"At times, when all the world's asleep, the questions run so deep, for such a simple man..."
We have had some discussion about international macroeconomics under a future Freegold system in the last two threads. And yesterday JR reposted an old comment of mine on the subject. As a companion piece to that comment, and also to add a new dimension to the discussion, I'd like to introduce a couple of new concepts. Let's call the first one "usable versus useless wealth" and the second concept we'll call "organic versus inorganic savings".
Usable versus Useless Wealth
For "usable" and "useless" wealth I'm calling everything in the physical plane except gold "usable wealth." "Useless wealth" would therefore be gold and paper/electronic savings. So obviously I am referring to the economic or living standard utility of something in the present. Gold would be the physical plane representation of "useless wealth" and paper/electronic savings would be monetary plane "useless wealth" because they both have little or no economic or standard of living utility to the saver. All they do is store purchasing power (more or less) with the promise of potential future purchasing power.
Let's look at an example. Costata wrote: "In other words I can't find an example of a country becoming rich via the monetary plane and then becoming wealthy in the physical plane."
In terms of "becoming wealthy" in the physical plane, I think we should distinguish between "usable" wealth (goods and services) and "useless" physical wealth (gold). One is usable right now for either production or consumption and the other is not.
It seems that the US became wealthy in "usable" wealth via the monetary plane exorbitant privilege granted by the ROW in 1922. It did have a period in the middle where it acquired a bunch of "useless" wealth (gold) while it provided the world with "usable" wealth in return, but lately that trend has reversed. And by lately, I mean the past half century.
So then the question would be how do you define "becoming wealthy"? Do you define it by having the most usable (in the present) wealth, or by foregoing usable wealth now in order to store useless (in the present) wealth for the future.
Here's one more example which JR sent me. It was published during the Great Depression on July 11, 1931 in the Magazine of Wall Street:
Gold Does Not Make Prosperity To men, as to nations, the possession of gold is a symbol of prosperity. Let's see. The United States has more gold than it ever had-and less prosperity. The banks are bursting with gold and barely meeting their dividends. Our great corporations have immense reserves of gold and their business is dwindling. All the nations are sending gold to us and our business with them is fading away. The truth is that large accumulations of gold are an inverse measure of prosperity.
Probably four-fifths of the gold in the Federal Reserve banks is idle - and nobody ever contended that idleness makes for prosperity. The fact is that except as it is used as the basis of bank credit, gold has no relation to prosperity. But when there is no business, there is no credit and gold is useless. In other words, business gives gold a utility value. Gold is dead until vitalized by commerce.
The piling up of gold in any country does not signify that it is prosperous; it merely shows that the country is giving other countries more goods than it receives; that it is parting with more usable wealth than it is getting back.
Today the United States is receiving gold and going without goods it would like to have. And because it is receiving gold it is selling less than it would like to. When we are prosperous, which means that credit is being freely extended, we need gold because it is the one commodity that mankind has agreed to accept on balance in place of the goods it would rather have. It is merely a balancing item in the offsetting of credits against debits. It might be epigrammatically said that prosperity "makes" gold and "unmakes" it instead of gold making or unmaking prosperity.
Okay, so that's the "usable versus useless" concept. You can disagree with my semantics if you want because I'm only trying to get the concept across.
Organic versus Inorganic Savings
What I'd like to call "organic savings" is when economic actors net-produce (produce more than they consume). "Inorganic savings" is when the monetary authority in a currency zone increases its reserves. And here reserves mean gold or foreign currency reserves. Assets denominated in a CB's own currency are not reserves. (I wrote more about the distinction of reserves in this post.)
For this concept I would like to draw your attention to a statement I've made many times that any gold inside a currency zone, public or private, is a viable reserve. That is, any gold inside a zone is "savings". But now I'd like to distinguish public and private gold and we'll call the private gold "organic savings" and the public gold (held by the CB or the government) "inorganic savings".
This concept works for paper savings as well as for gold savings, but we'll be looking at the future Freegold BOP machinations from a physical perspective which will exclude paper savings. So "organic physical savings" would be gold in private hands which is the product of an economic actor producing more than she consumes and purchasing "useless physical wealth" (gold) with the excess currency left over from "underconsuming".
"Inorganic physical savings" on the other hand would be gold purchased by the CB by printing currency. "Inorganic paper savings" would be like the PBoC purchasing US Treasuries by printing yuan. "But wait" you say, "the PBoC purchases Treasuries with US dollars it received through trade." This is true, but it also printed yuan in exchange for those dollars regardless of your perspective on the mechanism driving that transaction. You see, if the Chinese exporter had bought those Treasuries for his own savings, no yuan would have been printed. That would have been "organic paper saving". But by exchanging printed yuan for the dollars the PBoC is making those savings "inorganic" and at the same time it is managing the exchange rate of its currency. This equates to the PBoC printing yuan to buy gold as a currency management tool in Freegold.
The reason I am making this distinction is that I plan to show you that, in Freegold, the CB's inorganic "saving" and "dishoarding" actions will generally be the opposite of (or countercyclical to) the net-actions of organic savers in its currency zone when it manages its currency. Freegold will be much more smooth and balanced (than the $IMFS) even without CB interference, but we all know that in the real world CBs gotta do something to justify their existence, right? So I hope to show that their natural response will actually smooth cycles out even more than they would be without the CBs. And that's with everyone acting in their own self-interest.
The monetary plane is merely a reflection of the unsettled portion of the physical plane. It is simply remembered debt; it reflects uncompleted physical-plane trade. It, the "m-plane", reflects open transactions, those not yet extinguished. And the BOP, or Balance of Payments is the m-plane account for showing what has transpired and explaining what is presently happening from a macro perspective. It is often said that the Balance of Payments must balance. This is a tautology. It is like saying a sphere must be spherical. What it means is that if the BOP doesn't balance, you've made an error in your calculations, not that something needs to be done to bring it into balance.
The BOP never balances perfectly because they use aggregated, government-collected data which is inherently imperfect. It is only a tool that helps us understand what's happening out there in the real world by compiling macro data. It is a lens for seeing, not an active participant.
In a previous thread costata called current BOP accounting methods an anachronism. That may well be true, but I think he was trying to imply that it has some negative effect on reality. I don't think it does. And whether or not they change BOP accounting in Freegold, I think we can still use the current methodology to explain what will be happening in Freegold from a macro perspective. Again, that's all the BOP is—a lens that helps us understand what's going on.
I have done the "Freegold BOP" exercise a number of different ways and it seems to be hopelessly confusing trying to conceptually traverse a paradigm shift of this magnitude from a monetary plane perspective. What I have found is that the aggregated marginal actions of the various players in Freegold are counterintuitive given our immersion in the current paradigm. So I think we need to begin with the physical plane in order to understand how the macro m-plane will look in Freegold.
First of all, "useless" gold will flow in the opposite direction of usable goods and services at the margin. It's just like Another said, "gold and oil will never flow in the same direction." The same is true of the net-flow of "usable wealth" (goods and services) versus "useless wealth" (gold) in Freegold. "Usable wealth" and "useless wealth" will flow in opposite directions at the margin (deficit/surplus region). 
But physical gold exists in a (nearly) fixed amount (by weight), so we can imagine it "sloshing" back and forth (by weight) like the ocean moves back and forth expressed in the tides. What will prevent all gold from flowing uncontrollably into one country is the price of gold in that country.
And it is important to understand that savers alone determine the trade surplus. Non-savers trade goods for goods, but savers are the ones who "underconsume" thereby creating a trade surplus. We also need to distinguish between organic savers (you and I) and inorganic savers (CBs like the People's Bank of China). In Freegold these two types of savers will act in opposing ways which will have a damping effect which will smooth out the cycles, similar to the way opposing waves cancel each other out.
When you provide more usable wealth to the external world than you enjoy for yourself (consume), you will record the difference by buying gold. So when we see someone accumulating a lot of gold, we should think, good lord he's providing a lot of usable wealth in exchange for "useless" yellow metal. But on an aggregate (national or regional) scale, something like this could not go on forever or else all the gold would flow into that region. What stops this from happening is that gold's price will rise, rewarding the earlier savers while "punishing" the ongoing (newest) savers (underconsumers) with less gold by weight.
At some point the early savers will see enough reward (high priced gold) while the ongoing (new) savers will sense a "top" in gold and the flow will reverse. Savers in aggregate will start net-dishoarding. So how does this translate into the m-plane in Freegold? Let's view this as the organic hoard-dishoard cycle within a currency zone.
The upleg, when organic savers are accumulating gold and gold is flowing in, while the price of gold is rising and the country is exporting more "usable wealth" than it is importing, we'll call Leg A of the cycle. Then Leg B will be the dishoard leg of the cycle, when the zone is importing more usable wealth and exporting gold as the savers net-dishoard. (This is counterintuitive right now because we're thinking in terms of China and the US under the $IMFS. Seems like gold should be rising (dollar falling) in the US right now, but under Freegold it would be the opposite --> counterintuitive! --> because the trade deficit (more goods flowing in) would mean that savers are dishoarding (gold flowing out)!)
Freegold Currency Management
In Freegold, a currency manager will influence exchange rates by buying or selling gold. If a currency is trading higher than he wants, he'll purchase gold on the open market (doesn't matter where thanks to arbitrage) with freshly printed currency to weaken his currency. This will exert pressure for gold to flow into his zone and usable wealth to flow out. Normally he'll do this in a countercyclical way to what's happening with the "organic" savers. So our currency manager would most likely be inflating the currency (printing) and using that new currency to buy gold (weaken the currency while increasing reserves) during Leg B of the cycle described above (where the savers are strengthening the currency (to a point above where it "should" be given some measure of Purchasing Power Parity with its trading partners) by dishoarding gold).
If a currency is showing unwelcome weakness, he can sell his gold reserves on the open market. This will exert pressure for gold to flow out of his zone (or at least counteract the ongoing inflow driven by organic saving) and for usable wealth to flow in (or at least slow down the ongoing outflow (trade surplus)). He would do this during Leg A of the cycle described above, so as to be countercyclical to the organic savers. (Again, this is counterintuitive given our present immersion in the $IMFS. Who'd expect the PBOC to be selling official gold right now to reduce the trade surplus. Yet that's what they'd be doing in Freegold.)
So obviously a currency manager has nearly unlimited ability to weaken his currency (to counteract Leg B of the savers' hoard/dishoard cycle) but he is constrained by his accumulated reserves as to how much he can strengthen (defend) it (during Leg A). This actually makes sense because Leg B is when savers in the zone have stopped buying gold in aggregate (so that gold is no longer flowing in) and the printer can get them to start again by debasing their currency while simultaneously driving up the price of gold. In extremis the printer can stop the outflow of gold from dishoarding savers (and stop the net-inflow of goods and services) by buying every ounce sold by domestic (organic) savers with freshly printed currency.
I don't know if I would call that "pegging" a currency since gold is not the currency of a specific trading partner. But if you want to know how it would look on the FOREX, just imagine a steady gold price in the trading partner's currency and a rising gold price in your currency. The obvious arbitrage would lower your currency on the FOREX relative to the trading partner's currency with a stable gold price. Arbs would buy gold in the trading partner's zone and sell it in your zone delivering you an inflow of gold and the requisite outflow of "usable wealth".
I hope it is obvious to you that a zone which is experiencing an inflow of gold (in Freegold) is also experiencing an outflow of usable wealth. Gold is the symbolic token that implies you are providing more usable wealth to externals than you are using for yourself. Counterintuitively, the transactional currency of a zone experiencing this (in Freegold) is likely lower than it deserves to be on the FOREX. That's why its exports seem cheap to foreigners. So foreigners are buying more usable stuff from this country than they are selling to it. The currency manager would resist this by selling his own gold locally to stop the inflow of ("useless") gold which reflects the outflow of usable wealth. He is strengthening his currency by doing this and slowing exports of real goods (while also slowing imports of gold).
A currency manager can induce exports of real usable wealth and imports of ("useless") gold by inflating his currency to buy gold. This weakens the currency inducing the inflow of gold and the outflow of exports of real usable wealth. I realize this is counterintuitive (it seems obvious that a strong currency should buy more gold), but the easiest way to picture it is to imagine a currency manager doing this in isolation. He's printing and buying gold to weaken his overvalued currency. This is going to first cause gold to flow in but then the price of gold will rise. The currency manager could continue buying, say $10B in gold every day forever. And we could say that $10B in gold would flow into his reserves every day forever. But the reality is that the flow of gold by weight would slow and stop very quickly because the price of gold would rise so rapidly. At some point your $10B/day inflow of gold would be a fraction of an ounce.
So gold starts flowing out of a zone (and "usable wealth" starts flowing in) when the price of gold peaks and starts falling. The currency manager can counter this (for stability) by inflating the currency and buying some of that gold that the savers are dishoarding, slowing the export of gold and thereby slowing the import of "usable wealth".
So… When savers are hoarding gold, the CB is dishoarding. When savers are dishoarding, the CB is buying their gold with fresh currency. Over time this will minimize the flow of gold between currency zones and because the flow of gold is a reflection of an imbalance in the flow of "usable wealth" we can deduce that trade will be balanced and disruptive cycles and corrections will be minimized.
Will there be some paper debt involved across zones? Yes, because there is a time lag involved. But as long as savers and CBs aren't using that debt as their long term reserves/savings, it won't build up and it will reverse sides regularly. I think that this short term debt (call it the buffer) will still be reflected in the "Capital Account" of the Freegold BOP and the cross-border flow of gold will be reflected as a normal trade good. I don't think Freegold requires a revised BOP methodology.
As a parting thought, just remember that this BOP discussion is looking at Freegold from a macro (aggregated) perspective which is different from the personally subjective (micro) perspective in which it is usually discussed here. Things appear very different from the mountain top on the other side of a singularity. ;)
 A relatively tiny amount of gold will flow as a "usable" good along with the rest of the "usable wealth". There are a few electronic uses for which gold is irreplaceable. At the current price there are about 300 tonnes consumed every year in electronics. But, even at today's price, substitutes are being created for the less important ones. My brother is a materials engineer working for a major medical equipment manufacturer. He personally administers the physical application of gold to these vital electronics.
They coat vital electronics with gold not because gold is a good conductor (silver and copper are much better) but because a very thin layer of gold prevents the lesser metals from corroding. Corrosion inhibits conductivity. In one product he makes there is 10-cents-worth of gold at today's price. That product costs $2,500 to manufacture and sells to medical professionals for $10,000… and it contains 10 cents of gold. Even with a 40X revaluation the gold component will only be $4.
On these high-end medical applications they use sophisticated techniques for applying the gold. Much more sophisticated than the gold plating used on cell phones and thumb drives. My brother uses evaporation and sputtering which deposits a layer only a few atoms thick. Gold electroplating from a liquid onto cheap electronics deposits a much thicker layer, and those lesser electronic uses will likely be substituted with something like this.
It's kind of funny that a $50 cell phone today contains 50-cents-worth of gold while the gold-plated piezoelectric capacitor in a $10,000 piece of medical equipment only contains 10 cents. That's right, an ounce of gold is required for every 16,000 of these devices. And that particular capacitor requires a lot of gold, about 10 sq cm of surface area to be coated. For comparison, an integrated circuit chip requires anywhere from 0.1 to 2 sq cm of surface area to be coated in gold. An ounce of gold covers about 160,000 sq cm using these high-end techniques at a thickness of 1000 angstroms (0.1 micron, 0.00001 cm).
My point is that I foresee the amount of gold being used in electronic applications dropping significantly to maybe 100 tonnes per year in Freegold. That's out of the 170,000 tonnes of gold in storage. A 1,700 year supply overhang perhaps? Somehow I don't think Freegold will interfere with any vital industrial uses for gold.
PS. I'd like to take the opportunity of a postscript in a fresh post to highlight Victor the Cleaner's explanation of what Mario Draghi meant when he said "whatever it takes". Reposted from Screwtape Files:
It seems that most people don't understand the ECB. If Draghi says "within their mandate", he is referring to their inflation target "below but close to 2% annually" in the medium term (i.e. 2-3 year average).
He said he would save the Euro "whatever it takes". He didn't say he would save government debt whatever it takes. Some people seem not to get it that these two are completely different goals.
If you take the 2% inflation target seriously (and every single step by the ECB is consistent with the assumption that they do), you conclude that:
1) The ECB will print money in order to create inflation as soon as the medium-term inflation rate gets substantially below 2%.
2) In order to create this inflation, the ECB will have to purchase consumer debt with new base money (this is how you create price inflation). So their standard choice will be to buy government debt - government expenditures are largely consumption, either directly or through salaries, pensions, benefits.
3) In the inflation rate drops substantially below 2% in some countries, but not in others ("policy transmission distorted"), the ECB will buy government debt of these countries, but not of others - most governments spend mainly in their own economy which allows the ECB to target where they want to create inflation
4) The ECB has no mandate to create more inflation than the mentioned 2% annually. So they will make sure this doesn't happen either.
5) How will they do it? Well, that's easy. A lot of debt is being written off (Spanish home owners defaulting on their mortgages etc.), and several governments had to sharply cut down on their deficit spending. Both are deflationary. So the ECB could simply leave the market alone, and the Euro zone would get some price deflation. So the ECB has enough tools to limit the inflation rate at 2% annually.
6) What is the main mechanism that might cause an inflation rate higher than 2% in the medium run? This would happen if the commercial banking system or the ECB monetize the running budget deficit of their governments or if they monetize other consumer debt beyond about 2-3% of GDP annually.
7) How can this be prevented? Well, some governments have gotten into serious difficulties raising funding, and Ireland, Portugal, Greece, Spain are forced to cut down on public spending. How precisely? The interest rates they would have to pay for additional debt are going up.
See? Some idiots claim "Draghi wants to print and buy all government debt in order to lower the interest rates" and then "ECB is too stupid to really lower interest rates"?
How about this: ECB has purchased some government debt in order to create inflation in those countries in which inflation was dropping too much below 2%, but ECB never intended to lower interest rates?
Much easier explanation, isn't it?
8) So what do we conclude if we assume that the ECB is doing nothing other than their job, i.e. to maintain their 2% inflation target?
8.1) They will buy government debt if the inflation rate drops too much below 2% annually. In particular, if this happens in some countries, the ECB will buy the government debt of these specific countries (SMP).
8.2) Although the ECB may buy government bonds for this reason, they will make sure they do not artificially suppress the interest rates (in contrast to the Fed or the BoE).
8.3) As long as the inflation rate stays around 2%, the ECB will not monetize government debt, simply because this would create more inflation. In particular, this indicates a limit of the annual budget deficits that will end up on the balance sheet of the combined banking sector (commercial banks and ECB): no more than around 2-3% of GDP which would cause about 1.4-2.1% consumer price inflation in the steady state (assuming roughly 70% of government expenditures is consumption - you can adjust these figures if you have better data, the ECB certainly do have better data).
8.4) So while some debt will be bought by the ECB in order to maintain 2% inflation, some other debt will most likely be defaulted on. How much? I guess this will still be a lot.
8.5) If some politicians try to give the ESFS or ESM a banking license or to use government run banks in order to monetize their own debt, the ECB will have to obstruct these attempts, for example, by changing the requirements on the collateral they accept from these banks. Also, the northern countries will not like this and presumably already be influential enough to stop it.
When I was young, it seemed that life was so wonderful,
a miracle, oh it was beautiful, magical.
And all the birds in the trees, well they'd be singing so happily,
joyfully, playfully watching me.
But then they send me away to teach me how to be sensible,
logical, responsible, practical.
And they showed me a world where I could be so dependable,
clinical, intellectual, cynical.
There are times when all the world's asleep,
the questions run too deep
for such a simple man.
Won't you please, please tell me what we've learned
I know it sounds absurd
but please tell me who I am.
Now watch what you say or they'll be calling you a radical,
liberal, fanatical, criminal.
Won't you sign up your name, we'd like to feel you're
acceptable, respecable, presentable, a vegtable!
At night, when all the world's asleep,
the questions run so deep
for such a simple man.
Won't you please, please tell me what we've learned
I know it sounds absurd
but please tell me who I am.