To understand why the printing press-based creation of capital is not sustainable in the long run (really the very long run usually running into tens of years and sometimes even centuries…. unfortunately, we are living in one of those 'long runs' right now), we need to understand certain fundamental attributes of money. Historically, after over 5000 years of experiments, the markets standardized on gold (and to a lesser extent silver as well) as money. Money thus was a commodity whose utility was in its universal exchange value and as a store of value over a long period of time.

This leads to one particular attribute of money that is not well-understood ie. unlike other commodities, an increase in the supply of money confers no additional societal benefit at all. An increase in the supply of money merely serves the purpose of lowering the purchasing power of the existing stock of money. The reason this is so because money is useful only for its exchange value and not for its consumption value as is the case with other commodities. So even under a gold standard, an increased supply of gold bullion (very different from the increased supply of gold used for jewellery or other industrial applications), achieves no additional societal benefit. Any supply will do as well as any other supply ie. whether we have 1 million ounces of gold or 1 billion ounces of gold of money makes no real difference. The market will merely adjust the purchasing power of money, either upwards or downwards, as the supply of money warrants in relation to the amount of exchanges that need to be done within the society.

So what happens when we have a fiat currency instead of a hard currency standard? It has to be clearly understood that the fiat currency system can survive only under a monopolistic regime granted by government ie. when a private agency does what a Central Bank does, the activity is termed 'counterfeiting.' Were this not treated as an unlawful activity, the purchasing power of money would almost instantaneously be reduced to zero. So only by creating a government monopoly, we can temporarily postpone the inevitable outcome of hyperinflation.

Why am I saying temporarily postpone? History is the best judge for that observation and over the last 5000 years, every fiat currency introduced has failed without exception; just that some have lasted a little longer than others. To understand why this has to be the only eventual outcome, we need to ask the basic question of 'Qui Bono?' ie. who benefits under a fiat currency system? After all, if nobody benefits, we would not have the system in place in the first place.

What happens is that the owner of this fiat currency ie. the Central Bank, has unlimited power to create capital out of thin air. While this achieves no overall societal benefit as explained above, it serves an important objective of redistributing the existing stock of wealth in favour of the early recipients of this capital. So a fiat currency serves the purpose of taking wealth from one class of citizens and giving it to another in an apparently democratic fashion. This urge to achieve redistribution of wealth can never be resisted by any government… Just look at the last 5 years under Manmohan Singh and Y V Reddy (a PM not known for playing the class card unlike other politicians and a RBI Governor generally viewed as hawkish by the mainstream media) - and even under this duo, money supply increased by more than 20 per cent at an annualized rate. Even Greenspan did not expand money supply at this rate! So debasement of money is a guaranteed outcome of the fiat currency system.

The return of gold

The fluctuating fiat currency system that the world has had since Richard Nixon closed the gold window in 1971 has now pretty much come to an end. The rate at which US Fed Reserve chairman Bernanke is cranking up the presses to handle the current crisis is gong to ensure that the US dollar gets debased into oblivion over the next couple of years. By the time Obama completes his first term in office, the US dollar is going to be recognized world-wide as an IOU for nothing (it already is an IOU for nothing, but just that the rest of the world has not recognized the fact as yet). What happens subsequently is a topic that has been immensely speculated upon over the last few years.

Historically, major crisis events such as the one we are going through have turned out to be pivotal moments in history and decisions made during such times would have far-reaching consequences. For example, it was hyperinflation in the erstwhile Weimar Republic and the subsequent mass outrage that gave Hitler the opportunity to come to power. It is no different this time - and whether we make the wise choice of returning to a market based monetary system or we move towards one world order under a global currency as several political leaders have suggested would have repercussions for decades to come. Of course, it is my hope (whether it is based on rationality or polyannish optimism is something that only time will answer) that the title of this article comes to fruition.

Intrinsic value of gold

Irrespective of the choice, it is certain the price of gold has to increase substantially to reflect all the inflation that is being created by governments around the world as a response to the crisis. Most financial analysts find it impossible to define the intrinsic worth of gold as they cannot associate any cash flows or the rate of risk to holding gold. They fail to understand that gold derives value because it is 'real money' and hence the price of gold has to reflect the amount fiat currencies in circulation.

Using the above, the intrinsic worth of gold can be defined as total money supply divided by all available gold. The above is really a back of the envelope calculation and there are several factors such as the ones given below that is going to cause gold prices to go even higher than what the above calculation warrants.

• The total stock of gold mined is about 5 billion ounces to date. Of these, about 2 billion ounces is available in bullion form. While it's possible that at a higher price of gold, some of the gold used in jewellery and other applications might get converted back to bullion, it is quite unlikely that this gets anywhere close to the 5 billion mark.
  
• We are using the total money supply today under circulation (or really the 2006 numbers because the US Fed has not published M3 statistics after that). It is certain that the rate of increase in money supply is going to be substantially higher in the years ahead (and that's the real reason why the Fed stopped publishing M3) and so the above calculation is going to grossly understate the intrinsic worth of gold.
  The exchange rates of US dollar vis-à-vis other currencies. Today the US dollar is overvalued with respect to other currencies and when the realignment happens with the currency exchange rates, this would send the money supply as measured in US dollars even higher.
  

Without accounting for the above issues, the intrinsic worth of gold comes to about $9000/ounce (total money supply of about $45 trillion/5 billion ounces of gold). So gold remains hugely undervalued and it's certain that market participants will increasingly shift their holdings from paper currency onto real money in the years ahead.

2008 was a historic year in the sense that for the first time ever, the total stock of gold held by private citizens was greater than the stocks held with Central Banks. This process of returning papers to their original creators is going to continue in the years ahead and at least some of the Central Banks are going to be recognized for what they really are ie. glorified printing presses. The smarter Central Banks will start converting their foreign exchange reserves to tangible assets and I hope our own RBI embarks on this transition sooner rather than later.