Currency War Will End in Tears

The “currency war” is heating up, and all parties are pinning their hopes on the G20 summit in South Korea. However, this is reason to believe that the meeting will fail to achieve anything in this regard, and that the cycle of “Beggar-thy-Neighbor” currency devaluations will continue.
There have been a handful of developments since the my last analysis of the currency war. First of all, more Central Banks (and hence, more currencies) are now affected. In the last week, Argentina pledged to continue its interventions into 2011, while Taiwan, and India – among other less prominent countries – have hinted towards imminent involvement.
Of greater significance was the official expansion of the Fed’s Quantitative Easing Program (QE2), which at $600 Billion, will dwarf the efforts of all other Central Banks. In fact, it’s somewhat ironic that the Fed is the only Central Bank that doesn’t see its monetary easing as a form of currency intervention when you consider its impact on the Dollar and its (inadvertent?) role in “intensifying the currency war.”  According to Chinese officials, “The continued and drastic U.S. dollar depreciation recently has led countries including Japan, South Korea and Thailand to intervene in the currency market,” while the Japanese Prime Minister recently accused the U.S. of pursuing a “weak-dollar policy.”

As of now, there is no indication that other industrialized countries will follow suit, though given concerns that QE2 “at the end of the day might be dampening the recovery of the euro area,” I think it’s too early to rule anything out. While the Bank of Japan similarly has stayed out of the market since its massive intervention in October, Finance Minister Yoshihiko Noda recently declared that, “I think the [Yen's] moves yesterday were a bit one-sided. I will continue to closely monitor these moves with great interest.”
As the war reaches a climax of sorts, everyone is waiting with baited breath to see what will come out of the G20 Summit. Unfortunately, the G20 failed to achieve anything substantive at last month’s Meeting of Finance Ministers and Central Bank Governors, and there is little reason to believe that this month’s meeting will be any different.
In addition, the G20 is not a rule-making body like the WTO or IMF, and it has no intrinsic authority to stop participating nations from devaluing their currencies. Conference host South Korea has lamely pointed out that while ” ‘There aren’t any legal obligations‘…discussion among G20 countries would produce ‘a peer-pressure kind of effect on these countries’ that violated the deal.” Not to mention that the G20 will have no effect on the weak Dollar nor on the undervalued RMB, both of which are at the root of the currency war.
It’s really just wishful thinking that countries will come to their senses and realize that currency devaluation is self-defeating. In the end, the only thing that will stop them from intervening is to accept the futility of it: “The history of capital controls is that they don’t work in controlling foreign exchange rates.” This time around will prove to be no different, “particularly with banks already said to be offering derivatives products to get around the new taxes.” The only exception is China, which is only able to prevent the rise of the RMB because of strict controls for dealing with the inflow of capital.
In short, the “wall of money” that is pouring into emerging market economies represents a force too great to be countered by individual Central Banks. The returns offered by investing in emerging markets (even ignoring currency appreciation) are so much greater than in industrialized countries that investors will not be deterred and will only work harder to find ways around them. Ironically, to the extent that controls limit the supply of capital and boost returns, they will probably drive additional capital inflows. The more successful they are, the more they will fail. And that’s something that no new currency agreement can change.

New Zealand: No Forex Intervention

Despite reaching a temporary stalemate, the currency war rages on, and individual countries continue to debate whether they should enter or watch their currencies continue to appreciate. Nowhere is that debate stronger than in New Zealand, whose Kiwi currency has fallen 37% against the US Dollar since its peak in early 2009, and over 15% since June of this year.

With most countries, the war cries are coming from the political establishment, who feel compelled to demonstrate to their constituents that they are diligently monitoring the currency war. This is largely the case in New Zealand, as Members of Parliament have argued forcefully in favor of intervention. Prime Minister John Key is a little more pragmatic: He “says his Government is concerned about the strength of our dollar, but is not convinced intervention would work…politicians who think intervention can happen without economic consequences, are fooling themselves.” Showing an astute understanding of economics, he pointed out that trying to limit the Kiwi’s appreciation would manifest itself in the form of higher inflation, higher interest rates, and/or reduced access to capital.
This is essentially the position of Alan Bollard, Governor of the Central Bank of New Zealand. He has insisted (correctly) that the New Zealand is being driven up, so much as its currency counterparts – namely the US Dollar – are being driven downward, by forces completely disconnected from New Zealand and way beyond its control. Thus, if New Zealand tried to intervene, it would quickly be overpowered (perhaps deliberately!) by speculators. Ultimately, it would end up spending lots of money in vain, and the Kiwi would continue to appreciate.
Mr. Bollard has pointed out that a stronger currency is not without its perks: such as lower (relative) prices for certain natural resources, such as oil. In addition, since New Zealand is largely a commodity economy, its producers are being compensated for an expensive currency in the form of higher prices for milk, wool, and other staple exports. While its other manufacturing operations have been punished by the expensive Kiwi, its economy is still relatively robust. Thanks to a series of tax cuts and the lowest interest rates in New Zealand history, GDP is forecast to return to trend in 2010 and 2011.

New Zealand’s concerns are understandable, and there is an argument to be made for preventing the Dollars that are printed from the Fed’s QE2 from being put to unproductive purposes in New Zealand. At the same time, New Zealand is not such an attractive target for speculators. Its benchmark interest rate, at 3%, is relatively low compared to developing countries. Its current account balance is projected to continue declining, perhaps down to -8%, which means that the net flow of capital is actually out of New Zealand. In addition, while the Kiwi has appreciated against the US Dollar, it has fallen mightily against the Australian Dollar en route to a multi-year low.
Going forward, there is reason to believe that the New Zealand Dollar will continue to appreciate against the US Dollar as a result of QE2 and a general sense of pessimism towards the US. The same is true with regard to currencies that actively intervene to prevent their currencies from appreciating. Still, I don’t think the New Zealand Dollar will reach parity – against any currency – anytime soon, and after the currency fracas subsides, it will probably trend towards its long-term average.

Canadian Dollar Reaches Parity…Again

Last week, the Canadian Dollar became the second currency – after the Australian Dollar – to reach parity against the US Dollar. While the case for Loonie parity is not quite as strong as the Aussie’s, there is nonetheless reason to believe that it will continue trading at this level for the short-term.

It’s not hard to understand what’s driving the Loonie; the weak Dollar. As the Fed embarks on further monetary easing (QE2), investors are nervous that all of these new Dollars will be deployed in a speculative – rather than productive capacity. Emerging market currencies are particularly popular, with commodity currencies, such as the Canadian Dollar, not far behind.
According to Bank of Canada Governor Mark Carney, “The outlook for the Canadian dollar… ultimately reflects the economic fundamentals.” While he has threatened to intervene if currency markets are “disrupted” (i.e. if the Loonie rises to an unreasonable level), past history and the tone of Carney’s remarks suggests that the Bank of Canada will remain on the sidelines for the duration of the currency war.
From where I’m sitting, the Canadian Dollar (as with the New Zealand Dollar, the subject of my previous post), don’t deserve to benefit from the speculative wall of money that is flowing out of the US. The Canadian economy is projected to grow by only 1% in 2010, and after adjusting for the contraction in 2009, it is still the same size as it two years ago. Not to mention that the Canadian government issued a record amount of debt to shepherd the economy through the recession.
Most worrying is that Canada’s trade deficit is nearing a record high, and on an annualized basis is now approaching $30 Billion a year.  In addition, anecdotal stories suggest that Canadians are engaging in cross-border shopping and traveling abroad in great numbers to take advantage of relatively cheap prices. With the Canadian Dollar now at parity, these phen0omena are already becoming entrenched: “We would not anticipate much of an improvement in these trade patterns in the next couple of quarters,” said one economist.

There are two observations that can be made here. First of all, while Canada is certainly a natural resource economy, the boom in commodity prices  really isn’t helping Canada in the same way that it is helping Australia, for example. That’s mainly because Canada’s principal market for commodity exports is the US, which remains weak. In contrast, the booming economies of China and Greater Asia ensure an expansive and growing market for Australian natural resources. Moreover, as evidenced by a growing trade deficit, exports of commodities are being offset by an increase in imports: “Economists at Bank of Montreal and Desjardins Financial say weak trade will carve as much as three percentage points from GDP growth in the third quarter.”
The second observation is that currency markets are self-correcting, and that is especially true in the case of the Canada. As the Loonie rises, Canadian exports become less competitive, and consumers (sometimes physically!) start importing more. At some point then, the Loonie will reverse its decline, and the trade deficit will shrink.
However, if you drill deeper into the numbers, you can see that Canada is running a sizable trade surplus with the US. That means that the Canadian Dollar probably has room to rise further (or the Dollar has room to fall further), before the bilateral trade deficit would even close to narrowing. On a trade-weighted basis (perhaps against the Euro), the Loonie has few sources of fundamental support. For what it’s worth, analysts from CIBC World Markets seem to agree: they see the Loonie declining more than 5% over the next six months as the uproar over QE2 gradually fades, and the data shows that only a modicum of the newly printed US Dollars found their way into Canada.

Interview with Dollar Daze: Avoid Positions that Entail Currency Risk

Today, we bring you an interview with Mike Hewitt of Dollar Daze, whose “belief is that the paper currencies of the world are presently undergoing a devaluation.” Below, Mr. Hewitt shares his thoughts on the US Dollar, Chinese Yuan, inflation, and why you should be paying attention to Gold and other commodities.

Forex Blog: I would like to begin by asking about your background. What interested you in the US Dollar, to the extent that you decided to blog about it on a regular basis?

I first began investing in earnest around the top of the dot.com era in the late-90’s. At the time, I spent much time perusing the various mainstream media financial sites. I invested primarily into the heavily advocated technology stocks. Additionally, I worked at Nortel which at that time was Canada’s premier company, representing everything the so-called ‘New Economy’ entailed.
In 2005, I decided it was time to begin documenting articles of interest and place down some of my own thoughts and conclusions. Through several incarnations, this developed into what DollarDaze is today.
Of course we all know how the ‘New Economy’ ended. Like many of my peers, my investments plunged. While in terms of percentage the losses were staggering, fortunately since I was beginning, the actual dollar amounts involved were quite modest. From that early experience I decided that my understanding of how economics and markets worked needed to change.
I began reading various books and came across a chapter on central banking and fiat currency. For the first time in my life, I realized that gold did not back paper money – not the US dollar, not the British pound or even the Euro. No modern currency is backed by anything tangible. This topic became of great interest to me and I sought out any additional material I could addressing this issue.

Forex Blog: You blogged recently about the dilemma faced by the People’s Bank of China, whereby it desperately wants to limit its exposure to the US Dollar but that any attempts to actually do so would almost certainly cause the value of its reserves to fall? Can you elaborate on this, and explain what you believe to be the PBOC’s most likely course of action?

Beginning in late 2004, the PBOC began buying US debt at an impressive rate, and actually surpassed Japan as the largest holder in mid-2008. A large accumulation of any currency becomes a burden for the holder as they cannot be quickly unwound without driving the underlying currency down and precipitating the very capital loss that the holder is attempting to avoid. China’s situation today shares many eerie parallels to that of France in the 1930’s.
Following the events of WWI, France experienced a decade of currency instability. This ended when the French government mandated the French central bank to buy foreign exchange on the market to avoid excessive currency appreciation. This effectively pegged the French franc to the British pound sterling and U.S. dollar.
Through a process of maintaining an undervalued currency, France recorded trade balance surpluses. At one point it was estimated that the Banque de France held more than half of the world’s volume of foreign reserves.
When the Bank of England suspended their obligation to sell gold at a fixed price in response to a collapse of the banking system in continental Europe, the result was an immediate and sharp devaluation of the British pound. The central bank of France held an estimated £62 million in paper (at that time equivalent to over 450 tonnes of gold). In order to stem their capital losses when the pound sterling dropped, the central bank of France added fuel to the fire by liquidating much of their paper position.
Roll the clocks forward to the new millennium and we see a very similar scenario, but with different players. The Chinese government has enforced a pegged currency through the purchase of foreign reserves. But the important question is whether the end-game will be the same as before.
From what sources are available, the PBOC appears to be both gradually reducing their exposure to US denominated debt and perhaps more importantly, cycling out of longer-term US debt into short-term paper. Perhaps the PBOC can strategically use Bernanke’s QE2 as an opportunity to further reduce their exposure without instilling a panic flight from the US dollar.

Forex Blog: On a related note, I enjoyed your analysis of the “Growth of Global Currency in Circulation” and was surprised to learn that the Chinese Yuan is being printed at an even faster rate (relatively) than the US Dollar. With this in mind, do you think that calls for the Chinese Yuan to appreciate are unreasonable?

The PBOC has been expanding their money supply at a higher rate than the US Federal reserve for many years now. Much of the explosive growth in China is being fuelled by monetary expansion.
I would be hesitant to speculate on any fiat currency which is being produced in great quantities as being a source of strength. Yes, there are factors suggesting that the Chinese yuan is undervalued, but at the same time, the economy of China is not immune to the negative effects of an inflation induced boom caused by monetary expansion.
Interestingly enough, China experimented with paper money around 800 AD and fully abandoned it six centuries later following several boom-bust cycles. The first issue of official paper notes in Europe from a chartered bank was in 1661 by the Bank of Sweden.

Forex Blog: The Federal Reserve Bank has been accused of (inadvertently) stoking the ongoing currency war through the expansion of its Quantitative Easing (QE2) program. Given that all Central Banks continuously expand their money supplies, do you think accusation is fair? More importantly, do you think that the Dollar will continue to decline as this policy is gradually implemented?

I recently compiled statistics comparing expansion of the monetary bases for different currencies. The three largest are shown below.

As one can readily see, the monetary base of all three currencies are increasing, but it puts into perspective just how truly large the actions of the Federal Reserve were to the crisis of 2008. This chart doesn’t include any data from the QE2 program.
While these increases are not directly inflationary, they do present an enormous potential for currency debasement. These reserves can be thought of as being similar to what a major new discovery of a mineable deposit would have to the price of the metal. The price of the metal is only indirectly affected until the newly mined metal reaches the market, at which point it will plunge.

Forex Blog: You have criticized the Fed for its “ardent” fight against deflation. If you look at the experience of Japan over the last 20 years, it would seem to prove that deflation is associated with currency appreciation but economic stagnation? Do you think that deflation in the US would follow a different form?

I believe it important to be very specific with what we mean by saying ‘deflation’. Originally, the term ‘deflation’, and its counterpart, ‘inflation’, referred to changes in the money supply. At present, the term ‘deflation’ relates to decreasing prices. I think this change in definition obfuscates the issue because prices may decrease for various reasons – increased supply relative to demand, price wars, technological advances in production, or efficiencies in distribution – all affect price.
When stating Japan experienced deflation over the last 20 years, I speculate that this definition has been further restricted. Instead of now referring to general price levels, it is concerned primarily with asset prices. This continues to confuse the issue by further removing the cause-effect relationships of increasing supply on the overall economy.
At the peak of the Nikkei at the end of 1989, there was approximately ¥38.5 trillion yen in circulation. Twenty year later, that figure has more than doubled to ¥82.7 trillion. To me, that is inflation.
I would speculate that the US will begin a similar route, but holding the privileged status of being the ‘de facto’ reserve currency of the world, this will affect the global economy.

Forex Blog: The series of long-term currency charts that are displayed on your home page suggest that you subscribe to the Purchasing Power Parity (PPP) school of currency analysis. Is this a reasonable assessment?

I hope to update those charts to reflect the historical trend of different currencies relative to gold. The reason being is that they are currently based on CPI statistics from the BLS. Given that I do believe government statistics such as the CPI to be inaccurate of the real world, I am not entirely satisfied with these charts.
I hold that gold, being a material that functions well as a store of value, provides a much more objective standard to use as a measuring tool.

Forex Blog: Do you think that gold represents the best long-term hedge (aka store of value) in the context of the US Dollar’s continued decline? How do you reconcile the rise in Gold with the fact that inflation in the US is at a 50-year low?

I simply do not buy into the notion that the inflation rate, as measured by the CPI, is an effective method. While the fundamental notion of measuring a ‘basket of goods’ throughout time seems as a good methodology, the various manipulations through which this calculation is subjected (geometric weighting, hedonics, substitution) removes any credibility.
I know that I am paying more for groceries, gas, utilities and other general living expenses than I was before. John William’s site Shadow Government Statistics calculates the CPI the way it was done in previous years and finds the rate to be around 8-10%. That figure feels much more in line with my own personal observations.
Gold is moving up because its monetary value is being realized by a growing portion of the populace concerned with what the increasing money supply will do to the dollar.

Forex Blog: What is your medium-term prediction for the US Dollar. In other words, how will QE2, currency wars, renewed appetite for risk, etc. affect the Dollar after the next few years?

I advocate a strong fundamental position in vehicles which function well as a store of value, such as gold.
I would hesitate holding any position which is exposed to currency risk, particularly long-term bonds. These massive purchase programs by the US Federal Reserve are exerting an enormous downward pressure on interest rates. The Fed is called the buyer of last resort. They may soon find themselves to be the only buyer.
Equities are feeling more and more akin to participating at a casino. In the not too distant history, the purpose of buying a stock was to receive a dividend. Nowadays, it seems like greater fool theory is the rule. Like the flipping of over-priced condos, the goal is simply to find someone willing to pay a higher price to unload on.

Euro Correction is Here

You can think of this as a follow-up to my last post, entitled “Euro Due for a Correction,” in which I proclaimed that “investors got ahead of themselves when they pushed the Euro down 20% over the first half of 2010, but now they are in danger of making the same mistake, and are pushing the Euro too far in the opposite direction.” Since then, the Euro has indeed fallen 4%. In this case, however, I’m reluctant to toot my own horn, since there were other forces at work.
Namely, he sovereign debt crisis has officially spread beyond Greece, and “Contagion is definitely back on the table.”  Of chief concern is Ireland, whose banking sector is in serious financial turmoil: “Irish banking losses are estimated at up to 80 billion euros ($109 billion), depending on the forecast used, or 50 percent of the economy. As long as housing prices continue to fall, these losses cannot be capped.” At this point, it’s unlikely that the banks can remain afloat without (additional) government help. The only problem is that the government has already raided its welfare fund, and it is projected that additional support would leave a gaping hole in the budget, equivalent to 32% in GDP. Allowing the banks to fail, meanwhile, would lead to economic losses of 50% of GDP.
Portugal and Spain (rounding out the so-called PIGS countries) are also in trouble, with budget deficits of around 9% of GDP. Given that both countries are struggling economically, it is possible that austerity measures and budget cuts could backfire and worsen their respective fiscal situations. Like their Irish counterparts, Portuguese banks remain heavily reliant on access to cheap ECB credit in order to function. Spanish banks, meanwhile are plagued by distressed loans, which account for “5.6 percent of total Spanish bank loans — the highest level since 1996.”
Currently, their governments insist that they can get by without help from the European Commission. To be fair, they have managed both to issue new debt and refinance existing debt without serious difficulty. In addition, Ireland and Portugal have modest reserve funds which could tide them over for close to a year, if need be. The medium-term, however, looks less rosy.

If rising bond yields are any indication, these countries could be in serious trouble. Bond investors are not concerned about an EU bailout, which is seen as inevitable, at least for Ireland. After all, the European Financial Stability Facility that was created in May still has more than $500 Billion left in it. Rather, investors are concerned that they will be asked to take part in the bailout.
Germany, for example, is toughening its stance towards fiscally strained countries, and Angela Merkel has insisted that, “Highly indebted eurozone countries struggling to repay will be forced to restructure their debt in a process of ‘managed insolvency’ and that their creditors will need to take large ‘haircuts.’ ” Up until now, the EU has intimated that will provide a backstop against sovereign default, in order to assuage bond market investors.
This is changing, as German and French politicians insist that they are more beholden to their constituents/taxpayers than they are to their debt-ridden EU brethren.  Given that Germany is fiscally sound, it has pretty much nothing to lose (short of a breakup of the Euro) by playing hardball. In fact, it may actually benefit from scaring away investors, since a weaker Euro will strengthen its export sector.
Going forward, it seems safe to say that the Euro correction will continue, as investors continue to reevaluate their exposure to sovereign credit risk. According to the most recent CFTC Commitments of Traders report, “Investors last week slashed their bets in favor of the euro by 40% to a level not seen since early October.” Of course, given that the Dollar is plagued by its own set of problems, it’s unclear whether the EUR/USD will experience serious fluctuations. Against other currencies, however, the Euro will probably decline: “Those who want to go short euro should consider doing it on the crosses.”

Chinese Yuan Will Not Be Reserve Currency?

In a recent editorial reprinted in The Business Insider (Here’s Why The Yuan Will Never Be The World’s Reserve Currency), China expert Michael Pettis argued forcefully against the notion that the Chinese Yuan will be ever be a global reserve currency on par with the US Dollar. By his own admission, Pettis seeks to counter the claim that China’s rise is inevitable.
The core of Pettis’s argument is that it is arithmetically unlikely – if not impossible – that the Chinese Yuan will become a reserve currency in the next few decades. He explains that in order for this to happen, China would have to either run a large and continuous current account deficit, or foreign capital inflows into China would have to be matched by Chinese capital outflows.” Why is this the case? Simply, a reserve currency must necessarily offer (foreign) institutions ample opportunity to accumulate it.

However, as Pettis points out, the structure of China’s economy is such that foreigners don’t have such an opportunity. Basically, China has run a current account/trade surplus, which has grown continuously over the last decade. During that time, its Central Bank has accumulated more than $2.5 Trillion in foreign exchange reserves in order to prevent the RMB from appreciating. Foreign Direct Investment, on the other hand, averages 2% of GDP and is declining, not to mention that “a significant share of those inflows may actually be mainland money round-tripped to take advantage of capital and tax regulations.”
For this to change, foreigners would need to have both a reason and the opportunity to hold RMB assets. The reason would come from a reversal in China’s balance of trade, and the use of RMB to pay for the excess of imports over exports, which would naturally imply a willingness of foreign entities to accept RMB. The opportunity would come in the form of deeper capital markets, a complete liberalization of the exchange rate regime (full-convertibility of the RMB), and the elimination of laws which dictate how foreigners can invest/lend in China. This would likewise an imply a Chinese government desire for greater foreign ownership.

How likely is this to happen? According to Pettis, not very. China’s financial/economic policy are designed both to favor the export sector and to promote access to cheap capital. In practice, this means that interest rates must remain low, and that there is little impetus behind the expansion of domestic consumption. Given that this has been the case for almost 30 years now, this could prove almost impossible to change. For the sake of comparison, consider that despite two “lost decades,” Japan nonetheless continues to promote its export sector and maintains interest rates near 0%.
Even if the Chinese economy continues to expand and re-balances itself in the process (a dubious possibility), Pettis estimates that it would still need to increase the rate of foreign capital inflows to almost 10% of GDP. If economic growth slows to a more sustainable level and/or it continues to run a sizable trade surplus, this figure would rise to perhaps 20%. In this case, Pettis concedes, “we are also positing…a radical change in the nature of ownership and governance in China, as well as a radical redrawing of the role of the central and local governments in the local economy.”
So there you have it. The political/economic/financial structure of China is such that it would be arithmetically very difficult to increase foreign accumulation of RMB assets to the extent that the RMB would be a contender for THE global reserve currency. For this to change, China would have to embrace the kind of reforms that go way beyond allowing the RMB to fluctuate, and strike at the very core of the CCP’s stranglehold on power in China.
If that’s what it will take for the RMB to become a fully international currency, well, then it’s probably too early to be having this conversation. Perhaps that’s why the Asian Development Bank, in a recent paper, argued in favor of modest RMB growth: “sharing from about 3% to 12% of international reserves by 2035.” This is certainly a far cry from the “10 years” declared by Russia’s finance minister and tacitly supported by Chinese economic policymakers.
The implications for the US Dollar are clear. While it’s possible that a handful of emerging currencies (Brazilian Real, Indian Rupee, Russian Ruble, etc.) will join the ranks of the international currencies, none will have enough force to significantly disrupt the status quo. When you also take into account the economic stagnation in Japan and the UK, as well as the political/fiscal problems in the EU, it’s more clear than ever that the Dollar’s share of global reserves in one (or two or three) decades will probably be only slightly diminished from its current share.

A Return to the Gold Standard?

In my last post, I explored the possibility that the role of the Chinese Yuan (CNY) will expand to the point that it could rival – or even overtake – the US Dollar as the world’s preeminent reserve currency. Ultimately, I concluded that the constraints on widespread foreign ownership of CNY assets are too great, and that as a result, the Dollar’s position is safe for the time being. What about the notion that all currencies are doomed? In this case, the biggest threat to the US Dollar won’t come from China, but rather from gold.
This possibility is no longer hypothetical. James Grant (of the eponymous Grant’s Interest Rate Observer) has for many years tried to advance the case for a return to the Gold Standard. In a much-discussed editorial in the NY Times, Grant reiterated the idea that Central Banker are increasingly out of touch with economic reality, and lack any checks on their ability to print money and debase their respective currencies. Grant singles out the Fed for its non-stop quantitative easing programs, which could lead to hyper-inflation and foment additional asset bubbles. At the very least, it will cause the Dollar to lose even more of its value.
Grant’s editorial coincided perfectly (perhaps deliberately) with a proposal by Robert Zoellick, president of the World Bank, to reform the global economic system, with the goal of reducing economic imbalances. While most of Zoellick’s ideas are common-sense, his proposal to “build a co-operative monetary system that reflects emerging economic conditions.” and “consider employing gold as an international reference point of…currency values” stood out. While his comments created a veritable firestorm, they were grounded firmly in the reality that gold prices are rising and faith in the current fiat monetary system is declining.
The theoretical advantages and disadvantages of the gold standard have been mooted ad nauseum, and I don’t want to rehash all of them here. In sum, a gold standard is believed to be promote long-term price stability, eliminate hyper-inflation, a check on government debt issuance, and a transfer monetary power from Central Banks to the people (via the markets). Downsides include short-term price volatility, a heightened possibility of deflation, and the repudiation of modern monetary policy. Given the fact that paper currency in circulation vastly exceeds the supply of gold, a transition to the gold standard would be difficult to implement and would probably cause a substantial rise in the price of gold.
Personally, I’m not convinced that a return to the gold standard would promote economic/financial stability any more than the fiat money system. For example, just as large financial institutions dominate the current system, so they would be likely to dominate any other system, leading to the same lack of transparency and democracy. In addition, gold can also be lent out (with interest), leading to a similar propensity for asset bubbles and economic imbalances of every kind.
Just like currencies have relative value today (in terms of other currencies, commodities, assets, labor, etc.), so does gold. In that sense, saying seven units of gold is enough to buy a house is not really that different from saying it costs 10 units of paper currency to buy that same house. For instance, if Chinese producers charge 1 gold coin for their widgets while American producers charge 2, it will still result in a trade imbalance that will only correct when the Chinese standard of living catches up to the US standard of living.
Finally, gold is arbitrary. Why not a platinum standard or an oil standard? Based on the scarcity of those resources, prices would vary accordingly, much as they do under the paper currency system. Not to mention that gold is incredibly unwieldy, which means that it would be digitalized and used electronically just like paper currencies.
You could argue that this is actually a benefit of the gold standard, since it would be compatible with the current economic system, but at least it would lead to financial stability. Maybe I’m in denial like Ben Bernanke, but I just don’t see gold as the solution.  Asset bubbles inflate, and then they collapse. Economic imbalances will persist for as long as they are allowed to. If emerging market exporters get tired of receiving Dollars for their wares, then they will stop accepting it, the Dollar’s value will crash, and the US economy will have to rebalance itself. In a perfect world, there would be no irrational exuberance. In reality, the current system will persist, and life will go on.