Analysis/Comment Dr. Peter Morici: The risk of US default and return of the Gold Standard
By Professor Peter Morici
May 10, 2011 - 1:06 AM
Gold bars in the Federal Reserve Bank of New York’s Gold Vault
Dr. Peter Morici: The risk of US default and return
of the Gold Standard; Gold is selling for close to $1500 an ounce, up from $258
Jewelry and industrial applications absorb at least 80% of new supply. The
economic expansion of the 2000s and the recent recovery have boosted commercial
demand, but this alone cannot explain the persistent surge in gold prices.
The cost of bringing new deposits on line has been less than the market price of
recent years—investors see in gold what they cannot find in interest bearing
Exchange traded funds (ETFs) have made storing wealth in gold or simply
speculating easier. These store bullion for investors who have lost confidence
in the dollar, euro and yen, and may be a precursor of a new gold standard.
In 1944, the International Monetary Fund established a system of fixed currency
exchange rates. The dollar was fixed to gold and other currencies fixed to the
dollar. This system failed because rising production costs pushed the industrial
price of gold above its monetary value, and fixed exchange rates among
currencies proved unsustainable.
Productivity and competitiveness advanced more rapidly in Japan and Germany than
the United Kingdom, France and the United States, and balance of trade deficits
among the latter, impelled by fixed exchange rates, caused pound, franc and
When the pound and franc became overvalued, those were devalued against the
dollar, yen and mark. Ultimately the dollar became overvalued, President Nixon
ended the convertibility into gold in 1972, and the system of fixed exchange
rates was abandoned in 1973. Subsequently, the price of gold rose from $100 an
ounce to a peak of $700 in October 1980.
Over the next two decades, central banks demonetarized gold. Those increasingly
backed their currencies with dollars, and to a lesser extent marks (then euro)
and yen. Many sold off significant gold holdings. The price of gold fluctuated
but trended to lows of $255 in July 1999 and $258 an ounce in April 2001.
Two things made this possible. In the United States, Federal Reserve Chairman
Paul Volcker whipped inflation in the early 1980s and Presidents Carter and
Reagan put the American economy on the path of deregulation. Those unleashed the
mighty waves of productivity, innovation and growth through the 1990s, and made
the dollar a better and more stable store of value than gold.
In the new Millennium, the US economy has not been managed very well—by either
Republican or Democratic administrations. Dysfunctional energy and environmental
policies, and a dollar overvalued against yuan and other Asian currencies have
created huge US trade deficits. Dollars and Treasury securities have flooded
into international capital markets to finance American trade deficits.
Foreign central banks hold US government bonds and other dollar securities to
back up their currencies—commonly called official reserves—and foreign
governments and international investors hold bonds to store purchasing power for
future needs. Those holdings account for nearly half the $14.4trn dollar
With the national debt growing to about $1.6trn a year, the US government would
be flooding the world’s capital market with too many bonds but for the Federal
Reserve’s recent policy of quantitative easing—purchasing Treasurys to keep down
long-term interest rates. With that program scheduled to end in June, rates on
long-term Treasurys will likely rise, and the value of existing long-term
Treasury securities would fall.
A permanent decline in the value of existing long-term Treasurys would be
nothing less than a partial default on US debt. No surprise, investors are
hedging positions by adding gold.
To keep the yuan from rising against the dollar, China purchases nearly $350bn
in foreign securities—mostly in Treasurys. Some central banks are buying gold
again, and some economists have counseled the Peoples Bank of China to diversify
reserves from dollars into gold.
A significant devaluation of the dollar against the yuan seems inevitable, and
it will cause a wholesale downward adjustment for the dollar against other Asian
currencies too. With so much of what the world consumes now coming from China
and other Asian economies, the dollar will be worth a lot less to gold miners in
South Africa or Russia, and Asian currencies would be worth more. The yuan or
rupee price of gold might not rise, and could even fall, but the dollar price of
gold would increase, a lot.
International investors with wealth to park are foolish to put it in long-term
Treasurys; however, the currencies with the best prospects are backed by
governments with poor track records for controlling inflation or honoring the
rights of foreign investors. Could you tell your mother her money would be safe
in Chinese bonds?
If private investors continue to doubt the dollar and bet on gold, central banks
will be forced into gold. Investors won’t trust currencies backed by dollars,
and central banks would be just as foolish as private investors to trust yuan
Long-term contracts could require payments specified in terms of gold,
collateralized with deposits in ETFs, and even settled with drafts against these
funds—sort of gold denominated checking accounts.
Unless the United States gets its economic house in order, gold will become
money again, and national currencies will only be money if backed by gold.