The same phenomenon happened to World Bank President Bob Zoellick recently. In an editorial for the Financial Times Zoellick argued for the removal of the United States Dollar as the world’s reserve currency and its replacement with a basket of currencies including gold as a “reference point”. Popular economist Brad DeLong declared him the “stupidest man alive”, and Nobel Prize winner Paul Krugman referred to Delong’s insult as “much too kind.”
It’s not that Zoellick’s gold assertion was correct, but rather like Gore’s assertion, the context of Zoellick’s article is much broader than critics suggest. The US-Dollar acted as the international reserve currency for forty years and there is now no better time to discuss the system’s relevancy. Partly based on US political power, partly on its economic might, the system proved stable as long as American hegemony lasted and the rest of the world was willing to buy into a US-centric monetary system. But in times of a weak US economy and mounting conflicts over monetary policies triggered by the undervaluation of the Renminbi and the flooding of international markets with cheap Dollars, calls for a new system of international coordination of monetary policy are getting louder and more frequent. Thus, most commentators (and indeed policy makers) agree on the need to reform the current system.
DeLong and Krugman are right to criticize the idea for a “Gold Standard Light”. The reasons are numerous. Gold is still a somewhat mysterious item. Just as paper money it has no value in itself, but rather what we socially attach to it. Its special importance is somehow derived from the fact that it is beyond the control of a single nation and cannot – unlike any other currency – be devalued at will. Or can it?
The Wall Street Journal points out that gold supply is unlikely to match demand in case it increased in importance as a reserve currency. “(I)f China wanted to take gold to 25% of is reserves – around the level held by the ECB, for example – it would need to buy another 440 million ounces at today's prices. That's the equivalent of every ounce of gold dug up by every gold miner in the world for the next five years.” Given those enormous quantities, the effect on the gold market would be accordingly, highlighting the impact the decisions of a single country could have on a monetary system based on gold. So much for neutrality.
Second, any commentators still believe that changes in the gold price are largely due to changes in future expectations of inflation: if people believe inflation is bound to increase, they invest in gold as a “safe haven”. Thus, increasing gold prices would simply reflect increases in expected inflation. However, a quick look at the development of gold prices over the last two decades (and especially over the last months) suggests that the primary role of gold is that of any other speculative asset: not to store value, but to – well – speculate. Unregulated speculation would lead the price of gold to skyrocket once it became a more important part of the basket of reserves. For typical commodities in developed countries (timber, oil, wheat) this leads to increased prices and temporary hardship, but not aggregate economic destruction. If strongly tied to inflation, the speculation of gold during bad times would force governments to maintain their exchange peg by raising interest rates during a recession, leading to a deflationary spiral. So much for gold as a reference point for future expectations of inflation, as Zoellick envisages.
The suggestion that gold is the asset of choice in economically hard times is often heard these days. Private investors are lured into the allegedly safe haven of gold with the argument that it is something solid that you can take into your hands and thus has physical value (unlike stocks and bonds). As pointed out previously, this is plainly wrong and it is not difficult to imagine what will happen when the developing gold bubble eventually bursts. But it is all the more astonishing that a similar nostalgic, somewhat naïve belief in the value of gold seems to inform Zoellick’s proposal.
Another possible rationale would be the idea that gold is – unlike all national currencies – politically neutral. It is now commonplace to argue that the Renminbi is artificially undervalued and thus not an ideal candidate (to put it mildly) for a reserve currency. Zoellick acknowledges that. But nowadays the same holds true for the US-Dollar, and – although to a somewhat lesser extent - for the Pound and Yen. The Euro, given the still relatively independent ECB and the diversity of (balancing) interests within the EU, seems to be politically more neutral, although this would probably look very different from a Chinese perspective. In any case, what this suggests is that a single currency is insufficient for a new monetary system. A basket of the most important international reserve currencies that Mr. Zoellick proposes thus seems to be the obvious solution. But this is not the future, but the present. No country concentrates its reserves in one currency nowadays.
So, after criticizing Zoellick’s idea of using gold as an international reference why are we defending him? Because after the hysteria about one sentence is over, his editorial’s central idea is something worth discussing. The establishment of a “cooperative monetary system” in which all parties involved agree to refrain from interventions unless agreed upon by all is neither new, nor groundbreaking, but it is needed.
This is certainly a very distant goal. Who after all would expect the US and China to put down their monetary arms and thereby give up national sovereignty to some extent? Zoellick invokes the analogy of Ronald Reagan’s attempt to stop an increasingly protectionist Congress by coordinating monetary and trade policy internationally and thereby inducing domestic change. Accordingly, international cooperation today could be a way to circumvent domestic protectionist backlashes and currency wars. A nice idea, in theory, however, monetary coordination has in the past been extremely difficult and in cases where it was carried out lead to somewhat dubious results. Thus, it has been argued that Japan’s pledge to maintain a loose monetary policy led to a bubble and the subsequent crash of the Japanese economy in the 1990s, throwing the country into a prolonged recession. Many argue that the cure for European economic ills involves Germany embarking on a domestic policy, which increases inflation, thereby lowering the real exchange rate of deficit plagued countries such as Greece and Spain. This change in the real exchange rate would allow Spanish and Greek firms to gain competiveness in the monetarily tied European Union and lower their current account deficits, which hamper their economic prospects. Can anyone imagine German policy makers agreeing to assist the very governments it underwrote a bailout for at the expense of their domestic economy?
Another aspect of Zoellick’s proposal that deserves more attention than the return of gold is the inclusion of an (internationalized) Renminbi in the currency basket. There is currently talk of implementing the currency on the international level. President Sarkozy (as incoming head of the G20) is reportedly planning to integrate the Renminbi into the basket of currencies that is used to determine the value of the Special Drawing Rights (SDR), foreign exchange reserve assets administered by the International Monetary Fund (IMF). This would not only increase the importance of the SDR as a reserve currency, but also lead to a further reform of the IMF to represent today’s global economic structure rather than that at the time of the Bretton Woods conference in 1944. The IMF could then also serve as a better forum for policy coordination along the lines of Zoellick’s idea.
In his editorial Zoellick discussed a variety of worthwhile policy debates, many discussed here. Unlike Al Gore, Zoellick will probably not be remembered by most people in the world, but unfortunately those who do will probably only recall the time he suggested reverting to the gold standard, and not the time he brought debate on Bretton Woods III.