Are gold-backed currencies set to make a comeback?

Gold has grown increasingly popular over the past decade, as you might have noticed.

It's reached the point where it's regularly covered in Sunday supplements and on the television. Plenty of entrepreneurs are jumping on the bandwagon with bullion dealers, gold vending machines, and 'sell your gold' companies springing up everywhere.

Yet gold has retained that faint tang of lunacy about it. It may have gone mainstream, but it's still disreputable. Anyone with an eye to their intellectual credentials can't admit to liking gold. It's still a 'barbarous relic', of interest only to irrational 'gold bugs'.

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But even that may be changing now. The front page of this morning's FT reports that the head of the World Bank is calling for a new global monetary order. And there could be a role for gold in his grand vision...

Why QE2 is angering the US's rival countries

I'll get back to the role of gold as reserve currency in a moment. First we need to talk about why this is all becoming such an issue. As has been the case with most other financial crises of the past 20 years or so, it all comes down to the Federal Reserve.

No one is entirely sure what quantitative easing mark II - QE2 - will achieve (we'll be looking at this in more detail in the next issue of MoneyWeek magazine, out on Friday). But one thing's for sure - it has already angered many of the US's rival countries.

Here's German finance minister, Wolfgang Schaeuble: "With all due respect, US policy is clueless," reports Reuters. The problem "is not a shortage of liquidity". Pumping more money "into the market is not going to solve their problems".

Meanwhile, China's vice-foreign minister said: "They owe us some explanation. I've seen much concern about the impact of this policy on financial stability in other countries." Other emerging markets are up in arms, worried that a flood of cheap money will push up inflation in their fast-growing economies.

You can see why they're worried. As far as they're concerned, the US is trying to weaken the dollar. That may make US exports more attractive to foreigners. But it also makes foreign imports less attractive to US consumers. And that's not good news for export-dependent economies.

And there's no doubt that QE2 is causing ructions in the currency markets. There was a very interesting piece by Izabella Kaminska on FT Alphaville on Friday. I'll not go into the gritty details (I've highlighted the piece on my Twitter feed if you want to read it. If you don't follow me on Twitter, you can do so here).

To sum up, before Ben Bernanke started hinting that QE2 was on the way, traders were willing to pay a lot of money to protect themselves from a fall in share prices (by using options - you can find out more about how these work here). In other words, they were more worried about another slide in stocks than they were about share prices rising.

But as the market started to price in another bout of QE, the cost of insuring against a drop in prices started to fall. As investment bank UBS put it: "Why buy downside protection when the Fed has done it for you?"

That's why they call it the 'Bernanke put'. But what does this have to do with the currency markets?

US disruption of currency markets is a serious political issue

Well, here's the thing. Volatility in the stock market might have fallen since the Fed started to talk about QE2, notes Dean Curnutt of Macro Risk Advisors. But currency markets have become more volatile since QE2 was suggested. In other words, the Fed might be able to squeeze volatility out of one part of the market, but it's just popped up elsewhere.

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Messing about with stock market values, or even domestic property prices, is one thing. The impact might seep beyond your borders, but it's hard for other countries to complain. But wading in and disrupting currency markets has a real impact on other countries. As such, it's a major political issue. And while plenty of countries do it, none of the rest of them holds the world's reserve currency.

Hence all the talk of currency wars, and fears over potential trade wars. And that's why the president of the World Bank, Robert Zeollick, is telling the FT this morning what he thinks should come out of the next G20 meeting in Seoul this week.

He argues that we need another big agreement on the shape of global trade and the way the currency markets work. There's lots of the usual stuff in there - the US needs to tackle its deficit; China needs to become less export-dependent. Major economies should agree not to intervene in the currency markets; emerging markets need to make their own currency policies more flexible. It's all sensible stuff that we've heard before, but much easier to say than do.

The role for gold in a new global currency system

What is interesting about his piece though, is the notion that gold could play a role in a new global currency system. Zeollick suggests that the dollar, euro, pound and yen need to be joined by the renminbi in forming the backbone of such a system. But "the system should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values," he adds. "Although textbooks may view gold as old money, markets are using gold as an alternative monetary asset today". He's not exactly calling for currencies to be backed by hard assets again. But this notion of using gold as a sort of fixed reference point is a step in that direction.

Now, this level of exposure for any asset class always makes me worry that a dip has to be around the corner. And it wouldn't be surprising after the run that gold has had. But any concerted move to reintroduce gold into the global monetary system could only be good for the yellow metal in the longer run.

Interestingly, the idea that 'fiat' currencies would return to some sort of hard asset backing is one of my colleague Dominic Frisby's "trades of the decade". Subscribers can read his piece here. If you're not already a subscriber, you can read more about Dominic's trade - and the rest of our experts' views on the best investments for the next ten years - by subscribing now.

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