I would like to respond to Paul Donovan’s article “Gold has no serious role as a currency” that appeared in the Edge, 24 August 2009. Donovan contends that it is unlikely for gold to assume some kind of a central role in modern foreign exchange system simply because there isn’t enough of it. The argument, in our opinion, is flawed.
Discrediting gold on the pretext of its limited supply is common. This misunderstanding can perhaps be cleared using the equation of exchange: MV = PY. In the modern fiat-money-based economic system, for every flow of goods and services, there is the opposite flow of money. This is what fundamentally captured by the equation of exchange. The real goods and services are depicted by Y, commonly measured by the gross domestic product (GDP) at a constant price. In the Malaysian case, the Bank Negara Malaysia (BNM) measures Y using GDP at year 2000 prices. Any change in Y, therefore, depicts a change in the real goods and services. P is the general price level. Hence the right-hand side of the equation PY, is price times quantity, which is basically the nominal GDP.
M is the total money supply in the economy. There are many definitions of money but what is important here is money that is normally used for transactions, i.e. for the purchase of goods and services. Hence the appropriate definition here is the M2 that consists of currencies and coins in circulation, demand deposits and less liquid money like time deposits.The equation of exchange, therefore, simply says “price times quantity is what paid in monetary terms”. Nonetheless, in macroeconomics we have one more variable, i.e. the velocity of money circulation, depicted by V. Velocity is in the equation because the same money can be used again and again for economic transactions. That is to say, for example, a same RM50 currency note can be the medium of exchange for many transactions in the economy. The average times money changes hands is the velocity. Because the flow of goods and services is matched by the opposite flow of money, the equation of exchange is indeed an identity. Some regard it as ‘kindergarten material’ in economics and finance. Yes, as important as kindergarten material is to our later professional knowledge, the equation of exchange is a powerful tool to understand the world of economics and finance today.
For example if money supply were increased rapidly relative to goods and services, while velocity remains constant, the equation of exchange tells us this would only translate into a rising P, i.e. price levels. Perhaps we are reminded at this juncture of the Japanese occupation of Malaya in the early 1940s when the occupying army introduced huge amounts of duit pokok pisang, i.e. paper currencies that depicted the picture of a bunch of bananas hanging from a banana tree. This action simply translated into serious inflation.
Price levels can also increase, for a given amount of money supply, when supply of goods and services, Y, shrinks. This could happen due to natural catastrophes, for example. But as the famous monetarist, Milton Friedman pointed out, inflation is predominantly a monetary phenomenon, i.e. caused by over supply of money relative to goods and services. And this, of course, is easiest to occur when money itself is fiat, i.e. not backed to gold as was in the gold standard.It is indeed the indiscriminant increase in the global money supply, particularly the dollar, that has brought the world to its current economic and financial debacle.
Donovan implied in his article that since gold is limited in supply, there is no validity to gold as a currency benchmark. From the equation of exchange one can see the fallacy of this argument. For a given nominal GDP, i.e. the right-hand-side of the equation, one does not need equal amount of money on the left-hand-side. Clearly, the amount needed depends on the velocity of money circulation. The higher the velocity, the less money needed.
One can also verify this by comparing data on money supply and nominal GDP of nations and convince oneself that the amount of money supply is always lower than the nominal GDP. There are ways on increasing the velocity, directly or indirectly. Therefore if gold is used as a monetary benchmark, its short supply is not of true concern in a world of exchange.
For example, if one exports goods worth 1000kg of gold and imports goods worth 1000kg of gold. How much gold is needed to settle? None, of course. David Ricardo pointed out that when the monetary system works at the peak of its efficiency you don’t need any gold. Such efficiency can be increased by employing netting methods. Bilateral and multilateral payment arrangements (BPA and MPA) are powerful ways to achieve this and are certainly ways that can mitigate the current global financial crisis. Under BPA and MPAs, even countries with minimal reserves can trade, bolstering the fact that lack of gold to play the role of reserve currency is immaterial.
On the contrary, countries can leverage on the gold reserves they already have to increase trade further. The reason is gold need to be used only as a unit of account. Just using gold as a measure of value alone would bring about price and exchange rate stability, the very targets of many central banks.Consider the following MPA example that illustrates netting. Say, Indonesia-Malaysia-Thailand (IMT) growth triangle decides to implement the gold-based MPA among them. In such arrangements, the countries would trade as usual, with the respective central banks dealing with their importers and exporters in their own respective currencies. But nonetheless the gold-equivalence of the trade would be captured and settled periodically, say every three months.
Assume that in a particular quarter, the trade is as shown in Table 1 below. Malaysia exports 2 million and 1.5 million gold units worth of goods and services to Thailand and Indonesia respectively. Thailand exports 1.8 million and 2 million to Malaysia and Indonesia respectively while Indonesia exports 1.7 million each to Malaysia and Thailand.The MPA settlement for the above trade matrix is given in Table 2. Within the group, Malaysia’s trade is balanced, while Indonesia needs to pay Thailand only 0.1 million gold units. Hence the entire trade matrix, worth 10.7 million gold units is settled with only 0.1 million gold units. In the equation of exchange this is equivalent to increasing the velocity of money circulation.
Indeed, the netting can be enhanced with more participating countries and lengthening the period of settlement, thereby a huge trade matrix be settled with small amounts of gold. This was what Tun Mahathir Mohamad proposed in 2003 for Bank Negara Malaysia to implement among the Organization of Islamic Conference (OIC) countries and other trading partners.
The same principle can also be replicated for transactions between individuals and businesses, as is the case in Mutual Credit Clearance and Commercial Trade Exchanges. Hence, Donovan’s contention that there is not enough gold for it to play any meaningful role does not hold water. Indeed, it’s the shortage of gold supply that is partly responsible for giving that rare value to gold, for its obsession by humanity and its success as money throughout history, which it lost in 1971 due to political maneuvering.
Donovan also contends that a gold-based currency system would condemn the world to global deflation. Nonetheless, theoretical reasoning and empirical evidence point just to the opposite. Roy W. Jastram of University of California, Berkley, for example, showed the remarkable stability of gold’s purchasing power in a study of the English and American experience covering the period 1560 to 1976 (See Roy W. Jastram, The Golden Constant, John Wiley & Sons, 1977). Another study by the present author using recent data also produced similar conclusions.
Hence contrary to Donovan’s contention, gold is neither deflationary nor inflationary. Hence being a neutral currency, that is not a liability of any government, gold is most suited to play a central role in the post-crisis global monetary system.
On the other hand, the rapid production of fiat money by governments, particularly in current recessionary times, as noted by Donovan, which is likely to cause serious hyperinflation worldwide. Some economists are nervously watching the US commercial property bubble which is in the vicinity of $3 trillion and the humongous derivatives bubble which some estimates put it as high as $1,000 trillion as being potential to create a global financial tsunami at unprecedented scale. That tsunami, I believe, is not far and would bring an end to the gold vs. fiat money debate and thereafter force the world to search and put in place a sustainable monetary system.
Professor Dr Ahamed Kameel Meera Mydin
Dean, Kuliyyah of Islamic Banking and Finances
International Islamic University Malaysia
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