Inside investment: Golden mean
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Inside investment: Golden mean

In a recent speech, Federal Reserve chairman Ben Bernanke delivered a paean to 21st-century central banking. But investors confronted by extreme and unorthodox policy with uncertain outcomes are returning to their own version of the gold standard.

On March 20 Federal Reserve chairman Ben Bernanke delivered the first of four lectures at George Washington University, entitled Origins and Mission of the Federal Reserve. One fairly typical internet headline read ‘Bernanke trashes gold standard’.

He posited that the current monetary regime is enlightened and benign, quite unlike the mean old gold standard. The picture of the latter that he painted was one of a struggle for survival where life was "nasty, brutish and short" (as Thomas Hobbes characterized mankind’s lot in a state of nature) with frequent panics and depressions.

I think the contrary is the case.

Bernanke said that "a gold standard is at best a partial alternative to a central bank". It is important to note that a gold standard, in which paper currency in circulation is backed in full by gold reserves, is different from a gold reserve system in which the currency theoretically reflects a fixed amount of gold and the reserve is deemed enough to meet expected redemption requests. In the 19th century, the Bank of France maintained a gold standard while the Bank of England managed a gold reserve system.

Bernanke cited four problems with gold-based standards. First, he said, money supply must reflect the gold supply. This deprives the central bank of "flexibility" to manipulate money supply. Flexibility seemed to be viewed by Bernanke as an unalloyed good thing. Second, a gold reserve system produces fixed exchange rates among countries on the same standard. This deprives the central bank of the flexibility to manage exchange rates.

Third, there is not enough gold in the world for a full gold standard but a gold reserve system is subject to speculative attacks and runs if the holders of the currency suspect that the central bank is not exclusively focused on maintaining the fixed link with gold and capable of doing so.

And fourth, the gold standard leads to periods of inflation and deflation. When the gold supply increases faster than the economy, inflation ensues, but when the economy grows faster than the gold supply, there is deflation.

Good or evil?

A central bank’s flexibility to manipulate money supply and exchange rates to regulate the economy can be seen as an evil or a good depending on one’s point of view. Bernanke asked rhetorically if it would not be a terrible thing if unemployment were rising and the Fed could do nothing about it.

On the 70th anniversary of the release of the film Casablanca, what came to mind was Captain Renault’s oblique compliment to his German colleague when he first introduced him to Rick: "I’ll have you know that Major Strasser is one of the reasons why the Reich enjoys the reputation it now has." Perhaps, the Fed’s "flexibility" is one of the reasons we enjoy the depressing levels of employment and wellbeing we now have.

Yet there is something in what Bernanke says, particularly concerning the slow growth in gold supply. Of course, there would be enough gold to return to a gold standard if the price were raised to $30,000 to $40,000 an ounce. The US, for example has about 8,000 tons of gold and so the country has 257.2 million ounces worth about $424 billion at $1,650 an ounce. That is a piddling amount in Federal government terms, about half the sums spent annually on Medicare and Medicaid. If the gold price were $40,000 an ounce, however, US reserves would be worth about $10 trillion, probably enough for a gold reserve system.

This does not solve the problem of the slow growth of supply, however. New mine supply of gold is about 2,500 tons a year. Given the estimated base of 150,000 tons of gold in the world, this is only a 1.7% annual growth rate. If the world economy were to grow at 1.7% a year, stability would result. If the growth were greater, prices would deflate.

There is nothing inherently wrong with falling prices. In fact, we like the falling prices of electronics, clothing, cabbages, gasoline, and air fares. However, such falls are not compatible with an economic system based on credit. If a household or a business has substantial debt that is fixed to gold, it will be in trouble if its revenues deflate. A gold or gold reserve standard results in an economic system that can safely make use of debt only in moderate amounts for short-term purposes, such as working capital. We, however, have an economic system that relies on substantial and increasing amounts of semi-permanent debt capital.

Lincoln Rathnam, PhD, CFA, is an investment professional based in Singapore and Boston. In a career spanning almost 30 years he has managed equity, debt and venture capital portfolios and was a pioneer investor in emerging markets in the late 1980s

Governments therefore believe that they cannot adopt a gold standard, but individuals are increasingly doing so. Shares in gold ETFs are a paper currency on the gold standard that is available to everyone. Their potential as a store of value is being enhanced as the price of gold adjusts to reflect more fully its traditional role in the world economy.

So while central banks continue to explore the scary limits of fiat currencies, individual investors, finding themselves thrust into a Hobbesian struggle for existence, can and should defend themselves with their own personal gold standards and wait for better times.

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