QE3: A Properly Administered Currency Devaluation

By Lee Quaintance & Paul Brodsky, QB Asset Management

The following is the fourth in a series of posts by QB Partners. The third post is available for review here.

3. Devaluation & Transformation

The next global monetary system and the implications for assets and wealth

We debated whether to call Section 3 "Devaluation & Transformation" or ‘Transformation and Devaluation" because we could not be sure (or possibly know) which would be generally recognized first. We finally opted for "Devaluation and Transformation" because the world is already experiencing substantial currency devaluation. Currency devaluation is apparent through the process of prevailing inflation, even if the majority of economists and market participants are looking elsewhere. Transformation will come after this becomes more widely known.

The top graph below shows the percentage increase in prices for "the stuff we need" and the bottom graph shows the annual percentage change in the BLS’s CPI and the SGS Alternate CPI, which calculates the CPI as it was calculated in 1990. Shadow Government Statistics puts annual CPI growth above 10%.

In section 1 we criticized fractional reserve lending, which greatly distorts commerce, unfairly leads to inequitable wealth distribution within societies, and, in a debt-based monetary system, necessarily sows the seeds of monetary system demise. In section 2 we argued why commonly proposed solutions for a new monetary regime must fail because they do nothing to address the fundamental issue – overwhelming Western debt and the continued perpetuation of it. In section 3 we discuss the relevant issues that point to how a new monetary system will be constructed and we postulate how it may come to pass.

Monetary System Considerations

We think that once the existence and implications of widespread currency devaluation are widely recognized, the pace of devaluation will accelerate until the current system fails. The notion that following the collapse of the dollar system the world’s wealth holders and capital producers would accept another common debt-based currency in which to exchange capital and preserve wealth is highly unlikely. We think that when the dollar system fails it will have to be replaced by a hard money system.

First, we should all agree that there are two possible forms of monetary systems – one that is endorsed by the majority of major trade partners and one that is more disparate in nature, and therefore not a global system at all. The former naturally provides the world’s economic participants with more efficiency and transparent valuations for goods, services, labor and assets than the latter. So, the natural inclination of economic participants with a global purview is to gather around a form of currency that makes commerce efficient, less tribal. Further, governments like having taxing power over their citizenries, implying they are unlikely to accept as legal (for any extended period) a more random barter or black market system where willing counterparties privately exchange value "off the grid". Thus, we think there will always be a global reserve currency and a new one will be sought.

So then the problem before us is that the current system is failing, the public sector does not have a solution for it, and there must be a new global monetary system to take the place of the current one.

We expect the free market to set the future terms of global exchange. We do not write this out of ideology or hope but because it is the only possible way for necessary transformation to occur. As the current system breaks – whether acknowledged over time, through a sudden event or via official proclamation, wealth holders in all corners of the planet will set about finding value equilibriums for their assets and production. In fact the markets imply this has already begun. We would cite rising prices of precious metals and scarce resources in the face of "an uneven economic recovery" as the migration of wealth towards better warehouses of purchasing power.

Recognition as to the cause and impact of current trends seems to be broadening out and accelerating. At some point we would think that some stores of purchasing power will begin to rise parabolically in terms of existing currencies. Levered assets, offering negative real returns regardless of whether their prices may rise nominally, will lag. Some asset prices will no doubt fall in both nominal and real terms. We are highly confident this must occur. While we have quite a bit of conviction about various stores of value, how they will interact with events and with each other, and the path that events are likely to take; we have little conviction as to the timing of actual events.

Transformation – Official vs. Market Forces

We think the markets will continue devaluing various major global currencies as each comes under rotating pressure. The longer this lasts and the attendant higher the costs of goods, services and assets in all currencies relative to wages and output, the nearer we approach widespread confidence loss. Eventually, we expect the price function in the free market to break down, forcing the referees of the current system to call an official time out.

Though pressure to change the system should continue to build among global savers and in Western markets among investors, we think manifest transformation can only occur following a generally acknowledged crisis. As in 2008, we think policy makers will seek to return the markets to a state of "normalcy". Again, their only potential prescription would be money printing, yet this prescription would be the precise activity wealth holders would be rejecting. Thus, we think policy makers will quickly realize, if that do not know it already, that they are unable to mandate the value of goods, services, wages and assets via proclamation. It would have to be the other way around – the markets would have to determine value.

Only the private sector can decide how much a three-bedroom London flat is worth in crude oil terms, how much a factory full of Chinese workers is worth in New York private school tuition terms, or the value of Kansas acreage in Apple shares. When markets and economies seize, there will simply be no definable dollar prices at which a ’61 Lafite, a Pontiac and its parts, or a container of Bok Choy could be exchanged. We expect governments will be limited to trying to help the private sector sort out the means of quantifying that value. And so policy makers will only have input into defining the medium of exchange.

We have no doubt that some consumers and vendors will immediately try to begin exchanging value prior to official proclamation of a new medium. Value exchange might occur versus other goods, services and tangible assets (barter) or in terms of a medium of exchange in which counterparties feel reasonably sure will maintain purchasing power. However, the renewal of higher level commerce and trade may be a little trickier to jumpstart. A business inventorying barrels of oil would not be willing to exchange them for any amount of paper.

The important thing to keep in mind is that property will not necessarily change hands, especially if the transition is swift. We would wake up the next morning and still own our homes. Businesses that owned factories would still own them. If laborers had jobs on Tuesday they would have them on Wednesday, even if their bosses have no idea how to pay them. (Obviously, a lengthy, drawn-out process of declining confidence in currencies leading up to this period could elicit behavior that would affect property and production quite meaningfully.)

What we are discussing here is only a new way of measuring wealth and production, not the expropriation of them. If wealth and production are indeed transferred during this process then it will be the result of: 1) creditors legally enforcing their claims on distressed debtors; b) the market re-prioritizing its sense of value; and/or 3) governments using the transformational period to change laws and regulations that then serve to transfer wealth among economic actors (or towards governments).

Incentives suggest the time span to adopt a new system of value measurement would be brief. Otherwise black markets and bartering would gain influence and governments would lose control. This should make us optimistic that at some point a new way of measuring currency will come swiftly. We do not think international trade will stop for an extended period and we think the period of dysfunction will be relatively brief. There will be one new benchmark currency to take the dollar’s place and it will become obvious to all what it must be.

The Default Currency – Paper with Gold Backing

Gold has no mystical powers. Like today’s money, gold has very little intrinsic value because it does not provide its owner with much functional utility, apart from (cost-inefficient) electronic conductivity and a universal attraction to its aesthetic. As with paper money, one cannot eat it or use it to build shelter (although one could burn paper money to keep warm!). Gold is simply another medium of exchange that finds broad sponsorship when other media fail to provide sanctuary from purchasing power loss.

While gold advocates are quick to recount all the properties that make it the perfect currency (scarcity, divisibility, transportability, malleability, storability, non-corrosiveness, political impartiality, difficulty to counterfeit, fungibility, and redeemability), we think all such attributes will take a backseat to the one property that will make it the basis for the next monetary order – precedence. In an environment in which private sector counterparties are quickly losing faith (or have already lost faith) in all paper currencies and in which the political dimension is powerless to proclaim another baseless medium of exchange, all incentives will align towards expediency. We think it is highly likely that precedence and familiarity will make gold the default basis of the next monetary system, and that the mechanics of the next system will be modeled after the Bretton Woods Agreement.

Addressing Common Criticisms

Before proceeding, we are compelled to address a few common criticisms often levied against gold as a basis for currency.

Common Criticism: "There is not enough gold in the world to accommodate the size of the global economy."

QB: There is plenty of gold, at the right price, to accommodate the size of the global economy. In fact under a gold-exchange standard, only one ounce of gold would theoretically be sufficient because that one ounce is divisible. Paper currency would be distributed representing some increment of that one ounce. (The problem with one ounce in a straight gold standard would be redeemability.)

In its simplest theoretical form there can only be two identities that equal each other: the value of money must equal the value of all things not money (let’s call it "stuff"). Presently, all currencies including dollars and gold are competing components within the money bucket and everything else of value is in the bucket of stuff. An exchange of value does not have to use both buckets. In a simple example, one may exchange: 1) food for a blanket; 2) Euros for a business, or; 3) dollars for gold. The first exchange occurs completely in the stuff bucket. The second exchange pairs off value between the money bucket and the stuff bucket. The third exchange occurs entirely in the money bucket. This concept is logically profound and practical as a polestar for the relative value of each bucket to the other.

A preference for gold is an expression of the expectation for a devaluation of baseless currency vis-a-vis gold, given the aggregate exchange value of the stuff bucket. It is completely independent of widgets, farmland, and 25 year-old Scotch whisky. While the dollar price and gold price of such stuff changes, their intrinsic value does not. Unreserved credit denominated in dollars, yen or gold to date has merely distorted exchange values (and has done so in a cyclical fashion throughout history — e.g. the business or credit cycles). The aggregate value of the stuff bucket does not change but the intra-bucket exchange values do.

Thus, in a gold exchange standard the value of gold would have to represent the value of all goods, services, labor and assets in the world, the same way paper currencies do today. The relevant issue is not the size of the money bucket but its composition, and so the criticism that there is not enough gold to accommodate the size of the global economy is fallacious.

Common Criticism: "Gold as a basis for money is too inflexible to accommodate a dynamic global economy."

QB: The only reason to have gold as a basis for money is to enforce discipline on money lenders; they would theoretically not be able to lend out more gold than could be produced. So, the "inflexibility" that gold exacts is undeniable. In fact, that is the entire point.

It comes down to societal preference. A fixed exchange rate monetary system rewards real production and saving and penalizes leverage and political maneuvering. A flexible exchange rate system rewards the clever use of borrowed funds and penalizes savings and real production. We may all decide for ourselves which we prefer.

Objectively, it would seem that when one economy or economic bloc is at or near the top rung of the global economic ladder, then advocates for these economies should not want a dynamic global economy (who wants change when you’re at the top?). In fact it would seem that advocates seeking to perpetuate the stature of developed economies today would seek a shift to a fixed exchange monetary system, as doing so would lock-in systemic wealth.

Whether they know it or not, those expressing the common criticisms above are also expressing: 1) a preference for governments and banking systems to be partners in all exchanges of value, and 2) the continuation of current trends that are transferring aggregate wealth from developed economies to developing economies.

Common Criticism: ‘The gold standard was already tried and failed."

QB: The gold standard did not fail. The consistent failure has not been what backs (or does not back) money; it has been tolerating a system of fractional reserve lending that in turn allows lenders to cheat by creating and distributing unreserved net credit. This has perpetuated a debt culture of boom and bust. So, depending on your politics, either the public sector has repeatedly failed to adequately regulate lending, or private sector economic agents have repeatedly failed to recognize the real devaluation in their currency and have deserved to lose their purchasing power when busts have come.

Common Criticism: "In a modern economy, price deflation is death. Suppose you’re an investor and an entrepreneur comes to you with a proposal to build a factory, and the business plan shows next year the factory will cost 1% less to build and the products will sell 1% cheaper. Why build a factory today if you can get a 1% a year increase in purchasing power just by keeping gold in your mattress? You would need a very big or very certain return to lend it out or invest it."

QB: Exactly. Risk should be commensurate with reward. There should be no economic activity unless real sustainable margins support it. Using the example above, if enough decision makers delayed building factories it would be the result of genuine economics. This might mean that GDP might not grow and even shrink. So what? Affordability would increase in kind, labor would shift to where production is competitive, and the purchasing power of one’s savings would rise. The factors of production would benefit because efficiency would rise and labor would benefit because wages could be saved for future consumption.

Common Criticism: "Under a gold standard fewer factories would be built, real interest rates would be higher, and entrepreneurs and established companies would not have access to the cheap capital that generates high growth rates."

QB: And under a baseless money system we are seeing no factories being built, unreserved credit is inaccurately defining wealth, interest rates are negative in real terms, and the wealth gap is expanding as wealth is being transferred to economies actually producing capital. Under a sound money system (not only a gold standard but a more fully reserved lending system), the RIGHT amount of factories would be built, nominal interest rates would be low and real interest rates would be positive because there would be no inflation (the currency would retain its purchasing power). There would not be "cheap capital" or "expensive capital" – there would just be fairly valued capital.

Common Criticism: "When you get strong growth globally and a fixed amount of gold, you end up with not enough money to go around, and then a you have a banking crisis."

QB: At the right money/gold exchange rate there would always be the right amount of money, whatever that is. At equilibrium gold pricing, all debts would be fully reserved, which means that no new money need be created for the size of the economy. Banks only have crises because they issue more credit than they can cover.

We have noticed that the common criticisms of gold as the basis for a monetary system tend to confuse several issues, notably the relationship between quantity and price, the generational tendency to consider only nominal vs. accurately calculated real growth, and the misguided sense that arguing on behalf of the status quo serves the sustainable best interests of the West.

Gold – Stable Currency or Volatile Commodity?

In the West, gold continues to be largely misunderstood as a commodity implicitly dependent upon overall output growth, like consumable commodities. We think the process of buying gold in physical form or even buying mining properties is the process of converting one’s paper currency to hard currency. This act of conversion should be distinguished from the act of speculating on the future pricing of consumable commodities like oil, copper and wheat, which depend upon dynamic global supply/demand trends and shifting market preferences.

Despite a lot of chatter to the contrary, Western investors have virtually ignored gold. Less than 1% of all gold futures holders takes physical delivery. Thus, owning or shorting "paper gold" on liquid exchanges implies an accurate gold/USD exchange value for only about 1% of the notional amount traded. The barometer of gold’s complete value in US dollar terms is not determined by speculators with mismatched funding.

The value of other forms of paper gold may also be misleading. Gold ETFs total about 70 million ounces, or only about $120 billion and the aggregate market cap of gold and silver miners is far less than Google’s. The smallness of the paper gold market compares to about $26 trillion in global pension money alone – a sector that has dedicated only about 0.55% to precious metals expressions. If we include all investment portfolios, we get a commitment of just 0.15%. (If you like to round your basis points that would be 0%.) So for all the public clamoring, media attention and cheesy late night commercials looking to buy your gold, the yellow metal has not been endorsed by financial asset investors as a legitimate investment.

This may be entirely rational. We would expect that exchanges would close trading in such instruments during a period of chaotic transition. This introduces the risk of not being able to convert exchange-traded derivative paper to physical bullion. The necessary time span and valuation gap upon re-opening, and the unquantifiable means of settling all open-interest contracts and shares, would make such assets illiquid at the exact worst period for illiquidity to occur. And it seems entirely possible that there would be counterparty risk in all paper gold, even if such contracts are guaranteed by clearing agents.

We think it is accurate to think of physical bullion as a currency and equity in precious metal miners as sustainable gold investments. All other precious metal derivative forms, notably futures and equity-linked vehicles with pricing derived from futures, should be considered trading vehicles with limited range.

Physical bullion is held in strong hands, which has further implications for the future behavior of exchange pricing. Should fundamentals remain the same, commodity traders selling gold futures and equity traders selling precious metal ETFs should not be able to take exchange prices down in any great degree or for any length of time. (In fact it seems that many market technicians have recently learned that their charts are not applicable to precious metals.) There would simply be a supporting bid from official and private parties seeking to convert paper currencies into bullion.

We would argue that central banks and state-owned investment authorities holding trillions in paper dollar reserves and obligations have an ongoing bid that is relatively insensitive to exchange pricing. (The amount of gold that one may actually take delivery of from exchanges is very small at current pricing. By implication, if a central bank or monetary authority were to try to take more than is typically delivered then the exchange price would rise materially.) The large global currency converter is far more concerned with fundamentals, has deeper pockets, and therefore has far more staying power in their positions. (Perhaps this explains why policy makers from all sides are taking their time?)

Gold futures and other "paper gold" being priced on global exchanges, as well as other derivatives being priced off of them, do indeed seem to have an element of speculation among participants today, most of whom may not understand the factors that ultimately define the merits and risks of their speculations. If they did understand, we argue they would: 1) not see gold as a hedge against a rising CPI but as a hedge against the global deleveraging process; 2) bid prices much higher than where they are today, and; 3) take delivery of physical bullion rather than rolling their contracts.

When the exchange price of gold rises or falls on any given day, we think it is most accurate to think of this activity as the value of dollars falling or rising as the market continually handicaps the likelihood of the dollar’s viability. (We argue later that the market has mispriced not only the potential but the current terminal value.) Of course this is subject to being gamed by large global players. Every day the London fixing declines, those with access to physical bullion may purchase it at lower levels.

Nevertheless, whether the result of intuition, the slow absorption of sound logic coming from independent analysts, the lack of obvious investment opportunities in more familiar industries, low interest rates and therefore little opportunity-loss from not being invested in income producing assets, or the seasoning that only a multi-year established bull trend can offer, gold seems to be losing some of its Western stigma as the sanctuary of uneducated hillbillies toting around shotguns and Spam. Right or wrong, global central banks and many of the world’s most sophisticated wealth holders have begun accumulating it.

We think there is quite a long way to go before the broader population of financial asset investors internalizes relationships that makes them able to analyze whether gold, as a hedge against the deleveraging process and as a store of purchasing power, is prudent. And regrettably, there seems to be very little chance that the broader population will ever know. We taped an interview on a major network news show last year and after going through what we thought was a 45-minute cogent explanation of the fundamentals driving gold prices higher, we were amused and saddened by one of our lines they chose to air — "I like shiny things."

Natural Devaluation

You can’t fool Mother Nature. The process of diminishing purchasing power in a currency is the process of currency devaluation. Natural forces are leading the US dollar, and therefore all other global currencies, to be devalued vis-a-vis gold.

The graph below shows that the devaluation process is already well underway. A graph of rising gold prices expressed in various global currencies illustrates the degree to which wealth holders have been exchanging their home currencies for a more sovereign one. It takes many more US Dollars, Aussie Dollars, Euros and Yen to purchase an ounce of gold than it did a few years ago. Again, one may either think of this as the price of gold rising in various currency terms or the value of currencies falling in gold terms. The net effect is the same: baseless currencies are uniformly being devalued against gold. Those that converted at higher exchange rates (lower gold prices) have more purchasing power today as a result.

Thus far, devaluation has been slow and orderly. The price of gold has risen steadily since 1999, not coincidentally commensurate with the credit-generated peak in corporate equity prices. It made perfect sense to ignore gold from 1981 to 2000 in favor of a strategy of borrowing – outright or implicitly — to buy financial assets. The time until the private sector credit build-up would end (2006) remained far away and the current returns from financial assets were too great to ignore. In their blow-off phase from 1995 to 1999, corporate equities generated positive real returns even when deflated for credit growth. It would have been irrational to own gold.

After the corporate equity bubble burst in 2000 and credit migrated to real estate, it became entirely logical for gold to begin rising in anticipation of its bust. Unlike stocks, real estate prices were lifted by a self-generated multiplier effect. Fed models implied no need for tighter credit because it seemed that balance sheets were in equilibrium – assets and liabilities were ostensibly increasing in tandem at a sustainable rate. However the universe of bond buyers was uninterested in the absolute level of credit. The only thing that mattered to buyers of residential and commercial mortgage-backed securities was the spread between their funding levels and the income from their assets. The Fed was oblivious to the systemic duration and credit mismatch it was creating. Gold was not. The credit bubble would eventually have to burst and money would have to be manufactured.

Today, gold continues to creep higher in all currencies as it discounts the necessary de-leveraging. Obviously, there must be items off which the currency in question loses its purchasing power. Gold has always been the currency of last resort if and when baseless currencies stumble, and so it is the currency against which all others are being devalued today. We are in the second inning (baseball, not cricket) of the de-leveraging process. The process of devaluation has just begun in terms of magnitude. After it becomes obvious to all that money printing does not retire debt, the most expedient means of de-leveraging the system will be pegging money to an asset.

The Shadow Gold Price (SGP)

When we opened our Fund in February 2007, we had a very high level of conviction that gold was cheap in fiat currency terms. However, as former bond traders, we struggled with finding a framework in which we could define "fair value". The massive dose of central bank money printing in 2008 provided us with inspiration. The fair value of gold would have to be the price at which its aggregate value would back all outstanding baseless currency — in effect, the price at which debt-based currency would be transformed into asset-backed currency.

In a report distributed to our investors in December 2008 we divided Federal Reserve Bank Liabilities by US official gold holdings and dubbed it ‘The Shadow Gold Price". A few months later we began using the more conservative denominator, the Monetary Base, in our calculation. As it turned out, dividing the US Monetary Base by US official gold holdings happened to be the very formula used in the Bretton Woods system to establish the global fixed monetary exchange rate. Our logic was confirmed by long convention.

Under the Bretton Woods Agreement, the fixed conversion rate was mandated to equal $35.00 per ounce, the gold-implied price at which all currencies would be exchangeable for dollars. If the Fed were to print too much money, then holders of dollars or any currencies exchangeable for them could exchange their paper for gold at $35. If, theoretically, the Fed were to drain reserves, then holders of gold could exchange it for dollars. In this system, dollars and/or gold would theoretically retain their purchasing power. (Again, the reason for a fixed- exchange monetary system was to instill discipline on politically-motivated money creation so that the purchasing power of money could be sustained.) Given the amount of money printing and devaluation that has already occurred in dollars and all other global currencies since the demise of Bretton Woods, it is obvious that gold could no longer be priced at $35.00.

The "Flat" column in the table above shows our current SGP, which implies the substantial devaluation of purchasing power of the US dollar that has already occurred. Are we nuts? Are we asserting gold should be valued at $10,000/ounce when it is trading around $l,500/ounce in London and New York?

The SGP’s purpose is to provide a sense of magnitude as to how much the US dollar has already been devalued and how much further it may be devalued. (Obviously there can be no guarantees about future pricing.) We believe the Shadow Gold Price provides the intellectual framework for the magnitude of necessary future global currency devaluation. We feel most comfortable with this metric for two practical reasons: 1) there is recent precedent for its use and 2) it actually produces a lower figure than other valuation metrics that include systemic credit in their calculations.

Official Devaluation Done Right

In Section 2 we included "Official Devaluation Done Wrong". There is a more reasonable solution to the current debt fix that could be adopted immediately (or following a crisis when policy makers have enough political cover). This solution would place the global economy on a sustainable economic path and we are also confident that the masses would gladly endorse it.

We would think the actual process would theoretically look something like this:

• The Fed would enter into an agreement to purchase Treasury’s gold stock. Every Federal Reserve Note created to purchase this stock would be inflationary (additive to the existing stock of base money). (As an important aside here, much of the stock of US Treasury debt could be retired with these proceeds.)
• The Fed would then tender for any and all privately-held gold up to its established target price.
• If no privately-held gold is tendered, the expansion of the base money stock is limited to that created and swapped with Treasury in exchange for its gold. If, on the other hand, privately-held gold is swapped to the Fed, then the base money stock grows commensurately. Clearly, the trick for the Fed would be to find the "right" gold price that would increase the stock of base money by a notional amount targeted by the Fed. This, at first, would not be easy.
• The Fed would engage the private market in order to establish the credibility of the dollar’s new "gold- backing." Otherwise, confidence would become uncertain again. It would not be enough to simply claim gold-backing – the Fed would have to establish a market-clearing gold price in order for its newly- orchestrated policy to be credible.

Practically, we would expect the following three-step process:

1. To remediate all past monetary inflation and reset the global monetary regime, the Fed would tender for privately-held gold at or near the Shadow Gold Price (currently about $10,000 / ounce).
2. As the Fed purchases gold, the gold would flow to the asset side of its balance sheet. The Fed would fund those purchases through newly-digitized Federal Reserve Notes, which would flow to banks in the form of net new deposits. This would be a discrete monetary inflation event (devaluation) and a simultaneous deleveraging.
3. Once the Fed acquired enough gold from the markets, a gold price peg for the US dollar would be established.

Would this be a gold exchange standard? Yes, if that nominal exchange value is maintained in the open market by the Fed. No, if the Fed decides to periodically adjust the benchmark gold/USD exchange rate following the original exchange. Tinkering with the official gold price would be a pure example of a monetary agent conducting monetary policy (as opposed to targeting the Fed Funds rate as they do now, which in reality is executing credit policy, not monetary policy).

We think this operation would be seen as credible by the markets and by global economic policy makers. We further think some form of this operation will be done, whether the result of market-forced crisis response or, less likely, preemptive policy.

Inflationary or Deflationary?

If the US unilaterally devalued the dollar to gold and then fixed the price, would it be inflationary or deflationary? We think the answer to this question is entirely a function of the price peg level selected. If it is set too low it would ultimately be deflationary and if set too high it would ultimately be inflationary. Because the markets would be keenly aware of the immense gap separating the total stock of unreserved debt outstanding from the base money stock, (a direct function of the size of the Fed’s balance sheet). The Fed would have to accommodate the markets.

As we discussed in Section 1, when a modern bank makes a loan it is really loaning money today that will not exist until the Fed creates that money tomorrow. This game of "catch up" creates a "synthetic dollar short". So, if one concludes that the Fed must continue to aggressively expand the monetary base in order to re-establish and/or maintain the solvency of the banking system, then a much higher gold price is ultimately called for should the Fed look to back the dollar with the existing Treasury gold stock.

The current gold price necessary to simply reserve the existing stock of base money is almost $10,000/oz. pro forma for QE2 and correspondingly higher than that if more QE is coming. (We think there will be more whether it continues to target US Treasury obligations or, ultimately, gold. If we are right then this would imply ultimate reconciliation would be sooner rather than later, as the Fed is holding a burning match. The longer it delays, the higher the gold price would have to be.)

So it seems highly unlikely that any mechanism enacted to back the dollar with gold could be deflationary today. That said, if the price level peg is too low, what is inflationary at the margin today may be insufficient to retire the unreserved debts due tomorrow. In our view, this peg would have to be somewhat dynamic at the start until a true equilibrium ratio of base money to debt can be found.

The mess that we call a modern banking/monetary system took many years to create. We think a rational framework to re-establish long term equilibriums tomorrow will take much iteration before some sense of balance and stability is ultimately achieved.

Consequences of a Properly Administered Currency Devaluation

The benefits of such a properly administered formal devaluation would be immediate and profound to debtor economies. Global debtors would welcome it. The majority of people in developed economies are deeply in debt vis-a-vis the liquidation values of their assets. In practical terms, nominal wages and asset prices would rise following the devaluation while the notional principal balances of debt would remain constant. The burden of repaying debt would thus be greatly diminished, not the principal amount debt itself.

This would mean that banks and their shareholders, (that tend to be concerned only with nominal asset prices, revenues and earnings), would be relatively unaffected. In fact, the true solvency of Western banking systems would be reestablished because most bank assets would appreciate in nominal paper money terms sufficient to once again secure loan books.

Creditors and paper cash holders would suffer, including bondholders, savers, retirees, and foreign dollar reserve holders. But this may not be as painful in practice as it may first appear conceptually. Many individual bondholders are also asset holders that would benefit from a nominal shift higher in asset prices and improved nominal creditworthiness of their bonds. As with banks, lenders in the securitized shadow banking system such as pension funds would also benefit from the rising ability of debtors to repay their obligations.

Pensioners, on the other hand, would most certainly find that while the bonds their pension funds own have suddenly become "money good", they will be paid with bad money (already devalued). However, they too would benefit from the broader process of devaluation because their home or corporate equity would be more likely to rise. Additionally, it would seem inflating away the burden of repaying debt today would be far more beneficial to them, as it would act as a substantial economic stimulant. As for net savers, there are very few of them today in the United States. Cash balances are held against debt balances and levered financial assets. As for retirees living on fixed-income, we would presume fiscal programs coincident with a formal devaluation would somehow compensate them for lost purchasing power from the devaluation.

There is no way to sugar coat the fact that foreign dollar reserve holders would see a significant loss of purchasing power in their reserves. We may put our consciences at ease, however, by suggesting that the cost to them of devaluation is the price exacted for US consumers subsidizing the build-out of their economies. In the case of China, the West bought their exports on credit, which allowed them to convert to more market-oriented economies and build out their infrastructures.

Dollar devaluation would equilibrate global wage rates. Labor in debtor nations would become competitive with those in lower-cost exporting nations, which in turn would bring trade more into balance. Having a sound currency would allow prices to fall without having a deleterious impact on employment because affordability would rise in kind. Workers would naturally migrate where opportunity lay. This would naturally diversify the factors of production in the West back towards manufacturing, which in turn would greatly increase employment sustainability. Critically, workers would be able to save their wages rather than having incentive to consume more than they need or desire, or to speculate on over-levered assets.

The only reason we can think of that the United States would not eventually opt to sponsor an official dollar devaluation is because Treasury does not hold the gold it claims. But we do not see that as an issue. The United States holds the most valuable asset in the world…by far.

The full paper is embedded below