In this Edition
On multiple fronts there appears to have been a resumption of hostilities in the global currency wars. A subtle indication of this is the recently released report, Gold, the Renminbi and the Multi-Currency Reserve System, which I believe is highly significant for two reasons: First, it demonstrates that major global actors are now keenly aware and frightened of the possibility of a major breakdown in international monetary relations. Second, it suggests that these same actors are trying to contain the growing demand for gold as an alternative reserve asset and pre-empt an uncontrolled gold remonetization. These efforts will fail. A collapse of the current, unstable global monetary equilibrium is inevitable. Recent events indicate that the countdown has begun.
Breaking the Cease-Fire
Curiously, in the second half of 2011 and through most of 2012, notwithstanding the escalating euro-crisis, US ratings downgrade, Japan’s protracted nuclear disaster and sharply divergent global growth rates, there was surprisingly little volatility in foreign exchange markets. EUR/USD traded mostly in the historically narrow range of 1.40-1.25. USD/JPY was in a range of from 76-82. The Chinese renminbi held between 6.4 and 6.2. GBP/USD moved within 1.54-162. The Swiss franc was also steady at around 1.20 versus the euro, although this was the result of an explicit Swiss policy of capping the franc at that level.
In retrospect, it appears that this period was characterised by a general ‘cease-fire’ in the global currency wars ignited by the global financial crisis of 2008.[1] Rather than attempt directly to devalue currencies to stimulate exports at trading partners’ expense, the focus during this period was primarily on measures to support domestic demand.
There has now been a resumption of hostilities. The first shots were fired by the Japanese, where national elections were held in December. The victorious LDP party campaigned on a platform that, if elected, they would increase the powers of the Ministry of Finance to force the Bank of Japan into more aggressive monetary easing. The LDP also has voiced support for either a higher BoJ inflation target or a nominal GDP growth target.
Combined with poor economic data, this had a dramatic impact on the yen, which has subsequently declined by about 10% versus the dollar and 15% versus the euro. This is the weakest the yen has been in broad, trade-weighted terms since 2011.
Now it is understandable that Japan should desire a weaker yen. Japan is no longer running a trade surplus, in part because it is importing a record amount of energy following the decision to scale back the production of nuclear energy. Moreover, demographics are such that the proportion of retired Japanese is growing rapidly. As Japan’s ageing population draws down its savings to fund retirement, this implies that Japan will be saving less and consuming more relative to the rest of the world.
But while Japan has an interest in a weaker yen, many other countries have an interest in weaker currencies too. Much of Asia has been following a classic, mercantilist growth model ever since the Asian credit/currency crises of 1997-98, seeking to export more than they import. They are still inclined to follow this model, as it has succeeded in the past.
Of course it is impossible for all countries to be net exporters. The US is by far the world’s biggest importer. But given structural economic problems and associated high unemployment, US policymakers also have reasons to desire a weaker currency to stimulate exports and jobs. Much the same is true of the UK, arguably the leading candidate for the next big devaluation. Then there is the euro-area, which is suffering under a huge debt burden and desires to stimulate exports abroad to offset ‘austerity’ at home.
The BRICs (Brazil, Russia, India, China, South Africa) and other developing economies are well aware of mature economies’ problems and do not want to be the ones that pay for what they perceive, quite justifiably, as economic hypocrisy. Just who has been living beyond their means? Who has been borrowing and consuming, rather than saving?
It does, of course, take two to tango. The BRICs have been financing mature economies’ largesse—including financial bailouts—with their surpluses. But as the BRICs have stated on multiple occasions, they would far prefer for the developed economies to take their necessary economic medicine at the local, structural, supply-side level rather than to try and pass the pain of adjustment off on them.
A recent sign of such concern includes some rather provocative statements by Russian central banker Alexyi Ulyukayev. Russia is currently the Chair of the G-20 countries who seek to cooperate on global economic matters. Back in 2009 the G-20 agreed not to engage in competitive currency devaluations. Well they’re not exactly cooperating at present according to Mr. Ulyukayev, who has specifically accused Japan of breaking the cease-fire: “Japan is weakening the yen and other countries may follow,” he said recently. South Korea, one of Japan’s closest competitors in several major industries, has warned of possible retaliation for the weaker yen and both South Korea’s and Taiwan’s currencies weakened sharply this week. Even Norway, with a healthy economy at present, has recently indicated that it is concerned by the strength of the krone.[2]
The sad fact of the matter is, currency wars (ie competitive devaluations) are ‘zero-sum’ at best. At worst, they severely distort global price signals, thereby misallocating resources, and eventually morph into trade wars, in which economic protectionism destroys the international division of labor and capital, making economic regression all but certain. The 1920s/1930s are a classic case in point but there were similar such episodes in the 18th-19th centuries, the era of mercantilist economic policy debunked by, among others, Adam Smith and David Ricardo. (While the classicists were right about mercantilism, it should be noted that classical economic theory is deeply flawed in key respects.)
Given the destructive power of currency and trade wars, it should come as no surprise that policymakers in the developed economies are increasingly desperate to find a way to de-escalate and contain the conflict. But is this possible?
Is the OMFIF Report an Olive Branch to the BRICS?
Perhaps the best indication of growing policymaker desperation is a recent report prepared by the Official Monetary and Financial Institutions Forum (OMFIF), on behalf of the World Gold Council. In the report, the OMFIF argues that the international monetary system is approaching a transformation from a mostly ‘unipolar’ system centered around the dollar, to a ‘multipolar’ one of multiple reserve currencies, including the Chinese renminbi, which at present comprises only a tiny fraction of global FX reserves.
Most important, the report recognizes that monetary regime change is fraught with uncertainty. History is clear on this point. Also clear is that, historically, periods of global monetary uncertainty have been associated with central bank (and private) accumulation of gold reserves and, by association, a rising price of gold.
According to the OMFIF, this is the explanation for why central banks are accumulating gold today. It boils down to increasing uncertainty or, if you prefer, decreasing trust between countries, a natural consequence of the currency wars. OMFIF assumes that, in the coming years, uncertainty and associated gold accumulation will continue to increase, placing further upward pressure on the gold price.
It is difficult to argue with any of that. Indeed, in my book, The Golden Revolution (available here), I illustrate how the 2008 global financial crisis critically destabilized the international monetary system. In particular, the dollar is losing its dominant reserve currency status, yet there is no other existing fiat currency that can replace it. The euro has issues, the yen has issues and the renminbi has issues, although it is the ‘rising star’ in this group.
The OMFIF report then makes a recommendation that the best way to reduce the unavoidable monetary uncertainty ahead is to acknowledge that there should be a more formal role for gold to play in the international monetary order, in particular, that it should be included in the Special Drawing Rights (SDR) basket as calculated by the International Monetary Fund (IMF). The SDR is a global reference point for currency valuation and IMF member countries’ capital shares are denominated in SDRs.
This is a formalization of what was first proposed by World Bank president Robert Zoellick back in 2010. In a Financial Times article that I believe will be noted by monetary historians in future, he wrote that gold was already being treated as an “alternative monetary asset,” and that the international monetary system “should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values.”[3]
The OMFIF report also suggests expanding the SDR basket to include all the ‘r’ currencies, not only the renminbi but also the Indian rupee, the Russian rouble, the Brazilian real and the South African rand. This would be a formal recognision of the rising economic power of all the BRICs, not just China, and pave the way for their currencies’ use as reserves.
A Bureaucratic Pipe-Dream
Bureaucrats are naturally drawn to bureaucratic ‘solutions’ to problems. But cooperative solutions become unworkable when cooperation breaks down, as is increasingly the case in global monetary relations. In this context, the OMFIF report, while it sounds nice on paper, is a futile attempt to hold an unstable equilibrium together. The fact is the BRICs no longer trust the mature economies in monetary affairs.[4] Lacking such trust, the only viable way forward is to ‘de-nationalize’ money for international trade, thereby disarming those who would opportunistically engage in currency wars.
Gold is the only such non-national money, a currency that cannot be printed or otherwise manipulated by one country at the expense of another. Its supply is strictly limited by that which can be got out of the ground at economic cost within a given period of time. Thus gold stands in sharp contrast to all unbacked fiat currencies, the weapons of the currency wars. The OMFIF report dances around this fundamental difference between the two but ultimately stumbles. Yes, the OMFIF report recognises that:
[T]he previously dominant western economies have attempted to dismantle the yellow metal’s monetary role, and – for a variety of reasons – this has comprehensively failed. Gold thus stands ready to fill the vacuum created by the evident failings of the dollar and the euro, and the not-yet requited ambitions of the renminbi.
But notwithstanding the recognized failings of fiat currencies and persistence of gold, the report then moves on to recommend that gold and the major fiat currencies be treated as equals in the future monetary order, specifically, by:
…extending the SDR to include the R-currencies – the renminbi, rupee, real, rand and rouble – with the addition of gold. This would be a form of indexation to add to the SDR’s attractiveness. Gold would not need to be paid out, but its dollar or renminbi or rouble equivalent would be if the SDR had a gold content. By moving counter-cyclically to the dollar, gold could improve the stabilising properties of the SDR. Particularly if the threats to the dollar and the euro worsen, a large SDR issue improved by some gold content and the R-currencies may be urgently required. (Emphasis added.)[5]
From ‘dance’ to ‘stumble’ may be the wrong metaphor here, unless the stumble is meant to serve as a distraction for some slight-of-hand on the stage. Did you catch the subtle trick of logic in the above?
Allow me to explain. The “failings of the dollar and the euro” vis-à-vis gold are indeed “evident”: This is why central banks everywhere are in a scramble to acquire more gold and, in some cases (eg Germany, Venezuela, Turkey) to strengthen their custody of it through repatriation and changes in regulations. The dollar and the euro are no longer trusted as stores of value, at least not to anywhere near the degree that they were in years past.
But if your agenda is to try and contain the scramble for gold and prevent it from further displacing fiat currencies in reserves, how convenient if you implemented an international monetary system that would limit, through official, global arrangements, the degree to which gold could compete as an international money while still allowing for whatever amount of fiat inflation policymakers believe is required to devalue their excessive debts.
If gold “need not be paid out” then, as the price of gold rises, you just print more paper currencies as required to make up the difference! In other words, gold would be unable to serve as a brake on a general global monetary inflation. And “if the threats to the dollar and the euro indeed worsen”, then yes, just print more of those SDRs—a basket of dollars, euros, renminbi, etc—and who cares if the price of gold rises in tandem? You’re still inflating!
In context of the changed global economic landscape, the OMFIF report thus reads as a desperate attempt to sue for a compromise peace in the currency wars, to find a basis for agreement between the US, euro-area, Japan, and China and the other BRICs, to inflate in coordinated fashion thorugh SDR issuance, while at the same time keeping the golden genie in the bottle where, according to central-planning inflationists, it belongs.
Of course, just because an olive branch is extended does not mean it will be accepted. Is it really in China’s or the BRICs’ interest to participate in such an arrangement? Does China really want the ‘failing’ dollar and euro to keep depreciating? Or might China want to get paid for its exports in hard currency for a change?
Again, it all comes down to trust. Currency basket arrangements such as the euro or, as the OMFIF proposes, a global SDR with a token role for gold, only hold together as long as all the major players perceive that they serve their interest. The moment a player perceives otherwise, the system, lacking sound money foundations, falls apart. If the OMFIF report is indicative of the next step in the evolution of the global monetary system, then the past and current failures of the dollar and euro are destined to become the future failures of the SDR.
China must know this. I suspect the other BRICs do too. And numerous small countries, hardly irrelevant in the matter, are watching intently to see where this goes, while accumulating gold in the meantime, unsure of the outcome.
Why a Return to Gold Is the Inevitable Result of the Currency Wars
If the developments discussed above seem unprecedented, think again. We have been here before, namely, in the mid- to late 1960s, when the US and other Bretton Woods participating countries were struggling to maintain the gold price at $35/oz. There was lots of monetary inflation in the US and elsewhere by the mid-1960s and it was assumed by many that this would lead to price inflation in time.
European central banks, most of whom had accumulated substantial dollar reserves, were beginning to swap these for gold. Private investors sought to protect themselves with gold purchases. By 1967, while the official price for gold remained $35/oz, there was steady upward pressure on the market price in London. ‘Two-tier’ markets create arbitrage opportunities and, as more speculators got in on the game, the upward pressure on the gold price intensified.
In 1967, France, already having indicated from early 1965 that it was dissatisfied with the dollar-centric Bretton Woods system, abruptly withdrew from the pool. While this was a clear message to all that the official $35/oz gold price was unsustainable, encouraging yet more speculation, at the same time it meant that the remaining London gold pool participants had to cover for France’s significant absence by making even more gold available to the growing number of buyers.
This unsustainable arrangement lasted less than a year, with the pool collapsing entirely in 1968. The situation was now critical as the monetary system was without solid foundation. The upward pressure on the price of gold intensified yet again. The Federal Reserve was now frightened that a run on the dollar was imminent, with the pound sterling already under renewed attack. At one Fed meeting that year it was claimed that, "the international financial system was moving toward a crisis more dangerous than any since 1931."[6]
By 1971 the day of reckoning had arrived. The US had continued to sell gold into the market to suppress the price and to convert foreign reserves on demand into gold since 1968 but when even the UK was asking for a substantial portion of its gold back in summer 1971, it was clear that this effort was futile. Either the US would run out of gold or it would allow the gold price to rise and the dollar to ‘float’, that is, to devalue substantially.
President Nixon opted for the latter course, as he announced to the world on 15 August that year. The dollar was devalued and gold convertibility suspended indefinitely as a ‘temporary’ measure. But why did the world continue to use dollars as reserves when these were unbacked by gold? Because the US was still by far the largest economy in the world, the biggest importer and exporter. And while US finances were deteriorating at the time, they were in far, far better shape than they are today, with trade and budget deficits tiny as a percentage of GDP. Today, the picture is the complete opposite. US finances are in a far worse state than those of the BRICs.
The US and the other developed economies are thus no longer in a position to dictate terms in international monetary matters. The BRICs have made the point clear. They are going to begin to demand hard currency in exchange for their exports. A plan to this effect could be announced as early as their annual spring summit, held this year in Durban, South Africa, on March 26-27.
Keep Calm, Buy Gold, Get Out of Bonds
If the recommendation to accumulate gold in advance of its remonetization for use as an international money seems obvious, perhaps less obvious is to reduce holdings of bonds. Why should a remonetisation of gold lead to higher bond yields/falling bond prices? After all, the economic dislocations associated with international monetary regime change could well tip the world into yet another recession as the associated economic rebalancing takes place.
While we have come to associate rising yields with economic recoveries and falling yields with recessions, in fact, on a sound money foundation this relationship does not hold. Back when the world was on the gold standard, for example, yields sometimes rose in recessions and declined in recoveries. This is because the central bank was unable to manipulate the bond market with monetary policy.
Take the euro-area today as a contemporary case in point. As Greece, Portugal and Spain have tipped into deep recessions, their bond yields have risen as they lack national central banks which can buy their bonds with printed money. And investors have a choice whether to hold these bonds, or to hold the bonds of sounder euro-area governments, such as Germany, hence the wide spreads that investors demand in compensation.
A return to gold-backed international money will have much the same effect but at the global level. US Treasuries and other bonds will need to compete more directly with gold itself as a store of value or as official reserves. Interest rates will therefore need to rise to compensate investors for the very real possibility that the supply of bonds will just keep on growing to finance endless government deficits while the supply of gold remains essentially fixed.
Now I am under no illusions here. If the US, euro-area, UK and Japan face sharply higher borrowing costs in future, they are going to have debt crises similar to those faced by Greece, Portugal and Spain today. Indeed, with no one willing or able to bail them out, the associated crises may be more severe. The US and other indebted countries may resort to capital controls and even to selective default on their debt, such as that held by foreigners abroad.
If so, this will be another major escalation in the currency wars, one that will begin to resemble the 1920s and 1930s in its intensity. Those were sad decades, to be sure, in which much of the global middle class saw its savings wiped out at least once and, in some cases, twice. They didn’t care whether this occurred via inflation/devaluation or via deflation/default. Investors today shouldn’t care either. They should accumulate gold and certain other real assets in limited supply. These are the ultimate insurance policy against inflation, deflation, devaluation, currency and trade wars, financial crises, monetary collapse … you name it. The time to do so is running out.
Resources
[1] In the Amphora Report I have long followed the ‘currency wars’. My first take on the subject, BEGUN, THE CURRENCY WARS HAVE, dates from September 2010. The link is here.
[2] These various statements were reported in this Bloomberg News article that can be found here.
[3] Robert Zoellick, “The G20 Must Look Beyond Bretton Woods II,” Financial Times, 7 November 2010.
[4] Please see THE BUCK STOPS HERE: A BRIC WALL, Amphora Report vol. 3 (April 2012). The link is here.
[5] GOLD, THE RENMINBI AND THE MULTI-CURRENCY RESERVE SYSTEM, OMFIF, January 2013, p. 4.The link is here.
[6] Amateur historians take note: Federal Reserve Open Market (FOMC) minutes may be tedious for the most part but occasionally there are real gems to unearth, as is the case here. However, the transcripts are only released with a five-year lag. It will be interesting to see what was discussed—and not redacted—from transcripts from 2008 and 2009, when the Fed was involved in bailing out the bulk of the US financial system.
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