"Our guess is that if the chairman of the Fed is determined to debase the currency, he will succeed"

On August 15, 1971, thousands of years of gold’s role in monetary history came to an end.

That was the date President Nixon cut the U.S. dollar’s final link to gold. With that move, the age of fiat currencies began in earnest.

The U.S. dollar became backed by only “the full faith and credit of the U.S. government.” And advocating a role for gold in the global monetary system officially became fruitless.

Today, advocates still compare current central bank policy to massive money printing. After all, the beauty of gold is that no one can make any more of it.

Nobody listens to those crazy gold bugs though. Don’t expect that to change, even with Robert Zoellick, president of the World Bank, recently saying that the precious metal might be ready for a comeback role in the global monetary system.

Dramatic rise of the price of gold

Gold has risen from a 21-year low of $250 a troy ounce in mid-1999 to over $1,300 today.

This dramatic rise reflects falling confidence in the paper money issued by central banks. And it especially indicates a poor opinion of the world’s reserve currency: the U.S. dollar.

Many believe that the Federal Reserve’s use of unconventional monetary policy – like the $600 billion QE2 – has only made the situation worse. The World Bank President’s argues that policymakers can and should use gold prices as a measure of investor anxiety about their currencies.

However, the other side says that gold’s rise has everything to do with supply and demand. They point to stagnant mine output despite record prices as one of the reasons.

Indeed, global gold production did hit a peak of about 2,645 metric tons in 2001. And gold consultancy firm GFMS estimates it has stayed below that until this year.

Worse yet, mining output is shifting to riskier producers in Africa and Central Asia. Gold production is shifting away from the four traditional – and now mature – producing regions:

• The United States,
• Canada,
• Australia,
• South Africa.

The combined output of those four fell to only 756 tons last year from 1,260 tons in 2000.

Only a surge in gold scrap has cushioned the drop in mine output. Yet demand from growing the middle class in places like India keeps chipping away at its availability.

The camp that denies gold’s value as reflecting investor sentiment certainly likes to point to all of those facts as proving their point…

Does gold measure investor anxiety?

Yet there are a couple of arguments that show just the opposite… like the one from people who think any proper definition of inflation should include asset prices. They believe central bank policies should always consider the level of asset prices in creating policy.

They understand the dangers of asset inflation, especially in light of QE2′s stated goals. Ben Bernanke wants to drive up stock and bond prices… possibly leading to further asset bubbles and even bigger problems down the road.

Gold can signal a warning to those future problems, as Derry Pickford, chief economist at London hedge fund manager Sloane Robinson, says. “Gold, along with other asset prices, can tell us if there is an erosion in the general purchasing power of money rather than just the cost of current consumption.”

It may also say something else about the Fed’s current monetary policies. Consider that one of the traditional arguments against gold is that it pays no interest.

That barely matters anymore with rates in the U.S. so low that investors can’t generate much from holding cash either. Many people are simply opting to hold gold instead.

Many of them are doing so through bullion-backed ETFs. The largest of them – SPDR Gold Trust ETF (NYSE: GLD) – launched just six years ago but holds more gold than most central banks… almost $57 billion worth.

Additionally, some of the world’s largest hedge fund managers are taking on gold rather than dollars. John Paulson of Paulson & Co. and David Einhorn of Greenlight Capital both run hedge funds that made money during the global financial crisis.

And both have bought gold and created classes of shares in their funds denominated in it.

Don’t fight the Fed… It’s bound to win

Mr. Einhorn summed up his thoughts on the issue in 2009, when he wrote to his investors: “The size of the Fed’s balance sheet is exploding and the currency is being debased. Our guess is that if the chairman of the Fed is determined to debase the currency, he will succeed.”

In other words, don’t fight the Fed; it’s bound to win. And if it does, owning gold directly or through an ETF seems a very prudent idea.

As for the World Bank president’s aforesaid idea, don’t expect it to be taken seriously. There are too many powerful people who don’t understand gold or like its restrictions.

But that doesn’t mean the commodity loses any of its shine.

Disclosure: The author does not own positions in any of the stocks mentioned