In last week’s Insight, I analyzed the current geopolitical situation and concluded that it was now in the interest of the Shanghai Cooperation Organisation to break from the US dollar completely, by establishing a new monetary and banking system. By linking the yuan and rouble to gold, the SCO’s principal currencies would be insulated from manipulation by means of dollar currency rates, and their use as a weapon to undermine the Sino-Russian partnership. This article addresses some of the practical difficulties of establishing such a sound monetary system.

A return to sound money will require a radical reform of financial markets, as well as the laws and regulations under which banks and investment houses work. The weaknesses of the current fiat-money system must be identified and understood by reforming governments. It also amounts to no less than discarding the entire evolution of mainstream economic thinking that has evolved in the welfare states since the 1930s.

Revolutions of this sort normally occur after a major economic and financial failure, when the shortcomings of received wisdom are so glaringly obvious that it loses all credibility. Just occasionally, this can happen without the crisis occurring first. It appears, from what we can deduce as observers, that the assembly of the Asian and East European continent into a self-contained economic and financial unit presents such an opportunity. That was the thrust of last week’s article.

For those who have a thorough understanding of sound money and the benefits, it brings to an economy, the opportunity presented by Asia rejecting the West’s unsound money system should be welcomed. The lunacy of expanding the quantity of money as a cure-all for every economic malaise, real and imagined, has led to the widespread expansion of debt to unsustainable levels. It is no exaggeration to say that the global financial system, being based on the dollar, is now exposed to a final collapse, worse than that of the financial crisis of 2008-09, and leading inevitably to the destruction of the fiat currencies we use today.

The destruction of unsound money will not happen overnight. It will come from the central banks’ response to the next global debt crisis. In such a crisis, the banking system, being geared through the fractional reserve system, will cease to exist without central banks bailing it out with unlimited quantities of raw money.

There is little point in trying to predict the timing of this increasingly certain event, or how the crisis will first manifest itself. We know that the credit cycle progresses remorselessly from rescue, to recovery, to bust. The bust is yet to come. The bust, thanks to the groupthink imposed by forums such as G20 meetings and central banks liaising through the Bank for International Settlements, is increasingly a global affair.

If China, Russia and the SCO can grasp the opportunity to escape the unsound money-system of the Western establishment, they will at least partially insulate three billion people from a global currency disaster. That will ultimately benefit the rest of humanity. We must applaud that, even though the introduction of sound money policies in Asia will almost certainly bring forward the crisis in the indebted welfare-states; that is going to happen anyway. For this reason, the change from unsound monetary policies to the rigid rules of sound money must be progressed in such a way that blame is not apportioned to China and Russia for the monetary disaster that will befall us. Instead, we should be grateful that a significant core of global economic activity will escape widespread monetary destruction. The return to a gold standard and the insulation from financial catastrophe that China and Russia will hopefully provide should guide us in our post-crisis monetary reform.

The effect on commodity prices

By remonetising gold into the monetary system of a large economic bloc, demand for gold will be increased. We saw the reverse of this effect on silver in the period 1875-1900. When most countries with a silver standard demonetised it in in favour of gold. In the late nineteenth century, its price relationship with gold moved from exchange ratios corresponding approximately to Sir Isaac Newton’s ratio of 15.5, to considerably higher levels through a collapse of the silver price. Today the ratio is over seventy. The reason for the relative collapse in silver was not hard to understand. The removal of its use as money (except as coin tokens) meant it was then priced for alternative uses. While industrial uses of silver over the years have changed, its value as an industrial metal was always considerably less than for its former use as money.

Thus, it is with gold, demonetised from the financial system, but with an added twist. Under the cover of limited convertibility with the dollar, the dollar was continually debased following the ban on public ownership of gold under the Gold Reserve Act of 1934. Since the official price was raised to $35, the quantity of dollars and dollar credit has increased at a monthly compounding annualized rate of about 5%, until the last financial crisis, when that rate sharply accelerated to 12%, measured by the fiat money quantity. The monetary arrangements were set by the Roosevelt administration and then by the Bretton Woods Agreement. The objective was to permit the expansion of the quantity of dollars, while retaining the pricing stability of gold.  The removal of gold from the monetary system after the Nixon shock in 1971 was the inevitable conclusion of this dishonest arrangement, following which the gold price naturally rose, measured in dollars. Today, gold is approximately $1200 in its current demonetised form.