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Rule by paper or gold, politicians or markets?

Section: Daily Dispatches

Which Will Come Out on Top -- Paper or Gold?

Printing presses have been pumping out dollars and pounds. Little wonder many are seeking a more trusty store of value.

By William Rees-Mogg
The Times, London
Monday, November 9, 2009

Last week the price of gold rose to $1,100, the highest ever recorded. Gold is still an important measure of the world economy. The theory of the 19th-century gold standard was that gold was "real money" in the same way as landed property was "real estate." All types of paper money are capable of being created by banks or governments, so the supply is potentially unlimited. It was observed that gold holds its purchasing power over centuries, whereas paper money tends to depreciate towards the value of zero.

Of course, the rise in the gold price reflects the weakness of the dollar as well the strength of gold. I have been writing about the significance of the gold price since the early 1970s. The latest rise in price reflects the significance of gold as part of the world's monetary reserves.

The immediate cause of the rise was a purchase of 200 tonnes of gold bullion by the Reserve Bank of India from the International Monetary Fund. The Indian purchase is quite large in terms of the gold market, but not particularly large in terms of the Indian reserves. India's reserves now amount to $277 billion, of which this new purchase of gold amounts to only $6.7 billion.

The significance of the purchase is that it may be the start of a new phase in the struggle between gold and paper. Since 1971, when President Nixon ended the convertibility of the dollar into gold under the Bretton Woods Agreement, the world's central banks have tended to be net sellers of gold and net buyers of dollars. Now the Indians have decided that they have more dollars than they want.

Already Sri Lanka has followed the Indian lead, with a purchase of five tonnes of gold. If the new fashion spreads, and particularly if it is joined by China, then Asia would have decided that it is better to have gold which is rising in value than an unlimited supply of dollars which are falling in value.

In the 19th century, bankers trusted gold precisely because they did not trust other bankers, or the paper that other bankers issued. They could hold gold in their own vaults; it would not be dependent on other people's debts or on the printing of paper money. Most central bankers still believe that the purchasing power of money is ultimately determined by the quantity that is created.

Asian bankers know that the West, and particularly the US, has been creating new money in huge and unprecedented quantities. They must assume that this increase in the creation of dollars will result in a fall in the purchasing power of the dollar itself. China may or may not join in the movement to buy gold, but the logic of the market would justify it doing so. Why should China go on losing in dollars when the gold price is rising?

This new logic extends outside gold and outside currencies. The real struggle between gold and paper is a struggle for power. If paper money is the dominant form of currency, as it is at present, then the ultimate governors of the world economic system are the bankers who have the power to create money.

If, however, gold is regarded as the ultimate standard, as "real money," then the market decides the valuation. The floating rate system that emerged after 1971 depends on relatively stable relationships between different currencies. If countries develop a preference for gold over paper, then paper currencies will have to demonstrate that they have a stable value in gold, as they did in the years before 1971.

This may help to explain the strange events that occurred in the G20 finance meeting at St. Andrews. In the 1970s an American economist, James Tobin saw very clearly the speculation that would arise after Nixon ended the convertibility of the dollar into gold. Tobin, who later won a Nobel Prize, knew that gold had been the standard by which other currencies were valued. Once that was removed, he feared a growth of excessive speculation, such as the inflation of the 1970s, or the successive bubbles of recent years. He thought that this speculation could be controlled if it were taxed. He advocated a new transaction tax.

At St. Andrews, Gordon Brown unexpectedly advocated the adoption of a global Tobin tax. He was immediately repudiated by Timothy Geithner, the US Treasury Secretary, and by Dominique Strauss-Kahn, the head of the IMF. The proposed global Tobin tax has the support of Oxfam and of some left-wing economists, but without American support, it does not have the least chance of being adopted.

The Swedes experimented with a national transaction tax in the 1980s. It did not work because bankers avoided paying tax by transferring transactions to markets in which it was not imposed. The tax had to be abandoned in the early 1990s. This negative history must have been known to Mr Brown; perhaps the clumsiness of his diplomacy reflects the pressure he is feeling.

In Britain there is an urgent need for a new tax base. One can take almost any very large figure as the sum needed to balance the budget. At some point Britain will have to raise taxes and cut expenditure. It is hard to see where this additional revenue can be found.

No doubt it would be helpful to Mr Brown if the other governments would join him in policing a worldwide transaction tax on the banks. Britain would be a major beneficiary. Like the US, Britain has a combination of very large bank debts with a very large budget deficit. As a response to the recession, large sums of money have been injected into these economies. That has eroded global confidence in the pound and dollar.

If there is no Tobin tax, it will be difficult to rebuild confidence in these currencies, and the Tobin tax is not going to happen, if only because it would not work. Two factors emerge. Gold will be a stronger reserve currency than paper, and the market will increasingly decide national policies. "You can't buck the market," whether in taxes, in dollars or in gold.

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