How Africa Can Move To A Gold Standard
Our column last week on the monetary deflation and its effect on commodity producers received a lot of interest from a variety of viewers. Many wondered if there was any way that Africa could make itself relatively immune to the negative effects of floating exchange rates and fluctuating currency values.
The answer is yes. With the creation of a continent-wide gold standard Africa could avoid most of the negative effects that exist in today's international monetary environment.
We wrote about such an initiative in our special report on the African union. Today, in order to understand how Africa could move toward a continent-wide gold standard we run an excerpt of the monetary policy section of our report.
Here it is:
Today, better than any other time in her history, Africa is ready to receive the ideas of fixed exchange rates and optimal currency areas and ironically the best means to making these ideas reality is by returning to the regional currency boards of old on the way to a Pan-African currency backed by gold.
In transition to that gold standard we envision Africa being made up of 5 currency areas. North, South, Central, East and West. Each of these areas would have its own currency but that currency would be tied at a fixed rate of exchange with either the U.S. dollar or the euro.
The currency board would be the orthodox variety like that promoted today by Steve Hanke. And its operation would be simple and straightforward.
A currency board system would consist of the local regional currency - notes and coins - which are covered or backed 100% by foreign reserves denominated in the foreign anchor currency - either the U.S. dollar or the euro. The regional currency must trade at a fixed exchange rate with the foreign anchor currency. Some say that the currency board runs on "autopilot" because changes in the monetary base are controlled by the demand for the domestic base money (regional base money, in our case). Currency boards do not extend credit and they do not regulate commercial banks and because of that produce a high level of credibility and are largely free of political pressure. This confidence is also produced by the fact that currency boards can't produce inflation and can't finance government deficit spending. Other than a sufficient amount of foreign currency reserves, the currency board requires no preconditions and can be implemented rapidly.
Regional currency boards are an almost perfect response to Africa's recent monetary history produced by supposedly independent central banks. These central banks and the governments which created them have left behind a trail of hyperinflation, debt and instability, across the entire continent. While the ambition of the African independence movement was admirable, the monetary arm of that struggle has produced results that fall so far short of the lofty goal.
Regional currency boards would replace ineffective African central banks with a rule bound monetary policy free of the additional distracting and conflicting roles of bank regulation and credit management.
And because a currency board, every single day, would have to make its balance sheet public, the system can promote a trust between citizens, their government and their economy that central banks have only dreamt about.
In order to implement the currency board, the national governments in each region would establish a currency board law that would include an escape clause, which would allow the nations of the region to collectively replace the currency board with a foreign currency in the event that a dramatic inflation or deflation takes place. Under our system, the measurement of a deflation or inflation would be the dollar price of gold. This system we have referred to as a gold-price rule currency board.
After years of success under the regional currency board system Africa should be strong enough to move toward a continent-wide gold standard. In our estimation, Africa is the optimum currency region, superior to five regional currency board blocs. And in moving from the regional currency board system to a continent wide gold standard we would be in harmony with Mundell's advice on transitioning through monetary regimes: "The gold standard was a way of organizing a fixed exchange rate system without the need for political integration. This is not to say that there are no advantages to moving from a currency area to a monetary union. The former is a half-way house that confers many of the benefits of monetary union without the political integration that in the current world is unrealistic, or at least, premature. In any case, the best path toward monetary union is through irrevocably fixed exchange rates"
In November of 2000 I asked Nobel Prize Economist Robert Mundell whether he felt that Africa had the necessary qualifications to establish what he refers to as an "optimal currency area" and Mundell said that he did believe the continent has what it takes. He said that he has believed this for 30 years, having conducted a study for the United Nations in the 1970s on the effect that currency devaluations would have on Africa. Back then, Mundell said that he believed that "it would be a good idea" for the nations of Africa to form a monetary union.
However, "the big issue that Africa has to be concerned with is how to arrange an anchor currency because they do not readily have a dominant currency to use on the continent". Mundell suggested that Africa use a G-3 basket of currencies as an anchor. I then asked Mundell, "What about gold as an anchor?" And he said, " Yes, gold would be a good anchor for Africa but because one-fourth of the gold above ground is in the hands of the world's central banks, if these banks decided to sell gold into the market they could destabilize the gold price."
But if a way could be found to stabilize the price of gold, and protect it from the shock of a massive gold sell-off by the world's central banks, Mundell believes that Africa could form a monetary union in the form of a continent-wide gold standard.
We are quite confident that the effects of the possible "shock" that Mundell fears can be mitigated.
Of course we do recognize that if the supply of dollar liquidity, which is managed by the United States Federal Reserve, were to remain stable, a significant change in the demand or supply for gold could cause a sharp rise or fall in the dollar price of gold. But the sea of dollar liquidity so dominates the demand and supply of gold itself - which is stable, year after year - that the demand and supply of dollars is the dominant factor determining the supply of gold. Therefore, the management of dollar liquidity can always override changes in the price of gold caused by a change in the demand or supply of gold.
Stephen Shipman, executive Vice-President and Portfolio Manager for George D. Bjurman & Associates, Inc. explained this phenomenon recently. He said
"We have to think of the price of gold as a ratios of ratios. In the numerator there is the supply of dollars over demand of dollars; in the denominator you have the supply of gold for the demand for gold. The denominator is one so the numerator is where the change is. Why? Because the inventory of gold so overwhelms the new net supply so there is a self-enforcing scarcity. So how can it be that a specie with such a minute supply could ever significantly affect the price? It is true that if all of the gold in the world was dumped and there was no commensurate increase of liquidity by the Federal Reserve, the price would have to fall for a period of time. No question. But in that scenario you are talking about (described by Professor Mundell) the central banks of all of the nations of the world would be conspiring to sell 1/3 of the above ground gold at the same time. But, again, even a focus on that outside possibility would only be taking into account the denominator in the equation - you still have to ascertain what the demand and supply for dollar liquidity is at the time as well."
It is difficult to dispute that the Federal Reserve's management of the supply of dollars is a far greater factor than the supply of gold, in the long term. By 1998, the world stock above ground was 134,800 tons. Of that amount, central banks held less than one fourth of that - a total of 31,900 tons. The annual production of all of the world's gold mines in 1998 was 2,500 tons. To put that amount in perspective, consider that the country of India alone, annually consumes 700 tons of gold, primarily as jewelry. But, in the short term, it is possible for a massive sale of gold held by the world's central banks to destabilize the price of gold, if the Federal Reserve did not increase dollar liquidity simultaneously.
However, under this extreme scenario, the central bank of the African Union, through its foreign exchange reserves (dollar holdings) could actually purchase the gold being dumped by the other central banks. In May of 1999, the British Treasury announced that it planned to sell 415 tons of gold. This amount represented more than half of its gold reserves. The mere announcement is credited with causing the price of gold to fall by 10%. But had there been in existence, at the time, an African Union, the African Union could have announced that it was instructing its central bank to purchase the 400 tons of gold being sold by the Bank of England. The exercise would have cost the African central bank $900,228,000 (with gold valued at its current level of $270 per ounce) but it would have certainly been affordable, and easily so. In the process the African central bank would have acquired an additional 400 tons to marry with its existing stock of 629 tons (from what we estimate of the initial contributions of its members' gold holdings) to give the African Union 1,029 tons - the 6th largest supply of gold holdings in the world.
If the worst case scenario were to develop and the Western world's leading central banks conspired to sell half of their gold holdings at once, the African Union could still weather the storm and in the process end up becoming the home of the most powerful central bank in the world. If the U.S., Germany, France, Italy, Switzerland, the Netherlands and the European Central Bank all decided to sell half of their gold holdings, 10,598 tons, all at once, there is more than one scenario by which the African Union could survive the attack.
We will look at just one such scenario. It would require almost $92 billion to purchase 10,598 tons of gold valued at $270 per ounce. The African Union could purchase $50 billion of that amount with its foreign reserve holdings. The other $42 billion could be purchased as a result of the African Union borrowing the amount from its citizenry. The Treasury could simply print $42 billion dollars worth of Africanas (our name for the African Union's currency), in exchange for $42 billion in domestic or external debt, purchase U.S. dollars with them and then purchase the gold.The African Union could easily borrow the money, from foreign sources, if it had to, having the power of taxation over 700 million people. Even if the $42 billion burden were distributed over 300 million taxpayers, it would only require the government to raise an additional tax of $14 per person.
In fact, the African Union should relish the possibility of a mass dumping of world gold by Western central banks. It would represent a massive power shift with the African central bank ending up with gold holdings of over 11,000 tons of gold. A Pan-African gold standard backed by 11,000 tons in gold holdings on a continent where more gold is present than any other, would ensure that the Africana would become the most powerful currency in the world, setting the stage for Africa to become a leader in the area of financial intermediation, throughout the world.
The African Union, of course, does not need to hold half of the world's gold in order for its currency to be the strongest in the world. The power of the gold standard does not lie in the supply of gold that a country or union holds. Its power lies in its ability to provide an elastic currency that can accurately signal and respond to the velocity of money, resulting in a monetary regime that is responsive to the demand for money.
It is the signal regarding the velocity of money embodied in the price of gold that the Federal Reserve has failed to recognize for several years. Beginning in 1996 to the present, the dramatic drop in the price of gold from over $400 per ounce down to a low of nearly $250 per ounce signaled a monetary deflation which revealed that the Federal Reserve was not managing dollar liquidity in a manner which supplied sufficient dollars to match the demand for dollars. Very few economists have been able to recognize this unique quality of gold and have mistaken the drop in the price of gold as evidence of the demonetization of gold as opposed to a clear signal that insufficient dollars were being supplied by the Fed in light of the demand for money or the velocity of money.
However, George Gilder is one of the few who has made such a recognition and in a lucid manner, in the May 2001 edition of the American Spectator, Gilder explains how the demand for money, if not accurately gauged by monetary authorities, can result in negative consequences for an economy. He focuses his attention on the U.S. economy of the 1990s. He writes:
The low-pressure economy, however, hugely enhances the demand for money. It proliferates new companies and disaggregates existing companies, externalizing internal non-monetary exchanges. Since 1980 the share of the economy held by the Forbes 500 companies has dropped from 50 percent to 25 percent. By constantly reducing costs and increasing values, the low-pressure economy drives prices down dramatically in the highest growth sectors such as technology and these low prices reverberate throughout the economy. Because this surge in productivity is driven by little-understood applications of new technologies, much of the resulting deflation will be missed by traditional measures, especially by an economics establishment conditioned by decades of inflation-targeting. When prices drop because of new technological abundances, deriving from innovations such as the all-optical network, it signals a surge in productivity and opportunity that will enhance the demand for money. Previously adequate money supplies become inadequate in the face of the huge new demand unleashed by the collapsing new goods and services.
In the low-pressure economy deflation mimics inflation. Accustomed for years to real interest rates being lower than nominal rates because of the corrosive effects of inflation, monetary authorities easily slip into a regime where real interest rates are higher than nominal interest rates because of a deflation premium. Going to cash, investors bulk up savings and money market accounts boosting the measured money supply at the same time they are compromising the future demand for money by disinvesting from the companies that drive the economy. Pondering the numbers, economists will continue to warn against inflation and call for tighter monetary policy as they did throughout much of the Great Depression. They will oppose tax rate reductions in order to pay back debt or balance the budget, as Americans did in the 1930s and the Japanese did in the 1990s.
If the current administration and Federal Reserve follow these well trodden paths to failure, they will delay the onset of a tidal wave of new growth and opportunity. But they cannot stop it. The world economy is increasingly unified and if the U.S. gives up leadership, other countries will move into the breach and growth will shift to the low pressure regions.
Gilder is right and Africa can be one of those regions that "will move into the breach" and where "growth will shift". And Gilder's insights will be especially important in the African Union which will be undergoing a massive increase in transaction demand and increased productivity as it rapidly moves into industrialization, services, and information phases of economic development. The African union, through the establishment of the United States of Africa, with its currency tied to gold, can ensure that the demand for money is always satisfied by a proper supply. The intersection of the supply and demand for money will be at the equilibrium price of gold established by the African monetary authorities. Theoretically, it could be 500 africanas per ounce of gold. And the central bank would maintain that price, every day, all day. Actually, the price of gold would actually be allowed to fluctuate between the so-called gold points. For example, 495 africanas and 505 africanas. But the government would ensure that the price averaged 500 africanas per ounce of gold and it would honor that price for private citizens as well as institutions.
While the rest of the world would be recovering from the ending of the gold standard 30 years ago, Africa would be leading the return to fixity and clearly defined monetary standards.
By returning to the gold standard, regardless to what the United States and Europe did, Africa could set the stage for its preeminence the international economy.
Wednesday, August 29, 2001