Thursday, May 29, 2014

Can We Have a Virtual Gold Standard?

Beijing has contacted major banks and producers of gold asking them to support its bid to establish a Global Gold Exchange in Shanghai.

The stated aim of the initiative is to lessen the extreme volatility in the price of gold; but lurking not too far behind is the ambition to have the Yuan compete with the US$ as an international reserve currency.  (A reserve currency is one all governments must hold to facilitate trade.)

How realistic is that ambition?

The Chinese certainly seem to have the right credentials. Their economy is now, according to the latest World Bank purchasing power parity estimate, larger than that of the United States, and last year China overtook Germany as a global trader.

But I doubt if the Yuan will ever become the world's reserve currency, and that has nothing to do with China's credentials:  it's because I think the Information Age is creating the possibility of an entirely new monetary system, free of dependence on any single country, no matter how large and dominant.

To explain what this new option is, I have to provide some background.

Through most of history, the only acceptable international currencies were gold and silver, either coined or as bullion.

Paper money began as promissory notes issued by private financiers stating values in terms of gold (or more rarely, other precious commodities).

When governments began to issue paper currencies they were initially on a "gold standard" that imposed a ceiling on how much money was available for use. That proved a serious constraint in times of rapid economic growth or war, both requiring a swift expansion of finance.

Not surprisingly, governments went off the gold standard under pressure, and once that happened, the problem of international exchange rates became a primary concern: there was no agreed common measure of value.

The problem was especially difficult at a time when the leaders of imperial Europe believed the strength of a country was founded in its capacity to maximize exports and minimize imports.

To achieve that ideal they engaged in reckless manipulation of trade rules and currency exchange rates, dignifying their sharp tactics as "trade and monetary policy."

But all they achieved was endemic economic instability.

The major European empires sought to cushion themselves by monopolizing the markets of their colonies, but that only deepened the poverty of their victims, rendering them useless as consumers. 

Among the nations of Europe and North America, the volatility put all countries on a downward spiral of falling trade, consumption, production and employment.

As factories closed and millions lost their jobs, the world sank into the Great Depression of the 1930s. The mass misery of those times empowered fascists of the Left and Right, and a British-led effort to set them violently against each other mushroomed into the Second World War.

After the war, as the world's sole economic super-Power, the United States moved swiftly to create a system in which currency exchange rates were fixed and trade restrictions removed.

A new International Monetary Fund established the currency values of all its members in terms of gold at $35 an ounce. The US$ was deemed "as good as gold," and that freed the system from the rigidities of linking currencies directly to metal.

The IMF system functioned well until the massive export of US$ to fund postwar reconstruction in Europe and Japan, and to fight the proxy conflicts of the Cold War, caused a glut of the currency abroad.

When foreign governments with huge holdings of dollars tried to convert them into gold, Richard Nixon refused. The central agreement of the IMF was thus destroyed, and all currencies left to "float" to their market valuations.

That happened in 1972-1973, and since then, the world monetary system has lurched along with floating currency rates set by opaque, volatile "and staggeringly large international financial flows.

As the United States economy was by far the largest in the world and petroleum was priced in $, it became necessary for all trading nations to hold the currency in their own reserves.

That is what made the US$ the world's "reserve currency."  

Against that background it is quite clear that the Chinese ambition to have the Yuan replace the $ in international trade is a pipe-dream.

The Chinese economy is nowhere as large, diverse or vital as the American, and GDP comparisons based on PPP calculations will not impress hard-eyed financiers called upon to decide which currency they want to hold in large quantities.

In addition, the Information Revolution has opened up the possibility of an international monetary system with a fluid market-imposed gold standard operating largely on autopilot.

It could work something like this: exporters of a particular product or commodity would price it in terms of the domestic cost of gold in their countries. Importers would decide what was the best buy based on the gold price in their own countries. Supply and demand would set the purchase price.

Such an arrangement is possible because information technology can sift through enormous amounts of data to present buyers and sellers with clear choices.

The free global marketplace that would evolve from such interactions can be envisaged as a giant e-Bay, with a reformed IMF producing a periodically adjusted scale of currency valuations as reflected in millions of trades. It would also monitor overall balances in trade and payments flows and work with national authorities to head off problematic situations.

Such a system would provide a completely elastic gold standard for multiple currencies and with great economy of effort, take into account a diversity of social factors in exchange valuations.   

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