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.
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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.
Sources
What is the G-20 – Official G-20 Website
Bretton Woods system – Wikipedia
Fiat currency – Wikipedia