A New World Order

UPDATE: 19 MAR 2010: Given the debate on China and its currency peg, I thought this post from November 2008 would be relevant. It called for a new world order centered around a new monetary system. This idea has gained some currency as it is a chief aim of the Chinese going forward.

One big problem with the present set up is the Triffin Dilemma. The dollar’s role as a national currency with any domestic agenda of a balanced current account is fundamentally at odds with its role as the world’s reserve currency.  Especially post-Asian crisis, the desire by many was to accumulate US dollar reserves and that means running a capital account deficit/current account surplus with the US.

The current account imbalances become problematic during downturns and lead to protectionism, as I argued in my third post at Credit Writedowns just over two years ago. Below, I argue that only true economic turmoil and depression will bring people to the table.

The original article is below, posted on 12 Nov 2008 at 11:00. A good related article is The ultimate G-20 plan for a new monetary system: Paul Davidson

This Friday and Saturday, the leaders of the world’s largest nations are to meet in Washington at a summit of the G-20 members in order to develop a framework for extricating us from the worst financial crisis in 75 years. Expectations are not high. Although the crisis threatens to deepen, most pundits do not believe the G-20 can agree because their national agendas are so different.

Right now, we are presented with an historic opportunity to create a new economic world order. However, it is unlikely that this opportunity will be seized. Failure could mean a more severe crisis and economic chaos of the most severe kind. In this post, I will explain what sort of an agreement could work to restore some semblance of order and whether we may ultimately get to this framework.

Much of what I write here regarding fiat currencies, gold and inflation is unknown to the public at large even though the information is freely available. If more people informed themselves about economic history, we would be much better off economically.

Who are the G-20?

The G-20 is generally used as a proxy to represent the most inclusive list of the world’s economic leaders. It is not all encompassing — large, rich countries like Spain are not represented. However, it does bring together most of the major players. Below is a description of the organization from its own website.

The members of the G-20 are the finance ministers and central bank governors of 19 countries: Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, the United Kingdom and the United States of America. The European Union is also a member, represented by the rotating Council presidency and the European Central Bank. To ensure global economic fora and institutions work together, the Managing Director of the International Monetary Fund (IMF) and the President of the World Bank, plus the chairs of the International Monetary and Financial Committee and Development Committee of the IMF and World Bank, also participate in G-20 meetings on an ex-officio basis.

Therefore, a meeting of this group should be of great significance and lead to major outcomes to set us on the right path to dealing with the credit crisis. However, I am less optimistic about the prospect of a meaningful agreement toward eliminating global structural imbalances. Many nations have a vested interest in maintaining the status quo – the United States principal amongst them. Moreover, the U.S. is led by an administration that is just 2 months from its end. And, we probably have not seen enough carnage to force the relevant parties into developing a new framework. This will only happen at a figurative economic gunpoint.

The existing global economic framework

The existing economic structure came into being as a result of a 1971 decision by the Nixon administration to close the gold window ending the Bretton Woods framework that had lasted from 1944. This framework is based on floating exchange rates with the U.S. Dollar acting as the system’s effective anchor and world’s reserve currency.

What the U.S. dollar as the world’s reserve currency has meant is that the United States Government effectively sets the standard on monetary policy. Other nations, holding most of their reserves in dollars, must follow the U.S. if they want to maintain a relatively stable currency peg to the U.S. dollar. And, that gives the U.S. government a license to print money and inflate. Therefore, the United States benefits the most from the current global system.

Before 1971, the United States Government was constrained by a fixed peg to Gold. In fact, this peg was set at $35 per ounce and the United States pledged to redeem any dollars presented to it by foreign central banks for gold. This effectively meant that an arbitrage situation existed where foreigners could hold the U.S. dollars in reserve if they felt those dollars were worth $35 an ounce. Or they could exchange their U.S. dollars for gold. If the United States ran an inflationary monetary policy, foreign central banks would lose confidence in the dollar and redeem their dollars for gold, stripping the U.S. coffers of all its money.

The problem for the United States was that it wanted to spend more money than it had. All governments, left unchecked, will spend to their hearts content. In the 1960s, the U.S. government ran a "Guns and Butter" policy of increasing spending domestically while increasing military spending to fund the war in Vietnam. The Johnson administration did not want to increase taxes, so the U.S. inflated the money supply by printing more dollars. Foreign central banks started to become suspicious and eventually the French under the often anti-Anglo-American Charles de Gaulle started to redeem its dollars for gold.

However, excess U.S. Government spending and the Vietnam War continued into the Nixon Administration and on August 15, 1971, Richard Nixon closed the gold window. The U.S. went off the gold peg and a floating currency regime came into existence.

The current regime has meant inflation

After the U.S. de-linked from Gold, it was free to inflate as it pleased. However, there were nasty consequences: oil prices rose, commodity prices rose, gold rose, inflation rose, and the dollar fell. During the 1970s, the new economic regime meant a period of severe weakness for the U.S. dollar and the U.S. economy.

This period ended when Paul Volcker became the Chairman of the Federal Reserve Board in 1979 and proceeded to hike interest rates to unseen levels above 15% — which is unimaginable when compared to the 1% we see today. The result was a severe double-dip economic recession and stock market crash. But, the most important result was Volcker crushed inflation, setting the stage for an historic bull market during the 1980s and 1990s.

While Volcker’s drastic actions were laudable, it did not stop the U.S. Government’s urge to inflate. We were living in a world of fiat currencies. With the U.S. dollar still the world’s reserve currency, the U.S. was free to run budget deficits, trade imbalances, and inflate. So it did.

Unfortunately this inflation was not the consumer price variety that we had seen in the 1970s. As the United States deregulated, as the U.S. government privatized and as U.S. industry moved overseas, inflation was seen mainly in asset prices.

Moreover, when the stock market crashed in 1987, the Federal Reserve learned that monetary easing can work wonders in helping ease crisis. As a result, the Federal Reserve under Alan Greenspan developed an asymmetric monetary policy that flooded the economy with money whenever crisis or recession became a threat.

So, as the 1990s took shape, the world was awash in dollars. These dollars funded severe asset price inflation, not only in the U.S. but abroad, leading to severe boom bust cycles in Mexico in 1994-1995, Emerging Asia in 1997-1998, Russia and Brazil in 1998. And Argentina at the beginning of this decade.

The emergence of China as a deflationary counterweight to the United States was also helpful in maintaining consumer price inflation at low levels as China used a beggar thy neighbor currency policy which allowed it to become the producer of choice and export low cost goods to the rest of the world.


The end of the super bubble

All of this produced a certain sense of Nirvana for many for a very long time. However, underlying this were massive trade, currency and fiscal imbalances and a shed load of debt. It is the debt that tells one we have been experiencing inflation. All measures of debt and deficit in the United States have been rising for nearly a quarter century to levels never witnessed in history. Only recently have we again started to witness consumer price inflation from this underlying monetary inflation.

However, the credit crisis has interrupted this whole process. We are witnessing the most severe financial and economic crisis in three-quarters of a century. This in large part because the financial system had become so unstable that more debt and leverage just was not possible. In essence, the subprime housing crisis was a trigger for massive deleveraging globally. Nevertheless, monetary authorities are doing their level best to save this fiat currency monetary system by flooding the world with money – so much so that they must hide the mechanism behind this reflationary effort. I am skeptical as to whether they will succeed.

What the world needs now

We need an end to fiat money. Fiat money is what has caused the U.S. to inflate. And it is what has caused a massive super bubble and build up in debt.

If you go back in economic history, there have been numerous attempts to issue fiat money — money based only on the promises of the issuer. Every single time, these monetary regimes have failed. In the United States, many states issued their own money in the 18th and 19th centuries. But, the temptation to inflate was too great and these regimes failed too.

In order to promote stability, money must be backed by something of value like gold. Gold is a valuable commodity in limited supply. Because the supply cannot be increased, money supply cannot be increased excessively when the currency is backed by gold. Otherwise one runs into the problem that the U.S. ran into when it closed the gold window in 1971.

It also must be noted that the limited supply of gold is critical. If you look back in time to the 16th century, the Spanish economy went off the rails after it started to import lots of gold from the new world. The Spanish were the world’s superpower at the time. They found lots of treasure in the new world, particularly gold in the Incan empire. While stealing gold from the Incas seemed a blessing, it was a curse in disguise for Spain because it inflated the money supply, resulting in severe inflation in the Spanish economy and eventually economic collapse and ruin.

However, there is one problem with the gold standard right now: prices. The Federal Reserve has gold holdings of about 286 million ounces. However, the Fed has been inflating their balance sheet at an unprecedented rate to deal with this crisis. The Fed’s balance sheet liabilities were $900 billion in August. They are now approximately $2 trillion and well on their way to $3 trillion by the end of the year.

Therefore, the U.S. dollar would have to be pegged to gold at over $7,000 an ounce and as high as $10,000 an ounce. Gold trades around $700 an ounce in the open market. In a recent paper, QB Partners has also done the math for other currencies as well.

Aggregating the gold holdings of the ECB and the legacy central banks that comprise the Eurozone would imply a $6,300 gold price. Again using the Bretton Woods system as a model, the U.S. dollar and Euro might be designated as “global reserve currencies” because they could most easily be converted to gold. The remainder of participating global currencies could then be made exchangeable into U.S. Dollars/Euros at fixed, but amendable rates (floating foreign exchange rates).

The trickier part of converting paper currencies to a global gold standard would be persuading economies with high paper currency-to-gold ratios. Their paper currencies would suffer devaluations versus currencies with higher gold reserves. For example, the Japanese Yen’s gold price equilibrium would equate to nearly $40,000/ounce when calculated against the Bank of Japan’s gold holdings and the Chinese Renminbi’s gold price equilibrium would equate to about $117,000/ounce when calculated against the People’s Bank of China’s published gold holdings.

This makes a gold standard rather untenable. Moreover, the U.S. and the U.K., with high debt levels, are two economies that want to inflate in order to reduce the burden of their debt loads as everyone de-leverages. China, Russia, Brazil and the Middle East, with massive dollar reserves, have zero interest in going to gold because it would mean an enormous economic loss for these countries holding dollars.

So, my conclusion is that there can be no agreement to solve this crisis until we have a global economic shakeout, forcing the various interested parties to the table. In all likelihood this would mean severe economic turmoil and depression unless the monetary authorities can successfully reflate our way out of crisis. So, we will get a new world order only by plumbing the depths of a depressionary crisis or through the successful efforts of central banks to inflate their way out of trouble. And, if we want a new world order, it likely will need to be based on another tradeable asset in limited supply besides gold.

Whether we experience depression or see a successful reflation effort, the future after the crisis looks to be one predicated on much debt. De-leveraging will continue apace for some time and that is a very good thing.


What is the G-20 – Official G-20 Website

Bretton Woods system – Wikipedia

Fiat currency – Wikipedia

  1. Stevie b. says

    “Any thoughts on green currency?”

    If only I was that smart!

    But for starters maybe some currencies could become green currencies and gain some credibility by taxing all carbon at much, much higher levels. Economic revival could stem from a rush to alternatives to avoid the tax. It may not be pretty in the short-term – we’d all suffer and e.g. airlines might just suffer a bit more than many. But hell, we’re all going to suffer anyway and we need some sort of a Plan”B”.

  2. Stevie b. says

    Ed – thanks for the effort of this post. Seems like “they” will keep trying to make the existing system work until it seizes-up from extreme exhaustion. You’d think that gold has to play some sort of at least partial part eventually, not because it works but only because there seems nothing else that’s remotely credible.

    Perhaps we need to think outside the box. Perhaps we can create some sort of green currency based on progress towards a carbon-free future? Have you any ideas what the non-gold parts of the puzzle could be?

  3. Edward Harrison says

    Hi stevie b,

    you are right. we are going to defend the current system until we get either inflation or depression.

    If I am proven wrong and we do get these people to sit down at the table, the question will be what role could gold play. As you can see, it is a bit of a problem that we have inflated so much relative to gold. Basically, for Gold to work, we would have to see either a massive monetary contraction or a massive increase in the price of gold or both.

    I have been trying to think outside the box as to what else could replace gold. Can’t be real estate as that’s not tradeable. Can’t be oil as some have much more than others and you can increase the supply of it.

    Iron, Silver, Platinum, Palladium? I mean the only thing I am coming up with is commodities.

    And if we did start a new world order, we might have to shift around the supply of this stuff because, as we saw from the gold reserve example, some have a lot more than others: South Africa and Australia, for example.

    In the end, I always come back to gold, but I can’t fathom backing the dollar at the levels I just mentioned.

    As to what other alternatives there are, I’m tapped out. Any thoughts on green currency?

  4. Wag the Dog says

    I’m a relative newbie regarding monetary systems, but the ideal case seems to be that money supply should closely match productive capacity.

    Is gold really a good proxy for productive capacity? Wasn’t money already backed by gold prior to the Great Depression? It would seem that one would need to overhaul fractional reserve lending as well. Usury reform? Charging interest to be considered sinful once again?

    If only there were such a thing as an all knowing oracle that could expand and contract the money supply exactly as needed. Then the solution posed in Paul Grignon’s “Money as Debt” might actually be feasible.

    1. Anonymous says

      Interest rates guides capital. Low interest rates, or zero interest rates would be used more for non-productive activities. Credit has scarcity. If credit is opened to less productive activities with low interest rates, it crowds out credit being used for more productive activities, and productivity requires more resources than unproductive activity, and no, the gold standard wasn’t responsible for the Great Depression.

  5. Edward Harrison says

    The Gold Standard was not responsible for the Great Depression, although this is often said.

    The truth is that if the economy grew at 3% per year, this would translate into an appreciation of the currency of 3% vis-a-vis gold without the need for more gold to back the currency. Gold is merely a store of value. It has no other purpose except to allow arbitrage opportunities, which in turn rein in spending and inflation.

    The problem with gold is that inflators experience serious pain once they have to devalue because gold restricts their ability to further inflate. this isone reason countries abandoned the gold standard during the depression. see this article:


  6. Francois says

    Brilliant post!

    Looking at this from a different but related angle it looks to me like this:
    1. The debtors (US et al) want to maintain their hegemony by inflating their debts away so they can keep borrowing.
    2. Up and coming actors (China et al) want to become more powerful by
    subjugating the powers that be via aggressive industrial policies subsidized by exchange rate manipulations.
    Looks to me like we’re in for some major global dramatic developments in the near future.

  7. gnk says

    Great Post Ed.

    Jim Rickards (on King World News) recently mentioned the possibility of gold’s role in a new global monetary system with the G20 playing a greater role.

    I am inclined to think that gold will be used in the new monetary regime. Let’s just look at the actions of the global players, as opposed to reading their words.

    Central Banks have become net buyers of gold. India, China, and Russia are in gold accumulation mode. The Chinese need gold to stay at a low price during their accumulation phase. They are buying gold below market value from their own producers, and China has told their population to accumulate gold – why? They know that one day they will need to pull an “FDR” and take it. And then they will announce to the world that they have 4 thousand tons (or more) of gold. India will do something similar, but lacking domestic production, they will buy from their own people. Asking the Indian population to buy gold however, is like asking a fish to swim. No need for a pr campaign there.

    Europe and the US have drastically decreased their sales of gold, if they ever sold meaningfully at all. There is an obvious trend here… the preparation for the endgame.

    And one can’t leave out Soros either… the master of shorting currencies. This old fox is preparing for the greatest trade of his life. And being about 80yrs old, he is for sure taking his vitamins and staying healthy to experience the greatest trade of all, his magnum opus – when the 40 yr old experiment in pure fiat ends in a massive collapse to usher in the new era.

    But back again to his “ultimate bubble” quip. He knows that the world has gotten extremely crowded, that one part of the world can no longer consume a disproportianate amount of resources at the expense of others due to the manipulations of fiat and credit. He also sees the migrations of past bubbles that are ultimately leading to the greatest bubble of all to date, sovereign debt.

    Fiat distorts, it favors, it disfavors, it controls – unfairly so. The only debt free and (relatively) manipulation free and lasting thing is gold. Paper has failed. To allow the IMF to create new paper is recycling a failed experiment and opens the door for future control by conflicted sovereigns. Gold is objective and the only thing that sovereigns will ultimately, and begrudgingly agree on.

    But back to Soros. There is one more nuance to his “ultimate bubble” quip. Ultimate is the largest of a progressively larger series of bubbles. But it is also the end. There is nothing after “ultimate” – it is final. When gold reigns, the era of speculation is over. Speculation relies on rampant debt and fiat. Hedge funds, mutual funds, day traders et al, all rely on excessive debt to grow. That too will correct. It will not end completely, but I see a day when having a sizable trading account will be an extreme luxury. Therefore, the massive debt fueled fiat system that not only drove overconsumption, overindebtedness, and misallocation of capital, but also the flip side of that same coin – oversavings and overspeculation – will end – and thus too, will the era of bubbles – and I mean significant, global bubbles.

    We live in a finite world, and we are just finding that out. The size of the dinner table has not grown, but the amount of chairs at that table has. Either we resolve this thru conflict – war – or we resolve this thru grudging cooperation. Those are the only two coices we have. Moving to Mars is not an option right now.

Comments are closed.

This website uses cookies to improve your experience. We'll assume you're ok with this, but you can opt-out if you wish. Accept Read More