Gold broke through $1,200 per ounce this week, on rumors that the People’s Bank of China might increase the percentage of gold in its reserves. The dollar, the euro, sterling and the yen all have good reasons to weaken, yet in our current global fiat money system they have nothing to weaken against. Global foreign exchange reserves are at record highs, but there is nothing solid for central banks to buy. This all raises the interesting question: are we seeing the beginning of the end of the fiat money floating exchange rate system that has prevailed since 1973? And could something closer to a Gold Standard replace it?

At the extreme it is very unlikely that in the near future we will go back to a full Gold Standard. We’re unlikely in five years time to be wandering round with gold sovereigns or double eagles clanking in our pockets. Pity. However it’s quite possible for us to move some considerable distance towards a gold standard without actually getting to the final destination. And there are increasing signs that the world is heading in that direction.

The explosion in global liquidity in the last decade has had an effect on global central bank reserves, which increased 414% between 1998 and the second quarter of 2009 to $6.8 trillion, an annual rate of increase of 14.5%. This is more than three times the rate of increase of nominal Gross World Product of 4.6%. Put another way, central bank reserves increased from 4.2% of GWP to 11.1% during the ten years 1998-2008.

The world therefore has been flooded with liquidity; Alan Greenspan and Ben Bernanke and to a lesser extent their counterparts in the ECB, the Bank of England, the Bank of Japan and the People’s Bank of China have a lot to answer for. Effectively they have by their own actions flooded the globe with paper money and made ordinary currency and short term securities increasingly undesirable assets. It is thus not surprising that private sector investors and even central banks themselves are looking for something better. India’s purchase in October of 200 tons of IMF gold (at a then value of $6.7 billion) was not a fluke.

The central bank search for an alternative to paper money holdings naturally leads them in the direction of gold. Gold has very few uses, so theoretically could lose its value almost completely if the world’s markets decided that holding gold was no more sensible than collecting old tram tickets. However in practice even in the dis-inflationary and economically ebullient 1980s and 1990s the gold price dropped only to around $250 an ounce, a price equivalent to its extraction cost from the most efficient gold mining operations. (That cost is now around $400 per ounce.) After all, if investors had decided the stuff was of no interest, there’s 50 years supply of it just lying around, so there would have been no need to produce any more, and no floor from mining costs on the gold price. In that case, gold would probably have dropped to around the $50 per ounce at which it becomes a plausible substitute for other metals in industrial uses.

So the world has bench-tested the Keynesian theory that gold is a barbarous relic, and found it wanting. Even in the 1990s, a time of peace and apparent dis-inflationary prosperity investors, including central banks wanted to keep a certain portion of their reserves in gold. Ideologically driven decisions, such as then UK Chancellor of the Exchequer Gordon’s Brown’s sale of half Britain’s gold reserves in 1999-2002, quickly came back to haunt the fanatic, as inflation-free prosperity dissolved and the normal world of economic toil and monetary sloppiness returned.

There are three ways in which the world could move towards a gold standard without actually getting there. First, the world’s central banks, particularly the ones like China and Japan with the biggest reserve pools, could increase the percentage of their reserves kept in gold. According to IMF data, that percentage declined from 13.9% to 9.8% during the great increase in central bank reserves from 1998 to 2008 even though the gold price more than trebled during that period.

A return to even the modest 1998 percentage of gold reserves would result in gold purchases of $324 billion, surely enough to shift the gold market a fair whack. A return to a still modest ratio of gold holdings of 20% of reserves, which prevailed as recently as 1994, would result in central bank gold purchases of $867 billion, about eight years’ mine supply at current prices, and more than 15% of all the gold now in existence.

Second, the world’s monetary authorities could start targeting the gold price as part of their monetary management, aiming to keep it within a certain range, thereby preventing excessive monetary expansion and dampening excessive exchange rate fluctuations. A “hard money” Federal Reserve chairman, for example, worried about the value of the dollar, could seek to keep the gold price between $900 and $1,000. He would sell gold from Fort Knox when, as now, the price was above that range, but would maintain a stated commitment to buying gold if and when the dollar had strengthened sufficiently that the price fell below $900.

Such a policy would have the advantage that it would not result directly in manipulating the value of other currencies through central bank purchases or sales, thus minimizing the chances of protectionist retaliation. That’s an especially valuable advantage when, as at present, the world is in a difficult and lengthy recession. Of course, as the US sold gold from Fort Knox, the dollar might still decline against other currencies even as it rose against gold.

Finally, the world’s politicians could decide that unlimited money creation was a thoroughly bad thing, and impose restrictions upon their monetary authorities, attempting to move monetary creation to the kind of automatic, limited mechanism that a gold standard naturally imposes. As the United States moves into its sixteenth year of Greenspan/Bernanke sloppiness since the monetary relaxation began in February 1995, we hard-money types have come to think nostalgically, not of the Gold Standard period, which almost nobody now remembers, but of the period of monetary stringency, sound economy and inflation reduction under Fed Chairman Paul Volcker and President Ronald Reagan, in the early 1980s.

Since even Paul Volcker will not live forever, it is necessary to Volckerize the Fed by some artificial statutory means, so whatever expansionary Princeton economics professor a deluded President may appoint to chair the institution, it is forced to follow a sound monetary policy. The best form of such a restriction would be to mandate that the Fed must keep the two-year average of the rates of growth of the M2, MZM and M3 monetary aggregates between 2% and 4% annually. The average of several aggregates would be used to minimize the distortions from one aggregate or another wandering off in a funny direction through technological change. (For example MZM increased exceptionally slowly compared to other aggregates during the 1970s and M2, the aggregate Greenspan occasionally glanced at, rose exceptionally slowly compared to other broad aggregates in 1995-2006.) That would prevent inflation from taking hold, while being sufficiently flexible to allow for technology-driven fluctuations in price levels and sufficiently expansionary to permit normal economic growth without deflation.

Such a program would mimic the Gold Standard, in which the increase in money supply depended on the rate of discovery of new gold, which fluctuated only slowly except with major gold discoveries such as California in 1849 and the Yukon in 1896-97. However, since the world’s gold supply increases by less than 2% annually, an official Gold Standard may be thought somewhat deflationary – as well as giving apoplexy to the unfortunately numerous Keynesian economists who infest academia, officialdom and the media. A Volcker Standard, if sufficiently constitutionally embedded that short-termist politicians could not override it, would give the same advantages as a Gold Standard, without the dangers of deflation or Keynesian heart failure.

In three ways therefore, official gold purchases, gold price currency targeting, and a quasi-gold Volcker Standard, we are likely to approach a Gold Standard ever closer in the years to come. Inflationists and official opinion will sneer at the possibility. However the markets are already making it inevitable, fueled as they are by the excessive global money creation of the last fifteen years, and the money supply explosion since September 2008.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)