U.S. Default Risk and a Return to Gold?

Gold is selling for close to $1500 an ounce, up from $258 in 2001.

Jewelry and industrial applications absorb at least 80 percent of new supply. The economic expansion of the 2000s and the recent recovery have boosted commercial demand, but this alone cannot explain the persistent surge in gold prices.

The cost of bringing new deposits on line has been less than the market price of recent years - investors see in gold what they cannot find in interest bearing securities.

Exchange traded funds (ETFs) have made storing wealth in gold or simply speculating easier. These store bullion for investors who have lost confidence in the dollar, euro and yen, and may be a precursor of a new gold standard.

In 1944, the International Monetary Fund established a system of fixed currency exchange rates. The dollar was fixed to gold and other currencies fixed to the dollar. This system failed because rising production costs pushed the industrial price of gold above its monetary value, and fixed exchange rates among currencies proved unsustainable.

Productivity and competitiveness advanced more rapidly in Japan and Germany than the United Kingdom, France and the United States, and balance of trade deficits among the latter, impelled by fixed exchange rates, caused pound, franc and dollar crises.

When the pound and franc became overvalued, those were devalued against the dollar, yen and mark. Ultimately the dollar became overvalued, President Nixon ended the convertibility into gold in 1972, and the system of fixed exchange rates was abandoned in 1973. Subsequently, the price of gold rose from $100 an ounce to a peak of $700 in October 1980.

Over the next two decades, central banks demonetarized gold. Those increasingly backed their currencies with dollars, and to a lesser extent marks (then euro) and yen. Many sold off significant gold holdings. The price of gold fluctuated but trended to lows of $255 in July 1999 and $258 an ounce in April 2001.

Two things made this possible. In the United States, Federal Reserve Chairman Paul Volcker whipped inflation in the early 1980s and Presidents Carter and Reagan put the American economy on the path of deregulation. Those unleashed the mighty waves of productivity, innovation and growth through the 1990s, and made the dollar a better and more stable store of value than gold.

In the new Millennium, the U.S. economy has not been managed very well - by either Republican or Democratic administrations. Dysfunctional energy and environmental policies, and a dollar overvalued against yuan and other Asian currencies have created huge U.S. trade deficits. Dollars and Treasury securities have flooded into international capital markets to finance American trade deficits.

Foreign central banks hold U.S. government bonds and other dollar securities to back up their currencies-commonly called official reserves-and foreign governments and international investors hold bonds to store purchasing power for future needs. Those holdings account for nearly half the $14.4 trillion dollar national debt.

With the national debt growing to about $1.6 trillion a year, the U.S. government would be flooding the world's capital market with too many bonds but for the Federal Reserve's recent policy of quantitative easing - purchasing Treasurys to keep down long-term interest rates. With that program scheduled to end in June, rates on long-term Treasurys will likely rise, and the value of existing long-term Treasury securities would fall.

A permanent decline in the value of existing long-term Treasurys would be nothing less than a partial default on U.S. debt. No surprise, investors are hedging positions by adding gold.

To keep the yuan from rising against the dollar, China purchases nearly $350 billion in foreign securities - mostly in Treasurys. Some central banks are buying gold again, and some economists have counseled the Peoples Bank of China to diversify reserves from dollars into gold.

A significant devaluation of the dollar against the yuan seems inevitable, and it will cause a wholesale downward adjustment for the dollar against other Asian currencies too. With so much of what the world consumes now coming from China and other Asian economies, the dollar will be worth a lot less to gold miners in South Africa or Russia, and Asian currencies would be worth more. The yuan or rupee price of gold might not rise, and could even fall, but the dollar price of gold would increase, a lot.

International investors with wealth to park are foolish to put it in long-term Treasurys; however, the currencies with the best prospects are backed by governments with poor track records for controlling inflation or honoring the rights of foreign investors. Could you tell your mother her money would be safe in Chinese bonds?

If private investors continue to doubt the dollar and bet on gold, central banks will be forced into gold. Investors won't trust currencies backed by dollars, and central banks would be just as foolish as private investors to trust yuan denominated bonds.

Long-term contracts could require payments specified in terms of gold, collateralized with deposits in ETFs, and even settled with drafts against these funds-sort of gold denominated checking accounts.

Unless the United States gets its economic house in order, gold will become money again, and national currencies will only be money if backed by gold.