Plans to hitch the US$ to gold are doomed to certain failure

PUBLISHED : Tuesday, 28 August, 2012, 12:00am
UPDATED : Tuesday, 28 August, 2012, 3:38am

It's almost a year now since the price of gold hit an all-time record of US$1,921.15 an ounce.

At the time, gold euphoria was running high, with bulls confidently predicting the price would break through US$2,000 before the end of 2011.

It didn't happen. Instead of pushing higher, the rally ran out of steam and the gold price collapsed 20 per cent by the end of the year.

In recent weeks, however, the market has perked up again. In the last three months renewed investor buying has seen the quantity of gold held by exchange-traded funds rise by 2.6 million ounces.

As a result, the price has recovered by 10 per cent to hit US$1,672 yesterday (see the charts). Once again enthusiasts are forecasting gold will test US$2,000 an ounce before the year's end.

The conventional wisdom is that investors are buying on hopes the US Federal Reserve will embark on a fresh round of quantitative easing, lifting the market with a new flood of liquidity.

But there is a more intriguing explanation for the renewed bullishness. According to recent news reports, the US Republican Party may call for a return to the gold standard at its convention this week.

For those of us whose memory of pre-1971 financial affairs is a little hazy, the gold standard is the system under which the value of the US dollar used to be fixed in terms of gold, in much the same way that the Hong Kong dollar is pegged to the US dollar.

Enthusiasts want to re-introduce the gold standard because they believe it would enforce monetary discipline on a Federal Reserve addicted to printing money, stabilising the value of the US dollar and eliminating inflation.

Under the gold standard, gold would act as the main monetary anchor for the economy. The US dollar would be convertible into gold at a fixed price, and the stock of currency in circulation would be backed by reserves of gold, just as Hong Kong dollars are backed by US dollars held by the Hong Kong Monetary Authority.

Alas, there are a few problems with the idea.

The US Fed is now sitting on 8,133.5 tonnes of gold reserves, or 261.5 million ounces.

That means, if the Fed were to back the entire US monetary base of US$2.69 trillion with gold, it would have to fix its conversion price at US$10,286 for an ounce of gold.

That's more than six times the current price, which would provide a huge windfall for anyone lucky enough to be holding the metal.

(Alternatively, you could argue that pegging the US dollar at US$10,286 an ounce would involve an 80 per cent devaluation of the US currency against gold, which would hardly be a recipe for stability.)

Julian Jessop at independent research house Capital Economics suggests that the Fed could get away with holding gold against only a portion of the US monetary base. Backing just 20 per cent, say, would allow it to set the conversion rate at just above US$2,000 an ounce - not so far from the current price.

But that strategy would create problems in its own right.

At that price, the People's Bank of China might decide to take advantage of the convertibility undertaking and exchange some of its US$1.2 trillion holdings of US Treasury bonds into gold.

Unfortunately, even at US$2,000 an ounce the US holds only enough gold to cover half of the PBOC's portfolio of Treasuries.

That would leave the US authorities with just two options. Either they would have to suspend the US dollar's convertibility, abandoning the gold standard once again.

Or they would have to jack interest rates up high enough to persuade the Chinese and other investors to roll over their maturing Treasuries, rather than exchange them for gold. That would crush economic activity.

In short, there is no way a return to the gold standard could work. It's a crazy idea.