Monetary value in question The commodity formerly known as gold

The return of the Republican Party to the U.S. presidency has brought some of the weirder economic views of the political right back into polite discourse. George Bush, Jr., has already unveiled a budgetary plan offering large income tax cuts, without significant payroll-tax cuts. The Bush plan includes spending cuts, but unless the new administration is ready to take big lumps out of Medicare, Social Security and defence, the tax cuts on their own will offer the long-term pain of shrinking surpluses that turn into rising deficits, along with the short-term pain of interest rates that are higher than they would otherwise need to be during a six-month economic contraction.

The apostles of supply-side economics that championed the tax cuts have another article of faith, too. The gold standard may not be back on the table, but some of its proponents, who haunt the intellectual attics and garage lofts of the Republican Party, have at least been let back into the dining room.

Gold bugs may see this as a positive sign. After all, if countries went back on the gold standard, the reasoning goes, we could all look forward to a blissful, inflation-free future. Oddly enough, gold producers and their shareholders often seem to sympathize with the idea of gold-backed currencies, though it is hard to see how a fixed price for gold could offer much opportunity for gold producers.

Those that view gold as an assurance of currency stability and a guarantee of value might consider that the European Central Bank (ECB) and the central banks of the Euro zone countries have total gold reserves of 12,456 tonnes — about one-and-one-half times the gold reserves of the U.S. No currency outside the U.S. dollar is so heavily backed by gold. But since the unification of the Euro zone monetary system, at the end of 1999, the Euro has declined to US92 from US$1.17.

The Euro area, despite relatively high producer-price inflation, is showing lower consumer-price and wage inflation than the U.S. And even then, the Euro zone’s broad money supply — up 4.9% on the year — has grown more slowly than that of the U.S. It is not a sudden fit of irresponsible Euro-printing that has hurt the value of the currency; it’s the weakness of the underlying European economies, and what now appears to have been a severe over-valuation of the Euro when it was introduced.

The decline in the value of the yen is not a counter-example, though the Japanese central bank keeps a bare minimum of its reserves in gold. The yen’s fall from 100 to the U.S. dollar in 1994, to the present 117, has nothing to do with a fear that the Bank of Japan may start running the printing press around the clock; rather, it reflects a fear that the country’s current domestic demand slump may force Japanese industry to use up excess productive capacity by increasing exports. Japan’s problem is deflation, not monetary inflation.

Currencies move based on the economic conditions around them, and central bankers with greater or lesser monetary discipline are only one of those conditions. Moreover, gold is not the only way, or even the best way, of controlling governments’ urge to print money.

Nor is there any evidence — or even a reason for hope — that a return to the gold standard would increase demand for gold. Fixing the value of any of the three major Western currencies to gold would not mean that central banks would begin to buy gold; significantly, re-valuing the U.S. gold holding up from its present US$42.22 per oz. would increase the book value of the reserve sixfold without a single bar going into Fort Knox.

Having settled the more extreme position, what then of gold sales? What increasing the fraction of gold in the major central banks’ currency reserves could do for the gold industry is change the market’s psychology. Efficient-market believers would have been driven mad by the gold market of the 1990s. This market is an emotional beast, and has responded to a decade of whipping just as you’d expect a beast to respond.

But even then the psychological angle may not play well. The central banks of the Euro zone, along with the Bank of England, the Swiss National Bank and the Riksbank of Sweden, voluntarily capped their own gold sales in October 1999. The gold price briefly spiked to US$325 per oz. but has been on a fairly steady downtrend ever since. And all that happened with a limit on central-bank sales, to which several major sellers had agreed.

Perhaps central bank sales (and perhaps more significantly, the banks’ post facto announcements) were really only a short-term influence on the market and had relatively little to do with the long-term decline in the price of gold. Gold lease deals put more gold on the market than the sales ever did.

Above-ground gold stocks are enormous in comparison to demand, and much of that gold (33,000 tonnes) is controlled by central banks or by international institutions like the International Monetary Fund and the Bank for International Settlements. It is a bad use of their resources not to get some return on gold; taxpayers deserve better. It would be irresponsible to suggest the central banks should abandon the lease system.

Still, lease rates — which are again hovering just above 1% — are cheap compared to the cost of capital. Secure dollar-denominated government bills pay 5%. Inflation around the developed world, except for deeply troubled Japan, is running between 1% and 5%, making real lease rates negative in every major gold-producing country. The only plausible reason for such low rates is that there is too much gold available for lease.

The gold industry has been ready to chastise central bankers for years, complaining that selling and leasing by central banks is ruining the market for their product. But the borrowers of gold — the hedgers — are getting a very cheap ride when they lease, partly at the public’s expense and partly at the expense of the non-hedgers. And the hedgers invariably sell into any rally in the gold price, and build up forward positions whenever spot prices force future contracts higher.

That line of conduct is arguably the only responsible use of hedgers’ cash resources, but it’s very hard on their principal commodity. Consider the effect when two large South African producers — both in the no-hedging camp — sold forward in recent weeks.

Perhaps the industry needs to see just how much it has in common with the men in dark suits. Both the industry and the central banks have a similar problem. They have a lot of gold and it can’t just sit there. It has to go on the market, a market whose invisible hand may be winding up to give gold another very hard swat.