidence in fiat money per se is fairly unshakeable, and we are no longer dealing with a system overly dependent on a single currency. Of course, as with other macroscopic changes (1987 Crash, Asian boom, collapse of ERM), recognition by academic economists tends to come after the event, rather than before.

The problem may be not with the US Dollar specifically, but with all currencies based on economies that are run on mediocratic principles. After all, the US's problems are not unique. Britain has as bad a discrepancy between savings and borrowing. Australia, when I last looked, had a worse trade deficit relative to GDP. It may be confidence in the global financial system as a whole that is being called into question.
It is not loss of confidence in any particular currency that is at issue here; it is the loss of confidence in the standard that underlies the whole system. This, we argue, is what the price of gold responds to. After all, Bretton Woods was an implied gold standard, yet the price of gold soared in the 1970s when the system’s faults came to light. Its successful replacement with a fiat-money standard in the 1980s damped enthusiasm for gold for the next quarter of a century.

Consider where we are today: Fiat money makes the central bank the legally mandated guarantor of stability in an economy. As such, its credibility is the mast to which all economic decisions that involve future payments are tied. There would be trouble if central-bank credibility — specifically, that of the Federal Reserve — was ever called into question ... Similar to the 1970s, today we could be witnessing the gradual loss of confidence in a standard — but this time, it’s in fiat money.
The report closes on an ominous note.
We must also remember that the last period of fiat-money rule, from 1914 to 1925, ended with French, German and Austrian hyperinflation when their central banks blithely financed their governments’ budget deficits. The risk with this system is that it’s easy to abuse under extreme duress because the sole anchor is faith in the central bank’s reputation. If this is ever seriously called into doubt, gold’s return as a key monetary asset should not be dismissed.
(Extracts from Citi Private Bank: The View - Investment outlook March 2008, via FullerMoney)