Exchange-rate regimes: Why gold standards are not sustainable

pic by TMR FILE

OF LATE, there have been calls for a return to the gold standard for exchange rate determination.

Much of these revolve around the nostalgia surrounding fixed exchange rate gold parity systems like Bretton Woods and its prior versions. While it is true that the post-war period from the late 40s to the early 70s was indeed a period of strong and stable growth, it would be incorrect to attribute this to the gold standard alone.

For just as the Bretton Woods collapsed, at least two previous versions had also collapsed. In each case, the collapse was caused by massive speculative attacks on the reserve currency due to seriously misaligned exchange rates.

The key currencies simply did not have the gold reserves needed to maintain the fixed exchange rates.

Full convertibility, as with any fixed exchange rate, results in a huge contingent liability for the government. It is when speculators believe the government cannot meet this liability that an attack happens.

The government’s required commitment to a single rate implies a one-way option to speculators, effectively giving them a free put option at the expense of the central bank.

A second key problem with gold-backed systems is the huge cost of holding reserves. Aside from the direct costs of keeping the gold well protected, there is a much larger opportunity cost.

When reserves are in currency form, central banks typically invest in government bonds denominated in that currency. This means the central banks are able to earn a return from its reserves.

With gold being in physical form, such return is not possible. Given that central bank reserves are typically in hundreds of billions, this loss of earnings can be very substantial.

Gold is quite simply a non-earning asset. While capital gains from an increase in the price of gold is possible, the opposite is equally possible.

A gold-based exchange-rate regime has the disadvantage of placing governments in a straight-jacket. This is the third key problem with a gold-based system. Governments lose policy flexibility, in particular, monetary policy flexibility. As monetary expansion is not possible without an equal expansion in gold reserves, countercyclical policies are not easy to undertake.

Should slow growth in domestic output be accompanied by reduced exports, the resulting trade deficit will result in specie outflow and reduced gold reserves. For exchange rates to hold, the government will have little choice but reduce money supply. Such a forced pro-cyclical behaviour can potentially turn a downturn into a full-fledged recession.

It was this policy inflexibility and the need for mindless subjugation of domestic wellbeing to exchange-rate stability that caused governments to walk away from the system.

In today’s world with many random events affecting currencies and markets, the need for counter-balancing policies are all the more important.

In recent times, there has also been an Islamic angle to this. Though there is little by way of Quranic injunctions against fiat money, Prophetic tradition of having used gold- and silver-based money is often cited to justify a return to gold-backed currency.

But such logic is both frivolous and absurd, particularly if applied to other areas of contemporaneous needs. The real complain of such proponents is the prominence of the US dollar.

The fact that the world’s major producers of gold and those with known deposits are non-Muslim nations is lost. If at all an alternative is needed, a currency based on commodities/products of which Muslim nations are key producers, may be more logical.

Getting a consensus on its adoption is an entirely different issue. Recall the Arab dinar was an idea mooted decades before the Euro, but yet to come to fruition for the most superfluous of reasons.

Exchange rates and monetary systems are based on nothing but faith and confidence. Their historical evolution points to the absence of a foolproof system.

Sure, governments and central banks cannot be trusted with upholding seigniorage, but neither can any other entity be.

Prof Dr Obiyathulla Ismath Bacha is the professor of finance at the International Centre for Education in Islamic Finance. The views expressed are of the writer and do not necessarily reflect the stand of the newspaper’s owners and editorial board.