Gold demat? Why is the RBI suggesting a Ponzi scheme?

By Shanmuganathan Nagasundaram

I wonder if the works of Adam Smith, Henry Hazlitt and Frederic Bastiat should be required reading for would-be and current central bankers - whether in India or elsewhere in the world. Else, they would not be making a mockery of the vary basics of economics in their pronouncements.

Consider the latest “game-changer” proposal by Reserve Bank Deputy Governor Subir Gokarn - for the “dematerialisation of gold” . Firstly, I think what Gokarn is recommending may actually be illegal or unethical - but let’s leave that aside for a bit. I think it’s one of the most banal ideas that could have been floated to deal with the problem of high gold imports.

Suggesting dematerialisation is like suggesting a cold shower for high fever. The logic could be that since the body is hot, why not cool it down? Why go through the elaborate exercise of trying to identify the infection that is causing these symptoms?

But this is the remedy being proposed for the problem of high gold imports. Gokarn is treating the symptoms and not the root cause. The root cause behind Indians buying gold is currency debasement on account of the Reserve Bank running a very accommodative policy by monetising the fiscal deficits of successive governments. This can’t be addressed by making gold imports difficult or by “dematerialising gold”.

Why would I regard the demat proposal as illegal, or even immoral? What Gokarn is suggesting is that people should purchase gold through exchange-traded funds or some such vehicle without holding physical bullion. Now, how can this reduce gold imports or the current account deficit (CAD)? The only way it can possibly happen is by not having 100 percent backing of the metal behind the ETFs. There is just no other way to have a lower CAD for the same amount of gold sold. And in recommending such an action, Gokarn may be suggesting that ETF sponsors should run a Ponzi scheme.

How can a gold ETF meet its fiduciary obligations to clients when there’s no gold backing? Let’s say that gold prices go up by 20 percent in a year. If the investor demands an exit at this price, the only way the ETF can redeem his share is by taking money from the remaining (or future) buyers of the ETF. There is no foolproof mechanism for generating returns that can be aligned with gold prices without the 100 percent backing of physical gold. In short, what Gokarn is advocating smells like an explicit Ponzi scheme. Even Bernie Madoff was a bit more subtle.

Maybe, being an integral part of a gigantic Ponzi scheme (which is what fractional central banking really is, read Madoff, Madoff, Everywhere ), Gokarn sees his suggestion as par for the course.

What ahead for gold?

I have often wondered if the current crop of central bankers is the most dovish set we have ever had. And their advisors seem even more dovish. I often think of the RBI Governor, D Subbarao, as running a very loose monetary policy ( If Subbarao’s a hawk, he should be raising interest rates ), but last week we read a report suggesting that his policy advisory committee actually called for a reduction in rates when CPI inflation is running at 10 percent.

India is not alone. Alan Greenspan was one of the most prolific printers of money the world has seen in a long time. Just when we thought it couldn’t get worse, we got Helicopter Ben at the Fed, who has expanded the Federal Reserve’s balance-sheet at an astonishing pace. For the first 94 years of its existence leading up to 2007, the US Fed’s balance-sheet was a shade over $800 billion. In the next five years alone, Ben Bernanke has added another $2.2 trillion to date and is currently expanding it at the rate of $85 billion a month. Can it get any worse?

Sure it can. And it will. Listening to Dr Janet Yellen (currently vice-chair of the Board of Governors at the US Fed and widely tipped to replace Bernanke who may step down when his terms ends in 2014), it appears she advocates an even greater stimulus and, worse, negative interest rates. It doesn’t inspire any great confidence in the US economy or the competence of policy-makers. Rephrasing investor Marc Faber, “Dr Yellen makes Helicopter Ben look like a hawk”.

Now all of this should really be music to gold bulls. We would like to assure the RBI Deputy Governor that one would like to invest and profit in financial assets in a way that would benefit everybody in a growing economy. But if central bankers - and their fiscal cheerleaders- create conditions that virtually guarantee stagflation in the developed markets and sub-par growth with double-digit consumer price inflation in the emerging markets, one of the best ways to insulate yourself from the downside is by investing in real money rather than fiat currencies. This means gold.

I generally avoid making short-term predictions due to market vicissitudes and non-market forces involved in determining gold prices. Even so, I think we have set up an extraordinarily positive environment for gold prices to go up. I wouldn’t be surprised if gold prices hit $2,200-2,500 an ounce by this time next year.

Shanmuganathan “Shan” Nagasundaramis the founding director of Benchmark Advisory Services - an economic consulting firm. He is also the India Economist for the World Money Analyst, a monthly publication of International Man. He can be contacted at shanmuganathan.sundaram@gmail.com