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Saturday, November 27, 2010

There is gold in Zoellick's idea

There is gold in Zoellick's idea

In recommending a modified gold standard, the World Bank President is only anticipating the emergence of a new monetary order. Many countries are already wary of holding currency, and have turned to gold.

The President of the World Bank, Mr Robert Zoellick, has generated a storm with his article in The Financial Times of November 7, 2010, where he recommends a modified global gold standard to guide currency movements. He calls for a system involving the dollar, euro, yen, pound and the yuan, that would help in internationalisation of the reserve currency.

In this context, Mr Zoellick has argued that the system should also consider employing gold as an international reference point on market expectations about inflation, deflation and future currency values.

With the obvious problems being faced by the dollar, there is merit in a neutral benchmark.

Opponents of Mr Zoellick's proposal are concerned that a gold standard lacks the mechanism to offset deflationary pressures. Some analysts, like Martin Wolf, are of the view that there could be a flood of gold into a currency which is well-managed and that there could be severe deflation.

It is well known that when a country's currency becomes a reserve currency it becomes heavily indebted which, over time, shakes the confidence in the reserve currency.

This was the experience of sterling in the first half of the 20th century and the dollar in the second half. It is for this reason that the euro, the yen and the yuan resist becoming reserve currencies.

The Zoellick proposal has incurred the wrath of otherwise sober and balanced economists. For instance, Bradford Delong, Professor at the University of California (Berkeley), argues that attaching the world's economy's price level to an anchor that central banks cannot augment to ward off deflation is a major drawback of the Zoellick proposal. Some analysts feel that Mr Zoellick has rightly diagnosed that monetary policy is being overly politicised.

It is, however, recognised that a monetary system based on a commodity whose availability is dictated by natural conditions would not allow adequate discretion to tackle instability generated by a rigid system. There appears to be a contradiction in what the G-20 is endeavouring to do. While it is agreed that countries should not take recourse to competitive depreciation, the US Fed's policy of quantitative easing is weakening the dollar and thereby appreciating other currencies, particularly the yuan.

If the appreciating countries retaliate by printing money to foreclose an appreciation of their currencies, the world would be caught in an uncontrolled global inflation, which would inevitably end in a crash.

The Zoellick proposal should be a warning to the comity of nations that there is a need for caution in unbridled fiat money. Mr Zoellick's message is very clear that the present international monetary order is dying. And, as Reuters columnist James Saft says, when old religions die, new ones spring up to fill the void.

Mr Zoellick recognises that investors have figured out that currency holdings could be hazardous and that markets are already using gold as an alternative monetary asset. Saft argues that the Zoellick proposal is not a call for a return to the pre-1914 gold standard but a guide in the kindergarten of currency disputes.

Importance of Gold

Critics of Mr Zoellick consider any link with gold as anathema. It is pertinent to note that a number of major countries have over 60 per cent of their foreign exchange assets in gold — the US, Germany, France, Italy, Netherlands and Portugal. While there is so much talk about the irrelevance of gold in the international monetary system, it is not for nothing that the major industrial countries hold a large proportion of their reserves in gold and a number of other countries, including China, Russia, India and the West Asian countries are augmenting the proportion of gold in their foreign reserves.

In response to the wild and thoughtless criticism, Mr Zoellick has clarified that he was in no way advocating a return to the pre-1914 gold standard. He says that “gold is the elephant in the room” and policymakers need to take cognisance of this.

New Reference Index

Policymakers need to build on the Zoellick proposal. A reference index could be constructed which would include the major currencies and gold. Illustratively, initially gold could be given a weight of, say, 20 per cent and the major currencies 80 per cent.

Gradually, over time, the weights of gold and other currencies could be made equal. Each country could evolve its exchange rate policies bearing in mind the reference rate. This would avoid fractious inter-country conflicts. Mr Zoellick is being burnt at the stake by anti-gold zealots as he has sounded the death knell of their religion.

As the new international monetary order emerges, however, Mr Zoellick may well be beatified and could be on the way to sainthood as the founder of a new religion. Charles de Gaulle and his adviser, Jacques Rueff, who called for a return to gold in 1965, are perhaps chuckling in heaven!

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