NICHOLAS SHUBITZ: Fiat money trumps crypto and gold for Brics

An expanding Brics bloc has plans to develop alternatives to the dollar-based financial system, with a particular emphasis on increasing trade in local currencies. This process could eventually result in the creation of a new unit of account, based on a basket of Brics currencies that could one day serve as a global reserve currency.

While some have suggested that this currency should be backed by gold and other commodities, reverting to a gold standard remains inadvisable.

Though monetary systems in which a country’s currency is pegged to the value of gold are often promoted as a more stable and trustworthy means of conducting monetary policy, there are several drawbacks. The obvious problem is that a gold standard limits the ability of central banks to respond to economic downturns. If the amount of money in circulation is tied to a country’s gold reserves, this can make it difficult to stimulate a deflationary economy without debasing the currency.

Aside from the need for increased gold supplies, storage vaults and audits, the cost of purchasing gold to trade with other countries could also prove counterproductive. If the Brics have to purchase gold to be able to do business, it could hamper rather than stimulate trade, and would be more costly than simply using the dollar or yuan, especially when the gold price increases.

Rising gold prices could also cause investors to hold onto a gold-backed Brics currency as a store of value, creating deflationary effects in the real economy. Fiat currency systems provide central banks with the ability to increase or decrease the money supply as needed to stabilise the economy.

By setting an inflation target central banks are able to encourage a healthy balance between saving, investment and spending, while avoiding the dangers of deflation.

Ruled out

With central banks struggling to achieve inflation targets, and loose monetary policies such as quantitative easing worsening inequality by boosting asset prices more than real wages, the price of gold and bitcoin have risen, along with cynicism about fiat money. Though critiques of the state of the global financial system may be valid in themselves, there are several reasons the existing system remains superior to its historical and newly championed alternatives.        

Due to sluggish processing times, bitcoin has not emerged as a viable medium of exchange, and price volatility rules it out as a store of value. The volatility is caused by the limited supply of bitcoin, a lack of demand fundamentals, and a lack of a centralised authority to stabilise the value of the token. It has led enthusiasts to champion bitcoin as a type of digital gold. But gold has problems of its own.

The metal is also environmentally costly to mine and remains expensive to transport and store. Monetary systems based on gold can also produce inflationary or deflationary economic effects depending on fluctuations in the supply of the metal, and gold-based currencies can still be debased, as they have been throughout history, rendering the main argument for their use redundant.

Compared with bitcoin, gold has a far better record as a store of value. This is largely due to pricing efficiencies derived from real world gold demand for jewellery and electronics, and purchases of gold by central banks. As such, gold has fundamental demand dynamics that assist with price discovery and stabilisation.

Gold is also genuinely scarce, as opposed to arbitrarily scarce like bitcoin. Alchemists spent centuries attempting to turn lead into gold, and yet physical gold still cannot be conjured into being or recreated, and precious metals such as gold remain difficult to replicate or replace.

Significantly undervalued

Bitcoin can be replicated and improved on. The cryptocurrency has already been forked and copied often, and is incredibly energy inefficient. Furthermore, cryptocurrencies, of which bitcoin is but one of thousands, have no upper supply limit.

The gold price can still decline for decades at a time (as it did from 1980 to 2000) and gold remains significantly undervalued in relation to long-term increases in the money supply. The gold-to-monetary base ratio has declined about 90% since 1980 and 50% since 2008, which means despite a rising gold price in recent years the value of gold is still declining.

Based on this metric, which compares the gold price with the increase in money supply, the gold price would need to reach $2,500 per ounce to rival its 1980 high and more than $5,000 to match its 2008 high relative to the amount of new dollars that have subsequently been created.    

Trade in local currencies is the most straightforward, politically palatable means of dedollarisation, and could end up being the best pathway towards the development of a future joint trade currency. Creating rules for issuance may prove tricky, though considering private banks still issued dollar notes until as recently as 1935, central banks in Brics countries could be trusted to issue the currency as long as they fulfil certain agreed upon reserve requirements.        

While a partial gold backing for a new Brics trade currency could help increase confidence in a new unit of account, it is not a necessary requirement for a stable currency. Basing the currency on a basket of Brics currencies would have its own stabilising effect, with fluctuations in the value of the underlying currencies balancing each other out and moderating downside risks.

Though using gold as a share of these reserves might seem like a return to simpler times, it could just make the undertaking more complex. Similarly, while a joint Brics currency could still make use of blockchain technology, that is not a central requirement.

Considering the shortcomings of gold and bitcoin compared with fiat money, the Brics should adapt rather than abandon the current fiat monetary system. If properly managed, a fiat monetary system is still the best equipped to respond to economic shocks while striking the correct balance between saving, spending and investment.

• Shubitz is an independent Brics analyst.