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In go(l)d we trust

Frank Lee discusses the current and ongoing rise in the price of gold and the slightly altered promise on the back of the US Dollar.

Gold has functioned as money, a store of value and a medium of exchange for thousands of years. Developments of the capitalist system, however, meant that paper and then credit were issued as gold substitutes, or fiat (paper) money. In this sense fiat or paper/credit money was the first derivative, its value being based upon the underlying asset (gold) and the guarantee of this value by the central bank.

The gold standard meant that whenever a country experienced balance of payments deficits it would pay for these in gold to the surplus country. However, the gold standard came into disrepute during the 1930s when it was seen to have a deflationary bias. But the absence of a gold standard meant protectionism: competitive devaluations, tariffs and other beggar-thy- neighbour policies only prolonged and deepened the great depression.

Thus it was decided late in the Second World War (1944) during a meeting of the allied and neutral powers in Bretton Woods, New Hampshire, to install a dollar-gold based system of world trade. This agreement meant that the US$ would be tradeable for gold at a fixed rate of $35 per ounce. The other hard currencies would rest upon the dollar at fixed but adjustable rates. The margin of adjustment varied from between 2% to 6% depending on the country in question. The whole system lasted until August 1971 when the then US President, Richard Nixon, took the dollar and effectively the world off gold. Since that time we have had a purely fiat system of currencies resting on...well, essentially nothing, other than the belief that the US central bank will guarantee its value. From 1947 through 1967 unemployment averaged only 4.7% and never rose above 7%. Real growth averaged 4% a year.

Low unemployment and high growth coincided with low inflation. Since 1971 there has been higher average unemployment, slower growth, greater instability and a decline in the economy's resilience. In the United States, the period 1971-2009, had unemployment averaging 6.2%, a full 1.5 percentage points above the 1947-67 average, and real growth rates averaging less than 3%.

The US has since experienced the three worst recessions since the end of World War II, with the unemployment rate averaging 8.5% in 1975, 9.7% in 1982, and above 9.5% since the onset of the present downturn. During these 39 years in which the Fed was free to manipulate the value of the dollar, the consumer-price index rose, on average, 4.4% a year. That means that a dollar today buys only about one-sixth of the consumer goods it purchased in 1971.

The period since 1971 has been characterised by wage-stagnation, debt-fuelled growth with much turbulence and financial blow-outs, together with ongoing debt crises at the global periphery. But the problems of the periphery have now visited themselves upon the core economies of the north Atlantic and Japan.

Given that there was no longer any gold standard to impose monetary discipline, the monetary authorities presided over a massive expansion of debt levels private, household, company and banks which fuelled high growth rates: the great credit/property bubble of the late 1990s and early 2000s. In addition to private debt, public debt also expanded, particularly since trillions in bail-out monies were extended to insolvent financial institutions. Thus the liabilities on the banks' balance sheets were simply transferred to the balance sheets of the government.

The problem of sovereign debt had arrived. In democratic polities the temptation of printing your way out of fiscal problems is just too much of a temptation. And, as Oscar Wilde once opined, I can resist anything but temptation.' The central banks around the world gave in to this temptation and the private banks were allowed to expand their lending irresponsibly, all of which left us with a massive debt overhang which is blocking the road to recovery. What is more this expansion of global money supply particularly of the US$ - cannot but have a destabilising and inflationary effect internationally.

The upshot of this means that confidence in fiat money is beginning to wane. This explains gold's inexorable rise from $250 in 2001 to $1750 an ounce (at the time of writing) in 2011. If the monetary authorities around the world continue with their money printing antics, this process will simply continue.

To repeat, this is not a revaluation of gold, it is a devaluation of paper money. Some mechanism to control this global flood of fiat currencies must be found or hyperinflation is not too far down the road. Firstly the reserve status of the US$ must end. The United States is the world's greatest debtor nation. It is no longer appropriate that the dollar or indeed any national currency is suitable for a global trading system. A new system consisting of a basket of currencies and including gold has been suggested. This would be the first step to a global currency (Bancor) an idea of Keynes which he put forward at the Bretton Woods conference, only to be overruled by the American negotiator, Harry Dexter White. This at least seems worth looking into. The alternative is competitive devaluations, trade and currency wars and inflation. If the latter is to your liking then I would advise you to take George Bernard Shaw's advice and buy gold.