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    Hard money

    Oct 14th 2003
    From The Economist Global Agenda

    Money used to be backed by gold. Now it is backed by the promises of central
    bankers. Are these worth less than they were?

    IN BETWEEN saving the world from terrorism, President George Bush is finding
    time to dash off to Asia at the end of this week, first to Tokyo and then to
    Bangkok, where he will attend a meeting of the clumsily named Asia-Pacific
    Economic Co-operation, which sounds a little better as its acronym. There he
    will meet, among others, Hu Jintao, the president of the country American
    manufacturers most love to hate when they are not investing there.

    It is a racing certainty that the subject of China's currency, the yuan, and whether
    it should be revalued from its present 8.3 per dollar, will be high on the
    agenda, if not atop It is, of course, always lovely to talk, but
    although America wants a lower dollar, and wants one now (which is
    understandable for a country with a current-account deficit of 5% of GDP and
    a congenital inability to save), China couldn't seem to care less.

    Quite probably, then, tension will increase and the dollar will fall against
    other currencies that do not have such a firm peg. The rapidity of this fall
    will depend on two things. The first is the force with which Washington
    rattles its saber. On this subject, Buttonwood merely notes that next year
    is election year. The second is whether other countries, especially those in
    Asia which together hold $1.7 trillion of IOUs issued by the American
    government, are prepared to see the Treasuries in their portfolios rapidly
    devalued, their export competitiveness choked and deflationary pressures

    Japan has such worries in spades. Though the world's second-biggest economy
    nowadays receives less attention than it did, Japan's recovery started in
    the fourth quarter of 2001 and growth is picking up. But officials there are
    increasingly worried that a rising yen will choke it off. The yen is close
    to a three-year high against the greenback. Its rise accelerated after the
    recent G7 summit in Dubai, when America's weak-dollar policy became most

    Yet Japan needs the yen to fall because it needs inflation to help
    wipe out the massive debts the country incurred both during the bubble and
    in trying to get the economy going again after it had popped. Last week, the
    Bank of Japan further eased monetary policy, not in the usual way, by
    lowering the rate of interest, but by printing more money. The money supply,
    narrowly measured, is already rising at an annual rate of 21%.

    At some point, perhaps even the European Central Bank will wake up to the
    fact that the rising euro will keep the European economy close to recession.
    All of which is to suggest that none of the world's major currencies is
    especially alluring; for one reason or another governments in all three
    might want them to fall. Of course, they cannot all fall against each other.
    They can, however, fall against something largely unloved by those under the
    age of 50, and famously dismissed by Keynes as a "barbarous relic": gold.

    All currencies are backed by something. When the world was on the gold
    standard, that something was the yellow metal: the value of each pound
    sterling, dollar or French franc was determined by the (fixed) amount of
    gold that the central bank agreed to deliver against it. Now those
    currencies are backed by something altogether less tangible: central
    bankers' promises that the currencies will maintain their value. Quite
    probably, these promises are not worth as much as they were.

    It is only in very recent years that gold has lost its allure as a store of
    value. For centuries, the metal was virtually synonymous with money: the
    Egyptians were casting gold bars as money as long ago as 4000 BC. The gold
    standard's heyday was from the 1870s to the 1930s (with a brief interruption
    in the first world war). Britain left the standard in 1931, a move
    pronounced as "the end of an epoch" by no less an authority than The
    Economist. America did the same in 1933. One by one, other rich countries
    followed suit.

    The gold standard was revived in a famous agreement in
    Bretton Woods, New Hampshire after the second world war, but only in
    America, which by then had three-quarters of the world's gold stock.
    Although other currencies were fixed to the dollar, they were not fixed
    directly to gold. As other countries prospered, so America's current-account
    deficit began to rise and its stock of gold began to dwindle. By 1971,
    inflationary pressures were driving up the real value of the dollar. In
    August of that year, President Richard Nixon took America off the gold
    standard once again.

    Since then there has been a central-banking standard instead. The standard
    was set by Paul Volcker, the Federal Reserve chief who quashed inflation
    (which erodes the value of money) with draconian interest rates in 1980, and
    killed off the bull market in gold, which had climbed from $35 an ounce in
    1968 to $850 an ounce in 1980. In its place came a bull market in government
    IOUs. Bonds, after all, pay interest, unlike gold.

    But hard money can be an unpleasant medicine, and the problems facing
    central bankers have not gone away since Mr Volker's day. Inflation has
    shown up in more than the price of carrots: it has also pushed up the prices
    of shares and property. For understandable reasons, central bankers have
    been slow to spot and p r i c k asset bubbles. Thus have they swelled and popped
    in America and Japan in recent years, leaving mountains of debt in their
    wake, and weakening the credibility of central bankers as they try to
    control economies by tweaking the short-term rate of interest.

    It used to be that gold perked up only when inflation did. But perhaps
    central bankers' lack of credibility explains why the price of gold has been
    rising even as deflationary pressures have mounted. It now fetches some $370
    an ounce, down from its peak of nearly $390 last month, but way up from its
    price in the late 1990s, when it dipped to $253. Chris Wood, a strategist at
    CLSA, a stockbroker (and, in the interests of full disclosure, a former
    colleague at The Economist), reckons that the price could easily reach
    $3,400 or so-the level at the previous peak, adjusted for the rise in
    American personal income since then. "Gold will rise as confidence in the
    ludicrous powers still attributed to central bankers wanes," he says.

    Possibly, the debt mountains that economies have built up will have to be
    inflated away. But no one knows how savage deflation will have to get before
    central bankers take that step, nor how dramatic tensions between America
    and the rest of the world have to become before faith in central bankers
    slips still further. The Bank of Japan might be providing an answer to the
    first of those questions; Mr Bush and his team an answer to the second.

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