There He Goes Again…

Tun Dr Mahathir on free markets, regulation and gold:

Dr M: Banking, finance need to be regulated

…Former prime minister Tun Dr Mahathir Mohamad said governments must continue to oversee the regulation of banks and financial institutions.

“Unless the Government oversees and limits the ability for the market to abuse (the banking systems) then, of course, we are going to have this kind of (global economic) crisis…

…“This idea of a free market has become almost like a religion. You cannot question it, even when it fails,” he said…

…“And the abuses became rampant because of the idea that governments must not interfere with the financial market. (That) the market it seems would regulate itself,” he explained.

He urged for the gold dinar to be institutionalised as the standard against which all currencies were measured for the sake of stability.

“It’s something tangible and something that has value anywhere in the world,” he said.

However, he said the gold dinar system, if implemented, should only be used for settlements of international trade…

…“The US dollar has got no value whatsoever. It’s got no backing, no reserve. But we accept it as if it has some value and because we accept it, it has value,” he said.

I’m not a free market fundamentalist, nor do I believe in the doctrine of self-correcting markets (see this post). To me, market failure is as likely an outcome as well-functioning markets – we are after all dealing with human beings who are fallible. There is no “invisible hand” that infallibly guides markets to the first-best outcome that maximises social value and welfare. On the other hand, the market mechanism is infinitely superior to the alternatives – so in that sense, TDM has it right. Markets need regulation to ensure that they remain efficient and fair.

The stuff about gold however, is another matter. The underlying assumptions behind the desire for a gold based settlement mechanism is that gold has “intrinsic” value (and thus cannot be manipulated), and that its value is also stable relative to the price of other commodities and tradable goods.

There’s also an assumption in the Malaysian context that it’s the depreciation of the US Dollar that is the problem, which leaves the currencies of subject to competitive devaluation i.e. if it weren’t for the Dollar’s fall, the currencies of our other trade partners would have been more or less stable relative to the Ringgit.

None of these are correct. Regarding “intrinsic” value, I’d point to TDM’s statement on the US dollar – the same applies to gold. It only has value because everyone agrees it has value. For the year to date, global investment demand for gold comprises 39.8% of total demand (51.0% for 2Q 2010 alone). That compares to just 30.9% two years ago. And of the rest of total demand, over 60% is for jewellery and less than 10% for industrial uses.

In other words, gold is mainly being bought because 1) it’s pretty, and 2) people think it has value.

On the second point, regarding the stability of gold against other commodities, I’ve already done a post on that. The short version of my results were:

1. The value of commodities in gold terms is generally not a stationary series; and
2. The value of commodities in gold terms also has a higher variance compared to the US dollar price of these commodities.

The non-statistical-jargon version of the above is: the price of commodities in gold terms is not stable, which means the purchasing power of gold varies; and that the variance (i.e. the risk of changes in purchasing power) is actually generally higher than the US Dollar.

As for point three – that gold would be useful as a means of trade settlement – that would only be an advantage if the Ringgit cross-rates were stable. They’re not.

Technical Notes:

Gold demand and supply data from the World Gold Council.