(Crossposted from blog.atimes.net)

The World Bank president got it exactly right:

HONG KONG (MarketWatch) –- The president of the World Bank said in a newspaper editorial Monday that the Group of 20 leading economies should consider adopting a global reserve currency based on gold as part of structural reforms to the world’s foreign-exchange regime.

World Bank chief Robert Zoellick said in an article the Financial Times that leading economies should consider “employing gold as an international reference point of market expectations about inflation, deflation and future currency values.”

Zoellick made the proposal as part of reforms to be considered at this week’s G-20 meeting in Seoul.

“Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today,” said Zoellick.

He said such a reform would reflect economic realities and should be considered as a successor to the existing global currency paradigm known as “Bretton Woods II.” Bretton Woods II refers to the system which began in 1971, when U.S. President Nixon ended the dollar’s link to gold as established under the Bretton Woods agreement.

Zoellick said a return to some sort of currency link to gold would be “practical and feasible, not radical.”

“This new system is likely to need to involve the dollar, the euro, the yen, the pound and a renminbi that moves towards internationalization and then an open capital account,” he said.

A currency agreement combining structural reforms, currency stabilization and a convertible Chinese yuan were the key proposals that Francesco Sisci and I made in Asia Times exactly two years ago, and Reuven Brenner and I offered in First Things a year ago (subscription required).

Adding the dimension of a gold reference point is brilliant. During the late 1980s, we supply-siders promulgated a “Ricardian” gold standard, in which central banks would buy and sell currencies in order to stabilize the gold price in each currency (they wouldn’t have to own a great deal of gold to do this). It is not a gold fractional reserve system, in which claims on the banking system are payable in bullion, but a gold price reference, as Zoellick indicates.

We used to argue that gold was a good long-term indicator of the price level and that a stable gold price portended price stability. That is a naive view I abandoned fifteen years ago. If that were true, then we should have experienced a great deflation as gold fell from $800 at Christmas 1979 to well under $300 an ounce between 2000 and 2002.

Gold, I argued in a 1996 paper for Laffer Associates, should be thought of as a put option on the currency; the opportunity cost of holding gold instead of interest-bearing assets (plus storage costs) are the option premium. If central banks managed their currencies well, gold would trade at its commodity value, that is, around the marginal cost of production, which is now $600 to $700 for the largest mining companies. But if there is a risk that paper currencies will devalue by some extreme margin, it is worth holding gold as a hedge. We cannot price the option using the usual Black-Scholes formula or its variants because we do not know the volatility of a currency over the long term; this is a political matter and inherently uncertain. But if we think that monetary policy is headed to a disaster (QE2 will end up like the Titanic, in short), we will pay more for gold.

Effectively, Zoellick’s proposal to use gold as a reference would require central banks to manage the tail risk of monetary outcomes. The value of money depends on more than the short-term interest rate set by a central bank; it depends on the expected return to assets priced in that money. The entire range of policy instruments come into play. As Zoellick writes in his Financial Times op-ed,



When the G7 experimented with economic co-ordination in the 1980s, the Plaza and Louvre Accords focused attention on exchange rates. Yet the policy underpinnings ran deeper. The Reagan administration, guided by James Baker, the then Treasury secretary, wanted to resist a protectionist upsurge from Congress, like the one we see today. It therefore combined currency co-ordination with the launch of the Uruguay Round that created the World Trade Organisation and a push for free trade that led to agreements with Canada and Mexico. International leadership worked with domestic policies to boost competitiveness.
As part of this “package approach”, G7 countries were supposed to address the fundamentals of growth – today’s structural reform agenda. For example, the 1986 Tax Reform Act broadened the revenue base while slashing marginal income tax rates. Mr Baker worked with his G7 colleagues and central bankers to orchestrate international co-operation to build private-sector confidence.


Simply put, a central bank can afford a looser monetary policy if the economy is growing and demand for money increases.

He proposes:


What might such an approach look like today? First, to focus on fundamentals, a key group of G20 countries should agree on parallel agendas of structural reforms, not just to rebalance demand but to spur growth. For example, China’s next five-year plan is supposed to transfer attention from export industries to new domestic businesses, and the service sector, provide more social services and shift financing from oligopolistic state-owned enterprises to ventures that will boost productivity and domestic demand.

With a new Congress, the US will need to address structural spending and ballooning debt that will tax future growth. President Barack Obama has also spoken of plans to boost competitiveness and revive free-trade agreements.

The US and China could agree on specific, mutually reinforcing steps to boost growth. Based on this, the two might also agree on a course for renminbi appreciation, or a move to wide bands for exchange rates. The US, in turn, could commit to resist tit-for-tat trade actions; or better, to advance agreements to open markets.

Second, other major economies, starting with the G7, should agree to forego currency intervention, except in rare circumstances agreed to by others. Other G7 countries may wish to boost confidence by committing to structural growth plans as well.

Third, these steps would assist emerging economies to adjust to asymmetries in recoveries by relying on flexible exchange rates and independent monetary policies. Some may need tools to cope with short-term hot money flows. The G20 could develop norms to guide these measures.

Fourth, the G20 should support growth by focusing on supply-side bottlenecks in developing countries. These economies are already contributing to half of global growth, and their import demand is rising twice as fast as that of advanced economies. The G20 should give special support to infrastructure, agriculture and developing healthy, skilled labour forces. The World Bank Group and the regional development banks could be the instruments of building multiple poles of future growth based on private sector development.

Fifth, the G20 should complement this growth recovery programme with a plan to build a co-operative monetary system that reflects emerging economic conditions. This new system is likely to need to involve the dollar, the euro, the yen, the pound and a renminbi that moves towards internationalisation and then an open capital account.

This is the first really sensible plan to emerge from any of the major governments or international institutions since the crisis began. Zoellick, who was a senior official of the elder and younger Bush administrations, is one of the brighter lights in the Republican establishment. I hope the speech means that he’s running for Treasury Secretary in the next Republican administration. It’s the first real sign that someone on the Republican side has gotten the big economic picture right.

Articles by David P. Goldman

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