Smith Faculty Opinion Article	May 16, 2006
By Dr. Peter Morici, Professor of International Business EMAIL WEB SITE

The Return of the Gold Standard?
Gold is selling for more than $700 an ounce, up from $258 in 2001.

Jewelry and industrial applications absorb 85 percent of new supply. Production has fallen a bit as industrial demand increases but this alone cannot explain surging prices. Bringing new deposits on line would cost less than $700 an ounce.

The big new players are exchange traded funds. These store bullion for investors who have lost confidence in the dollar, and these 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 set to the dollar.

This system failed because rising production costs pushed the industrial price of gold above its monetary value, and fixed exchange rates proved unsustainable. Productivity and competitiveness advanced more rapidly in Japan and Germany than the United Kingdom, France and the United States, and trade imbalances caused pound, franc and dollar crises.

When the pound and franc became overvalued, those were devalued against the dollar, yen and mark. When the dollar became overvalued, President Nixon ended the convertibility into gold in 1972, and the system of fixed exchange rates was abandoned by the end of 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. They increasingly backed their currencies with dollars, and to a lesser extent marks (then euros) and yen. Many sold off significant portions of their gold. 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 and Presidents Carter and Reagan put the American economy on the path of deregulation. Those unleashed the mighty waves of productivity and innovation, created the U.S. prosperity of the last 15 years, and made the dollar a better and more stable store of value than gold.

In recent years, though, record budget deficits, dysfunctional energy and environmental policies, and a dollar overvalued against yuan and other Asian currencies have created huge U.S. trade deficits. Dollars and dollar denominated securities have flooded into international capital markets. These now total $5 trillion, increase $700 billion each year, and erode confidence in the dollar.

To keep the yuan from rising against the dollar, China purchases more than $200 billion in foreign securities. A few central banks are buying gold again, and some economists are counseling the Peoples Bank of China to diversify reserves from dollars into gold.

A significant revaluation of the dollar against the yuan seems inevitable, and it will cause a wholesale adjustment for the dollar against other Asian currencies. 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 won price of gold would not rise and might fall but the dollar price of gold would increase, a lot.

International investors with wealth to park are foolish to put it in dollars; however, the currencies with the best prospects are backed by governments with poor track records for controlling inflation or honoring commitments of foreign investors. Could you tell your mother her money would be safe in Korean or Chinese bonds?

If private investors continue to doubt the dollar and bet on gold, central banks will be forced into gold. Investors wont trust currencies back by dollars, and central banks would be just as foolish as private investors to trust won or yuan denominated bonds.

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.

Peter Morici is an economist and professor at the Robert H. Smith School of Business at the University of Maryland. He is a recognized expert on international economics, industrial policy and macroeconomics. Prior to joining the university, he served as director of the Office of Economics at the U.S. International Trade Commission.