The concept of Freegold is something that means different things to
different people. It is amazingly simple, yet curiously complicated.
We are on the path, yet the world races at a snail’s pace.
From my point of view, Freegold is not a “solution for” but will be
the “result of” the current financial mess that we are in today.
To better understand what lies ahead, one must be
willing to have an open mind and think objectively.
More importantly, the seeker must be willing to
set aside triggering emotions that
prevent thinking as the ‘other’.
–Ender (9/23/08)
_________
different people. It is amazingly simple, yet curiously complicated.
We are on the path, yet the world races at a snail’s pace.
From my point of view, Freegold is not a “solution for” but will be
the “result of” the current financial mess that we are in today.
To better understand what lies ahead, one must be
willing to have an open mind and think objectively.
More importantly, the seeker must be willing to
set aside triggering emotions that
prevent thinking as the ‘other’.
–Ender (9/23/08)
_________
Today marks the twelfth anniversary of my blog. Twelve is a sublime number, one of only two. You can read about it at the link, but I'm not going to bore you with number theory here. Everyone can clearly see how important this year is.
This is the Year of the Lens. On New Year's Eve, I wrote that, rather than trying to predict specifically what would happen this year, I'd just say that whatever happens, it will be big, and I'll help you see it more clearly than anyone else by simply viewing it through my lens.
Changes and new developments are coming at us fast and furious this year. I'm not sure Ender's "snail's pace" even applies in 2020. It's like a perfect storm of change and new developments, and with only 72 days left until the election (I put a countdown timer in the side bar), I'd say we're right in the tiny eye of the storm at this moment, with the eyewall raging around us in all directions. So for this post, I thought I'd take advantage of the momentary calm, and point my lens back at Freegold itself.
Freegold means different things to different people as Ender said, and that can get confusing at times. So I thought it might be helpful to briefly explain what it means to me, how it looks through my lens...
You can read the rest of my "Twelve" post at the Speakeasy. A subscription is $110 for six months, or about 60 cents a day. With everything that's going on this year, there are more subscribers and more commenters than ever at the Speakeasy, and if you would like to join, there's a subscribe button in the side bar.
I've written 23 posts already this year, and this one I'm sharing here was posted three months ago, on May 12, 2020:
From Bretton Woods to Freegold
An Epic Road Traveled
An Epic Road Traveled
This is gonna be a long one, kids, so buckle up…
In June of 2014, I began writing a series of posts that I didn't complete until May of 2015, five years ago almost to the day. They were based on an epiphany I had in June of 2014, about what Freegold is really all about.
I had been struggling with a post called "Settlement", but something was missing. I showed a draft to FoNoah, and this was his response:
"Sorry FOFOA, this post misses the mark for me. It's far too short and does not even get my "wisdom detectors" stirring. (Usually your Posts get them flashing Defcon 5).
I never really totally understand your major Posts, but I always "know" that they contain major "wisdom". I am always left with the feeling that one day - after I have re-read them many times I will gradually begin to understand the concepts. Not so with this one.
Funnily enough, I was just re-reading Think Like a Giant (It is Gold that Denominates Currencies) today, and trying to figure out for myself why Oil does not and cannot. I would love to see you expand this Settlement Post to include the Russian/Ruble/Euro discussion and what options exist for settlement in ?? You would need to spell it out one small step at a time for the dumb ones like myself."
That was on April 10th, 2014. So I put the post on the backburner for a couple of months, and then, out of the blue, it dawned on me what I was missing. It's hard to describe the feeling, but it gets your mind racing as you start processing everything you thought you knew through this new filter, and unexpected things start clicking into place.
I needed to write it all down, but I also needed to go back and explain the historical context in which it came to me. It was clearly going to be a big project. I knew where I was going with it, but I needed to give each step of the way a proper amount of attention.
In the end, the process encompassed a whole year. Two years later, FoNoah reread the series and it finally clicked for him. He emailed me all excited:
"Hello FOFOA – Happy New Year again to you and Mrs. FOFOA
I have just finished [rereading the series]. This time around I kicked the wife out of the house and sat in a quiet corner for three days straight. I made sure I understood each sentence before going on to the next… it only took me 2-and-a-half years to get there! [It's] a bloody MASTERPIECE."
FoNoah passed away 11 months later from cancer. RIP.
What I've done here is I've combined the series into one post, edited it, and updated it. That's why it's a little long. So enjoy…
Bretton Woods
As we know, world war two left Europe and the world economy
destroyed. Many thinkers of that period thought that the world was
about to enter a decades long depression as it worked to rebuild
real assets lost in the conflict. It was this war that so impacted
the idea of looking positively toward the future. The past ideals
of building solid, enduring, long term wealth were lost in the
conception of a whole generation possibly doing without! In
these fertile grounds people escaped reality with the
New Idea of long term debt, being held as a money
asset. Yes, here was born the American Experience
that comes to maturity today.
-ANOTHER
_________
destroyed. Many thinkers of that period thought that the world was
about to enter a decades long depression as it worked to rebuild
real assets lost in the conflict. It was this war that so impacted
the idea of looking positively toward the future. The past ideals
of building solid, enduring, long term wealth were lost in the
conception of a whole generation possibly doing without! In
these fertile grounds people escaped reality with the
New Idea of long term debt, being held as a money
asset. Yes, here was born the American Experience
that comes to maturity today.
-ANOTHER
_________
In 1933,President Roosevelt issued Executive Order 6102 "forbidding the hoarding of gold coin, gold bullion, and gold certificates within the continental United States." That restriction stood for 41 years until it was lifted in 1974 by an act of Congress "to permit United States citizens to purchase, hold, sell, or otherwise deal with gold in the United States or abroad."
In 1935, the United States Treasury had 9,000 tonnes of gold, 8,998 to be exact. Then, in 1971, when President Nixon officially closed the gold window, the US Treasury was back down to 9,000 tonnes, 9,070 to be exact. In the middle of that 36-year span, US Treasury gold hit its peak at 20,663 tonnes!
This post is about Freegold and dollar collapse/hyperinflation, the two primary topics I've covered for the last, almost 12 years now. As this is the year of the lens, I'm going to try to show you how I see the big picture, through my lens, all in one post.
In order to see how the dollar can collapse, you need to understand how and why it is overvalued today, not just in the monetary plane with its monumental overhang of "financial savings", but also in the physical plane of production and trade. By the end of this post, you might be surprised to discover how the dollar would still collapse even if we could hypothetically erase all of the dollars and "financial wealth" that has accumulated in the system.
Also by the end of the post, I hope you will see how simple Freegold really is, but for those of you who are impatient, or don't like to read long posts, or don't care about understanding things deeply and would rather just have an abstract that can be easily dismissed so you can get back to the stuff you already know, here's the gist of it.
Freegold is all about gradual, natural and automatic adjustment mechanisms in the modern world of fiat currencies. An adjustment mechanism is quite simply anything that periodically corrects physical plane imbalances. In economics, the term "adjustment mechanism" is often used to describe the flow of gold between different countries back when gold was used as base money in those countries. But this is not at all what Freegold is about, so I am using the term in a much broader sense that applies at any scale, from the global scale on down to the individual.
Whenever you buy a gold coin, or even a coffee at Starbucks, that's an example of an adjustment mechanism at the individual level. Monetary plane balances (like "financial wealth", the "idea of long term debt being held as a money asset", or even cash in your wallet) represent physical plane imbalances. Whenever monetary balances are reduced, real world imbalances are reduced. Likewise, when monetary balances are accumulated, physical plane imbalances increase. It's a simple concept and a simple view.
The flow of money within a common currency zone, like the United States for example, is the most basic and automatic adjustment mechanism. Other adjustment mechanisms include changes in wages and in the prices of various goods and services in general, and in different locales, and the movement of people and capital from one location to another.
Wherever multiple currencies interact, like on planet Earth for example, changes in the exchange rate between them are the primary adjustment mechanism. Fixing, pegging or otherwise manipulating the exchange rate of different currencies does, in fact, preclude other adjustment mechanisms and causes imbalances to accumulate, often to the point that abrupt adjustment becomes unavoidable, economically disruptive, and financially destructive, in other words, painful.
Currency collapse and hyperinflation are natural but not gradual adjustment mechanisms, as are controlled devaluations. Floating exchange rates are a more gradual adjustment mechanism between different currency zones.
These adjustment mechanisms have always been with us, so the real change in Freegold is the "gradual, natural and automatic" part. Gradual (or ongoing) is self-explanatory, but what I mean by "natural and automatic" is that these ongoing adjustments will be allowed to happen or made by choice, not forced or induced by a central bank, because such ongoing adjustments will be in the self-interest of anyone in a position to choose, on any scale.
I'm sure that some of you are already skeptical about what I'm saying. You're probably thinking that Freegold relies somehow on gold and whether or not it's embraced by the masses. But here's another thing that will probably surprise you in the end. Gold has very little to do with "Freegold the monetary system"! Gold is not a key part of the monetary adjustment mechanisms in Freegold. The price and physical movements of gold won't even matter to the monetary system. Any movements of gold in price, ownership or location will be irrelevant to the monetary system of the future.
Freegold is the true unshackling of gold from the monetary system. In Freegold, a properly functioning monetary system requires nothing of gold. In Freegold, the international monetary system won't require gold to change price or location in order for it (the new IMFS) to function. That's why it's called Freegold. Gold is finally and truly set free from its shackles to the monetary system.
To understand the complete severance of gold, it is helpful to understand how gold interacted with the monetary system in the past. Before WWI, gold was base money in the monetary system. That is, it was commercial bank reserves. And as such, the flow of gold worked as an adjustment mechanism, even between different countries, without changing the exchange rate of different currencies.
It worked like this. Say you have one country with a strong economy that is running a trade surplus with another country that has a weaker economy. Some surplus amount of goods and services flows from the stronger to the weaker, and net monetary payments flow from the weaker to the stronger economy. Gold was a hard base money that couldn't be created at will, so the flow described led to a surplus in the base money stock and thereby an increase in the effective money supply of the stronger economy—the effective money supply is the aggregate of commercial bank liabilities (credit money) and base money circulating outside of the commercial banking system—and a deficit in the effective money supply of the weaker economy.
Changes in the money supply corresponded to demand for goods and services from each country, so eventually the trade flow reversed and the imbalance corrected. It didn't matter that the two countries used different credit money currencies because the base money was the same currency, gold. So as money flowed, even across different currency zones, change in the local effective money supply and its corollary—demand—was the adjustment mechanism.
That was before WWI. After WWII, it was quite different. Gold was no longer base money reserves in the commercial banking system. Instead, it was reserves in the central banking system, and central bank liabilities were base money reserves in the commercial banking system. This was a big difference in terms of adjustment mechanisms between different currency zones. Gold still flowed, but its flow had the exact opposite effect—it effectively blocked the adjustment mechanism from working on the economies in different currency zones because its flow was a de facto manipulation of the exchange rates of the currencies.
This was deliberate, and it's what Another was talking about in the quote at the top of the post. Following WWII, productive capacity in Europe had been devastated and needed to be rebuilt. The Bretton Woods monetary system was the first fully negotiated international system of fixed and/or pegged exchange rates between various currencies. This new monetary system (in concert with the World Bank and the subsequent Marshall Plan) effectively provided support for Europe while it rebuilt its productive capacity such that, as Another put it, a whole generation of Europeans wouldn't have to "do without" during the reconstruction process.
July 2, 1944: United Nations delegates from 44 nations gather for a group portrait outside the Mount Washington Hotel, where the Bretton Woods Conference is taking place.
American productive capacity was in good shape following the war. After all, other than Pearl Harbor and a few minor attacks, the theaters of destruction were not on US soil. So, by fixing the exchange rates of European currencies to the dollar, Europe was able to maintain a standard of living that its devastated economy would have otherwise been unable to provide.
The only way this was possible was for Europe to run a trade deficit with the US while it rebuilt its own productive capacity following the war, and the agreement between the Allies, signed in Bretton Woods a year before the end of the war, created the mechanism that made this possible. Understand that there is no difference between "fixing" and "manipulating" when we're talking about exchange rates. "Fixing" and "pegging" are euphemisms for "manipulating". We often think of "exchange rate manipulation" as a unilateral act to gain some perceived advantage, but there is no effective difference whether it is unilateral or a bilateral or multilateral agreement. Bretton Woods was a coordinated system of manipulated exchange rates.
As I already mentioned above, there is a fundamental difference between gold being the reserve in the commercial banking system and gold being a reserve at the central bank level. The difference is the effect caused by the flow of gold. Gold did flow this way and that during the Bretton Woods years, but it wasn't an effective adjustment mechanism, nor was it physical plane settlement. It was actually an anti-adjustment mechanism and a mere monetary plane operation to effect the desired exchange rate manipulation.
Here's a tough concept which I'll explain in greater detail later. At the central bank level, any change, up or down, in "foreign reserves including gold" is essentially a currency exchange rate manipulation. "Foreign reserves including gold" can be simply called "reserves" as opposed to "domestic assets" on any central bank's balance sheet. The asset side of every central bank's balance sheet contains two things, reserves and assets. "Assets" are denominated in the CB's own currency, and "reserves" are not. That's the critical difference between reserves and assets.
Any time the asset side of a CB's balance sheet increases or decreases through purchases or sales, its liabilities increase or decrease as well. This is simple accounting. So any time a CB purchases or sells reserves, it is effectively manipulating the exchange rate between its own liabilities and one or more foreign currencies, including gold. Manipulating exchange rates is the main purpose of CB reserves. It's a bold statement, I know, but I'll show you that it's true.
In Freegold, CB reserves will not change much if at all, just as you'd expect in an unmanipulated (clean) floating exchange rate regime. CB reserves will just sit there, unchanged, static, with a sign on them that reads "break glass in case of emergency." Below a prudent level, CBs do need to accumulate reserves by weakening their currency (manipulating it lower) so that they have them later to strengthen (manipulate higher) their currency's exchange rate in case of an emergency. But beyond that prudent level, CB reserves are not necessary, and any change in a CB's reserves will signal to all others that the CB is manipulating its currency's exchange rate one way or the other.
WWII was just such an emergency. We can tell, simply by looking at the gold flow during the Bretton Woods years, how long it took Europe to get back on its feet after the war.
"Fiat 33"
"Fiat 33" was a term that FOA used to describe the bifurcated dollar system after 1933. Inside the United States, the economy that represented the dollar, gold was no longer an option as a money asset for net producers. Executive Order 6102 criminalized the possession of monetary gold by any individual, partnership, association or corporation. Thus, fixing the exchange rate of European currencies to the dollar was ideal for "the New Idea of long term debt, being held as a money asset."
"As we know, world war two left Europe and the world economy destroyed. Many thinkers of that period thought that the world was about to enter a decades long depression as it worked to rebuild real assets lost in the conflict. It was this war that so impacted the idea of looking positively toward the future. The past ideals of building solid, enduring, long term wealth were lost in the conception of a whole generation possibly doing without! In these fertile grounds people escaped reality with the New Idea of long term debt, being held as a money asset. Yes, here was born the American Experience that comes to maturity today."
Bretton Woods was a negotiated, coordinated, multilateral exchange rate fix. America was the strongest economy at that time, and it therefore had the strongest currency. A currency reflects its economy, and an economy that's capable of running a trade surplus (producing more than it consumes) is going to have a strong currency that will rise in its exchange rate with other weaker currencies. An economy that is not capable of producing more than it consumes will have a weak currency relative to stronger economies and its exchange rate will decline. By fixing the exchange rates of all weak European currencies to the strong American dollar, this adjustment mechanism was neutralized.
We tend to think of the dollar as "fixing" its exchange rate with gold during this time. But, in fact, that was not precisely the case. The dollar was actually defined as 1/35th of an ounce of gold, and the gold price was in fact fixed in London in pound sterling. The London gold fix was generally a simple reflection, via arbitrage, of the exchange rate between the pound and the dollar. So the dollar wasn't technically "fixed" to gold, it was simply defined as a certain weight in gold.
So the European currencies fixed their exchange rate with the dollar, which was defined as a certain weight in gold, and London fixed the exchange rate of its pound sterling to the price of "street gold" (another term FOA used which refers to the non-monetary physical gold marketplace). Now, the way you fix (manipulate) an exchange rate is to supplement either supply or demand so that supply equals demand at your desired price.
In the case of Bretton Woods, that meant either supplementing the supply of dollars and/or the demand for European currencies wherever dollars and the various European currencies were exchanged. This is exactly what happened. Theoretically, the US could have simply printed dollars and bought up 40 different foreign currencies to supplement dollar supply and foreign currency demand, or it could simply buy gold. Alternatively, the European CBs could have bought up their own currencies with their dollar reserves.
Well, the European central banks didn't have enough dollar reserves, but they did have gold! So the US printed dollars, which it used to buy gold from the European CB who then used those dollars, purchased with their gold reserves, to supplement the supply of dollars and the demand for their own currencies at the currency exchanges, keeping their exchange rates locked at the desired level. This exchange rate manipulation gave Europeans and their currencies the same purchasing power as the strong dollar, even though their economies were war-torn and needed to be rebuilt.
FOA made the distinction between "fiat 33 cash" and "the more golden foreign cash." On the surface, the distinction seems quite simple. Dollars within the United States were not redeemable in gold after 1933, but dollars held by foreigners were. Still, your average foreign exporter couldn't send his surplus dollars to the Fed in exchange for gold. That official exchange window was only open to foreign CBs. But foreigners could exchange their dollars for their local European currency—at the fixed exchange rate—and then buy gold on the open market in Europe where it was still legal to do so, and where London did its best to keep the price of "street gold" fixed to the pound which was fixed to the dollar which was defined as a certain weight in gold. Is your head spinning yet?
The thing is, this wasn't even an issue until the European economy got back on its feet and was finally able to start running a surplus (producing more than it consumes) once again. That was around 1958.
The numbers above tell a story. A lot of European gold was moved to London and the US for safekeeping during the war, and the incomplete accounting of the time shows it as belonging to the Bank of England and the US Treasury. As you can see, perhaps close to 10,000 tonnes were moved to New York and Fort Knox by 1940. Following the war, the US number drops a bit, but the numbers that I think tell the real story are 1935, 1952, 1957 and 1971.
In 1935, US gold is at about 9,000 tonnes. In 1952 it peaks at over 20,000 tonnes and sort of plateaus for five years through 1957. Then it begins a dramatic 14-year decline back to 9,000 tonnes, at which point the Bretton Woods gold exchange system abruptly ends. Notice that the US Treasury is listed as having almost the same amount of gold in both 1940 and 1956, about 20,000 tonnes. The difference is that, in 1940, the US was holding half of that gold for safekeeping on Europe's behalf, but by 1957, the US owned it all.
The numbers tell me that Europe must have run a significant trade deficit with the US from 1945 until about 1952. Then, from 1952 through 1957, trade between Europe and the US was roughly balanced, requiring only minimal exchange rate intervention. But by 1958, Europe was back on its feet and running a surplus.
This meant the opposite of the previous situation. The European CBs now had to supplement the supply of European currencies and the demand for dollars in order to keep the exchange rates fixed at their established levels. This meant printing European currencies and using them to buy dollars from their European exporters.
It wasn't clear at the time that this US deficit situation would carry on indefinitely, so it sufficed perfectly well, for exchange rate manipulation purposes, for those European CBs to just accumulate dollars rather than always exchanging them for gold. In fact, according to the agreement at Bretton Woods, dollars and gold were equal. But the agreement also required, under specified circumstances, the repurchase of foreign-held balances if requested by the CB holding the balance.
The CB being asked to repurchase its own currency had the option "to pay either in the currency of the member making the request or in gold." The IMF worked kind of like a multilateral "currency swap" facilitator, and with the IMF, such repurchases of one's own currency above a specified amount were obligatory, and usually had to be paid for in gold. This repurchase of one's own currency as it built up abroad was a good practice which kept the aggregate monetary base from exploding. Every bilateral repurchase reduced the monetary base—and therefore the balance sheets—of both CBs.
I think it's a fair assumption that the initial transfers of gold from the US Treasury back to the ownership of European CBs in the late 50s were essentially a bookkeeping exercise to keep the dollar monetary base at a reasonable level. After all, the gold didn't physically move, only its allocation at the Fed depository changed. But something else quickly changed that situation. That something else was the reality underlying FOA's "fiat 33" concept.
1945-1957
There wasn't much pressure in the West on the price of "street gold" fixed in London at about £12.4 per troy ounce, which was equal to $35 during these years. The reason is that Europe as a whole was net-consuming and therefore not saving, and in America saving in gold was prohibited—American net producers earned "fiat 33" and it worked out spectacularly for them.
There are stories of gold trading as high as double the London price in certain places in India and China during the 40s, and of some Saudis taking advantage of this arbitrage opportunity. But much of the gold flowing to the Saudis at $35 per ounce came out of the US gold stockpile via Saudi Aramco rather than from the London "street gold" market.
So what we have during these years are two major players running surpluses in the West, America and Saudi Arabia. American net producers earned "fiat 33" and grew accustomed to "the New Idea of long term debt being held as a money asset," while the Saudis received a little bit of Europe's gold via official channels that passed through the US Treasury. But this situation changed once Europe was back on its feet and started net producing in 1958.
1958-1971
The purpose of this section is to give you a new perspective on the Bretton Woods gold flow, the transformation of the dollar, and the early years of "the American Experience that comes to maturity today." There are often many different ways to view an event, none of which is necessarily more correct than another.
For example, the transfer of gold ownership to the US Treasury following WWII could be viewed as the United States printing dollars and buying European currencies (which Europe then had to repurchase with gold) in order to support the weaker European currencies while weakening its own. Or it could be viewed as the European CBs buying dollars from the US with their gold reserves in order to flood the currency exchange with easy dollars. Or it could be viewed as a necessary concession for the $13B in loans and grants the US gave to Europe between 1948 and 1951.
In any case, 1948 through 1952 was the fastest period of growth in European history. Industrial goods production increased by 35%, and agricultural production surpassed pre-war levels. The poverty and starvation in Europe at the end of the war quickly ended, and Europe entered what the French called "Thirty Glorious Years" of economic growth. 1952 also marked the absolute peak in US gold, and 1958 marked the beginning of its decline.
Sometimes viewing something in a new light reveals a deeper truth about what actually transpired. There is debate about how much of Europe's quick recovery should be credited to the Marshall Plan loans and grants. I say it doesn't matter. Perhaps it gave Europe's economy a turbo boost, but Europe was rebuilding regardless. What matters is that the fixed (manipulated) exchange rates agreed upon in Bretton Woods elevated the European standard of living above what its economy was capable of producing during those early post-war years.
It is precisely the same mechanism, official exchange rate manipulation, aka structural support, that later elevated America's standard of living above what its economy was otherwise producing. The big difference, and why no one ever called it an "exorbitant privilege" for Europe in the late 40s and early 50s, was that Europe was in a state of emergency, poverty and starvation when it began for them, and America, on the other hand, was the strongest economy in the world when Europe began supporting the dollar's exchange rate in 1958.
Another different perspective I want to share with you is that FOA's "fiat 33" concept has less to do with the official convertibility of the dollar than you probably thought. It has much more to do with "street gold" than with the official flows of "monetary gold" held by the CBs.
Buying gold with your surplus income is a choice and a preference. That's what it's really about. Practically speaking, there's no difference between an America where it's illegal to buy gold and an America where nobody wants to buy gold.
As I said, the European CBs technically could have hoarded just dollars, not gold, and the Bretton Woods exchange rate manipulation scheme could have gone on indefinitely. But something else happened after 1958, after Europeans started net producing and saving once again in aggregate. Suddenly there was upward pressure on the price of "street gold" in London.
To manipulate the exchange rate between the pound sterling and gold meant, as with currencies, to supplement the supply and/or demand of each such that they were equal at the desired price. And for the London gold fix, this suddenly meant supplying official gold reserves from the Bank of England (BOE).
Throughout the first decade and a half of Bretton Woods, the price of gold in London rarely moved more than a penny or two a day, and was easily kept within its desired range of about $35 to $35.20 without any problem. Then, on one day in 1960, the price of gold in London jumped $5 to $40 per ounce.
The irony of this situation was that the European CBs had to sell gold to the US Treasury during the early years of Bretton Woods while Europe was running a trade deficit, and now that Europe was back on its feet running a surplus, they had to sell gold to their own public (as well as to the Saudis who were no longer receiving official shipments via Saudi Aramco). But notice that the gold being purchased by net producers in Europe was not being purchased in dollars. It was being purchased in the local currencies wherever gold was sold, but those local currencies had the same purchasing power as dollars due to the fixed exchange rate regime.
The point here is that the distinction between FOA's "fiat 33 cash" and "the more golden foreign cash" is not so much about the dollar and its official convertibility at the central bank level (the gold window) as it is about the preference, choice and ability of individual net producers who want to buy "street gold" with their surplus income. As I said, the CBs would have been fine just buying dollars in terms of the agreed-upon exchange rate manipulation scheme, but because of the preference of non-American individuals for gold, the European CBs found themselves in a position of selling their gold reserves whether their economy was running a deficit or a surplus. So gold had to flow, and it had to flow from the US Treasury, which still had almost half of all the CB "monetary gold" in the world.
That was the beginning of the London Gold Pool. The way the pool was to work was that the BOE would supplement the supply of physical gold as needed in the public "street gold" marketplace whenever the price started to rise. The BOE would then be reimbursed its gold from the pool according to each member's agreed percentage. The pool started with 240 tonnes of gold, and the contribution percentages were as follows:
US - 50% (120t)
Germany - 11% (27t)
England - 9% (22t)
Italy - 9% (22t)
France - 9% (22t)
Switzerland - 4% (9t)
Netherlands - 4% (9t)
Belgium - 4% (9t)
The gold pool started out with 240 tonnes in 1961. On its final day in 1968, the fix required 225 tonnes from the pool. The day before, 175 tonnes. The day after, they declared a bank holiday and closed the London gold market for two weeks.
All told, the gold pool reportedly lost 3,000 tonnes of CB gold to "the street". On paper, the US Treasury covered 50% of it, but in reality, it all came out of the US stockpile because the US owed gold to the other pool members due to the Bretton Woods fixed exchange rate regime. Gold rarely moves physical locations—it just changes ownership—but in this case the US actually had to fly several planeloads of gold over to London to cover its debt.
That was the end of the dollar—and all other fiat currencies by proxy—being defined as a certain weight in street gold. When the London gold market reopened, the price quickly rose from $35 to $44 per ounce. But even more significant than that, in my opinion, is that when it reopened, the London gold fix had switched from pound sterling to dollars. What better way to telegraph to the world that the dollar was no longer defined as a weight in gold? This switch of the gold fix from pounds to dollars is worth a little extra thought. It was quite remarkable, even if it was hardly noticed.
If you define the dollar as a certain weight and fineness of gold, then how can you even price gold in dollars? That would be like pricing dollars in quarters, in a public market with a daily fix. "Today the dollar is worth four quarters. Thank you, and we'll be back tomorrow with another daily fix." Switching the fix to dollars at the collapse of the gold pool was quite significant!
Of course, not every individual net producer chooses to buy gold with all or even part of his or her own surplus earnings. All that matters is that gold is available for those who do choose to buy it. The "fiat 33" distinction meant that gold demand did not stress the dollar within its own economy. But again, there's no practical difference between people not being allowed to buy gold and them no longer wanting to buy (or even thinking about buying) real physical gold.
"Fiat 33" laid the groundwork for a global monetary system that would not be stressed by gold demand from net producers. It worked until 1958.
Here's a question to ponder. Did "fiat 33" end in 1974 when E.O. 6102 was repealed? Or did the "fiat 33 distinction" end in 1971 when Nixon officially closed the gold window making all dollars irredeemable in gold? Is everyone in the world using "fiat 33" today, or is nobody using it since gold is now legally tradable everywhere?
There are at least two ways to look at it, aren't there?
"Freegold the monetary system" was a concept born from lessons learned during the Bretton Woods years. But I'd like to point out a couple of simple observations. First, notice that closing the gold window and essentially locking all CB gold in place, ending its flow, did not end the trade imbalance. The US deficit not only continued to this day, it expanded.
Second, since 1971, 100,000 tonnes of new gold has been mined, yet the world's central banks today hold 7% less monetary gold than they did in 1971. In 1971, the seven European former members of the London Gold Pool held a combined 15,660 tonnes. Today they hold a third less, 10,444 tonnes. Even Saudi Arabia's official gold reserves have increased by only 227 tonnes since 1971. So where did 105,000 tonnes of gold go, if not into the monetary system?
Yes, Freegold was a concept born from lessons learned during the Bretton Woods years, but from a monetary system perspective, it has little to do with gold. It's far more about something else. Freegold is about gradual, natural and automatic adjustment mechanisms in the modern world of fiat currencies, and in the international monetary system that means a clean, floating exchange rate regime, the opposite of Bretton Woods.
The Mount Washington Hotel in Bretton Woods, NH
1944 – The Bretton Woods Agreement
I think that Bretton Woods was an honest, timely and noble effort. I think that each participating nation negotiated with honor and the best of intentions, each protecting its own interests while also pushing toward an agreement that took only 22 days to reach but lasted for 27 years. To get a sense of the atmosphere at the end of the 22-day negotiation between 730 delegates representing 45 nations, I recommend reading Henry Morgenthau's closing address. He was the US Treasury Secretary from the height of the Great Depression in 1934, to the end of WWII in 1945, and the head of the American delegation at Bretton Woods.
I also suggest familiarizing yourself with the original Articles of Agreement of the IMF agreed upon in 1944. Here's the original document, and I recommend reading pages 11 – 59 of the pdf, or at least Articles IV (par values of currencies) and XVII (how to make amendments). XIX (explanation of terms like "reserves") and Schedule A (the specific quotas) are also worth a peek. Later, I'll be taking a closer look at one amendment in particular.
The goal at Bretton Woods was twofold. It was to establish an international monetary system that would foster growth and free trade, and to assist in the post-war reconstruction of Europe. The International Bank for Reconstruction and Development (World Bank) was created for the latter, and the IMF for the former.
The pre-war Depression-era years were marked by competitive currency devaluations and defensive trade restrictions like tariffs, both of which reduced international trade, inhibited growth, and even contributed to international tensions going into the war. The IMF Articles of Agreement were a reaction to the protectionist tactics of the 30s.
Fixed exchange rates were the most significant outcome of the Bretton Woods conference, and they were a direct response to the exchange rate manipulations (competitive devaluations) of the 30s. But I want you to take note of the fact that the solution they came up with for the problem of uncoordinated exchange rate manipulation was coordinated exchange rate manipulation.
From "A brief post on competitive devaluation" in The Economist:
"When the Depression struck, this gold standard became a noose around the necks of struggling economies. Economies with overvalued currencies struggled to compete in export markets and ran trade deficits which led to gold outflows."
Uncoordinated (competitive) devaluations overvalue your trading partner's currency which, unless he devalues in response (a currency war), eventually lead him to trade deficits and gold outflows. The Bretton Woods solution had the same effect. First it overvalued the European currencies which led to gold outflows while allowing them to run a trade deficit during reconstruction, and then it overvalued the US dollar beginning around 1958, which led to gold outflows and a trade deficit which continues to this day.
Yes, the dollar has been overvalued because its exchange rate has been supported by Europe and others since at least 1958. This has had a profound effect on America. It has transformed the US economy from what it was in the 50s into what it is today. This is the American experience that comes to maturity today.
The Dirty Float
SteveH asked where it all started so I told him "Jamaica Accords".
In good order, Cage Rattler found a nice rundown about the
entire evolution of the world monetary system. Everyone
here should read all of it because it helps put into perspective
much of the Historical material that we analyze.
As for an international or heads of government signed accord,
the Jamaica is as close as you will ever see. Often, in politics,
protocols are but forced standoffs. Just like when two armies
stop shelling each other. Someone makes the wise observation
that "the generals must have come to an agreement to stop fighting".
Yet, a reporter, trying to make a "responsible" assessment to the
public, asks "when will we see a copy of the contract?"!
My friend, the observer exclaims, "the events and
the actions are the agreement"! –FOA (8/2/99)
_________
Exchange rate stability has long been promoted by economists and desired by central banks. But when Freegold was officially launched for the first time on April 1, 1978 (don't worry, I'll explain in a moment), it was a shock to economists and central bankers alike that the dollar plunged 15% against other currencies and 30% against gold in just 5 short months. The USDX is around 100 today, so that would be like a plunge to 85 by October. Gold is at $1,700 as I write, so that would be like gold breaking through $2,200 in the next few months.
I realize that doesn't seem very alarming given the volatility of the last decade, but try putting yourself back in 1978. We'd recently come off the Bretton Woods system in which currencies traded for 25 years within 1% of their par values. The dollar had previously declined as much as 10% over 5 months, but this time it dropped 7.5% in a single month. Some of the European central banks knew what had changed, and they knew it wouldn't stop there, nor would its effects be limited to the United States. This realization would change the course of monetary history for the next 35 years.
What happened on April 1, 1978 was that the 2nd Amendment to the IMF Articles of Agreement went into force, officially legitimizing floating exchange rates and allowing each CB to choose its own exchange rate policy. They could choose to float their currency or tie it to any external anchor with the sole exception of gold.
In other words, gold was officially set free from its shackles to the monetary system for the first time in history. The 2nd Amendment not only set gold free, but it also effectively established the first ever fiat currency floating exchange rate regime. Together, those two things constitute Freegold, and that's why I said it was officially launched on April 1, 1978… then it was quickly aborted by the same European CBs who had lobbied for it. But I'm getting a little ahead of myself.
The Smithsonian Agreement
Under the Articles of Agreement of the International Monetary Fund, the Bretton Woods system required currency exchange rate transactions to stay within ±1% of their fixed par value with the dollar. To maintain this tight range, the foreign public sector--the European central banks--had to fix their currency exchange rates each day by supplementing either supply of or demand for their own currency or the dollar. Before 1958, this meant buying dollars with gold. After 1958 it meant buying dollars with newly printed currency.
Par values could be adjusted only with prior approval from the IMF, and only if there was a "fundamental disequilibrium", a notion that was never precisely defined. But by 1971, fundamental disequilibrium was systemic, and this rigid system was under great tension. In a situation reminiscent of the last days of the London gold pool, the Bundesbank had to buy a billion dollars in a single day on May 4, 1971, in order to maintain its par value. The next morning it had to buy another billion dollars in just the first hour. At that point it made the decision to let the mark float.
In the weeks that followed May 5th, pressure on the dollar grew to extreme levels as the foreign private sector (often called "the speculators" when it goes against the status quo, but I prefer to simply call it "the market") bet on an imminent dollar devaluation. But while each CB could propose a change to its own par value against the dollar, it wasn't so simple to effect a change in the dollar itself. Under IMF rules, a uniform change in par values (which was what a dollar devaluation was by definition) required a majority of the voting members to agree to simultaneously revalue their currencies against the dollar, and many countries didn't want to do this because they thought it would negatively impact their exports to the US. Besides, they didn't mind printing to buy dollars to maintain their par values because the dollar was still technically convertible to gold at $35 per ounce, a 22% discount to the market price at that time.
Then, three months later on August 15, 1971, a Sunday, President Nixon shocked the world by announcing that the dollar was no longer convertible to gold, and that a new 10% tax on imports would remain in effect until US trading partners agreed to revalue their currencies against the dollar. That announcement brought the "Group of Ten" (Belgium, Canada, France, Italy, Japan, the Netherlands, the United Kingdom, Germany, Sweden and Switzerland) to the bargaining table at a meeting at the Smithsonian Institution in Washington, D.C. in December of 1971. The group agreed to devalue the dollar and the import tax was removed.
The Snake in the Tunnel
One of the results of the Smithsonian Agreement was the idea of a 2.25% trading band. The dollar was devalued with a new set of par values for the other main currencies, and the tight band of 1% in Bretton Woods was widened to 2.25%.
Four months later, in the "Basel Agreement" on April 10, 1972, the members of the European Economic Community (EEC) conceived the idea of the snake in the tunnel. It was an easy explanation of the Smithsonian Agreement setup, but more importantly, it distinguished the snake (the European currencies) from the tunnel (the dollar), opening the possibility of the snake existing without a tunnel. It also marked even tighter European cooperation than the Smithsonian Agreement technically required.
Here is the explanation of the snake in the tunnel from Wikipedia:
"With the failure of the Bretton Woods system with the Nixon shock in 1971, the Smithsonian agreement set bands of ±2.25% for currencies to move relative to their central rate against the US dollar. This provided a tunnel within which European currencies could trade. However, it implied much larger bands in which they could move against each other: for example if currency A started at the bottom of its band it could appreciate by 4.5% against the dollar, while if currency B started at the top of its band it could depreciate by 4.5% against the dollar.
If both happened simultaneously, then currency A would appreciate by 9% against currency B. This was seen as excessive, and the Basel agreement in 1972 between the six existing EEC members and three about to join established a snake in the tunnel with bilateral margins between their currencies limited to 2.25%, implying a maximum change between any two currencies of 4.5%, and with all the currencies tending to move together against the dollar."
The snake in the tunnel marked the trailhead of the dirty float trail which is ending today, as well as the beginning of Eurocentric exchange rate cooperation that ended with a common currency in 1999. But the snake left its tunnel after barely one year.
Exchange Rate Anarchy
Lest you got the impression that Bretton Woods was a strict disciplinary system under a tyrannical master (the IMF), let me assure you that it was not. Regardless of how it was written, in practice, it was a system of voluntary cooperation (more or less) between CBs. In fact, enforcement was pretty slack. It was actually more of an honor system.
Some countries used "multiple" par values, and some never declared any par value at all, essentially floating their exchange rates without incurring any sanctions. And most par value adjustments (unilateral de- or re-valuations) were not run through the IMF as was required.
When Bretton Woods started, the IMF had 44 different member currencies. By the mid-1970s, that number was up to 127. The point of mentioning this is not that some of the members disobeyed the rules, but that most of them followed the rules voluntarily, without any serious threat of sanctions. The international monetary system yearns for a set of rules that everyone can easily follow, voluntarily. But from mid-1972 until 1978, anarchy was a good description of the international monetary system.
In June of '72, the UK decided to float the pound, followed by Italy in January of '73. In February of '73, the EEC had to buy $3.6 billion just to keep the snake in the tunnel. Then on March 1st, the EEC temporarily closed its foreign exchange markets and pulled its snake out of the dollar tunnel allowing it to float as a group against the dollar. Japan and Switzerland followed. Over the next three years, a number of international meetings were held in attempt to deal with the chaos, to somehow make sense out of the anarchy, and to try to codify it into a new set of rules that would be agreeable to the majority.
In September of '73, a new IMF "Committee of 20" (the full name was the Committee on Reform of the International Monetary System) met in Nairobi to begin constructing new IMS rules. Two basic ideas were agreed upon in Nairobi. 1. Stable but adjustable exchange rates were the goal. At the time, that seemed to mean something in between fixed parities and floating exchange rates. And 2. There should not be a single national currency with the privileged position of the dollar in that all other currency pairs must not only watch their exchange rates with each other but also their combined relation to the dollar.
A few weeks after Nairobi, the oil crisis hit, and with it came a dramatic rise in the general price level of raw materials and food. In April of 1974, the EEC met informally in the Dutch town of Zeist where they decided that their gold reserves should be mobilized (bought and sold with each other and with the free gold market) at the free gold market price in order to help the struggling European oil and raw material importing countries. Some even took the additional step of revaluing their gold reserves from the current $42.22 to the market price which, at the time of the meeting, was $174 per ounce.
Then, in June of 1974, the IMF decided to change the value of an SDR from gold to a trade-weighted basket of 16 different currencies. International monetary links to gold and the dollar were quickly disintegrating, but the monetary system continued to destabilize. One by one, European countries severed their ties to the snake, including France in July of 1975, until it was little more than a worm with just five remaining members.
The Jamaica Accord
By 1976, the Bretton Woods monetary system was little more than a distant memory, but the Articles of Agreement for the International Monetary Fund were still the rule book for the international monetary system which had grown from 44 to 127 members. The US had broken the rules in 1971, but by 1976, everyone was breaking the rules.
So what do you do when everyone is breaking the rules? That's right, you rewrite the rules! And that's precisely what the Committee of 20 set out to do when it met again, this time in Jamaica, on January 7-8, 1976.
What came out of that meeting was the 2nd Amendment to the IMF Articles of Agreement. The 1st Amendment was back in 1969, creating the SDR as a supplemental reserve asset. But the primary achievements of the 2nd Amendment were sweeping; a full rewrite of Article IV—Obligations Regarding Exchange Arrangements, as well as the abolition of the official price of gold and authorization for central banks to carry out gold transactions at free gold market prices.
Regarding exchange rate policy, the new Article IV laid down the general objectives as promoting and fostering growth and stability, while avoiding "erratic disruptions" and exchange rate manipulations that prevent effective adjustment mechanisms, "or to gain an unfair competitive advantage over other members." Each member would have 30 days after the Amendment went into force to notify the IMF of its chosen exchange rate policy. The range of possible choices was unlimited except for one single restriction. The sole limitation was that no member could choose to maintain the value of its currency in terms of gold.
In addition to Article IV, the 2nd Amendment mentions gold in five more of its 31 Articles as well as in four of its 13 Schedules. Here are the highlights:
Under Article V: Operations and Transactions of the Fund, Section 12, it made provisions for the sale of IMF gold back to its members that want it back and for other purposes excluding "the management of the price, or the establishment of a fixed price, in the gold market."
Section 12. Other operations and transactions
(a) The Fund shall be guided in all its policies and decisions under this Section by the objectives set forth in Article VIII, Section 7 and by the objective of avoiding the management of the price, or the establishment of a fixed price, in the gold market.
[…]
(e) The Fund may sell gold held by it on the date of the second amendment of this Agreement to those members that were members on August 31, 1975 and that agree to buy it, in proportion to their quotas on that date.
Under Schedule B: Transitional Provisions with Respect to Repurchase, Payment of Additional Subscriptions, Gold, and Certain Operational Matters, it says that any existing obligations for a member to pay gold to the IMF will now be paid in SDRs:
2. A member shall discharge with special drawing rights any obligation to pay gold to the Fund in repurchase or as a subscription that is outstanding at the date of the second amendment of this Agreement, but the Fund may prescribe that these payments may be made in whole or in part in the currencies of other members specified by the Fund.
Under Schedule C: Par Values, in the case that adjustable par values are ever reestablished based on an 85% majority vote [bracketed notes are mine]:
1. […] The common denominator shall not be gold or a [single] currency [like the dollar in the past].
Under Schedule K: Administration of Liquidation (of the IMF)
9. The Fund shall determine the value of gold under this Schedule on the basis of prices in the market.
The 2nd Amendment was approved and adopted in April of 1976, and went into force two years later on April 1, the first day of the second quarter of 1978. It is still in force today. You can read the new Article IV here, as well as the full text of the IMF Articles of Agreement as they stand today.
Q2 1978
Q2 1978 marked the first and only major change in the official rules governing international currency exchange rate policy in the last 75 years, legitimizing floating exchange rates and allowing each CB to choose its own policy. Coincidentally (or not… probably not), it also marked the first quarter since the collapse of the Bretton Woods fixed exchange rate system that European central banks, in aggregate, stopped buying dollars.
The term "dirty float" has two components. "Float" refers to the private sector, "the market" as I like to call it, or "the speculators" as the public sector likes to call it whenever it upsets the status quo. And "dirty" refers to the public sector resisting market forces, also known as CB intervention whenever "the speculators" disturb the status quo.
Even though the snake pulled out of the tunnel and the European currencies began floating against the dollar in 1973, it was still a dirty float all through the 70s, until Q2 1978 when it suddenly went clean. To give you an idea of the abruptness of this "going cold turkey" change, during the two preceding quarters, foreign CBs in aggregate bought $16B per quarter, or about $5.3B per month, just to support the dollar exchange rate. But in Q2 they not only stopped buying dollars altogether, they actually sold $5B of their dollar reserves during that quarter. (Ref: Robert Triffin (Nov. 1978) The International Role and Fate of the Dollar Foreign Affairs p. 13/281)
Also coincidentally (or not… probably not), May, the 2nd month of the 2nd quarter of 1978, marked the beginning of the largest and quickest decline in the dollar exchange rate that had ever occurred. A five-month, 15% waterfall-like decline in which 50% of the fall happened in October alone, the last 20% of the time period.
Overvalued
There's a very simple way to know if a currency is overvalued. If its currency zone is running a persistent trade deficit, the currency is overvalued. It's as simple as that. But the causes, cures and consequences are a little more complex, especially for the dollar.
From mid-May until October 1st, 1978, the dollar declined 8.5% on the USDX. October 1st was the date of the annual meeting of the IMF which, in 1978, was held in Washington. At that meeting, European central bankers urged then Fed Chairman G. William Miller to take tough action to stem high dollar inflation, the persistent US trade deficit, and the dollar's steep decline, which was already seen as disastrous for the global economy.
The dollar was the only real international currency at that time, and it was estimated that as much as 80% of all private sector international transactions outside of the US were conducted in dollars, simply for want of an international currency. This was called the Eurodollar market, and it was estimated to be $560B circulating through banks outside of the Federal Reserve System, so any abrupt decline in the dollar's exchange rate threatened both global trade flows and the entire international financial system.
But the dollar's decline only accelerated in October, plunging another 8% over the next four weeks. Here are a few excerpts from newspaper articles during that time.
Newsweek
October 2, 1978
International Finance
By Paul A. Samuelson
Lord Keynes used to say there are two opinions in economics, public opinion and inside opinion… Inside opinion is split on the state of the dollar. Poll bankers and foreign-government officials. I think you will learn their views resemble the following.
1. The decline in the dollar exchange rate relative to the German mark, the Japanese yen and the Swiss franc is a disaster.
2. President Carter, Treasury Secretary Michael Blumenthal and Under Secretary of State Richard N. Cooper must bear the blame for unwillingness to intervene to support the dollar.
[…]
By contrast, take a pool of 5,000 U.S. economists gathered at a convention. Or better, sample views of the 1,000 who specialize in international finance and macroeconomics. Three quarters would hold the following quite different opinions…
1. If the dollar floats downward (or upward, for that matter), that is a good or bad thing depending upon whether it represents a movement toward or away from equilibrium.
2. The great advantage of getting away from the shackles of pegged exchange rates, a la the old Bretton Woods regime or the limping gold standard, is that it permits each country to pursue its own economic objectives.
[…]
The annual meeting of the International Monetary Fund and World Bank, now taking place in Washington, is a forum in which the above contrasting views will be debated both publicly and in the hotel corridors. Somehow a unified insiders' consensus will have to emerge.
There are yet few signs that the U.S. trade deficit is on its way toward being permanently reversed. I must therefore warn against the tempting assumption that the dollar has already dropped so much that it can be safely assumed now to be an undervalued currency. Agnosticism is still in order. One must counsel Carter against premature agreement to peg the dollar by massive interventions and binding guarantees.
Chairman G. William Miller of the Federal Reserve Board is aware that the U.S. recovery could turn into a 1979 mini-recession. I trust that he and his Fed colleagues will not yield to Continental bankers' demands that we deliberately court a recession to fight inflation and defend existing dollar parities.
Xinhua General News Service
OCTOBER 28, 1978
U.S. Records more trade deficit in September
DATELINE: Peking
The U.S. registered another trade deficit of 1.69 billion dollars last month, the 28th in a row, the U.S. government announced yesterday…
The U.S. trade deficit has been a cause for the steep slide in the value of the dollar. Reuter reported yesterday that the U.S. dollar exchange rate fell to 1.7595 against West German mark and 178.23 in terms of Japanese yen. On October 26 last year, the dollar traded in London at 2.26 mark and 251 yen.
Newsweek
November 13, 1978
SAVING THE DOLLAR BUT RISKING A RECESSION
By LARRY MARTS with RICH THOMAS, THOMAS M. DeFRANK and ELEANOR CLIFT in Washington, PAMELA LYNN ABRAHAM in New York and bureau reports.
[…] In theory, a falling dollar makes imports more expensive and thus helps domestic manufacturers compete. But in practice over the past few years, domestic producers have seized on rising import prices as an excuse to raise their own prices, not undersell the competitions.
Perhaps for the same reasons, the falling dollar hasn't helped the U.S. balance of payments, as long promised. In theory, a falling currency discourages imports and spurs exports. There is always a lag in this benefit, known to economists as the J-curve. But for the U.S., the downward leg of the J has seemed interminable. And the nation's persistent deficit in its accounts with the rest of the world spews more dollars overseas and in turn, in a vicious circle further erodes their value.
The dollars abroad multiply not only from the U.S. deficit, but in the course of normal banking operations. By one common measurement, the Eurocurrency pool swelled from $360 billion in 1974 to $700 billion last June, and $560 billion of the total was in dollars. For a while, expanding world trade and the need to finance oil payments at quadrupled prices absorbed the increasing flow of dollars. But lately, as The Times of London put it last week, "There are more dollars around than people want." Since the U.S. inflation rate considerably exceeds those of the strong-currency nations, dollars are increasingly suspect as a store of value, and more and more investors tend to prefer assets denominated in Deutsche marks, yen or Swiss francs.
BUYING AMERICAN CHEAP
The result: the dollar's exchange value has plummeted far below its realistic purchasing power - that is, a dollar in the U.S. will buy far more goods and services than its equivalent in, say, marks will buy in Germany. And in growing numbers, foreign holders are taking advantage of this disparity by using their cheap dollars to buy vast quantities of common stock, farm land, houses and factories in the U.S.
But the most frightening potential effects of a continued dollar decline could be a catastrophic world crash. At some point, foreign holders of dollars might become so nervous that an orderly fall in prices could turn into a panicky rout, with investors and speculators frantically trying to find havens for their money. Since there is no equivalent to the dollar - all the Deutsche marks outside Germany, for instance, amount to only $84 billion-the result would be a frantic rise in the price of everything in harder currencies, a collapse of the dollar, stringent exchange barriers and a virtual halt to world trade. The only consolation, as Carter's financial aides saw it, was the bitter old adage that a whiff of panic both permits and forces a Head of State to take steps that would be unthinkable in normal times…
Solomon's Kitchen Sink
Late in the day on October 24th, President Carter was scheduled to make a speech announcing his new anti-inflation plan. But a copy of the press brief was leaked to a banker about an hour before the speech, and word quickly spread that the details of the plan were weak. Front running the yet-to-be-news, a sell-off of the dollar began in Singapore which was the only dollar market open at that time, and it continued around the globe dropping the USDX another 4% over the next four days.
Treasury Under Secretary for Monetary Affairs, Anthony M. Solomon, had been working on a contingency plan ever since the IMF meeting at the beginning of October which Treasury insiders had started calling "Solomon's Kitchen Sink" because it called for throwing "everything but the kitchen sink" at the problem of the dollar's declining exchange rate. Following the Oct. 24th disaster, Solomon's plan became the plan.
This time Carter insisted on strict secrecy prior to announcing Solomon's plan. One of Carter's aides later reported that he wanted to maximize impact at the time of the announcement, saying "One of the pleasures in this is punishing the damn people who have been underselling the dollar." Carter, together with Treasury Secretary Blumenthal and Fed Chairman Miller, made the announcement a week later, on November 1st, this time right before the New York stock market opened.
Aside from one suspected leak in Switzerland, the elements of timing and surprise in Carter's bear trap bombshell worked, catching traders short and exposed, and delivering the dollar a quick 10% bounce. One trader commented, "They really clobbered the foreign traders. No one will dare make a move for several months. The losses must have been staggering." Even Jim Sinclair gave a comment to Newsweek, saying the mood was like a funeral for anyone who had recently jumped on the currency market bandwagon.
Carter's kitchen sink approach was a multi-front attack on the dollar's weakness, from buying up international dollar liquidity through "massive intervention" in the foreign exchange market and tightening domestic liquidity by raising interest rates and bank reserve requirements, to quintupling the size of the ongoing US Treasury gold auctions from 9 to 46 tonnes per month. Carter's war chest of foreign currency ammunition was declared to be $30B, $5B already held by the US at the IMF, and another $25B in foreign currency that would be borrowed, primarily through expanded swaps with foreign CBs.
The expanded swap line agreements were arranged with Germany, Switzerland and Japan the week before the announcement (thus the suspected leak in Switzerland). The plan was that the US Treasury could, at any time it wanted, exchange dollars for German marks, Swiss francs and Japanese yen and use them to buy dollars on the open market. The foreign CBs would hold the swapped dollars as reserves until the market calmed down and the Treasury was able to repurchase the foreign currency and swap it back again.
Notice that this was essentially the same mechanism as the dirty float prior to Q2 1978—the foreign CB prints new currency which gets used to buy dollars on the open market and the foreign CB ends up sitting on dollar reserves—with a few notable differences. One difference was that the US Treasury was now in control of the timing and magnitude of the manipulation rather than the foreign CB. Another was that the US Treasury couldn't do it on its own like the foreign CBs could. It needed their support and cooperation. And the last main difference is that it was done belligerently, to scare the private sector market, rather than quietly in the background.
I also want to note that it was widely believed that Carter's domestic monetary tightening, the largest interest rate increase in 45 years, a full percent from 8.5% to 9.5%, would likely induce a recession in the US economy, making it a surprisingly conservative move which concerned some of Carter's fellow Democrats. It was a bold and risky move that most people were optimistic about, even if they were split on whether it went too far or not far enough.
Here's part of a good article from November 13th to give you a feel for the mood following Carter's November 1st announcement:
Newsweek
November 13, 1978
YES...BUT
By Paul A. Samuelson
President Carter scored a smashing tactical triumph. His surprise counterattack against the speculators turned the dollar around, sending it up against the yen, mark and pound. The dollar price of gold, always a barometer of psychology about U.S. inflation and stability, plummeted.
The Carter team is beaming. Bankers and businessmen applaud, complaining only that it should have been done earlier. Main Street likes a President who is doing something-anything. Naturally it likes a medicine man who sends up its common stocks.
What do economists think? Is the battle against inflation at long last getting somewhere? Will the euphoria last? Is $30 billion a large enough fund to succeed in pegging the dollar at its new parity? What will be the price that the American economy will have to pay if the first tactical victory is to be consolidated into a lasting strategic success?
The jury of analysts cannot be expected to arrive at unanimous verdicts on every one of these crucial questions. But there should be possible a reasonable consensus on the important variables that will be decisive in determining the longer-run consequences of our new economic game plan.
First, here is the hard-boilded interpretation. Carter, knowingly or naively, has acted to create a 1979-80 recession. High interest rates, sustainable only by a tight monetary policy on the part of the Federal Reserve, will choke off housing starts, dampen investment spending, turn around inventory growth and undermine consumers' incomes and willingness to spend.
Indeed, the only effective way of bringing down inflation in the short run is to cool off the economy, increase unused plant capacity, add to the supplies of unemployed labor. This hard boiled school does not blame Carter for engineering a recession. It was inevitably coming, anyway. Now it will come earlier. Probably it can therefore be a milder and shorter recession. By Election Day 1980, candidate Carter may well be glad that he grasped the nettle 24 months ago.
SWEAT AND TEARS
These economists may be right. Political economy is not, however, so exact a science that you should put all your bets on a full-fledged recession in 1979. For one thing, the President and Congress may not in fact persist in their defense of the dollar and determination to fight inflation at all costs. After the cheering has died down, once there begin to be complaints from the electorate about layoffs, declining real income, and melting corporate earnings, Washington Democrats may begin to falsify the hopes of European bankers.
For another thing, a considerable part of the hysteria about inflation and the bottomless floating dollar was just that-hysteria based more upon the self-fulfilling fears of the market mob than upon objective evidence that U.S. inflation was escalating out of control and that our trade deficit was incapable of being cured by a finite depreciation of the dollar.
[…]
IN SUM
My own view is that pegging exchange rates is usually unwise. Usually governments defend the indefensible. Usually they present speculators with juicy heads-I-win tails-you-lose chances. I do not deem it philosophically sinful for government to intervene-only for the most part stupid.
But occasionally that rare opportunity arises when government can counterspeculate successfully. This may have been just such an opportunity.
I must still remain an agnostic on the longer-run question: has the dollar fallen enough to make our costs so competitive as to ensure curing of the basic U.S. balance-of-payments deficit?
Only time will tell. Meanwhile, I must warn against the notion that a recession is our only salvation.
The Belgrade Confrontation
The dollar's exuberant bounce in November was rather short-lived. In December it fell 5% and in June and July of 1979 it did it again. By September 28, 1979, the dollar was 4% below where it had been a year earlier, and back down to the same low level it was in late October, 1978. Meanwhile, the price of gold had more than doubled from its kitchen sink low in November.
In July of 1979, a desperate Jimmy Carter, facing numerous problems including a tough reelection campaign, fired five of his cabinet members including Treasury Secretary Blumenthal, reportedly calling him "inept" in a private conversation. Fed Chairman G. William Miller left the Fed to become Carter's new Treasury Secretary, and Paul Volcker, the President of the New York Fed and former Treasury Under Secretary for Monetary Affairs during the Nixon Administration, was chosen to be the new Fed Chairman.
The annual IMF meeting that year was to be held in Belgrade, Yugoslavia, from September 28th to October 5th. Volcker and Miller would both attend. You won't hear much about this meeting anywhere else, but my readers know that I have mentioned it numerous times. That's because it marks an important turning point in monetary history.
FOA: We are, today, at the very conclusion of a fiat architecture that is straining to cope with our changing world. Neither the American currency dollar, its world reserve monetary system or the native US structural economy it all currently represents will, in the near future, look anything as it presently does…
…one important, almost unthinkable question; what if current trends are moving away from using our dollar reserve system? Even further, let's ask; what if the last decade's efforts to prolong dollar use, both internally and worldwide, have inflated its worth to such an extent that it's now vastly overvalued? Asking more; what if the architects of a competing currency system and the major players that helped guide its internal construction, all took a hand in promoting the dollar's extended life, its overvaluation and its use; so as to buy time for this great transition in our money world?
In my analysis, Belgrade marks the resumption of the dirty float that abruptly ended in Q2 1978, and the beginning of foreign public sector (CB) structural (dirty float) support that carried the dollar for the next 40 years.
Back in Q2 1978, a series of meetings in Europe made great strides toward monetary union and a "European Monetary System" resulting in the European Currency Unit or ECU, the predecessor to the euro, which was introduced in March of 1979.
In May of 1978, the European League for Economic Cooperation or ELEC, an influential private sector organization, unanimously approved a proposal for "A European Parallel Currency as a Shelter Against Exchange Rate Instability". The proposal, which was drafted by Robert Triffin, urged the adoption of a European currency tentatively named the Europa as "an attractive alternative to the parallel currencies widely used already in transnational contracts which cannot, obviously, be denominated simultaneously in the national currencies of each of the contracting parties. The exchange rate of an appropriately defined European parallel currency would be less volatile [than those of the Eurodollar, Euromark and other Eurocurrencies most in use today], its fluctuations remaining more moderate vis-Ã -vis the national currencies of member countries, as well as vis-Ã -vis other currencies." (Ref: Robert Triffin (Nov. 1978) The International Role and Fate of the Dollar Foreign Affairs p. 11/281)
In June of 1978, the European Economic and Social Committee or EESC, another influential organization representing the European private sector, met in Brussels and produced an opinion paper on "Community Approach to the Present International Monetary Disorder" to be submitted to the EEC. It concluded that "the Community must not abandon the objective of complete economic and monetary union, in spite of the failures and setbacks. In the present international monetary disorder, the EEC should gradually form an "area of stability", which would help in restoring world monetary equilibrium. The ESC will continue its work in this field, examining other aspects of economic and monetary union with the aim of determining the requirements for the creation of a common currency which can help restore equilibrium to the national monetary system." (Ref: Economic and Social Committee of the European Communities (June 1978) Monetary Disorder p. 98)
Then in early July of 1978, the European Commission met in Bremen, Germany where German Chancellor Helmut Schmidt and French President Valéry Giscard d'Estaing proposed the European Monetary System (EMS) and the European Currency Unit (ECU). Both would begin eight months later in March of 1979.
According to a paper by Robert Triffin four months later, "The first reactions of the Carter Administration to the Bremen proposals were ambivalent. The Administration reiterated both long-standing U.S. support for European monetary union, and U.S. skepticism over its feasibility. High-ranking Treasury officials also reiterated U.S. support for making SDRs the principal instrument for international settlements and reserve accumulation, "but, of course, without eroding the traditional role of the dollar." This is, of course, a contradiction in terms since the dollar has been, since the war, and remains, by far the major instrument in both these respects. American officials also expressed some fears about the inflationary potential of ECU issues and accumulation — as though the use of the dollar had not proved wildly inflationary and was not one of the main arguments for an ECU alternative more controllable by the Europeans than the unlimited acceptance by their central banks of dollar overflows.
"Finally, and most bizarrely, they voiced their concern about the fact that the new system might deter the strongest currencies from appreciating sufficiently against the dollar. While it is true that such appreciation might be slowed by being more evenly spread out from the present "refuge currencies"-primarily the mark and the Swiss franc —to a broader range of currencies, Washington's major worry should be exactly the opposite: an excessive, rather than inadequate, depreciation of the dollar vis-Ã -vis the ECU and the European currencies anchored to it. Possible switches in international demand from a weakening dollar to a stronger ECU would indeed threaten to accelerate dollar depreciation and so to make the dollar more and more undervalued. If this were to happen, the clamor for protection against U.S. "exchange-rate dumping" might become nearly irresistible abroad, and the depreciation of the dollar might also trigger a panicky reaction here at home toward protectionism and even some forms of exchange controls and restrictions. Americans and foreigners should accept a depreciation of the dollar sufficient to restore our price and cost competitiveness in world trade, but should not be expected to tolerate the much deeper depreciation that might be —and perhaps already is being—triggered in the exchange markets by the diversification of portfolio holdings from a near-monopoly of the dollar into a broader range of "parallel currency" alternatives. The Europeans are even more anxious than we are to avoid such a danger, and to participate with us in the joint defense and readjustments of the dollar rate vis-Ã -vis their currencies." (Ref: Robert Triffin (Nov. 1978) The International Role and Fate of the Dollar Foreign Affairs pp. 11/279-12/280)
Meanwhile, at the same time as serious plans for a pathway to European monetary union were taking shape, the dollar collapsed until Carter threw everything but the kitchen sink at it, most of which was borrowed from European CBs. After a one-month bounce driven more by rhetorical shock and awe than fundamentals or technical intervention, the dollar spent the next ten months returning to its pre-bounce lows even as Carter fired his Treasury Secretary who would have been in charge of exchange rate interventions, which brings us to Belgrade.
Having made the decision to proceed toward European monetary union and ultimately a common currency, and to structurally support the existing dollar reserve system until it was complete, the euro architects (the core European central banks, probably Germany, France, Italy, the Benelux countries plus Switzerland) would have faced two distinct but related challenges regarding the dollar: controlling both domestic US and international dollar liquidity.
Controlling international dollar liquidity was easy, and dirt cheap from a European central bank's perspective (although it had a cost to its local economy in the form of an artificially-suppressed living standard). All the foreign CB had to do was print new currency and use it to buy dollars on the open market whenever the foreign private sector lost interest in buying dollar-denominated US assets.
There was a very real fear at the Belgrade IMF meeting that the global financial system was on the verge of collapse. A collapse in the dollar's exchange rate was one problem, but the more challenging problem was that the Fed's interest rate increases had failed to tame domestic money supply expansion—some of which spilled over into the foreign exchange purchasing new imports—and therefore failed to sufficiently reduce the US trade deficit which was still 400% higher than in 1976. This represented $25B in new dollars or dollar-denominated US assets that would have to be absorbed by someone each year, just to maintain the status quo.
$25B per year doesn't seem like much by today's US trade deficit standards, but in hindsight we can add up how much of it actually needed to be absorbed by the foreign public sector (as opposed to the profit-driven foreign private sector). Adding up the US trade deficits from 1971 through 2019, the total comes to $12.8T. Of that, a full third, or $4.3T, was absorbed by foreign CBs. We see that number on the Foreign Official holdings line of the TIC data put out by the US Treasury.
The biggest problem isn't "the excessive dollar overhang piled up in the past" as Triffin called it, it's that the US has become structurally dependent upon it continuing to pile up more and more each month, and that's not something the US controls. Possibly trying to head off this potential future nightmare, the core European central bankers confronted Paul Volcker in Belgrade with "strongly stated recommendations" that stern action needed to be taken immediately.
Back in the US, the Federal Reserve Board had spent the past year deeply divided and indecisive. It was a perfect example of the Fed's dueling (dual) mandates. On the one hand, there was the emerging recession for which the Fed doves wanted looser monetary policy, and on the other hand was the rising inflation rate for which the hawks preferred tightening. Paul Volcker was well known as one of the hawks. As Chairman of the Fed, Miller had been weak, hardly ever expressing his own opinion, always seeking a compromised consensus, and troubled by any dissent.
During his interview with President Carter for the chairman's seat, Volcker recalled, "I told him the Federal Reserve was going to have to be tighter and that it was very important that its independence be maintained." He thought this would exclude him from the seat, but Carter picked him anyway, tacitly coming down on the side of inflation being a more pressing concern than recession.
In his first meeting as Chairman in August of '79, Volcker expressed his desire to take bold action, but he also said that it should only be done during a crisis. Less than a month and a half later, his idea for bold action had taken shape as a fundamental change in Fed policy from controlling interest rates, to letting the market take control of interest rates and the Fed directly targeting the money supply aggregates, and his crisis had also apparently arrived just as he was leaving for Belgrade on September 29th.
Volcker flew over on the plane with Miller, now Carter's Treasury Secretary, and Charles Schultze, chairman of the Council of Economic Advisors. On the plane ride over, Volcker explained his new plan to the two Carter advisors who made it clear to him that they didn't like it and neither would the President.
After meeting with his European counterparts, Volcker unexpectedly left Belgrade, three days before the end of the conference, leaving the rest of the US contingent behind. According to a Fed paper published in 2004, "Chairman Volcker arrived in Washington on Tuesday, October 2, with his ears still resonating with strongly stated European recommendations for stern action to stem severe dollar weakness on exchange markets. His unexpectedly early return fueled market rumors that action dealing with the crisis might be imminent. This had a stabilizing effect on commodities markets, with futures markets opening lower on October 3, retracing some of their sharp increases on the previous several days." (Ref: David E. Lindsey, Athanasios Orphanides, and Robert H. Rasche (2004) The Reform of October 1979: How It Happened and Why Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C. p. 21)
The next regular FOMC meeting was scheduled for October 16th, but as soon as he got back from Belgrade, Volcker held three secret meetings, one on Thursday the 4th, a conference call on Friday the 5th and another meeting on Saturday the 6th.
Meanwhile, back in Belgrade where the IMF meeting was still going on, Saudi Arabia took the opportunity to address the West. The American Banker reported on 10/4/79:
In another development here Wednesday, a strong warning was delivered to Western governments by Saudi Arabia, which said in effect that it could continue to pursue a responsible oil policy only if the West pursued a responsible monetary policy.
The strength of Saudi Arabia's view was underscored by the fact that its governor of the World Bank and [International Monetary] Fund was availing himself for the first time in six years of the opportunity given to all governors to address the joint meetings.
Sheikh Mohamend Abalkhail, the Saudi Arabian Minister of Finance, said, "it would be naive to pretend that a continuous erosion of our financial resources through inflation and exchange depreciation could not provoke reactions. We have undertaken to provide a larger supply of oil to promote more orderly conditions in the oil market and promote a higher level of sustained growth of the world economy. But we are finding it increasingly difficult to maintain our policies under prevailing instabilities in exchange markets coupled with high levels of inflation in industrial countries."
The American Banker also reported on rumors that Swiss and German central bankers were not exactly happy with the Treasury's direct intervention in their currency exchange rates over the previous year, and that they may have even done their own counter-intervention against US interventions earlier in the year. Even though I'm referring mainly to the USDX in this post, an index of the dollar versus a basket of currencies, US interventions were made against specific currencies, primarily the German mark and the Swiss franc, using marks and francs borrowed from their CBs.
The Belgrade meeting ended on October 5th, and back at the Fed, Paul Volcker's FOMC meeting began at 10AM on Saturday the 6th. By 1:30 they had a unanimous vote, and a press conference was scheduled for 6PM that same day. At the press conference, Volcker began his explanation of the reasons for the Fed's unscheduled actions thusly:
"I think in general you know the background of these actions; the inflation rate has been moving at an excessive rate and the fact that inflation and the anticipations of inflation have been unsettling to markets both at home and abroad. That unsettlement in itself and its reflection in some commodity markets is, I think, contrary to the basic objective of an orderly development of economic activity…"
Aftermath
The Fed's actions that day have been called the most significant change in Fed policy since 1932. The details of the change are not really relevant to this post, but basically the Fed switched from a "gradualist" policy targeting money demand, to a policy directly targeting money supply. (If you are interested in the details, you can read all about them in The Reform of October 1979: How It Happened and Why.)
The relevance of Volcker's October 6 surprise is not the specific actions he took, but the timing. As I said earlier, Belgrade marks an important turning point in monetary history. It marks the resumption of the dirty float that abruptly ended in Q2 1978, and the beginning of the foreign public sector (CB) structural (dirty float) support that carried the dollar for the next 40 years. So while Vocker's stern actions ("with his ears still resonating with strongly stated European recommendations for stern action") made all the headlines, there was plenty more going on quietly in the background on the European side that made no headlines.
You might also be starting to pick up on a distinct cultural difference between the American and European sides in the way their public sectors influence the private sector (the market). The American side tends to prefer bold announcements and subtle innuendo meant to scare the private sector back into line, rather than real, sustainable action, while the European side tends to prefer quiet, behind-the-scenes action. The result is that the Americans and their bold headlines often get the credit of causality for what follows.
What followed the Belgrade meeting and Volcker's subsequent "stern actions" was that the US trade deficit dropped 21% in the first year and another 17% the next year. With fewer dollars being created and therefore fewer flowing overseas, the USDX began climbing immediately, and inflation began its decline shortly thereafter. With the market now in control of interest rates, the Fed Funds rate, the interest rate at which banks trade reserve balances at the Fed with each other to meet overnight reserve requirements, rose from around 11% to 20%. The US had two recessions, a very short one in 1980, and then another one from mid-1981 through 1982. And I think we're all familiar with what happened in the commodity futures markets, especially gold. Gold rose from $385 on October 5th to $850 3½ months later on January 21st, then quickly fell back into the $600s, ending the year 1980 at $590, up 12% for the year and up 53% since Belgrade and the stern actions.
Two Versions of History
First, here's the Fed's version of the story in brief:
"A quarter-century after Paul Volcker’s monetary policy reform in October 1979, the profound significance of restoring price stability for the nation’s prosperity is widely recognized. Taming the inflation problem of the 1970s did set the stage for a long period of prosperity, as Volcker and many others had hoped. Over the past two decades, the nation has enjoyed greater price stability together with greater economic stability. Expansions have been uncommonly long and recessions relatively brief and shallow." (Ref: David E. Lindsey, Athanasios Orphanides, and Robert H. Rasche (2004) The Reform of October 1979: How It Happened and Why Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C. p. 1)
And here's Another version, as told by FOA and edited by me. I'm not here to tell you which one to believe, I'm merely presenting them both so that you can make up your own mind. ;D
FOA:"For decades hard money thinkers have been looking for "price inflation" to show up at a level that accurately reflects the dollar's "printing inflation". But it never happened! Yes, we got our little 3, 4, 8 or 9% price inflation rates in nice little predictable cycles. We gasped in horror at these numbers, but these rates never came close to reflecting the total dollar expansion if at that moment it could actually be represented in total worldwide dollar debt. That creation of trillions and trillions of dollar equivalents should have, long ago, been reflected in a dollar goods "price inflation" that reached hyper status. But it didn't.
That "price inflation" never showed up because the world had to support its only money system until something could replace it. We as Americans came to think that our dollar, and its illusion of value, represented our special abilities; perhaps more pointedly our military and economic power. We conceived that this wonderful buying power, free of substantial goods price inflation, was our god given right; and the rest of the world could have this life, too, if they could only be as good as us! Oh boy,,,,,, do we have some hard financial learning to do.
[…]
Our recent American economic expansion has, all along, actually been the result of a worldly political "will" that supported dollar use and dollar credit expansion so as to buy time for Another currency block to be formed. Without that international support, this decades long dollar derivative expansion could not have taken place. Further, nor would our long term dollar currency expansion produce the incredible illusion of paper wealth that built up within our recent internal American landscape.
[…]
For another currency block to be built, over years, the current world economy had to be kept functioning. To this end the dollar reserve system had to be structurally maintained; with its IMF agenda intact, gold polices followed and foreign central bank support all being part of that structure. Truly, the recent years of dollar value was just an illusion. An illusion of currency function and value, maintaining the purpose of holding the world financial and economic system together for a definite timeline. Politically, the world does not hate America; rather they hate the free lifestyle our dollar's illusion value brought us yesterday and today.
[…]
In the past if the system began driving the dollar too high and forcing US trade deficits, the Fed would raise rates to throw us (USA) into an economic recession that broke the vicious deficit trade cycle. Knowing full well that it would be a short recession policy because "noone" would jump the dollar ship before the medicine could work. Looking around back then we see there was no other reserve currency ship to jump to. We either lose jobs and profits from an "overvalued currency" or from an induced recession. The first can lead to a financial breakdown, the last corrects things after only a short while. Naturally, we embarked on the quick fix of a fast recession.
This is why our times are so very different now. What we came to know over this 20+ year period as a strong America in a high dollar, was always something our money creators were striving to fight against. We truly have always been inflating our currency for these many years in an attempt to keep the natural effects of the IMF reserve system from spiking the currency too high up. Again, if we had a regular currency, our policies would have been reflected in sky high prices for everything. What most of us know as price inflation reflecting money supply inflation.
Ever since the Euro was seen by US policy makers as an eventual success, our treasury has tried to put its best "New York Spin" on the ongoing process. Simply stated; from the early to mid-90s we are in favor of a strong dollar policy. In reality, with the advent of the Euro and the evolving stance of the BIS, this has made our "economy killing" strong dollar unavoidable.
There is no way the Fed can create a new recession now without everyone jumping ship for another currency reserve. There is no possible way the Euro Zone will suffer as big a downfall as the US in another policy induced recession. Just looking at their closed economy and debt structure tells that story by itself. Any US slowdown means a run for the Euro, yet weakness in the Euro means the US must inflate at a torrid rate. We now stand toe to toe and wait to see who will fall first. All the while our world dollar gold markets are caught in the cross fire!
This is where we have been for the last decade. This explains why the DOW and all its paper cousins have enjoyed the effects of a massive, ongoing dollar expansion worldwide without any official policy interference. Right when we were to the point of changing policy to slow things down, the Euro was to be introduced in a year or two and risked taking away or sharing the dollar's standard.
[…]
The lesser of the two evils today (and this is the one the ECB / BIS enjoys watching) is our current frozen policy. We can no longer cut off the strong dollar / growing deficit cycle by raising rates and invoking a recession as in the past. This time we must continue to pump the reserves at all costs in a process that only floods the world with more dollars. It's called a currency hyperinflation and is one we (as US people) have never witnessed in modern times. The pressure has built up full volume now as all escape valves are being closed. We are well on the way to a derivatives exploding event that will break into the open with a cascading dollar and full force US price inflation.
[…]
But once we get to that stage, I expect that a super US economic downturn will ensue. Then the fed will go wide open and cover everything in sight to keep us going!"
"Wait… WHAT?! Is the dollar too strong or too weak? Does the Fed want it stronger or weaker, and what does Europe want? I'm confused!" Yes, I know it's confusing (especially with everyone talking about The Dollar Short™ keeping it strong). But it's not about too weak or too strong at this point. The dollar is simply overvalued, and has been since 1958 when the Bretton Woods gold flow reversed. In the 1960s, that overvaluation was reflected in the European accumulation of dollars and the one-way gold flow. Today it is reflected in the perpetual US trade deficit, which over 45 years has become structural and immutable within the status quo.
The foreign private sector use of dollars as the primary international currency (which still continues today) overvalues it. Back in the 60s, the Bretton Woods foreign public sector exchange rate fixing encouraged this foreign private sector use of the overvalued dollar. Ever since then, the foreign public sector (foreign CBs) simply supplemented the private sector use to keep the world economy functioning in the absence of an alternative international currency. That structural support (aka, the dirty float) appears to have ended in 2013. (Foreign Official TIC holdings in Dec. 2019 were $4.0775T, flat compared to Nov. 2013 at $4.0742T, which was the month that China's TIC holdings peaked at $1.3167T, currently at $1.0923T)
Back in 1978 at the bottom of the dollar's plunge, it was still overvalued. The plunge was stopped because the public sector stepped in, but what the European CBs learned from that experience was the difference in motivations between the public and private sectors. The private sector is very simply motivated by profit, while the public sector is motivated by its desire for exchange rate stability. They learned that, without their structural support (supplementing private sector demand for an overvalued currency via the dirty float), the private sector (the market) will not support a currency if such support turns unprofitable, regardless of the fact that it would collapse the whole system.
The answer to this problem was to create an alternative international currency, with sufficient depth and liquidity to match the dollar, so that they could eventually stop supporting an overvalued national currency (which while it was dirt cheap to them personally, still cost their local economies by suppressing their overall standard of living) just to prevent a collapse in the modern global economy. The answer was the euro, and it was already well in the works after the July 1978 meeting in Bremen. The last piece to the puzzle was that the dollar system obviously needed foreign public sector structural support in order to buy the time necessary to meet that goal.
The dollar didn't plunge in 1978 because the foreign private sector stopped using dollars. The dollar was still the only choice at that time. It didn't plunge because the Saudis stopped pricing their oil in dollars. They didn't. In fact, the price of oil was rising dramatically at that time and the dollar still plunged. The reason it plunged is that foreign private sector use, including oil, is simply insufficient to support such an overvalued international currency. Non profit-motivated structural support is required to hold such a system together for an extended period of time. We can know this is true by the fact that a full third of the US trade deficit over the last 48 years came from the foreign public sector in aggregate supporting foreign dollar settlement with CB storage.
Back to FOA:
"The game is to let the US economy suffer from its own bloated expansion by moving slowly away from supporting foreign dollar settlement with CB storage. This is more than enough to end the dollar's timeline as we are already stretched to the leverage limit. They know that Greenspan has but one policy to use and that will be super printing. He is doing it now, right on cue!
[…]
Remember back in the early 80s or even further back into the 70s. All we heard was how the dollar was finished and going to crash and burn. Books about hyper inflation and the need for gold / swiss francs were all over the place.
I read all of them to gain perspective and also acted on some of their advice. Made some money on it too. But even then, something just didn't completely ring true about the whole scenario. Indeed, in hindsight, gold never did return above $800, the dollar didn't hyper inflate and most of the world kept using the dollar as a reserve.
Today, we can more fully understand why so much of that early insight failed to deliver.
True, the dollar was seen as a basket case back then. It had just been pulled from its gold bond and prices were going up all around us. However, because the world had been on a semi dollar / gold standard, all nations that had previously signed onto using the US buck as their currency reserve now did so with even more resolve. More important, it seemed that using gold itself was out of the question as every country's Central Bank bought dollars as fast as we printed them. The dollar still settled most all trade accounts while dollar reserve buying made an obvious show of support for this world system. No matter how much bad press was offered, they were staying on track and they have continued to do so right up into the 90s!
But all of this flew in the face of what every economist was saying back then. The common understanding of the era was: if the US didn't stop over printing its money, we would all experience a major price inflation,,,,,, and no one could stop it! Again, "major" inflation didn't happen and to ask a further question: if the dollar system was so bad, why didn't the world just dump the reserve system and refrain from using it further? In other words, let the dollar be "the US dollar" but don't use it as a backing for your own money system.
Going against the logic of "sound money": throughout all the currency turbulence of the 70s and 80s era (including today), the US never did rein in the over printing of its currency. It continued almost non-stop money supply expansion for its local economy and in addition sent a good portion of its cash all over the world. On and on the US trade deficit continued to do its work of feeding ever more US cash into foreign economic systems. We printed paper currency by borrowing it into existence,,,,,, used it to purchase real goods overseas ,,,,,, while foreign governments actively soaked up this dollar flood by expanding their own money supply.
Like this: When you buy an item externally, a dollar is sent overseas to pay for it. Usually, through the world currency trading arena, that dollar is converted into the local currency of the nation which the goods came from. But more often than not,,,,,,, as we print that dollar out of thin air, the foreign government takes the dollar into its reserve account and prints one of their units for deposit in the local economic system. They do this because: if the foreign CB didn't save the dollar as a currency reserve ,,,,,, and sent it back into the world currency markets to "buy" an existing unit of their money supply,,,,, this action would drive up their currency value vs the dollar and make the price their goods non-competitive in world markets. In other words, a US citizen couldn't use a printed (borrowed) dollar to buy an item for $10.00 that outside the "dirty float" of exchange intervention would cost $15.00.
This is how the "dollar reserve process" inflates the money supply worldwide as we (USA) run a trade deficit for our benefit. It keeps the dollar exchange rate higher than it would naturally be thus allowing a US citizen to buy goods at a cheaper price than our expanding money supply and implied currency value would normally dictate. A process in and of itself that invites still more dollars to flow out and purchase still more external goods. Had foreign CBs not taken so many dollars, the ever expanding US money supply would have long ago impacted currency exchange rates and forced a major price inflation internally (in the US). Yes, the major inflation so many saw coming,,, back then,,,,, would have arrived,,,,, then.
So why did these other CBs do it? The standard explanation was that this created a market for their goods here in the US. Yes that's true, but it begs the question; did no one in their land want to buy goods manufactured locally,,,,,, and pay for them with the same printed money supply? Why is it the US could inflate its money supply to buy cheaper goods externally for no more than the price of printed paper? But, in the same country our paper was sent to, they couldn't print their own currency to buy their own goods? Why couldn't they raise their real standard of living somewhat using the same process like the US,,,,,, and doing so without the burden of inflation or importing foreign currencies?
Again, why would our printed, inflated money movements not create price inflation for us (USA) in goods purchased externally? What if they (foreign goods producing countries) printed an amount of their money equal to the inflow of dollars,,,, but, without holding paper dollars as reserves to back it,,,,, bought the exact same goods from themselves. Common prevalent economic theory says price inflation would result? Or would it? Or better said: why them and not us?
Again, and as above,,,,, In the 70s, it was widely held that the dollar reserve system forced other countries to inflate their local currencies, thereby importing dollar price inflation. But, as time went by,,,,, indeed a decade or two now,,,,,, the same process continued non-stop, with no change. It seemed that some "other" countries had found a "new way" to somewhat circumvent the dilemma. Or was this "new way" something sold to them in order to extend the dollar system's timeline?
Many of the lesser third world countries experienced a combination of sporadic hyper inflation and deflation as we forced the dollar reserve system down the throats of their citizens. Their people's living standard constantly fell as they worked ever harder to produce more goods in return for more of our printed dollars. But, instead of using the extra inflow of dollars (positive trade balance) to buy their own currencies in the local system,,,,, thereby keeping their currency strong,,,,, they used that dollar flow as collateral to borrow (from IMF and international banks) more dollars from the world dollar float (mostly called Eurodollars). The lure (or the hard sell) was that they could build up their infrastructure,,, increasing their production efficiencies (human productivity),,,, thereby raising the national standard of living. Further, they were sold the unneeded idea that even if they didn't completely use the dollar surplus to borrow more, they should hold those dollars in reserve (buy and hold US treasuries) and print more of their own money!
Again, it seemed they had no advocate to push for their own best interest. No one told them that their people already worked cheaply enough to more than offset the competitive loss of a stronger local currency. No one told them that with a strong local currency structure,,,, (that using the dollar surplus to buy their own currency would create),,,,,,,, would allow them to borrow in their own capital markets. A more go slow approach that builds long term benefits. This process would free them from the entanglements of making international debt payments in another money. Indeed, the costs of those involvements later proved overwhelming!
For third world countries, their international dollar debt exposure eventually locked them into a servitude to the dollar reserve system. Despite all their natural and human resources, currency involvement had taken a lion share of any productivity increases and increased lifestyle this modern world offered.
However, it did help the cause for the dollar reserve system. By creating an ever growing international debt in dollars, eventual dollar demand to service this debt would only increase. Thereby keeping its value artificially high. In addition, any leftover floating dollars quickly took the form of US treasury debt held in these small countries treasuries. There they were used to further hyper inflate their own currency supply.
For the more developed gold owning countries of the G-7, they had a different question in mind. Again, if taking in inflated dollar reserves was the act of importing US dollar inflation into ones local economy,,,,, and in the process creating a market for your goods overseas,,,, why not just print your own currency [the euro] without taking in dollars,,,,,, and in doing so give the same buying power the US citizens have in your market,,,,,, to your own people?
If it's not price inflationary to take in part of a world "inflated dollar supply" and create jobs for your people locally,,,,,, why would it be any more inflationary to print your own currency outright? Indeed, why does one need a dollar inflow to legitimize the same money inflation process? That being currency inflation to create jobs?
Why should we (as dollar asset holders) think about this question? Because someone else is and doing something about it today!
Today,,,,,, and after all of this,,,, the dollar never did crash from price inflation. At least nothing like what was expected earlier in the last two decades.
The dollar reserve system was never going to fail then because the major world economic powers were willing to use (waste) all the productive efforts of the world's people to keep it running. Looking back we now understand the thinking behind this… There was no other currency structure strong enough or deep enough to carry the load.
[…]
So, dollar hyper inflation never arrived and gold did not make its run because world CBs bet your productive efforts on supporting the dollar reserve. In the process, the US standard of living was raised tremendously on the backs of most of the world's working poor. But this is not about to last!
Not long after the US defaulted on its gold loans,,,, dollars held as gold certificates,,,,,, major thinkers began the long process of forming another world currency. One that would not maintain the fiction of a gold standard with the somewhat fixed gold prices inherent in such a system. The creation was distorted, to say the least. Just as the River in my first post was often seen in distortion, so too was this currency issue. It began with the European Currency Unit (ECU) [agreed upon at the Bremen meeting] and has later progressed to its present state of the Euro.
After operating on a fiat system for 20+ years people are starting to realize that the only thing that backs a currency is the real productive efforts of their people. Yes, over time we always borrow more than our productive efforts can pay back and proceed to crash the money system. But what else is new? (smile)
We call this a money's "timeline" and it's as new an idea as life, death and taxes! Time and debt age any money system until it dies. The world moves on. Only this time gold is going to play a different part in the drama. We will all watch it unfold.
[…]
What changes is the recognition of what we do produce for ourselves and what we require from others to maintain our current standard of living. In the US this function will be a reverse example from these others. We will come to know just how "above" our capabilities we have been living. Receiving free support by way of an overvalued dollar that we spent without the pain of work.
[…]
We are, today, at the very conclusion of a fiat architecture that is straining to cope with our changing world… Trained from birth, as all Western thinkers are, to read everything economic in dollar system terms; we, too, are all straining to understand the seemingly unexplainable dynamics that surround us today.
[…]
Indeed, as an ongoing trade deficit in the US has become irreversibly structural to the integrity of the local economy and remained in this function for many years; the legal tender function of foreign dollar reserves comes very much into question.
[…]
The relatively small goods "price inflation" so many gold bugs looked for will be far surpassed and the "hyper price inflation" I have been saying is coming is now being "structurally" set free to run.
Why "structurally", why now?
For years now, "politically", the dollar system has had no support! Once again, for effect,
"Politically NO", "Structurally Yes"!
[…]
To this end, I have been calling for a hyper inflation that is being set free to run as a completed Euro system alters Political perceptions and support. That price inflation will be unending and all encompassing. While others call, once again, for a little bit of 5, 10, 15% price inflation, that lasts until the fed can once again get it under control,,,,,,,,, I call for a complete, currency killing, inflation process that runs until the dollar resembles some South American Peso!"
China
FOA wrote that last bit on October 3, 2001, stating unambiguously that structural support (the dirty float) had ended. So what happened? Well, China happened. This is an image I used in my 2011 Moneyness post and my 2012 Inflation or Hyperinflation? post:
On December 11, 2001, China was admitted into the World Trade Organization. I don't know if the idea was "sold" to China in order to extend the dollar's timeline, or whether they did it on their own following the lead of other third world countries, but China's central bank immediately started buying dollars by the tens of billions in order to keep its exchange rate pegged to the dollar while its international trade grew in leaps and bounds. We don't know Another's take on this turn of events because, unfortunately and coincidentally, FOA stopped posting five days after China joined the WTO.
A good gauge of China's structural support for the dollar, and one that is easy to watch, is China's Treasury holdings. From 2002 through 2013, the Chinese central bank purchased US Treasury debt equal to 19% of the total US trade deficit during those years. For comparison, all of the OPEC countries combined, including both public and private sector Treasury purchases, covered only 3% of the US trade deficit during the same time frame. There's only one reason for the PBoC to purchase that many dollars, more than any other country, and that's to manipulate its currency exchange rate, i.e., to peg it to the dollar.
Yet over those 12 years, China took determined and concerted steps, year after year, toward having an internationally-convertible currency, steps which gradually reduced its need to manipulate its exchange rate with the dollar in particular. When China joined the WTO, the yuan was not allowed outside of China. But by 2014, the yuan was trading in 12 hubs outside of China, including several in Europe and Asia, with many more on the way.
China had also set up bilateral currency swap agreements with 25 different central banks covering 42 different countries. The big one, the Eurosystem, 18 countries in one deal, was established on October 10, 2013.
Most remarkable, though, was that one month after the ECB deal, China's US Treasury holdings peaked, and since then they have dropped by more than $220B. In fact, all Foreign Official holdings are flat for the last 6 ½ years! That is, public sector (CB) buying of Treasuries, aka the dirty float, is virtually nonexistent for more than six years now.
If you want to see whether a central bank is manipulating its exchange rate or not, just watch for significant changes in its foreign currency reserves. And if you want to see whether the dollar's exchange rate is being manipulated by foreign central banks, watch for changes on the Foreign Official holdings line of the Fed's TIC report (although that is less useful as of the last month, due to the Fed's new Foreign and International Monetary Authorities, or FIMA Repo Facility, established on April 6, 2020, to prevent foreign CBs from dumping their USTs on the open market).
Manipulating exchange rates to achieve exchange rate stability actually creates an unstable situation. It requires the perpetual overvaluation of some of the currencies, preventing adjustment mechanisms from automatically correcting imbalances. This leads to a structurally unbalanced and therefore unstable international currency system.
With built-in (structural) imbalances, currency devaluations when they happen are generally larger and more disruptive than the crisis that caused them. A better, more stable system would be clean floating exchange rates where imbalances are corrected gradually through the exchange rate. In such a system, crises would not affect the monetary plane disproportionately the way they do today due to these longstanding and structural imbalances.
The hard part is transitioning away from dependency on past valuations that were based on longstanding structural imbalances. In order for a clean float to work and deliver sustainable exchange rate stability, you need a clean starting point without any built-in imbalances. This means weathering one final devaluation storm that will shake all currencies free from their dependency on past valuations.
To weather such a storm, you might first build an ark (the euro) like Noah did, and then let it float. Perhaps you foresaw the coming flood (in 1978/79) and figured out a way to hold it off long enough to build your ark. I have my ark. Do you have yours?
The Value of Reserves
Just like savings are extremely valuable to the individual come illness or old age, public sector monetary reserves have a similar value to the commonwealth in the case of unforeseen crises. No one knew this better than Europe, having used its gold reserves following WWII and again during the oil crisis in 1974. But the dollar's near-collapse in 1978 revealed a fundamental problem with the new dollar standard. The very act of accumulating foreign currency reserves overvalued that currency creating an unstable situation that itself could cause the crisis that would devalue the reserves just when you needed them most. The only way to avoid the crisis was to keep buying more, even as their ultimate uselessness was revealed. Gold was obviously different.
Thoughts like this have undergone an evolution of sorts since 1944, especially among central bankers. It is good to have sufficient reserves in case of emergency, but not all reserves are created equal. And not all reserves serve the same purpose. And yes, a CB can accumulate too many reserves, which is wasteful and unnecessary.
Fixed exchange rates like we had in Bretton Woods require the accumulation of CB reserves to maintain the fix. On the surface, such transfers of CB reserves seem to be settlement, or the adjustment mechanism for correcting imbalances. But in practice they are quite the opposite. They are not settlement, they do not correct the imbalance—they perpetuate it—and they neutralize natural adjustment mechanisms by blocking signals of strength and weakness from reaching the private sector.
With floating exchange rates, the transfer of CB reserves is simply not necessary. The exchange rate responds gradually to changes in relative strength. Imbalances are "settled" on a daily basis through changes in the exchange rate, eliminating the need for the faux-settlement that is reflected in changes to the reserves portion of a CB's balance sheet. Said another way, if the reserves on the CBs' balance sheets sat there untouched and unchanged, lying still, simply being there in case of a crisis or emergency, the automatic result would be a clean floating exchange rate system.
This evolution of thought that moved the goal from fixed to floating exchange rates is nearly complete and universal. It went from fixed, to fixed but adjustable, to floating. The dirty float of the last 45 years or so was never a goal or solution. It was always an awkward intermediate step.
Back in the Bretton Woods system, the IMF was like a pool of foreign reserves which could be drawn upon by any member with insufficient reserves of its own. In a way, it was kind of like an insurance policy for CBs. They paid into it with their subscription, and then, when needed, they could draw out foreign reserves to be used for the specific purpose of fixing (manipulating) their exchange rate.
Today the IMF still works similarly, as a kind of foreign reserve insurance policy, but the big difference is that if you find yourself in position of needing to draw reserves from the IMF, it is now an explicit condition that you not use those reserves for directly manipulating your exchange rate. Today it is often countries that used up their own reserves trying to do the dirty float the expensive way that find themselves needing IMF help, and the prerequisite is that they stop manipulating their exchange rate and let their currency float. That's what I mean by nearly complete and universal.
Ukraine is a good example. Ever since the collapse of the Soviet Union and the hyperinflation that followed, Ukraine has been fixing and pegging (manipulating) its own currency to the US dollar, periodically suffering devaluations every time a new crisis hits. Following the Asian crisis in '98 it devalued, then in the 2008 global financial crisis it devalued again, and then in 2014 when I wrote the first version of this post, it devalued for a third time.
During Bretton Woods, the IMF would have provided Ukraine with the foreign currency needed to maintain its fixed exchange rate, perhaps after officially devaluing it. But in 2014, the IMF simply provided a loan of foreign currency to help them meet international payment obligations on the condition that they quit pegging and let their currency float:
IMF Says Ukraine Qualifies for Second Tranche of Loan
Bloomberg
Jul 18, 2014
An International Monetary Fund mission will recommend that the lender’s board approve the second installment of a $17 billion bailout to Ukraine.
The Washington-based board will meet to approve the disbursement of $1.4 billion, the mission said today in an e-mailed statement from Kiev. The eastern European country met conditions including allowing its currency, the hryvnia, to float freely, said the mission, which has been visiting the Ukrainian capital since June 24…
Think about how this policy reflects the evolution of thought that has transpired, especially among central bankers. The 2nd Amendment to the IMF Articles of Agreement, which is still in force today, gave each member the freedom to choose its own exchange rate policy, from fixed to floating, with the sole exception of fixing to gold. And today they insist on a clean float, among other conditions, if you need their help.
Reserves are so valuable in the case of a crisis or emergency. Whether you're an individual or a sovereign nation, don't you think that having sufficient non-borrowed reserves in a crisis would be preferable to relying on help from someone else, or relying on an "insurance policy" that may not be around when you need it, and even if it is, comes with a long list of conditions? And you also need to consider the quality of those reserves. Are they such that they might go poof just when you need them the most?
This is where gold fits into the picture! It is prudent to have a sufficient amount of reserves, and it is possible to figure out roughly what that amount is, though it varies by individual or CB. But it is wasteful to have more than a sufficient amount. It is wasteful because excess amounts will most likely never be needed and the cost of acquiring them is an unnecessary reduction in standard of living, both for the individual and for the currency zone.
Imagine an obsessive hoarder who lives like a pauper just to die with millions in savings and no one to leave it to. Unspent, unused, and wastefully acquired at the cost of an unnecessary reduction in lifestyle. It's the same for a currency zone whose CB accumulates more reserves than it could ever reasonably expect to need. The point is, the prudent course of action is to accumulate reserves up to a reasonable amount, and then let them lie still, untouched, unchanged, for years on end, until that unforeseen crisis or emergency arrives. This is the value of reserves.
Global Economic Stagnation
"This brilliant, modern free trade system and all of its benefits
cannot be implemented using the US dollar as a reserve currency.
It shuts off commerce that in turn limits the use of commodities
such as oil, metals, food and the like. Many hail the low price
inflation in the US as a victory and ignore the intent other
nations had in following "free trade". That being to promote
a world economy, not just a US economy.
Understand that the increased use of commodities is a good thing.
It's not just for the purpose of making rising chart pattern so
speculators can sell their calls! Commodity usage creates real
things and helps the lives of real people. When citizens gain
real productive mechanisms, they hold real wealth. Some would
have you believe that third world people are enriched by saving
US treasury bonds, not true! The only way to increase world trade,
with an eye on building new consumers in all countries, is to
remove the overhang of "dollar settlement"."
FOA (3/14/99)
_________
cannot be implemented using the US dollar as a reserve currency.
It shuts off commerce that in turn limits the use of commodities
such as oil, metals, food and the like. Many hail the low price
inflation in the US as a victory and ignore the intent other
nations had in following "free trade". That being to promote
a world economy, not just a US economy.
Understand that the increased use of commodities is a good thing.
It's not just for the purpose of making rising chart pattern so
speculators can sell their calls! Commodity usage creates real
things and helps the lives of real people. When citizens gain
real productive mechanisms, they hold real wealth. Some would
have you believe that third world people are enriched by saving
US treasury bonds, not true! The only way to increase world trade,
with an eye on building new consumers in all countries, is to
remove the overhang of "dollar settlement"."
FOA (3/14/99)
_________
In 1938, nine years into the Great Depression, an American economist named Alvin Hansen, sometimes called "the American Keynes", introduced an economic hypothesis called "secular (meaning permanent) stagnation". His idea was that fundamental economic forces might have been conspiring in a vicious cycle that prevented economic recovery resulting in permanent high unemployment and low growth.
The main forces in 1938, according to Hansen, were a declining birth rate and over-saving which was keeping people from spending (in Keynesian terms, an oversupply of savings in an aging population was suppressing aggregate demand). Shortly thereafter, however, WWII and the baby boom that followed discredited Hansen's theory, consigning it to little more than an economic footnote.
75 years later, on November 8, 2013, Hansen's secular stagnation hypothesis became popular once again when Larry Summers revived it during a speech at the IMF. He followed that up with an article in the Financial Times:
"Is it possible that the US and other major global economies might not return to full employment and strong growth without the help of unconventional policy support? I raised that notion – the old idea of “secular stagnation” – recently in a talk hosted by the International Monetary Fund…"
Summers' invocation of Hansen's "old idea" as a way to explain the current state of global economic stagnation in 2013 brought comment and criticism from all corners of the Economics sphere. Those weighing in on the idea included names like Richard Koo, Barry Eichengreen, Paul Krugman and Alan Greenspan. The Economist called secular stagnation "a baggy concept, arguably too capacious for its own good."
David Wessel, a prominent Economics journalist, suggested that "today's advocates of secular stagnation are as myopic [as Alvin Hansen was in 1938]," and that "we just have to be patient." And Barry Eichengreen wrote, "Secular stagnation, we have learned, is an economist’s Rorchach Test. It means different things to different people."
Paul Krugman loved the idea:
"I was very annoyed when Larry Summers made a big splash talking about secular stagnation at the IMF’s 2013 Annual Research Conference – annoyed not at Larry but at myself. You see, I had been groping toward more or less the same idea, and had blogged in that general direction (Krugman 2013) – but it wasn’t forceful, and Larry rightly gets credit for making the topic a front-burner issue… In what follows, I’ll lay out four reasons why secular stagnation deserves the buzz it’s now getting."
I think the reason that Krugman found it so exciting was because, as he wrote in his chapter in an e-book titled Secular Stagnation:
Facts, Causes and Cures, it may have some radical implications and therefore "requires a major rethinking of macroeconomic policy":
"Suppose that the economy really needs a 4% inflation target, but the central bank says: “That seems kind of radical, so let’s be more cautious and only target 2%”. This sounds prudent, but it may actually guarantee failure. In other words, the problem of getting effective monetary policy, always difficult at the zero lower bound, gets even harder if we have entered an era of secular stagnation.
What about fiscal policy? Here the standard argument is that deficit spending can serve as a bridge across a temporary problem, supporting demand while, for example, households pay down debt and restore the health of their balance sheets, at which point they begin spending normally again. Once that has happened, monetary policy can take over the job of sustaining demand while the government goes about restoring its own balance sheet. But what if a negative real natural rate isn’t a temporary phenomenon? Is there a fiscally sustainable way to keep supporting demand?
In this chapter I’ll leave these questions hanging. The crucial point, for now, is that the real possibility that we’ve entered an era of secular stagnation requires a major rethinking of macroeconomic policy."
That e-book explains what secular stagnation means to 23 different economists. But for the purpose of this post, I'm going to focus mainly on what it means to Larry Summers, since he brought it up back in 2013, and to Paul Krugman who largely agreed with Larry and was mostly concerned with low inflation in the US.
One thing I should mention is that Larry Summers' "New Secular Stagnation Hypothesis" was a little different from its predecessor. Hansen's secular stagnation hypothesis in 1938 was essentially an observation of (what he thought was) permanent damage (or at least permanent changes) in the economy for which there was no cure. Hansen's "secular stagnation" was simply an explanation for why the economy had entered a state of permanent (or at least indefinitely long term, aka secular) stagnation.
Unlike Hansen's dismal outlook, Larry Summers wanted you to know that his "New" secular stagnation (SecStag for short) can be cured, by people like himself, by macroeconomists and public servants: "Today, secular stagnation should be viewed as a contingency to be insured against – not a fate to which we ought to be resigned." "Finance is too important to leave entirely to financiers."
Something we should always bear in mind, especially in complex discussions like this one, is the difference between cause, symptom and cure, and similarly, the difference between observation, prediction and prescription. Larry Summers reminds us of the important distinction between prescription and prediction with regard to financial bubbles: "Some have suggested that a belief in secular stagnation implies the desirability of bubbles to support demand. This idea confuses prediction with recommendation. It is, of course, better to support demand by supporting productive investment or highly valued consumption than by artificially inflating bubbles. On the other hand, it is only rational to recognize that low interest rates raise asset values and drive investors to take greater risks, making bubbles more likely."
One of the criticisms of Summers' SecStag theory is that our economic model expectations are simply too high, that this is not stagnation we are experiencing, but rather a reversion to the long-term mean. Another criticism is that economic model growth measurement standards are simply outdated and not capable of properly counting Internet technology (IT) innovation as growth. Both make valid points about the shortcomings of economic models, but both also miss the big picture, in my view, which is that there really is a physical plane impairment that has been with us for a very long time, and has simply been masked by the same monetary plane phenomena that causes it.
Back in 1986, Larry Summers, along with Olivier Blanchard (who went on to become the chief economist at the IMF from 2008-2015), noticed a certain ratcheting down in the employment numbers of prime-aged males in Europe starting in the 1970s. It was expected that, following a recession, employment would bounce back to previous levels, but in Europe they saw this "ratcheting down" starting in the 70s. In their 1986 paper titled "Hysteresis and the European Unemployment problem", they coined the term "Eurosclerosis" because they thought it was only a European problem. That was in 1986, but later data showed that, from 1990-2012, that same "sclerosis" was happening in the US and China even more so than in Europe.
The point is, what secular stagnation means to Larry Summers is a long-term economic impairment that extends all around the world. It doesn't necessarily mean zero or negative growth, but it does mean that real (physical plane) growth potential has declined substantially, and that this decline, this "ratcheting down" or "sclerosis" in real economic potential, is due to a monetary plane phenomenon. Summers makes it clear that this is more than just a hangover from the 2008 financial crisis, that it has been happening since at least the 1990s but that it was camouflaged by the stock market and housing bubbles. On this much, Larry and I are in full agreement.
The basis of Summers' hypothesis is that we have a lack of demand (spending, consumption, capital investment and borrowing) facing a glut of savings (too much saved money flooding the system and driving down interest rates and lending standards as it faces a lack of demand from qualified borrowers). Summers believes that, in general, there is an equilibrium that is reached between savers and investors, and that the real interest rate (the nominal "safe" interest rate that can be earned without risk, minus the rate of inflation) is what shifts investor preferences at the margin from saving money (safety) to investing (risk-taking).
Furthermore, he believes that there is a theoretical real interest rate that corresponds with full employment, i.e., sufficient economic growth. He calls this theoretical rate the FERIR, which stands for the Full Employment Real Interest Rate. Others just call it the "natural" interest rate. Summers argues that this theoretical interest rate, which would be the target interest rate for a CB interested in economic growth and full employment, is now stuck well below zero. And because it is below zero, it cannot be practically reached by conventional monetary policy, including QE, and that's why we're stuck in the land of financial bubbles and secular stagnation. His bottom line is that "SecStag may force policymakers to choose between sluggish growth and bubbles."
I'm sure that some of this sounds familiar to my readers. I have been writing for years about how a glut of passive savings crowds active money out of prudent activities thereby retarding the entire financial system. For years I have made the point that investing requires active specialization, and should therefore not be a passive activity. That naturally-passive, risk-averse savers are a large and distinct group, separate from investors, traders and speculators, and that only in the present dollar-based international monetary and financial system (the $IMFS) are they forced to swim with the sharks.
I have been writing for years about how the $IMFS has an unnecessary and terminal conflict built into its very DNA, like a congenital aneurysm just waiting to burst right when you least expect to die. How using the same medium (the dollar) as both the primary and secondary media of exchange (i.e., using the same unit—or fixed/pegged units—as both the tradable credit unit and the primary monetary reserve/savings asset) leads to friction, an inevitable conflict of interests between the real economy and the financial one.
Also, more than 20 years ago, FOA identified the dollar system itself as the cause of retarded economic growth. He said "the narrow margins it produces [in the real economy outside of the US/dollar-based financial one] shut down entire economies." He wrote, "This brilliant, modern free trade system and all of its benefits cannot be implemented using the US dollar as a reserve currency. It shuts off commerce…" See the quote at the top of this section! He also wrote that the $IMFS leaves "entire countries economically impaired in an effort to maintain the fictional valuations of 'US assets'."
"Shuts off commerce", "economically impaired"; doesn't this sound like economic stagnation? From the quote at the top: "Commodity usage creates real things and helps the lives of real people. When citizens gain real productive mechanisms, they hold real wealth." He's talking about people owning productive businesses that generate income and create the "demand" for other goods and services when he says they hold real wealth. And the $IMFS, says FOA, prevents such "demand" from growing, while, instead, maintaining "the fictional valuations of 'US assets'."
“Effective demand is dead in the water” and the effort to boost it via bond buying “has not worked,” said Mr. Greenspan. Boosting asset prices, however, has been “a terrific success.”
That's from the Wall Street Journal reporting on an interview in which Alan Greenspan was asked about Larry Summers' secular stagnation hypothesis. There was wide agreement in 2014 that "effective demand was dead in the water." What there was not much agreement on was why, what to do about it, and whether or not it was a "secular" (long term) problem.
It's easy to believe that saving and investing are merely different ends of a preference continuum of "demand for safe assets" in which an overall shift toward investing spurs economic growth, while a shift toward saving or "safe assets" puts on the brakes. It's what virtually every economist believes. If that's what you believe, then the cause of economic stagnation must be one of several explanations for an overall shift towards saving and deleveraging. And the cure, depending on whether you believe it to be a secular problem or not, can range from "we just have to be patient" to more government deficit spending and the official embrace of higher inflation rates to encourage spending, consumption and capital investment while discouraging saving.
If you can raise the inflation rate, then that makes the real rate of return on safe assets even more negative, which should cause savers to either spend or invest rather than sitting in "safe assets" that are losing value in real terms. That's the theory anyway, and here were Larry Summers' prescriptions:
What is to be done?
Broadly, to the extent that secular stagnation is a problem, there are two possible strategies for addressing its pernicious impacts.
• The first is to find ways to further reduce real interest rates.
These might include operating with a higher inflation rate target so that a zero nominal rate corresponds to a lower real rate. Or it might include finding ways such as quantitative easing that operate to reduce credit or term premiums. These strategies have the difficulty of course that even if they increase the level of output, they are also likely to increase financial stability risks, which in turn may have output consequences.
• The alternative is to raise demand by increasing investment and reducing saving.
This operates to raise the FERIR and so to promote financial stability as well as increased output and employment. How can this be accomplished? Appropriate strategies will vary from country to country and situation to situation. But they should include increased public investment, reductions in structural barriers to private investment and measures to promote business confidence, a commitment to maintain basic social protections so as to maintain spending power, and measures to reduce inequality and so redistribute income towards those with a higher propensity to spend.
Some economists think that all we need is Summers' second prescription, primarily sufficient fiscal stimulus (i.e., much more government deficit spending), but Paul Krugman particularly likes the first one, the higher inflation rate target, so much so that he gave a presentation titled "Inflation Targets Reconsidered" at a 2014 ECB Forum in Portugal. In the presentation, he argued for raising the inflation target from 2% to 4% or even higher. Here is part of that presentation [brackets are mine]:
Inflation Targets Reconsidered
Over the course of the 1990s many of the world’s central banks converged on an inflation target of 2 percent. Why 2 percent, rather than 1 or 3? The target wasn’t arrived at via a particularly scientific process, but for a time 2 percent seemed to make both economic and political sense. On one side, it seemed high enough to render concerns about hitting the zero lower bound mostly moot; on the other, it was low enough to satisfy most of those worried about the distortionary effects of inflation. It was also low enough that those who wanted true price stability — zero inflation — could be deflected with the argument that official price statistics understated quality change, and that true inflation was in fact close to zero.
And as it was widely adopted, the 2 percent target also, of course, acquired the great advantage of conventionality: central bankers couldn’t easily be accused of acting irresponsibly when they had the same inflation target as everyone else.
More recently, however, the 2 percent target has come under much more scrutiny. The main reason is the experience of the global financial crisis and its aftermath, which strongly suggests that advanced economies are far more likely to hit the zero lower bound than previously believed, and that the economic costs of that constraint on conventional monetary policy are much larger than the pre-crisis conventional wisdom. In response, a number of respected macroeconomists, notably Blanchard (2010) and, much more forcefully, Ball (2013), have argued for a sharply higher target, say 4 percent.
But do even these critics go far enough? In this paper I will argue that they don’t — that the case for a higher inflation target is in fact even stronger than the critics have argued, for at least three reasons.
First, recent research and discussion of the possibilities of “secular stagnation” (Krugman 2013, Summers 2013) and/or secular downward trends in the natural real rate of interest (IMF 2014) suggests not just that the probability of zero-lower-bound episodes is higher than previously realized, but that it is growing; an inflation target that may have been defensible two decades ago is arguably much less defensible now.
Second, there are actually two zeroes that should be taken into account in setting an inflation target: downward nominal wage rigidity isn’t as hard a constraint as the interest rate ZLB, but there is now abundant evidence that cuts in nominal wages only take place under severe pressure, which means that real or relative wage adjustment becomes much harder at low inflation. Furthermore, we now have reason to believe that the need for large changes in relative wages occurs much more frequently than previously imagined, especially in an imperfectly integrated currency union like the euro area, and that such adjustments are much easier in a moderate-inflation environment than under deflation or low inflation.
Finally — and this is the main new element in this paper — there is growing evidence that economies entering a severe slump with low inflation can all too easily get stuck in an economic and political trap, in which there is a self-perpetuating feedback loop between economic weakness and low inflation. Escaping from this feedback loop appears to require more radical economic policies than are likely to be forthcoming. As a result, a relatively high inflation target in normal times can be regarded as a crucial form of insurance, a way of foreclosing the possibility of very bad outcomes.
This paper begins with a brief review of the standard arguments for a higher inflation target, then deals in turn with each of the further arguments I have just sketched out. I conclude with some speculation about the unwillingness of many central bankers to consider revising the inflation target despite dramatic changes in our information about how modern economies behave.
1. The two zeroes
If you polled the general public about what rate of inflation we should target, the answer would probably be zero — full price stability. Some economists and central bankers would agree: either they view any erosion of the purchasing power of money as illegitimate, in effect a form of expropriation, or they argue that even mild inflation degrades money’s role as a unit of account. There is even a case for persistent deflation: Milton Friedman’s optimal quantity of money paper famously argued that prices should fall at the rate of time preference, so that the private cost of holding cash to add liquidity matches its zero social cost.
In practice, however, the great majority of both economists and central bankers advocate modest positive inflation. Why? Because of the two zeroes.
The first zero is a hard one: nominal interest rates cannot fall below zero (except for trivial deviations involving transaction costs or the role of bills as collateral), because people always have the option of holding currency. This in turn sets a lower bound on the real interest rate, which can’t fall below [zero] minus the expected rate of inflation.
Meanwhile, central banks are trying to stabilize their economies, which means trying to set policy interest rates at the Wicksellian natural rate [Summers' FERIR], the rate consistent with more or less full employment. The problem is that the real natural rate of interest clearly fluctuates over time, rising during investment booms (whether these booms are well-grounded in fundamentals or reflect bubbles), falling when economies face adverse shocks. If expected inflation is low, this raises the possibility that there will be periods in which the central bank cannot cut rates to the natural rate, leading to output below potential and excess unemployment.
A positive expected rate of inflation reduces the size of this problem, because it allows real interest rates to go negative; and the easiest way to ensure that expected inflation is positive is to pursue a monetary policy that keeps inflation stable at a modestly positive rate.
Notice that he mentioned the "Wicksellian natural rate" which I noted as being the same as Summers' FERIR. This theory of interest rates was Knut Wicksell's most influential contribution to Economics, published in 1898, and it comes from the Austrian School which theorized that an economic boom happened when the natural rate of interest was higher than the market (or monetary) rate of interest. The inverse would be that an economic slump, or stagnation, would happen when the natural rate (or FERIR) was lower than the market rate of interest, which Larry Summers showed that it was.
You might be wondering why I included such a long excerpt from Paul Krugman's paper. I did that on purpose, because I thought it was very good and provided some important insight into central banking. This being a gold blog, some of you probably assume that I think Paul Krugman is always wrong, perhaps even an idiot. But that assumption would be wrong. For example, on the subject of the gold standard and the unrighteousness of hard money (see here), and on whether or not normal inflation is akin to theft (see here), I'm basically in agreement with Paul, more so even than with the hard money camp (i.e., gold is like distilled, pure physical wealth, and in that sense it is "monetary wealth" in that it is kind of like the ambassador representing the physical plane while residing in the monetary plane and acting as its most liquid physical reserve asset. Other than that, any entanglement between money (economic credit) and gold (pure physical wealth) is unrighteous at best, and deadly at worst. True wealth is hard, but true money is "easy" by definition. Hard money is practically an oxymoron if you really consider the money concept. Therefore if normal inflation is theft, then so is the value you lose when you buy a brand new car and drive it off the lot. Misusing something as a wealth reserve is user error, not malfunction).
Where Paul and I differ is in our perspectives on the big picture. Think of it like this: The $IMFS is like a fishbowl, and we are all like goldfish swimming around in that confined environment, wondering why our economy has stagnated and why there's no more room to grow. Krugman, Summers and everyone else are all trying to understand the cause in order to cure the problem within the confines of the fishbowl, while the fishbowl itself is the limiting factor.
It should be no surprise that a fish, immersed in water inside a fishbowl, would not identify the glass boundary as the problem and recommend breaking it in order to grow. Most would not even be aware of the bowl, and even if they were, breaking it would seem like a suicidal means of escape. So imagine that global stagnation is a real problem, but that all 23 economists and virtually everyone else discussing its possible causes and cures are all viewing it from an inside-the-fishbowl perspective, and that what I am offering you is an out-of-the-fishbowl view, even though I'm stuck inside the fishbowl just like everyone else.
What if I told you that the fishbowl is only an illusion? That even though it confines us, we remain inside its boundary not because it really exists, but because we think it exists? And what if I told you that there's a big ocean out there, just waiting for us to break free from our self-imposed confinement? Does this analogy resonate with any of you?
Remember the scene in The Matrix where the little boy is teaching Neo how to bend a spoon like Uri Geller? The boy says, "Do not try and bend the spoon… that's impossible. Instead, only try to realize the truth." "What truth?" asks Neo, and the boy responds, "There is no spoon." Neo puzzles, "There is no spoon?" And the boy explains, "Then you'll see that it is not the spoon that bends, it is only yourself."
I used the Matrix analogy back in 2010, in How Can We Possibly Calculate the Future Value of Gold? Here's a quote:
"This transfer of wealth that is coming is not a direct and equal transfer. It is not like pouring one pitcher into another. It is more like flipping a switch on the virtual matrix. Turning off the monetary plane that hovers over the physical plane and claims to tell you how much "stored purchasing power" everyone has. When you turn it off, all that purchasing power disappears in a flash. And then what lies beneath is exposed in daylight, the real physical world. No real capital is destroyed, only the myth is destroyed. But true capital is exposed and revalued."
When the "virtual matrix" blinks off, which in this present analogy is a fishbowl, more than just the value of gold will be affected. $IMFS financial structures that support existing malinvestment while stifling competition will fail, uneconomical practices will face the harsh reality of the open sea, and economical ideas will have the space to grow and flourish. And lest any of you think this is a utopian dream I'm describing, I'll just add that it will be hell on wheels for many fish to adjust to the reality of the ocean.
My View
As I said, I agree with Krugman and Summers on the symptoms of global stagnation. Where I disagree is on the causes and cures. This is what my Freegold lens (my out-of-the-fishbowl perspective courtesy of Another and FOA) reveals—a different cause and cure for today's global economic stagnation.
Okay, let's start with the low inflation problem. Remember that low inflation combined with a low or negative natural interest rate (the FERIR) leaves central banks stuck between a rock and a hard place, the rock being sluggish growth and the hard place being financial bubbles and instability. But with loose monetary policy and explosive growth in the money supply since the 1970s, what could possibly account for almost four decades of low inflation?
I'm talking about consumer price inflation here, which is where the rubber meets the road. Physical plane (the real world and the real economy) price inflation has been surprisingly low relative to growth in the monetary plane (the financial sector and the money supply). Here's how FOA described it:
FOA (10/3/01; 10:21:26MT - usagold.com msg#110)
"For decades, hard money thinkers have been looking for "price inflation" to show up at a level that accurately reflects the dollar's "printing inflation". But it never happened! Yes, we got our little 3, 4, 8 or 9% price inflation rates in nice little predictable cycles. We gasped in horror at these numbers, but these rates never came close to reflecting the total dollar expansion if at that moment it could actually be represented in total worldwide dollar debt. That creation of trillions and trillions of dollar equivalents should have, long ago, been reflected in a dollar goods "price inflation" that reached hyper status. But it didn't.
That "price inflation" never showed up because the world had to support its only money system until something could replace it. We as Americans came to think that our dollar, and its illusion of value, represented our special abilities; perhaps more pointedly our military and economic power. We conceived that this wonderful buying power, free of substantial goods price inflation, was our god given right; and the rest of the world could have this life too, if they could only be as good as us! Oh boy,,,,,, do we have some hard financial learning to do."
In a world with many different fiat currencies, the value of each one is a reflection of its economy. "Where the rubber meets the road" means where the monetary plane meets the physical plane, meaning that a currency is worth what its economy produces that can be bought with that currency. But price and value are not necessarily the same thing in the world of many different currencies.
In order to price something, you need a numéraire. So while the value of a currency is what its economy produces that can be purchased with that currency, the price of a currency is its exchange rate with other currencies from other economies. In a clean float with Freegold, I think that the price and value of each currency will be pretty close to equal, but that's not the case in the $IMFS.
The $IMFS is characterized by two things that work in tandem to not only misprice currencies relative to the physical plane, but to systemically cement the mispricing and make it cumulative over the long term rather than cyclical with periodic corrections. The two things are public- and private-sector capital flows between different currency zones. Capital flows between currency zones are monetary plane movements that cause physical plane imbalances, also known as current account or trade imbalances.
The public sector uses fiat currencies—primarily the US dollar—as international monetary system reserves, and the private sector uses fiat currencies—primarily the US dollar—as wealth items, collateral, financial reserves and savings. Private sector capital flows into the dollar and US-based dollar-denominated investments overprice the dollar relative to its physical plane value. This happens with other currencies as well, but the dollar is the one that the foreign public sector, by doing the dirty float, prevents from periodically correcting. The result is the perpetual US trade deficit that hasn't reversed in 45 years.
The perpetual US trade deficit is what reveals that the dollar is overvalued. This is caused by the foreign sector buying dollars as investments, savings and reserves. The foreign sector is divided into two subsectors, the foreign public sector and the foreign private sector. The foreign public sector is the foreign CBs, like the ECB and the PBOC. The foreign private sector is everyone else.
The foreign private sector loves all kinds of US investments, and it buys lots of dollars because of this love affair with Wall Street and the various US markets. This overvalues the dollar and causes the US trade deficit. But the foreign private sector isn't a constant source of dollar support because it acts only from the profit motive. Every once in a while, US markets come down and the foreign private sector flees out of the dollar. That's when the dollar exchange rate declines.
For the past 45 years, certain foreign CBs have kept their currencies more or less pegged to the dollar. This meant buying dollars whenever the dollar's exchange rate declined. In effect, this acted as a "stop gap measure" for the dollar, and prevented its overvaluation from ever correcting. In effect, this exchange rate pegging with the dollar was the structural support that I write about. The foreign public sector bought dollars not with a profit motive, but for quite opposite reasons which translated into buying dollars whenever the rest of the foreign sector was fleeing from the dollar and its markets. This was structural support.
FOA (03/20/99; 11:34:12MDT - Msg ID:3615)
"Entire countries are economically impaired in an effort to maintain the fictional valuations of "US assets"! … It was the longest "stop gap measure" I have ever known to exist! A tremendous success by any standard, to keep the dollar stable for such a time. Many think it was "good old American know how" that did it. Well, now we will see…"
I apologize for repeating myself, but I think this is important. In essence, the "dirty float" or unofficial pegs to the US dollar were structural support. Not that they were primarily responsible for the overvaluation of the dollar (the foreign private sector was), but they kept it from collapsing and correcting each time the private sector retreated, including in the 2008 financial crisis. To understand how this structural support is responsible for the low inflation rate "problem", at least in dollar terms, please read this quote from FOA, as many times as it takes until it sinks in:
Friend of Another (9/22/98; 18:01:45 Msg ID:96)
"Using an overvalued dollar makes one feel as there is no inflation, even though there has been massive dollar currency inflation over the last twenty years (the real cause of price increases is when the exchange rate is allowed to balance a negative trade deficit)."
Many things, of course, can cause price inflation. Physical plane prices are really just the relative values of different things expressed using a common numéraire, and those relative values change all the time for many different supply and demand-related reasons. But overall inflation is a monetary phenomenon, a change in the price of the numéraire itself, which, as I said above, requires another numéraire. We often think of it as a case of more money versus fewer goods and services resulting in price inflation, but that's not necessarily the case when the global monetary and financial system promotes the hoarding rather than the spending of money acquired as surplus revenue.
Think about a trade surplus country like China, which accumulated nearly $4 trillion in foreign currency reserves. We can think of that $4T as surplus revenue that was accumulated over 15 years, but the truth is that it was accumulated merely as a consequence of the dirty float of the Chinese currency. The effect was that it kept the price (the exchange rate) of the dollar elevated when it would have otherwise declined. This kept US imports cheap in dollars when they would have otherwise become more expensive. In other words, it kept US price inflation lower than it would otherwise have been. This effect is the same whether it is the foreign CBs or the foreign private sector hoarding dollars, but together, in tandem, the two sectors have kept the dollar perpetually overvalued for decades.
Another way we tend to think about inflation is as a decrease in production (supply) relative to consumption (demand) that results in an overall shortage of goods and services and therefore an overall rise in prices. But that doesn't necessarily work either. The US is a good example of an economy in which consumption (demand) is greater than production (supply), even as the US is one of the largest producers in the world. This is evident in the US trade deficit. Each month we consume about $45B more goods and services than we produce. The extra supply comes from abroad, where the rest of the world (ROW) in aggregate is producing about $45B more goods and services than it consumes each month. The ROW (in aggregate) is also buying about $45B in dollars for investment purchases, savings or monetary reserves each month.
As long as those two numbers are pretty close to each other, the US capital inflow and the US trade deficit, the dollar's exchange rate will be pretty stable. If the dollar is rising, then either the ROW is buying more dollars (capital inflow is increasing), or else US consumption (demand) is declining relative to US production (supply). Likewise, if the dollar is declining, then either the ROW is buying fewer dollars (capital inflow is decreasing or even reversing), or else US consumption is rising relative to US production. But when we look at these two variables, changes in net consumption happen relatively slowly while capital flows can literally turn on a dime.
Now, imagine that the $45B per month capital inflow suddenly stopped. You can imagine any number of causes, but perhaps a global pandemic coinciding with a dramatic stock market crash would suffice. It doesn't even need to reverse and become a capital outflow, so you can imagine the money that's "already inside the US" dying on the vine, while money that's not already in dollars finds greener pastures elsewhere. As I've laid it out for you here, it should be clear that the dollar's price (its exchange rate) would eventually plunge toward its physical plane value. The dollar's current price is based on a constant monetary inflow each and every month, not a balance of trade, so if that inflow stops, the price of a dollar ultimately drops.
When that happens, even if no price tags are changed inside or outside of the US, the prices of imports from the ROW will appear to have risen from the perspective of the dollar holder. I hope you can see the "relativistic" effect on the prices of imports and exports when currency prices (exchange rates) change. While US imports will appear more expensive from inside the US, US exports will appear cheaper from the perspective of the ROW, and this relativistic (relative to your frame of reference) effect is present without changing any local price tags.
I don't want to spend too much time on this point, but what it means is that, in an open system with many different currencies, the two things that characterize the $IMFS subjugate, supersede and overpower local inflation drivers. Those two things, once again, are oversized private sector international capital flows, and their structural counterpart, public sector capital flows known as the dirty float. As FOA said, "the real cause of price increases is when the exchange rate is allowed to balance a negative trade deficit." In the present case, the cause of price stability in the $IMFS is the dirty float, in which exchange rates are not allowed to balance trade.
In a clean float, you'd have more closely balanced trade, and therefore the local inflation drivers targeted by monetary policy would begin to reassert their influence. Private sector capital flows would still have an effect, but it would correct itself periodically. And because changes occur more slowly in the physical than in the monetary plane, imbalances driven by private sector financial drifts would not become structural, cumulative and therefore systemically dangerous. Furthermore, the predicted transition implies a smaller financial sector, smaller international capital flows, and a shift from financial pyramids and volatility churning into real economic enterprises as the most profitable focus for "hot money".
People, especially economists, tend to think they understand the causes of inflation. What I am proposing is that, inside the $IMFS fishbowl, most of them are wrong, or at least what they understand theoretically is subjugated globally by the $IMFS and the dirty float.
In my view, where we are today is stuck in a physical plane (real economy) that is subjugated, superseded, overpowered by and therefore subservient to the monetary plane (oversized financial capital flows). We have actually achieved a remarkable level of price stability for most of the world and for a very long time, but at what cost? In my view, there are two big costs: persistent economic stagnation in a relatively stable price environment, and inevitable periodic currency collapse.
Price stability mandates are only a means to an end which is a healthy and sustainable real economy, and yet, almost ironically, today's price stability continues at the cost of global economic stagnation. But this economic rut that we're in is not the only cost. Price inflation has been within acceptable levels for a very long time, aside from the occasional currency collapse or hyperinflation. And that's the second cost: the occasional currency collapses and bouts of hyperinflation.
You see, structural imbalances leave our landscape of many currencies vulnerable to abrupt and devastating corrections. It's like the tectonic plates on which we all live. The immense pressure that builds up around the edges is belied by the stable ground we feel most of the time, but every once in a while those plates correct themselves with disastrous effects.
Even with a higher target inflation rate like Krugman and Summers both recommend, monetary policy would likely have little or no effect as it stands today. In fact, we can see with our own eyes that it has little effect, as central banks have printed trillions in new reserves, practically monetizing consumption directly in some cases, while lowering both short and long term key interest rates to unprecedented lows, and still no effect on inflation.
And even if they could get inflation up, I doubt that it would have the intended effect on the real economy. A certain rate of price inflation may well accompany the kind of economic growth that economists and central planners desire, but I'm not sure causation works in the opposite direction like they hope it does. In other words, economic growth may cause inflation, but inflation does not cause real economic growth. Here is a concrete example of what I mean:
By 1933, the annual US inflation rate was below -10%. Prices had fallen 60%, industrial production was down by half, millions were homeless and a quarter of the workforce was unemployed. FDR's inauguration on March 4, 1933 marked the lowest point in the worst depression in history, and it also occurred in the middle of a bank run. By the end of that day, 32 of the 48 states had already closed their banks, and the very next day, the day after his inauguration, FDR declared a four-day national bank holiday while Congress worked out a change in the dollar monetary system.
That monetary change of rules stopped price deflation in its tracks. By May, the monthly rate of inflation hit an annualized rate of 10%, and it even hit 40% annualized in June.
The positive inflation rate, however, did little for the real economy in which unemployment remained in double digits until WWII. Five years after FDR's inauguration, Alvin Hansen would propose his secular stagnation hypothesis, and only gearing up for war in 1941 would finally drag the US economy out of its rut, and unemployment back down to low single digits.
During the post-war years of 1946-1953, with the US economy roaring on its own, cranking out a trade surplus with Europe as evident in the gold inflow which peaked in 1952, we saw some of the highest price inflation rates ever, reaching 20% in 1947 and 10% in 1951. The point, once again, is that even though inflation may well accompany periods of economic growth, it does not follow that higher inflation rates cause higher economic growth.
Money Hoarding
For that matter, neither does low inflation—also known as price stability—cause economic growth. In my view, today's price stability has the same cause as today's low interest rates, which is also the same cause as today's global stagnation. As I've said many times before, correlation does not imply causation, and the treating of symptoms rarely cures the disease.
The "cause" that I am referring to is massive, systemic and global money hoarding. Money, at its essence, is credit. It is the credibility of future production revenue made spendable in the present (see Moneyness 2: Money is Credit). That is how new money comes into being, and then it circulates right along with the rest of the money pool as a medium of exchange in the present.
The hoarding of such credits, however, overvalues the unit of account itself, as the credits that are not hoarded enjoy a present purchasing power that would otherwise be lower if all existing "fungible credibility" circulated, and such credits were only held as short term balances rather than as wealth reserves. Hoarding, by the way, includes re-lending the credits to someone else, which is the primary way money is hoarded.
The re-lending of credits earned as surplus revenue simulates the money creation process without actually creating any new money, again overvaluing the unit itself as the credits enjoy a present purchasing power that would otherwise be lower if new money had actually been created. Re-lending is fine and normal to a degree. That degree is where it is done professionally, with one's own surplus revenue.
Where it becomes hazardous is when it is done systemically and passively by savers who leave it up to someone else to determine the lending standards. All of this money circulates in the same pool, so using credits as the system's reserves and the passive savings of virtually everyone in the world crowds the banks and professional investors within the financial and monetary arena. This crowding pushes the banks and professional investors into riskier and more questionable activities in order to make a living.
The result is low interest rates (because there is too much money competing for a limited pool of credible borrowers), lower lending standards (because passive money is being managed by people who make an up-front percentage and then have no more skin in the game), low inflation (because the process itself systematically overvalues the currency on an ongoing and cumulative basis), and economic stagnation (once debt and malinvestment levels reach a certain point of saturation). That's where we are today, in my view, on a global scale.
Money hoarded as savings or foreign reserves must find a vehicle to be hoarded into. This creates a massively oversized and passively generic demand for debt and equity investment vehicles, which leads to bubbles, malinvestment, debt saturation, across-the-board unprofitability, and ultimately to persistent economic stagnation where uneconomic and unprofitable businesses continue operating at a loss just to service their debt, and in some cases where government stimulus is involved, just to keep people employed. We see this happening everywhere today, even in China.
It is a vicious feedback loop, and it only gets worse as the viability of new products becomes secondary to their corporate presence in the investment markets. One of the main criticisms of the secular stagnation hypothesis, which I mentioned earlier, is that innovation and growth in the IT sector is underappreciated by economists. But just consider how many of the new rising stars in the tech industry are more about the business of selling shares than creating real economic value.
In essence, global savings (because in the $IMFS "savings" is defined as money hoarding) has outstripped profitable investment opportunities. There are more "savings" in the world today than there are truly-economic opportunities to make a profit, therefore the very act of saving for the future today worsens imprudent lending standards, inflates valuation bubbles in overpriced (and therefore unprofitable) industries, and promotes the illusion of new rising stars of productivity like Pets.com and Candy Crush.
In supply and demand terms, there is too much savings relative to investment opportunities that are profitable due to real economic value creation. The return on "savings" (interest in the case of debt and dividends or profits in the case of equity) is low because there is too much supply (savings) relative to demand (profitable opportunities). These are exactly the conditions in which bubbles arise—when "savings" or investment capital are in overabundance.
If you think it's good for the economy or for society in general to loan your surplus revenue to someone else, or to buy a company's stock, or even to stuff it in your mattress for later, guess again. You are part of the problem. If you're willing to give it away and forget about it, that's fine, but if you're hoping to reclaim that purchasing power at some point in the future, you are only adding to the congestion that is bringing the global economy to a standstill.
FOA (3/14/99; 16:17:55MDT - Msg ID:3362)
"Ironically, the very prospect of free world trade, so fought for by the American Administration, is the condition that the IMF/dollar system cannot handle! The debt built up from all of the past, unfree, protectionist old world trade is killing the transition. The policy is to sell free trade and the narrow margins it produces as they shut down entire economies because the low profits cannot service the old debt. Do you follow the logic and the problem? This brilliant, modern free trade system and all of its benefits cannot be implemented using the US dollar as a reserve currency. It shuts off commerce that in turn limits the use of commodities such as oil, metals, food and the like. Many hail the low price inflation in the US as a victory and ignore the intent other nations had in following "free trade". That being to promote a world economy, not just a US economy.
Enter the Euro! Understand that the increased use of commodities is a good thing. It's not just for the purpose of making a rising chart pattern so speculators can sell their calls! Commodity usage creates real things and helps the lives of real people. When citizens gain real productive mechanisms, they hold real wealth. Some would have you believe that third world people are enriched by saving US treasury bonds, not true! The only way to increase world trade, with an eye on building new consumers in all countries, is to remove the overhang of "dollar settlement".
The US started the free trade movement but quickly backed away when it was realized that the US currency, backed by debt through the fractional reserve system, would suffer severe inflation in the transition. Government guarantees would require the treasury (and Fed) to print unbelievable amounts of new currency to cover the unserviceable debt that Free Trade would create!"
FOA (03/20/99; 11:34:12MDT - Msg ID:3615)
"It was understood some time ago that the $US would indeed become "debted out" as digital currencies go. It was the logical conclusion to the world reserve money being removed from the gold exchange standard… We arrive at the final result today, with the dollar so expanded that it is failing the "free trade conversion" the world so craves. Entire countries are economically impaired in an effort to maintain the fictional valuations of "US assets"! …
It was the longest "stop gap measure" I have ever known to exist! A tremendous success by any standard, to keep the dollar stable for such a time. Many think it was "good old American know how" that did it. Well, now we will see "who knows how" as the world unwinds all of this dollar debt! …
As it is, this is created through BIS manipulations of foreign exchange (dirty float) and official money flows out of all non reserve currencies … One might have expected that others (as in the markets) would already be deducing the "secret moves" and re-evaluating the value of the dollar accordingly… this is not a "New York day trade", but rather a world money transformation that will affect you "down to the shoes on your feet"… Also, history usually documents that the most earth moving events were obvious, all along, but no one believed them!"
The Cure
The cure for global stagnation, I think, is very simple. In fact, unlike Krugman and Summers, I don't have a prescription. What would be my recommendation is already happening, so I only have a prediction for how and why it will end.
There is a common misconception that the sale of foreign goods and services in exchange for US dollars is what overvalues the dollar—foreign oil priced in dollars being the prime example, but China has also been selling other goods in exchange for dollars for a long time. In other words, it is a misconception that the international use of dollars as a medium of exchange is what keeps the $IMFS going.
This misconception, sometimes called the petrodollar theory, is so common that it is ubiquitous, not just in the conspiratard community, but in the mainstream as well. So I'm going to explain briefly the truth of the matter. You will need to understand this if you would like to accurately understand how and why it will end.
There are two ways for the foreign sector to buy dollars. One is by trading goods and services for them, and the other is through the foreign currency exchange. So, as a foreigner, you can buy dollars either with goods and services or with another currency. I'm not even necessarily talking about trade directly with the US, because you can buy dollars from other foreigners in both of these ways as well.
The US trades more than $2.2T worth of goods and services with the rest of the world each year. We export $2.2T worth of goods and services, and in exchange for them we also import $2.2T worth of goods and services. Dollars are the medium of exchange for all of them, so, as you can imagine, there is a large pool of dollars circulating internationally. Think of it like this: A foreign exporter buys dollars with his goods and services, and then he sells the dollars to a foreign importer (in exchange for the local currency) who then uses the dollars to buy goods and services from the US. This happens each year to the tune of more than $2.2T.
In my scenario, you have $2.2T in dollars being bought with goods and services, and another $2.2T being bought with foreign currency (by the foreign importers who buy goods and services from the US). That would be balanced trade if that was all that was happening, but it's not. At the foreign currency exchange, where dollars are bought with foreign currency (rather than goods and services), there is also another group of dollar buyers competing with the foreign importers.
For simplicity's sake, let's call this second group the foreign investors and central banks. On average for the last decade, this group has bought about $500B each year which it has used for purposes other than buying goods and services. In 2006, this group's dollar buying peaked at an all-time high of about $750B, but for the last 11 years (2009-2019), it has averaged just over $500B per year. Instead of buying goods and services, these dollars were purchased in order to be hoarded, i.e., to buy dollar-denominated financial assets, like US stocks, bonds, Treasuries, real estate and foreign direct investment (FDI) inside the US.
The easiest way to understand the effect I'm trying to explain is to picture this second group bidding against the first group. The first group is foreign importers who buy $2.2T each year to be used to buy US goods and services. The second group is foreign investors and CBs who buy $500B each year to be used to buy US financial investments (aka IOUs). Together, they represent a foreign sector demand for $2.7T in dollars per year, which overvalues the dollar and causes the physical plane imbalance more commonly called the US trade deficit.
As I said above, we (the US) export $2.2T and we import $2.2T worth of goods and services. But we also import an extra $500B worth of goods and services which meets that extra demand for dollars from the second group, the foreign investors and central banks. Those extra imports are our trade deficit, and the important point here is that our trade deficit is caused solely by that extra demand for dollars from the second group, the foreign investors and foreign CBs. It is not caused by the fact that so many goods worldwide can be purchased in dollars that most American importers aren't even aware that other currencies exist.
The fact that many goods and services worldwide—once again oil being the prime example—can be purchased with US dollars does play a supporting role, but it is not the cause of the dollar's overvaluation. And in order to accurately understand how and why the $IMFS, and therefore global stagnation, will end, you need to understand its true cause. Oil being priced in dollars supports the dollar's overvaluation only insofar as the foreign oil producers themselves choose to hoard the dollars they earn as surplus revenue.
Secondarily, it provides the central banks engaged in the dirty float a false pretense for their excessive purchases of US dollars. You'd be surprised at how many people actually believe that China bought trillions of dollars as a rainy-day reserve fund simply because oil, food and many other global necessities are priced in dollars.
The cause of the dollar's overvaluation is the exorbitant hoarding of dollars by foreigners, including both foreign investors (which, yes, includes some of the foreign oil producers, though not to a great extent) and foreign central banks doing the dirty float. And of those two (foreign investors and foreign CBs), it is the CBs that were the cause of the perpetuation which lasted many decades, because they were the ones who bought dollars when everyone else was not.
Eliminate that particular cause, and you don't immediately eliminate the overvaluation, but you do end its perpetuation. And that's where I think we are today (and have been since 2014 when I originally wrote this post).
There were a number of articles back in 2014 around the time I was writing this, both in the conspiratard media and in the mainstream, like this, this and this, about how the "epic collapse in crude prices" as ZH called it (oil had just plunged to $75 per barrel!) spelled doom for the dollar. $45 oil didn't doom the $IMFS in 2009, nor did $26 oil in 2001 or $16 oil in 1998, and $10 oil didn't doom it last month. (Something else is!) The oil narrative is predicated on the common misconception that I outlined above, and is therefore wrong. But that doesn't mean the system is not doomed, it only reveals an inaccurate understanding of how and why it will end.
According to the narrative in those "petrodollar" articles I linked, the fat lady should have already sung, if not in 2008, then at least in 2012, 2013, 2014, 2015, 2016, 2018, or surely last month. Yet the dollar is stronger this year than it has been since 2002! There must be a better narrative, and there is.
Here's a chart by the French bank BNP Paribas from the Reuters article above. It shows what it calls "petrodollar exports" which it says were negative in 2014 for the first time in 18 years.
Like I said, if this were the whole picture, then the fat lady would have already sung, but it's not and she hasn't… yet. I think this chart is misleading in many ways. "Petrodollar exports" is supposed to mean dollars spent on foreign oil priced in dollars that were then "recycled" back into US financial markets and other dollar-denominated debt. But all it really shows is foreign private sector dollar investment from part of the ROW. Excluded from the chart are Japan, Europe and the foreign CBs.
Look at 2008 in the chart. The blue is Asia excluding Japan, and it's negative in 2008. Yet 2008 was the PBOC's second-largest dollar buying spree ever, with an accumulation of $250B in Treasuries that year. The PBOC surpassed 2008 two years later in 2010 by buying $265B that year, and notice that the entire "petrodollar exports" for 2010 in that chart don't even total $200B. I don't have the data for the chart, but it looks like about $185B for 2010. In 2010, our trade deficit was $499B. $265B was purchased by the PBOC, and about $185B from "petrodollar exports", for a total of $450B. Something must be missing, and it is. Europe's private sector!
Notice, also, that those two years, 2008 and 2010, contained big dips in the dollar's price. In 2008, the dollar hit its all-time low of 71.5, and in 2010, it plunged from 88 in June down to 76 in October, a 14% plunge reminiscent of Q2 1978. Remember I said that CBs doing the dirty buy dollars when everyone else is running away? Well it appears that the PBOC did just that, and it's not in that petrodollar chart.
Here's another chart, this one by Frank Knopers of Marketupdate.nl. It doesn't entirely complete the picture, but it fills in a good portion of what's missing:
This chart is only Treasuries, and you'll notice it's quite large precisely where the "petrodollar exports" one was small, and small where the petrodollar one was large. In this chart, Asia is red, and you'll notice how it dominates in 2008-2011 while in the last chart, where Asia was blue, it was but a minor concern. Also look at 2006, and how it's actually the lowest point in the past decade in this chart while it was the highest point in the last one.
We're looking at an incomplete picture in both of these charts, and also if we take them together the picture is still incomplete. That's because the total capital flow includes sectors, markets and actors that are not accounted for on either one of these charts. But if we understand how the balance of payments works, then we know that the physical plane trade deficit is the sum total of the monetary plane (capital) flows, of which these two charts merely give us a partial view.
Now imagine that the monetary plane "capital inflow" into the US suddenly stopped, turned on a dime, panicked, or whatever… it just vanished—poof. It would look something like this:
Notice that the numbers no longer balance. Suddenly the US is trying to import $2.7T in goods and services while only exporting $2.2T in goods and services. This puts an extra $500B in dollars per year into the foreign sector for which there is no longer a demand. As I said above, the demand caused the flow in the first place and, because the foreign public and private sectors worked in tandem, perpetuated it for decades. But, remember I also said that changes in net consumption happen slowly while capital flows can literally turn on a dime. The inertial differential between the two planes is critical in this instance.
One way or another, however, those numbers will balance in short order. Perhaps the red numbers could drop from $2.7T to $2.2T, or the black numbers could increase to $2.7T. Think about what would have to happen in short order, in real terms, for either of those scenarios to work. To foresee how these two numbers will reconcile, you must think in real, physical plane terms. You must think about those numbers representing a real volume of goods and services flowing in either direction, and the inertia of the demand to keep that real volume unchanged.
What you'll find, if you play out this thought experiment honestly, is that the weakest link in the whole system, the one that will lose its grip and make those numbers meet, is where the rubber meets the road—the prices that connect the dollar to the physical plane of goods and services. First the price of a dollar (its exchange rate) will slip, because there is suddenly a $2.7T supply meeting a $2.2T demand. This will have two initial effects. 1. It will send more dollars back to the US bidding up the price of US goods and services (real price inflation). 2. It will make those US imports appear relatively more expensive from the frame of reference of the dollar holder (relativistic price inflation).
Normally, this would mean a quick devaluation of the dollar, say for simplicity of calculation, by 50% or something. If that happened, you'd see those numbers rising quickly, but with the black numbers rising faster than the red until they meet at $4.4T (a 50% devaluation of the dollar). In real terms, US exports would have remained the same, but US imports would have shrunk from what would have been $5.4T after the devaluation to only $4.4T, an 18.5% reduction in imports in real terms, and a 100% reduction in net consumption by the US as a whole.
The sudden elimination of net consumption by the US as a whole is what FOA called "crashing our lifestyle," but he added in the very next sentence: "Something our currency management policy will confront with dollar printing to avert." A simple devaluation of the dollar would not only eliminate our trade deficit immediately, but in the case of the dollar because it is the global standard for savings and reserves totaling around $100T, it would deliver a global haircut in real terms to the value of those savings and reserves. Nominally they would still be the same, but their real value would have been halved.
That, alone, would probably be enough to start a cascading avalanche of panic out of dollar holdings that would take the dollar much lower than the initial devaluation. But what FOA wrote—"Something our currency management policy will confront with dollar printing to avert"—is even more true today than when he wrote it and will, in my view, precede and amplify the avalanche, making the US dollar look more like the Zimbabwe dollar than the krona, peso or ruble in the end.
The reason I say it is more true today than when he wrote it is that, when he wrote it, the US private sector was the primary net consumer. But ever since the 2008 financial crisis, the US private sector is no longer a net consumer. We have, in essence, already "crashed our lifestyle." Yet the US as a whole, which in sectoral terms means the US private sector plus the US public sector (the USG), hasn't crashed its lifestyle at all.
Beginning in 2009, the net consumption of the US public sector, the US federal government, with net consumption defined as spending in excess of income, has been equal to or greater than the net consumption of the US public and private sectors combined. Stated simply, the USG's budget deficit has been equal to or greater than the US trade deficit for the last six years.
What this means, if you play out my thought experiment honestly, is that "the sudden elimination of net consumption" will be borne entirely, or at least almost entirely, by the one entity that can unilaterally, not unlike Mugabe, "confront with dollar printing to avert" (or at least attempt to avoid) bearing the brunt of that crash of lifestyle. That singular entity is the USG, and that's the basis for my view of how the US dollar will come to look more like the Zimbabwe dollar in the end.
That's what I wrote back in 2014, those last several paragraphs. But we're past thought experiments today. Today (2020) we have a real scenario playing out right before our eyes. It's a scenario that's both "crashing our lifestyle," and which the government is "confronting with dollar printing to avert." There are differences, but the end result will be the same. The river still ends at the ocean.
FOA (3/17/2000; 9:16:57MT - usagold.com msg#13)
"The years spent traveling this road were done to prepare the world for an escape medium when the dollar finally began its "price" hyper-inflation stage.
Few investors can "grasp" that in reality, our dollar has already been hyper inflated , but without the higher price effects. Years of deficit spending, over borrowing, debt expansion have created an illusion that the dollar was immune to price inflation. This illusion is evident in our massive trade deficit as it carries on with no negative effects on dollar exchange rates. Clearly other investors, outside the Central Banks were helping in the dollar support process without knowing they were buying into a dying currency system.
The only thing that kept this process from showing up in the prices of everyday goods was the support other Central Banks showed for our currency through exchange intervention. As I pointed out in my other writings, this support was convoluted at best and done over 15 to 20 years. Still, it's been done with a purpose all this time. That purpose was to maintain the dollar for world economic trade, without which we would all sink into depression."
FOA (9/23/2000; 9:26:10MD - usagold.com msg#39)
"Again; it's the dollar that's caught in a vice because its exchange value is rising while its native buying power is somewhat the same. In order to balance the dollar's strength, native goods prices should be falling. By staying the same, its effects on our exchange rate process makes the local price of US goods ever more noncompetitive to sell to world markets."
Trail Guide (10/21/00; 08:50:07MT - usagold.com msg#: 39569)
"Once the ball starts rolling, it's good bye dollar overvaluation,,,,, and hello US hyper inflation. Especially if we want to keep our DOW and financial structure away from bookkeeping failure. Roaring prices for goods, yes, but bookkeeping failure, no! This is how a real inflation plays out!"
Trail Guide (10/24/00; 10:58:56MT - usagold.com msg#: 39784)
"Our currency will be lowered to non reserve status no matter what route we take. Just as in many other historic examples and present examples around the world, nation states always choose hyperinflation when no other way out is offered. No nation on earth has ever cascaded themselves into deflation once they are off the gold money system."
FOA (12/02/00; 11:40:02MD - usagold.com msg#49)
"It's almost impossible to compare our outcome of all this to other opinions because we have built our actions and testimony upon the one-way flow of this timeline transition.
We say "one way and one way only" and waver not! Own physical gold and position one's other interests with regards to a changing reserve currency dynamic...
In our time and for the first time in the modern US dollar history, the US will embark into a classic hyperinflation for the sake of retaining its own lessened dollar for trade use. As destructive as that might be to players in this financial house, it is better than immediate total economic failure. It will evolve in a form much like the course of any other third world country, if its currency too was suddenly deprived of world reserve status. We will, like people the world over, learn to live with it and live in it. Truly, our dollar and economy will not go away, but its function, use and value will change dramatically."
FOA (07/27/01; 15:20:44MT - usagold.com msg#85)
"Make no mistake, we are not calling for price inflation to end the dollar's reserve reign! We are calling for "inflationary policy" to dethrone it while said hyperinflation follows…
The very changes needed in our money universe, today, would kill dollar demand by devaluing all dollar assets in super higher gold prices. The debts and the dollars would remain; only 90% of their current illusion of value would vanish. Hyperinflation in prices of all wealth objects will be the workout result of this process. As such, opposing dollar political motive will force the US to give the markets what is needed; both gold and gold prices beyond imagination."
FOA (11/2/01; 12:35:27MT - usagold.com msg#128)
"The evolution of Political will is now driving the dollar into an end time hyper inflation from where we will not return. That is our call."
The hyperinflation I envision may seem extreme and inconceivable, but I don't think it is. Nor do I think it is all that bad. As there are usually two sides to everything, there's a good side to dollar hyperinflation as well! ;D
Yes, it will destroy probably $100T in savings and monetary reserves worldwide (not counting the fancy derivatives), but it will also destroy the debt those savings and reserves are built upon. And in so doing, it will destroy the virtual fishbowl that today confines the global economy, holding it in a state of secular stagnation. Yes, this is the cure, breaking the fishbowl, and like I said, I don't offer a prescription for getting it done, because it's happening on its own, right before our eyes.
Superstitious defeatists as I call them think that something or someone will intervene and prevent the cure by supporting the dollar in its hour of need. I don't think so. Not this time, because all signs are that the dirty float is finished.
Just look at Foreign Official Treasury holdings. They are at $4.2T today, and they have been right around $4T for 7½ years now. The dirty float is dead. Long live the clean float.
FOA (4/19/01; 17:50:29MT - usagold.com msg#65)
"The dollar is toast because most of the world doesn't like the management policy. They didn't like it in 71, but tolerated it because gold was supposed to keep flowing in repatriation payments. And if they didn't like it back then, they god awful hate it now!
We like to think that the dollar is what it is because we are so good. (smile) But, the truth is that for over a two decade period +, none of our economic policy, our trade financing policy, our defense policy or our internal lifestyle policy has pleased anyone outside these borders. We managed the dollar for us (U.S.) and the rest could just follow along.
Our fiat currency has survived all these years because others have supported our dollar flow in a way that kept it from crashing its exchange rate. We talk and think like we are winning the tug-of-war when, in fact, they just aren't pulling too hard. Waiting for their own system to form up."
Looking Forward
As I wrote earlier, my predicted transition implies a smaller financial sector, smaller international capital flows, and a shift from financial pyramids and volatility churning into real economic enterprises as the most profitable focus for "hot money". I know that many of my readers find this "glimpsing the hereafter" stuff challenging. I mean, everyone's into stocks and bonds today, right? So won't they run back into the warm embrace of paper IOUs right away?
Well, remember the Roaring 20s when everybody including the shoeshine boy was in the markets? After that crash, the average saver did not want to touch the stuff for four or five decades, and that was without hyperinflation wiping out his or her "savings" to 0.01% of their previous purchasing power. This time, I think it will be quite obvious that the only things "left standing" will be "real things".
Even among real things, the degree of purchasing power retention in real terms will vary greatly. This should lead to the usual mentality of risk reduction and channel future savings to a different focal point than today. And it's not just about the focal point which is for truly surplus (i.e., not needed anytime soon) revenue, but all forms of real wealth that enhance one's standard of living through their presence and use will gain widespread appreciation. Like nice, heirloom-quality household goods and furniture, instead of the cheap crap we buy today with the virtually-unlimited credit from an overvalued currency.
Ensuring that you own your home free and clear by retirement is another thing we should see post $IMFS, because it reduces risk. And no, I'm not talking about anything like the housing market speculation of today. All this "glimpsing the hereafter" stuff is based on common sense flowing from the elimination of money hoarding which will have proven so disastrous through the reset. This is what FOA explained so brilliantly, how our very human nature leads our behavior, especially through change.
One other thing I mentioned earlier that I want to expand upon in this final section is that any central bank purchases of gold, or any foreign currency for that matter, beyond a level that is prudent for normal international banking liquidity needs and emergencies (a level which I might add that all major CBs already have in reserve), are just currency manipulations that punish the workers in their own economy by reducing the purchasing power of their wages and transferring that purchasing power to someone else. Such transfers do not increase aggregate demand (i.e., purchasing power), they only transfer it from one person to another.
You may have seen the term "GOMO" used recently, which means Gold Open Market Operations or a CB buying or selling gold on the open market. While this idea has been associated with Freegold, I will tell you now that I don't agree that it is part of Freegold, a good idea, or even that we should expect to see it tried by the incompetent. Don't count on GOMO, because it's not what you are probably thinking it is.
I see a lot of people falling into the trap of thinking that "physical gold purchases can only be good no matter who's doing it", because they are thinking of their own holdings and projecting that personal feeling onto a CB that represents an entire economy made up of both debtors and savers. If you thought it was hard to think like a giant, it's even harder to think like a CB. A giant can underconsume and save just like us, but if a CB tries to do the same thing, it's not really saving. It is merely preventing the exchange rate from balancing trade via the relative prices of goods and services, and thereby mispricing its currency and unnecessarily punishing its own labor force.
Look at China. From joining the WTO to 2015, the PBOC accumulated $4T in foreign currency reserves. To do that, it printed $4T-worth of yuan base money. Such printing should have been massively inflationary in China, but it wasn't. Look at China's inflation rate over that same time period:
Pretty mild for having printed $4T in new base money, right? The PBOC didn't stimulate demand in its own economy with all that printing, instead it suppressed demand locally and transferred it to someone else… to us in the US! That's all the PBOC did by manipulating its currency. It punished its own workers in its own economy by lowering the purchasing power of their wages below where it would have been otherwise, and it transferred that purchasing power to us.
Now, if a CB buys gold instead, it will be punishing the workers in its own economy in the same way, by lowering the purchasing power of their wages below where it would have been if it hadn't bought gold, and it will be transferring that purchasing power to… you guessed it… anyone who has gold! Sounds good, right? Well don't count on it, because it doesn't increase aggregate demand or consumption, it only transfers it. Gold is not a form of monetary policy, even if someone at the ECB inappropriately mentioned it along with debt and other market assets.
Gold falls under reserves, and not monetary policy, by the ECB's own definitions. It's on every single ECB weekly statement:
Items not related to monetary policy operations (includes gold, foreign currencies and foreign debt)
Items related to monetary policy operations (includes things like lending facilities, refinancing facilities, deposit facilities, LTROs, securities market programs, etc…, many different things, but not gold)
Monetary policy will be the same in Freegold as it is today… raising and lowering interest rates or other ways of easing and tightening, and buying debt if rates get too low. The difference is that they'll only do it within their own currency zone, because the dirty float will be finished.
The ECB's own statements make it clear, every week: Monetary policy, by definition, is stuff you do at home; Reserves—gold and foreign currency/foreign debt—and operations pertaining to reserves, are not part of monetary policy. They are exchange rate manipulations, and the ECB has made it clear that they aren't doing that anymore. Monetary policy won't change in Freegold. If you hate this system because of CB monetary policy, then you'll probably hate the next one as well.
What will change is that exchange rates will no longer be manipulated, therefore foreign currency, foreign debt and gold will just sit there, unchanged, on the CB balance sheets. Simple as that. The CBs will still mess with interest rates, reserve requirements, and buy debt and other stuff within their own currency zones, because that's what has at least a little effect on aggregate demand.
Transition!
The purpose of this next section is to further explain and define the "clean float", and to show why the dollar's collapse is an integral part of it. My view of the future international monetary system is one of a predominantly (but not mandated) "clean float" in currencies, which is the monetary side of what I call "Freegold". Physical gold movements will only settle the voluntary imbalances of individual past and present savers, not aggregated imbalances as those will be corrected gradually, through the clean float. I should add that I see this as an effect of Freegold, not a prerequisite.
Back in January of 2015, someone asked, "Should the USD strengthen too much… can the FED buy euros without calling it a peg, but say ... active monetary operations... - a strategy to shake off speculators, and so on."
Yes, the Fed could certainly do so at the behest of the US Treasury. But the irony of this transition is that the US itself has been running a clean float since 1971. It's the ROW that has been running a dirty float against the dollar.
The dirty float is any official or unofficial exchange rate fix, peg, floor, ceiling or band defended by the public sector (CB). That's what causes imbalances to grow to system-busting levels, because the public sector steps in whenever the profit-driven private sector panics which is when it would otherwise correct. Occasional FX interventions for the purpose of combating unusual volatility, as long as there is no target exchange rate level, can certainly happen within a clean float. I'm not a purist. ;D
The majority of CB FX interventions are done visibly, for all of the logical reasons, and also empirically as well as admittedly according to a survey by the BIS. (The rare reasons for secrecy, according to the survey, are 1. to not actually affect the exchange rate when the goal is simply to acquire defensive reserves, 2. in cases where the intervention is expected to fail, 3. when the CB doesn't want to intervene but is forced to do so by politicians, 4. where intervention is inconsistent with other policy objectives, hence confusing signals will be given, and 5. where the central bank is not sure what it wants to achieve.)
For the US dollar, FX interventions are executed by the Fed under the direction of the US Treasury. This happens very rarely. In fact, it only happened twice from 1996 through 2006. The US has been philosophically and openly opposed to exchange rate manipulations of all kinds since 1971 (except for that brief time in 1978 when it asked Germany, Switzerland and Japan to print and swap their currencies for dollars to help Carter throw everything but the kitchen sink at the problem).
Today's dollar is essentially in a similar position to a currency that has been supporting its own overvalued exchange rate by running down its foreign reserves and will inevitably collapse when they run out, only it hasn't been doing that. The rest of the world has been doing it to the dollar, putting it in that position. In terms of foreign currency reserves to deploy in defense of the dollar when it finally starts to collapse, the US has fewer than Korea, Indonesia, Mexico, Peru and Columbia.
Of course it also has its gold, but that was not earned through running a surplus recently, it was earned through running a surplus 70 years ago and would have been long since gone were it not for the genius of Nixon, so US gold can't really be deployed in any meaningful way (yet). Treasury will ultimately be put in the singularly-unique position of having to both print like Mugabe to keep the bloated government functioning, AND simultaneously beg the same foreigners it has been telling to stop currency manipulation for the last five years, to start massively printing their own currencies to manipulate the dollar. Ouch!
It's difficult to even imagine the insane contradictions of the situation, but I imagine that's what FOA had in mind when he wrote about the US Treasury "shipping ever higher priced gold to defend an ever lower valuation of dollar exchange rates," but only "within official channels"(!), as physical gold returns "to official hands in Europe in exchange for Euros" which will presumably be used as FX reserves to support an ever lower dollar. "American policy has only the wish to manipulate its currency valuations with official currency trading" (in other words, IMO, meaning through the occasional FOREX interventions rather than a return to BW-style CB fixing or the post-BW dirty float of unofficial pegs and channels/bands) which is why "it will be in the US advantage for gold prices to rise and rise strongly" so that Treasury can get enough euros for its gold to at least slow the dollar's collapse. Remember, gold doesn't work well in currency defense at its discount market price, "just ask the Koreans and Indonesians". ;D
FOA (08/24/01; 10:54:30MT - usagold.com msg#101)
Part 2
=============================
I have presented this topic many times and again state that "all gold paper will burn". Most mine values included. Then and only then will gold values soar as physical units traded. Not before. As an adjunct, the illusion of most American paper wealth will also burn with this process that transitions the dollar away from reserve status.
At the right time the Euro Zone will withdraw from the IMF, leaving the US and its factions as the only support for dollar credit assets held overseas. Then the evolution of SDR use our guide knows so well will be complete. This will leave the SDR interpretation open to only one avenue to finding support: its basket currency function dissolved, gold will have to flow from American based stocks. With most of the present official credit gold leverage built upon IMF protocols, the US will find itself shipping ever higher priced gold to defend an ever lower valuation of dollar exchange rates.
With the world credit gold markets paralyzed in default and dollar credibility placed in question along with American economic stamina; physical gold will return to official hands in Europe in exchange for Euros. A paradox observed as high gold places more demands upon Euros and sends the dollar ever lower.
=====================
In all of this Alan Greenspan will say goodbye. A gentleman of his ability and stature will find no use for a position he cannot change from; a good general does not only retreat. Any lesser player can buy public and treasury debt for the purpose of constant hyper inflation; there is no policy strategy or gamesmanship in this.
As for gold being a problem to buy in the USA? Once again, I point out that American policy has only the wish to manipulate its currency valuations with official currency trading. It will be in the US advantage for gold prices to rise and rise strongly. An acknowledgment to Euro planning and a defeat for 30 years of American gold misuse. If treasury gold is traded at all, it will be within official channels to help control dollar values.
However, as paper gold values freeze up and their use fails the public, physical bullion brokers will become a popular as "crude oil" is to producers. I wish you "a deep well" in your affairs, my friend, and will respond more for a time.
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Thanks Mr. speaker,,,,
Thanks all
TrailGuide
That was fun, but let's get back to the question, "can the FED buy euros without calling it a peg, but say ... active monetary operations... - a strategy to shake off speculators, and so on?"
As I said, yes they can! But the problem is the US trade deficit. You see, a normal currency (that is, any currency other than the global reserve currency) generally feels upward pressure when its economy is either growing strongly due to a low starting point or already in a healthy surplus position. That's usually when those CBs start buying foreign exchange reserves in order to keep their currency down (at least that's what they do in this system).
The dollar, on the other hand, feels the same exact upward pressure even though its economy is living on food stamps and has been in deficit for 45 straight years. That's the curse of the reserve currency! The curse is that your situation, your status quo, is based on others buying your currency as reserves and investments, and that includes the foreign private sector which does so based purely on the profit motive.
How Normal, Profit-Driven Payment Flows Relate to Currency Exchange Rates
In broad, general terms, there are two main flows that affect the exchange rate of a currency. They are the two main components of the BOP or Balance of Payments—the capital and the current accounts. As bookkeeping accounts, they are both in the monetary plane, but I think they are easiest to understand as the capital flow being the monetary plane, and the current account being more closely tied to the ongoing trade flow or physical plane. In essence, the current account is just as it sounds, current, or present, or in the here and now, and the capital account is the flow of monetary plane claims, or nominal credits and debts relating to the past and the future.
To those who are experts in the BOP, this may seem like an overly simplistic view. But I’m not trying to explain the BOP. I’m simply using it broadly to explain the concept of payment flows relating to the present, past and future, and how they interact to affect currency exchange rates.
When we talk about payment flows, we are really talking about the net flows. There are flows happening in both directions in both the current and capital accounts. And if the flows in both directions were equal, they would cancel each other out and have no effect on the exchange rate. But if there's a little more in one direction than the other, that's a net flow which does have an impact on the exchange rate.
In general, a net flow in the current account is matched by a net flow in the opposite direction in the capital account. If you have a net outflow of payments for goods in the here and now, also known as a trade deficit or current account deficit, then you likely have a net inflow in the capital account which balances the two. The outflow in the current account matches the inflow in the capital account, and in a clean float, changes in the exchange rate of the currency make sure they match. In a clean float, it's a perfectly natural adjustment mechanism, kind of like how supply matches demand because changes in the price make sure they match.
The capital account inflow is basically investment money flowing in. It can be lending from foreigners, stock or bond sales to foreigners, real estate sales to foreigners, the sale of ownership stakes in local businesses to foreigners and so on. The capital account is basically the sale of claims on local future payment streams to foreigners. It's the sale of things that cannot actually be moved or exported, but their future revenue is what is being sold. This contrasts with the current account which generally pays for stuff that can and is being moved and exported or imported currently, or in the present, as well as services rendered in the present.
The sale of claims on future payment streams to foreigners goes on the capital account, but when those payment streams start flowing, the yield payments go on the current account, because the business or debtor or whatever is yielding in the present. So the current account is not a perfect representation of the balance of trade in the present, but it is close enough for our purpose.
So what we have is four different flows which add up to a single net flow. We have the current account outflow (payment for imports and foreign services), the current account inflow (payment for exports and services), the capital account outflow (locals making foreign investments) and the capital account inflow (foreigners making local investments). Add them all up and they should balance, or net out to zero. But in reality they don't.
In reality, there is always a net flow in one direction or the other. And that flow is not necessarily reflected in the BOP (because it is supposed to balance by definition). Instead, it is reflected in one of two things. It is either reflected in a change in the currency exchange rates (if they are allowed to change), or it is reflected in a change in central bank foreign exchange reserves. If either (or both) of those two things are in motion, then there is a net flow of payments, also known as an imbalance, driving that motion.
Net private sector, profit-driven payment flows do represent an imbalance. If there wasn't an imbalance, there would be no net flow. And as exchange rates change, they correct that imbalance, keeping the BOP balanced. But when central banks intervene in the foreign exchange market, the imbalance is not corrected, and is instead built up and accumulated as foreign exchange reserves.
We see this most clearly in the Bretton Woods system because it was automatic. Exchange rates were fixed, so imbalances in net private sector, profit-driven payment flows simply built up and accumulated as central bank dollar and gold reserves. But in the dirty float of the last 49 years, it's a little less clear what is happening.
Of course we know about the US trade deficit, but that's only half of the picture. The US has also been running a capital account surplus. The BOP balances by definition, so it doesn't reveal much about overall net flow, or imbalance. The only way to deduce the net flow is to look at the two places it shows up, 1. changes in the dollar's exchange rate and 2. changes in foreign central bank dollar reserves.
My general thesis is that, whenever the dollar's exchange rate is rising, the net inflow is coming primarily from the foreign (profit-driven) private sector, and when the dollar's exchange rate is declining is when I'd expect to see foreign CBs begin intervening in their foreign exchange markets. Smaller CBs will sometimes do this just to keep their currency from appreciating versus the dollar, but larger ones have, in the past, done it simply to support the dollar reserve system, which we learned from Another.
The Mechanics of CB Foreign Exchange Interventions
Central bank foreign exchange interventions generally act in opposition to normal, profit-driven payment flows, and therefore have a different motivation than the private sector. If private sector payment flows are driving a currency's exchange rate down, the profitable move would be to short or sell that currency, but the intervening CB would do the opposite. If a currency is rising, the profit-driven private sector might buy that currency for the appreciation alone, while the not-for-profit public sector CB might print and sell.
This is not a new idea. Think about quantitative easing. When the Fed was buying mortgage backed securities, it was buying the crap that no one else wanted; it was buying the non-performing stuff at overvalued prices. That's not a profit-maximizing strategy. Frontrunning the Fed, however, is.
The BIS is constantly doing research on the behavior of central banks. You might have thought of the BIS as the boss of central banks, but perhaps it's better to think of it as a trade association, kind of like a union. The BIS employs a bunch of economists and researchers who are constantly sending out surveys to up to 90 different central banks. Some respond, and some don't, and then the economists at the BIS analyze the data, write papers about it, and hold conferences to discuss stuff that would put most of us to sleep in about 30 seconds.
One of their areas of research and discussion is the motives, techniques, mechanics, tactics, implications and effects of central bank foreign exchange interventions. In 2005, they released the results of a three year survey of central banks spanning 2002-2005, a two day conference in Basel, and 26 research papers. Here are the titles of the papers, and they can be downloaded here.
Foreign exchange market intervention in emerging market economies: an overview
3 pages
Motives for intervention
15 pages
by Ramon Moreno
Governance aspects of foreign exchange interventions
21 pages
by Paul Moser-Boehm
Foreign exchange market intervention: methods and tactics
16 pages
by David Archer
Intervention: what are the domestic consequences?
26 pages
by Madhusudan Mohanty and Philip Turner
Survey of central banks’ views on effects of intervention
15 pages
by Dubravko Mihaljek
The effectiveness of foreign exchange intervention in emerging market countries
17 pages
by Piti Disyatat and Gabriele Galati
Foreign exchange intervention in Argentina: motives, techniques and implications
5 pages
by Claudio Irigoyen
Provision of FX hedge by the public sector: the Brazilian experience
8 pages
by Afonso S Bevilaqua and Rodrigo Azevedo
Flexible exchange rate regime and forex intervention
12 pages
by José de Gregorio and Andrea Tokman R
Foreign exchange market intervention in Colombia
11 pages
by José DarÃo Uribe and Jorge Toro
Forex interventions: the Czech experience
12 pages
by Tomáš Holub
Foreign exchange market operations: the recent experience of Hong Kong
9 pages
by Peter Pang
Defending the strong side of the band: the Hungarian experience
6 pages
by Zsolt Érsek
Foreign exchange intervention and policy: Bank Indonesia experiences
11 pages
by Bank Indonesia
Approaching a decade of no foreign exchange intervention – lessons from Israel
8 pages
by Meir Sokoler
Foreign exchange intervention and foreign exchange market development in Korea
13 pages
by Gwang-Ju Rhee and Eun Mo Lee
Central banking intervention under a floating exchange rate regime: ten years of Mexican experience
22 pages
by José Julián Sidaoui
The Reserve Bank of New Zealand’s new foreign exchange intervention policy
11 pages
by Kelly Eckhold and Chris Hunt
Forex interventions in Peru: 2002-2004
13 pages
by Adrián Armas
Exchange rate policy and foreign exchange interventions in Poland
10 pages
by Jerzy Pruski and Piotr Szpunar
Foreign exchange intervention in Saudi Arabia
8 pages
by Muhammad Al-Jasser and Ahmed Banafe
South Africa: official foreign exchange operations
3 pages
by South African Reserve Bank
Foreign exchange policy and intervention in Thailand
7 pages
by Financial Markets Operations Group, Bank of Thailand
Monetary and exchange rate policies in the post-crisis period in Turkey
9 pages
by Fatih Özatay
Foreign exchange intervention in Venezuela
9 pages
by Iván Giner and Omar A Mendoza Lugo
Why does any of this matter? Well, as I said, I believe that the future of the international monetary system is one of a predominantly (but not mandated) “clean float” in currencies, which will be an effect of, not a prerequisite for, and is the monetary side of “Freegold”. And, in fact, the trend is already moving in that direction, even back in 2005!
There are emerging market currencies, and there are developed market currencies. There are also big currencies that are held as reserves by other CBs, and smaller currencies that hold the bigger ones as reserves. These two delineations are not the same. In fact, most big currencies in developed markets have all moved to the clean float already, and the big currencies in emerging markets are moving there now.
The above research by the BIS was focused mainly on emerging market CBs and a few of the smaller developed market currencies. The dollar is, of course, the main reserve currency, but the pound, euro and yen are also reserve currencies, and a few of the larger emerging market currencies are starting to be held as reserves now too.
These larger currencies have a very large volume of “turnover” in the FOREX markets, so any direct intervention, unless it is of ridiculous size (like Japan, 7% of GDP in ’03-’04, which would be like China buying $655B in one year (China’s largest year ever was ~$390B in ’08-’09)), is going to have a relatively small impact. For this reason, most large currencies have already adopted a floating exchange rate regime and now rely on the monetary policy channel of influence (inflation and interest rate targeting) and the signaling or expectations channel (“jawboning”).
Smaller CBs/currencies, on the other hand, have overwhelming potential firepower according to the BIS: “Central banks in emerging markets have indeed an overwhelming potential “firepower”. The ratio of official reserves to average daily turnover is vastly higher in emerging markets than in industrial countries – on average, official reserves were 15 times the size of daily turnover in emerging market currencies, compared with less than half in smaller industrial countries. It is therefore not surprising that the threat of intervention – and hence its potential effectiveness – is much greater in emerging markets than industrial countries.”
This makes sense, doesn’t it? While a small jet ski can turn on a dime, the largest ships might require up to a two mile turning radius, and several miles to come to a full stop. Why should it be any different for currency exchange rates? ;D
Here are a few more interesting quotes from the same paper as the “firepower” quote:
“All of the central banks in the sample that do not intervene have adopted inflation targeting frameworks and floating exchange rate regimes. It is interesting that one central bank that operates a fixed exchange rate regime intervenes seldom, relying most of the time on interest rates and other instruments affecting interbank liquidity, while one that operates what is nominally a floating exchange rate regime intervenes regularly.
[…]
The most frequent daily intervention volume (the mode) has declined by almost 50% over the past three years, and at USD 29 million in 2004 was fairly small. The largest daily intervention volume in the sample amounted to USD 5 billion or 780% of the average daily turnover in that country’s foreign exchange market, boosting official reserves by 38%. The smallest interventions amounted to just USD 0.5 million. In sum, relative to the size of foreign reserves, the size of interventions (with the exception of the largest one) has been negligible.
[…]
…the average daily turnover of most actively traded emerging market currencies – the Hong Kong dollar, the Korean won and the Mexican peso – represents only a fraction of the turnover in the Australian dollar, the Swedish krona or the Swiss franc markets. The small size of interventions relative to average daily turnover noted above is therefore not a result of increased turnover in foreign exchange markets but of small size of interventions.
[…]
Only two economies operating under a fixed exchange rate regime reported data for Table 2. One of them did report higher mean and mode sizes of intervention than central banks operating under managed or floating regimes. Interventions by managed floaters were also larger on average than those by free floaters.”
According to the BIS research, there are four main channels of influence used by central banks. They are:
1. The Monetary Policy Channel (inflation targeting etc… pretty self-explanatory)
2. The Portfolio Balance Channel (basically QE)
3. Signaling or Expectations Channel (“Jawboning”)
4. Order Flow (direct FOREX intervention, 82% is done in the FX spot market and the rest through forwards, swaps, options and debt according to the BIS)
The first three are basically clean float friendly. And most major CBs now rely only on the first three, as a practical matter and as part of their commitment to a free floating exchange rate regime. The smaller CBs that engage in direct FOREX interventions do so for different reasons, only some of which pertain to a dirty float or fixing/pegging their exchange rate.
Among the CBs specifically cited in the BIS study spanning from 2002-2005 were Hong Kong SAR, Korea, Malaysia, Philippines, Singapore, Thailand, Taiwan, Columbia, Mexico, Chile, Brazil, Peru, Argentina, South Africa, Saudi Arabia, Turkey, Israel, India, Russia, Australia, New Zealand, Japan, Czech Republic, Hungary, Poland, Sweden and Switzerland. Some of these CBs use direct FOREX intervention as a means of maintaining an exchange rate fix, peg or dirty float, but other motivations are at least as common as that.
Among the other motivations for direct intervention are reserve accumulation and calming disorderly markets or damping unwanted exchange rate volatility. Following the currency crises in Asia, Argentina, Brazil, Mexico, Russia and Turkey, high foreign exchange reserves have become viewed as an insurance policy against future crises. And sometimes they need to rebuild their reserves following a period of defending against weakness. And in countries whose currencies are not widely traded in deep and liquid international FOREX markets, the CB needs to maintain a certain level of foreign currency for the purpose of supplementing international liquidity in its local banking system.
This latter purpose does not necessarily mean the CB is running a dirty float, even if it is intervening directly. In fact, for a currency that is not widely convertible, the central bank maintaining a prescribed level of foreign currency by buying and selling directly into its thin currency market actually emulates a clean float. If the international liquidity needs of its local banking system are draining its foreign exchange reserves, then its exchange rate is higher than it would be in a deep and liquid clean floating market.
So to stop the drain, the CB lowers its exchange rate, the one it offers to its commercial banks. And to get the reserves back up to a prescribed level, it lowers its exchange rate even more, until it’s lower than it would be in a deep and liquid clean floating market. This causes foreign exchange reserves to rise, and once back at the prescribed level, it raises its exchange rate again. In this way, by maintaining a constant level of foreign exchange reserves, the central bank is keeping its currency at an exchange rate dictated by the free market, effectively emulating a clean float, even though it is engaging in direct intervention.
Methods of transacting direct FOREX interventions
According to the BIS study, there are basically three ways central banks intervene directly in the FOREX market. The first is transacting directly through the banks, market makers and brokers. The second is utilizing electronic trading platforms, and the third is by holding auctions. Here’s a little more from the David Archer paper:
“Choice of transaction method
Transacting directly – usually by telephone – with market-makers. In such cases, the central bank is operating as would a corporate customer of the market-maker, calling to request to be quoted a bid and offer price, then transacting at the quoted price.
[…]
In many countries, electronic trading platforms exist. …in some countries (Brazil, Colombia, Hungary, Korea, Peru, the Philippines, South Africa and Turkey) central banks daily conduct formal or informal surveys of market-makers’ net open positions, and have other information relevant to assessing likely positions. The trading platform itself might be configured to provide information to the central bank on the current flow of orders yet to be transacted… as the accompanying paper on Survey of central banks’ views on effects of intervention discusses, the majority of central banks believe they have an informational advantage that can be tactically useful when intervening…
[…]
Conducting auctions, ie inviting bids from counterparties chosen with reference to a range of factors, including settlement risk and their track record in supporting market liquidity. Auctions can set the quantity and allow the price to be market-determined (as in Colombia and Mexico), or vice versa. Auctions fit well with a strategy in which the central bank wants to maintain transparency, assure neutrality as between individual counterparties, and indicate a willingness to allow market determination of the exchange rate.
[…]
Amongst the respondents to the BIS survey, there was no clear predominance of any particular dealing method, as Graph 2 indicates. Choice of dealing arrangement seems to depend largely on the technology available… As to the issue of visibility, the majority of those central banks that indicated a preference for anonymity also indicated that they will occasionally deal directly with large corporates (public sector as well as private sector) in offmarket transactions. But the sample size is too small to draw any strong associations.”
For all images, click image to view at full size
The surveys used in this research were conducted in 2002, 2003 and 2004, and 23 central banks participated. There are a lot of charts and graphs in the various papers containing data that’s way out of date since it was collected and analyzed more than 15 years ago, but I gathered for you some of the tables that I thought were both interesting and applicable to this discussion. Plus, unlike data which gets old, these tables are more about the relative motives, methods and tactics of CBs with a known proclivity for intervention, which change more slowly. In fact, notice the change in this first one. From just 2003 to 2004, the number of CBs conducting FOREX interventions dropped by 5%.
To finish this section, I’ll close with the concluding remarks of David Archer, whose focus was most apropos to this discussion:
“Concluding remarks
Central banks from emerging market economies these days have considerably more experience with foreign exchange market intervention than their developed country counterparts. The range of techniques and tactics deployed is clearly wider than has been the case with intervention by developed economies over the last three decades or so. That is especially the case in three areas: the use of direct controls, consistent with the stage of development of many of these financial markets; the sale of option contracts by auction; and the use of foreign currency debt denomination or indexation as a supplementary tool (the latter two techniques featuring in Latin America). However, the great majority of intervention across the group takes conventional forms, with spot transactions in the most liquid part of the wholesale market predominating.
Although intervening central banks within the emerging market group tend to rate their interventions as quite successful, and although they devote substantial resources to monitoring their foreign exchange markets, in general they are loathe to attribute success to the selection and use of “clever” tactics. To be sure, a number of instances can be found where monitoring procedures have helped with the timing and structure of intervention. But equally, the view to be obtained through intensive monitoring remains murky and the ability to predict outcomes remains limited. As one participant at the meetings suggested, the selection of technique and tactics is an ongoing process of adaptation with no small amount of trial and error.”
To recap, we have normal, profit-driven, private sector payment flows—both in the here-and-now ongoing trade of goods and services, and in the financial plane of debt, equity and their many derivatives—driving exchange rates. And then on the other side we have central bank foreign exchange interventions—which have many motives, all of which are different from the profit motive of the private sector—occasionally pushing back against the private sector.
The reason I spent so much time on the CB side is because I wanted to give you a real feel for what is actually going on there. I want you to understand that none of it is structural support for the dollar or the $IMFS in the way that A/FOA explained. Even China, whose “support” I think explains 2001-2013 (including the GFC), had a different motivation than the European central banks who supported the dollar from 1979-1999 in order to launch the euro.
The very first line in Ramon Moreno’s paper on motives for intervention covers China—“Central banks intervene in foreign exchange markets in order to achieve a variety of overall economic objectives, such as controlling inflation, maintaining competitiveness or maintaining financial stability.”—yet nowhere in the paper does it even mention the motive that A/FOA explained. The point is that, even though, because of its incredible size, China’s dollar peg emulated the structural support of the previous two decades, it was not the same thing. True structural support for the $IMFS ended at the turn of the century, and what we have today is willy-nilly support, both foreign official (through 2013) and foreign private sector (to present).
Almost all central banks have come around to the virtues of the clean float, and what this means is that even “foreign official” willy-nilly support is likely to be nonexistent this time. My personal view is that it’s almost exclusively the foreign private financial sector that’s sustained the dollar for the last 6 ½ years, investing in anything and everything American, from stocks to bonds to real estate to fine art from Christie’s and Sotheby’s in New York City, thinking it’s all a safe haven store of value for whatever may come. Any and all foreign financial flows into dollar-priced assets are what supports the $IMFS. Remember my bomb shelter analogy?
The Emerging Market Dollar Short Doom Vortex™
After the lessons learned from the abrupt currency devaluation crises in the 90s, emerging market CBs and their governments made a few changes. They stopped borrowing in dollars (at the sovereign level), and started accumulating massive dollar reserves through a newfound policy of centralized currency depreciation (purportedly a valid adjustment mechanism). Emerging market foreign exchange reserves skyrocketed, from $500B in 1999 to $5.9T in 2013.
Just like FOA said, they could borrow from their own financial markets, and they did (at the sovereign level). The emerging market governments are no longer so vulnerable to an unexpected devaluation in their own currency like they were in the 90s, but this new development also sent a signal to Western, yield‑hungry fixed income investors that emerging economy capital markets were finally safe.
Trillions in private money flooded into these markets in search of a yield, first to the local-currency-denominated government bonds, and then—especially after the global financial crisis in 2008 and ZIRP—into dollar-denominated private sector bonds, and the emerging market corporations ate it up like candy on Halloween! It’s not all dumb fixed income investor money (some of it is from dumb banks too), but this dollar-denominated emerging market debt monster really ballooned over the past decade. And the dollar’s current strength is not only killing it, but the whole mess is actually a vicious circle, or feedback loop, or doom vortex, that causes even more dollar strength, and more financial distress, and more economic stagnation in emerging markets.
The doom vortex of a rising dollar and global stagnation is pretty simple. You have foreign companies with trillions in dollar-denominated liabilities (backing bonds held by international investors) on their balance sheets, and assets denominated in their local currency. As the dollar appreciates and the local currency depreciates, their balance sheets become impaired as liabilities overwhelm assets, leading to corporate distress, freezes in expenditures, and a general slowdown in their emerging market economy. The slowdown causes foreign investors to sell those bonds, which raises lending costs to the already distressed companies, which exacerbates the situation and powers the doom vortex.
Now think about how emerging market CBs who have been watching the strong dollar strangle their economies might react to the next sudden downturn in the dollar’s exchange rate. In the past they might have reacted by directly intervening in the FOREX market to resist their own currency’s appreciation, but this time the dollar's collapse might just be a very welcome development, and one not to be resisted.
Why the dollar’s exchange rate must collapse
As I've been saying, Freegold implies a clean float, and we are almost there already. What’s standing in the way is the perpetual nature of the US trade deficit and the overvaluation of the dollar it implies, and the only way that can be resolved is through a collapse in the dollar’s exchange rate.
There are two main flow dynamics to bear in mind here. The first is the BOP, or how the capital and current accounts balance each other out vis-Ã -vis the currency exchange rate. And the second is the interplay between the foreign public and private sectors who have each maintained the dollars perpetual overvaluation at different times and with different motivations.
Regarding the second flow dynamic, as I already stated above, my general thesis is that whenever the dollar’s exchange rate is rising, the net capital account inflow is coming primarily from the profit-driven foreign private sector, and when the dollar’s exchange rate is declining is when I’d expect to see foreign CBs begin intervening in their foreign exchange markets. The reason is quite simple. When the dollar is declining is when the foreign CBs will see their own currencies appreciating and intervene to protect what they view as a trade advantage (a weak currency). And when the dollar is rising is when the profit seekers will want to join the upward momentum and the CBs will have no reason to intervene. So it’s really a quite natural observation.
Regarding the first, the BOP, our perpetual current account/trade deficit means we also have a perpetual capital account surplus, a constant and never-ending net inflow of foreign investment money into US financial assets. Relating this to the second flow dynamic, I believe the never-ending nature of the perpetual inflow is due to the foreign public and private sectors taking turns at the pump. A very simple example is that, from August 2008 through March 2009 (the period of the financial crisis stock market collapse), China’s CB purchased $218B in US Treasuries according to TIC data, which was more than its net purchases over the last 11 years combined (2009-present).
The US current account and trade deficits peaked back in 2006, and throughout the mid-2000s there was a chorus of mainstream economic pundits, including Paul Krugman, Larry Summers, Ken Rogoff, Martin Wolf, Nouriel Roubini, Brad DeLong and Brad Setzer (h/t JP Koning) explaining how this implied an overvalued dollar and its eventual collapse. Of course Peter Schiff was doing it too, and John Rubino started his popular Dollarcollapse.com around that same time.
Also around the same time, an interesting and controversial theory appeared which tried to explain the perpetual US trade deficit by proposing that the US is in fact not a net debtor, but a net creditor, if we simply factor the awesomeness we export out to the rest of the world into our current account data. The authors of the theory, Ricardo Hausmann and Federico Sturzenegger, dubbed this mysterious and magical American export “dark matter”. But “dark matter”, according to them, is more than just American mojo. It actually consists of the expertise and know-how we export to the rest of the world, both in business and finance, the safety and stability of our amazing financial products which acts like insurance against the instability in the rest of the world, for which it pays a premium, and the fantastic liquidity of our financial markets, for which the rest of the world pays an additional premium.
If we could somehow put a price on such a valuable product as “dark matter” and count it as an export, says the theory, then we’d see that our trade with the rest of the world is actually balanced, and all the free stuff we’ve been getting for more than 45 years now has actually been paid for with sheer awesomeness. Brad DeLong explained the theory well in a 2006 post on his blog titled Dark Matter:
“The late Rudi Dornbusch said that one of the infallible warning signs that we are near the collapse of an overvalued currency associated with an unsustainable trade deficit is when highly intelligent and respected economists begin evolving plausible theories that–this time–the trade deficit is sustainable.
Now come Hausmann and Sturzenegger (2005), “U.S. and Global Imbalances: Can Dark Matter Prevent a Big Bang?” (Cambridge: Harvard CID Working Paper) with a theory that the U.S. trade deficit is not so big and not so unsustainable after all.
[…]
In the BEA’s book-value accounting, in 2006 U.S. companies will invest $600 billion in foreign direct investment elsewhere in the world–building factories, establishing links in value chains, taking over existing foreign-owned businesses, and so forth. In HS’s accounting, that $600 billion in visible FDI will be accompanied by $300 billion worth of “dark matter” organizational and technological know-how that American firms carry to their operations abroad. The FDI flow will thereafter generate as much income as would a pure $900 billion bricks-and-mortar FDI flow.
In the BEA’s book-value accounting, U.S. residents will also purchase $600 billion in foreign securities, and U.S. banks and other corporations will acquire $400 billion in loans payable and other credits. The gross overseas asset accumulation of Americans will thus amount to about $1,600 billion (in the BEA’s book-value accounting) and to about $1,900 billion of income-producing assets (including the $300 billion of “dark matter” that boosts the income-producing potential of U.S. FDI).
Now let’s look at the liabilities side. In the BEA’s book-value accounting, in 2006 foreign governments will invest $800 billion acquiring U.S. securities–Treasuries, Fannie Maes, and others. Because the U.S. is at the center of the world monetary system it has the “exorbitant” privilege of being able to sell its securities at lower interest rates. In HS’s accounting, that $800 billion consists of the U.S. providing foreign governments and central banks seeking foreign exchange reserves with $600 billion of income-producing potential and an extra $200 billion of “dark matter” liquidity.
Similarly, foreign private investors will spend $700 billion acquiring U.S. securities, which HS assess as consisting of $600 billion of income-producing potential and $100 billion of extra security–insurance because whatever happens to foreigners’ assets in their home countries, their U.S.-housed assets will still be there.
In addition, foreign companies will make $300 billion of FDI investments in America, and foreign banks and companies will acquire $600 billion in loans payable and other credits from U.S. residents. The gross accumulation by foreigners of assets in America will thus amount to about $2,400 billion (in the BEA’s book-value accounting), and to about $2,100 billion of incomes-producing potential (plus an extra $200 billion of liquidity and an extra $100 billion of security provided by the superior qualities of [the assets]).
[…]
The way that HS see it, U.S. trade is nearly balanced. We are importing some $2,000 billion and exporting some $1,200 billion of regular goods-and-services every year, but we are also exporting (a) $300 billion of technological and organizational knowledge via FDI, (b) $200 billion of liquidity services by serving as reserve banker to the world’s central banks and governments, and (c) $100 billion of security services by giving foreign private investors a safer place to plant their wealth. Properly evaluated, HS argue, U.S. trade is nearly balanced.
The debate over HS’s “dark matter” claims is rolling around the internet, with Willem Buiter and Ricardo Hausmann exchanging views at Martin Wolf’s distressingly ovary-free Martin Wolf’s Financial Times Economic Forum, Brad Setser harassing Hausmann and Business Week’s Michael Mandel from his perch at Roubini Global Economics, and Michael Mandel parrying at his Economics Unbound.
Do I believe in Hausmann and Sturzenegger’s “Dark Matter”? No. This post is in the interest of explicating an interesting line of argument only.
I believe what Rudi Dornbusch said: that when highly intelligent and respected economists begin evolving plausible theories that–this time–the trade deficit is sustainable, that is the time to start running for the hills, because the crash is near.”
On one hand, I agree with Brad DeLong and the rest of the critics of this theory that it is simply wrong. On the other hand, I have to agree with Hausmann and Sturzenegger that there has been a certain awesomeness imbued in the dollar and its financial markets. Where I probably differ, however, is whether this quality of awesomeness—this “dark matter” product—is an export or an import. I think it is an import, as it only exists because of the structural support provided by European central banks throughout the 80s and 90s in order to buy enough time to make it to the launch of their own dollar replacement. Here is FOA on this matter:
FOA (02/09/01; 14:24:03MT – usagold.com msg#59)
Current background
Make no mistake, CB support for our US unit is the only reason its exchange rate didn’t plunge, throwing us into a massive, local price inflation. And, because most other countries held dollars as a reserve, they would have inflated also. All this support was done in order to stop a complete economic trade breakdown before EMU. A decades long wait.
The trick for the CBs was to keep holding dollars and even expanding those holdings as needed to balance US trade deficits. Deficits, by the way that have not only been negative for a long time, but have grown explosively during the 90s and right up and thru EMU. This dollar support made sense because holding reserves in a failing currency, while building a new one offered little loss potential. Yes, once the new system began to function, your dollar holding’s value would eventually be reduced almost to nothing. But those reserves only represented support for the system itself, not actual buying power in the native currency’s land, USA. You see, once a permanent trade deficit becomes structural to the function of the currency’s economy, those dollars,,,,,, those units of reserve buying power,,, can never return for the purchase of anything! Without killing the exchange rates and native economic structure first. Yes, in the case of what comes first (chicken or egg), you cannot send dollars home to buy useful goods at a reasonable price if the whole trade structure fails. In the US’s example, used here, local inflation would drive the dollar prices of everything we export through the roof, long before all the goods were bought. Completely, negating any and all exchange gains from a falling dollar exchange rate.
Trail Guide (02/15/01; 17:02:46MT – usagold.com msg#: 48325)
Reply
Eventually, as the dollar works its way toward becoming just a regular money, its exchange rate will tumble. Vastly aggravated by our world class trade deficit. A deficit, I might add, that has become structural to the function of our economy in a non price inflation manner.
FOA (08/06/01; 09:37:25MT – usagold.com msg#91)
Gold Mobilization
Indeed, as an ongoing trade deficit in the US has become irreversibly structural to the integrity of the local economy and remained in this function for many years; the legal tender function of foreign dollar reserves comes very much into question. It begs this suggestion: does the international dollar have any internal political force backing its value overseas?
FOA (10/3/01; 10:21:26MT – usagold.com msg#110)
The makings of a dust storm
For another currency block to be built, over years, the current world economy had to be kept functioning. To this end the dollar reserve system had to be structurally maintained; with its IMF agenda intact, gold polices followed and foreign central bank support all being part of that structure. Truly, the recent years of dollar value was just an illusion. An illusion of currency function and value, maintaining the purpose of holding the world financial and economic system together for a definite timeline. Politically, the world does not hate America; rather they hate the free lifestyle our dollar’s illusion value brought us yesterday and today.
FOA (10/8/01; 08:04:08MT – usagold.com msg#113)
Gold on the trail.
Once off the last possible connection to a gold exchange standard, the dollar became a modern political tool. Little more than a derivative of value that depended upon what it could buy within our American borders. While this will be the fate of every new currency in our modern world, the US was politically and structurally unprepared for this shift in dynamics. We left our currency in this international pot, subject to every bit of unknown economic evolution that would come along. Because we could not walk away from the free lunch it brought us, that evolution dynamic is now upon us. The price we will now pay is the complete loss of dollar utility.
We managed this threat with help from our Euro friends; somehow thinking they enjoyed and wanted our fleecing their lifestyle to the same degree we did it to the rest of the world. Their cooperation, we will find out, was but a structural policy that bought time; time for a dollar replacement to be made.
You see, our perpetual trade deficit is the structural foundation underlying everything, and the US dollar exchange rate is the key. “Make no mistake, CB support for our US unit is the only reason its exchange rate didn’t plunge, throwing us into a massive, local price inflation.” Foreign public sector (CB) support wasn’t meant to bolster our markets, it was meant to slow the decline of the USD whenever it became unprofitable, so that it wouldn’t plunge into the abyss. A dollar consumer price inflation that matches the dollar’s past currency inflation would end the US trade deficit in a heartbeat, and the entire $IMFS along with it.
In Freegold, with the clean float it implies, there will still be trade deficits and surpluses, but they won’t be perpetual with a cumulative imbalance that builds up until it collapses. There will still be financial markets in key financial centers around the world that will drive trade imbalances at various times, but they will correct periodically and revert to the mean. There will still be reserve currencies which will be the larger, more liquid currencies that will be held in some proportion by the smaller CBs for the purpose of international liquidity in their local banking system. But none of them will be structurally supported—bought for the sole purpose of maintaining an imbalanced system. And gold will be the primary reserve asset held by CBs as an insurance policy against future crises.
In the future, if you look at a long-term balance of trade chart for any of the reserve currencies, you will see that it bounces back and forth from surplus to deficit and back again on a regular basis. Today we really have four reserve currencies, the four in the SDR basket (the dollar, the pound, the yen and the euro), plus China’s yuan is also becoming a reserve currency of sorts, simply because, like the dollar and the euro, it is a currency representing one of the largest economies in the world.
Take a look at the balance of trade charts for these five currencies, and see if you notice anything different about one of them:
One day soon, these will all start looking like the middle third of the Eurozone chart, because that’s what a clean float looks like. The problem is that getting the US chart there will require a collapse in the USD exchange rate, which will be accompanied by full-blown hyperinflation.
Think about how that will look on a nominal chart like above. I think it will probably look like a blowout to the down side as, nominally, the US trade deficit will explode to huge negative numbers, while it collapses to zero in real terms. And then once the new dollar is established (minus a few zeros via The Great Lopping™), it will be at zero in both nominal and real terms and begin fluctuating up and down like everyone else.
Conclusion
I think the clean float, as I imagine it operating in Freegold, is basically already here, and now it’s just the foreign private sector piling into The Dollar Bomb Shelter™, global stagnation (The Dollar Short Doom Vortex™) and possibly a few other technical phenomena playing out that are supporting the dollar and the entire $IMFS as it gasps for its last few breaths. I don’t think it (the clean float) has been here for a very long time, but maybe for the past six years or so, since 2014.
Our perpetual trade deficit is really just an effect of the rest of the world’s monetary and financial actions, not a cause. But even so, it has become structural to not only the entire global financial system, but to our own economic system and, most importantly, to our voracious and spendthrift federal government, who also controls the US dollar printing press in extremis (which is right around the corner, extremis that is).
Our current account/trade deficit exists in the current/present/here and now, and it requires an ongoing here-and-now net inflow in the capital account. If that net inflow stops, reverses, or even just slows down considerably (which it already has), our trade deficit will shrink and disappear in real terms no matter what our government tries.
All of the large currencies in the world are, for the most part, floating freely now, and after the past few years, the small CBs have good reason NOT to resist an appreciation of their currencies brought on by a declining dollar. Central banks, both large and small, are already conditioned for the clean float. Much of what they already do today is “clean float friendly”, and those interventions that are not will go against their self-interest the next time they are “warranted”, i.e., next time the dollar depreciates rapidly.
True structural support ended at the turn of the century, and what we have today is willy-nilly support, both foreign official and foreign private sector. And because of the Eurodollar (The Dollar Short Doom Vortex™) debt problem, the strong dollar being driven by the foreign private sector is choking emerging market economies. So this time a collapsing dollar will be a godsend to their CBs, and not something to resist.
Suffice it to say that I don’t expect the foreign public sector to resist even the most dramatic decline in the dollar’s exchange rate, and once that avalanche picks up momentum, I don’t think even Superman would be able to stop it. So now I think the only question left is: What could kick it off?
Any way I look at it now, it seems apparent that the clean float is already here, the inflow of foreign capital must have stopped by now, at least on a net basis, and all that’s left is for the dollar's Wile E. Coyote moment to come to its inevitable end. Either that, or maybe it will just be strawberry fields forever for those of us lucky enough to live in the magical land where exporting our sheer awesomeness brings in all the free shit we could ever need and want, and wires us the monthly free stimulus money to buy it.
To quote Another, “we watch these changes together, yes?”
In this post, I traced the evolution of the global exchange rate regime over more than 75 years, from the fixed exchange rates of Bretton Woods, to the "exchange rate anarchy" of the 1970s, to the dirty float of 1979-2013, and now to the clean float that will take us "a thousand years" into the future. At the top, I made a statement about gold having little to do with the monetary system in Freegold:
I know that some of you are skeptical about what I am saying. You're probably thinking that Freegold relies somehow on gold and whether or not it is embraced by the masses. But here's another thing that will probably surprise you in the end. Gold has little to do with "Freegold the monetary system"!
I knew when I first wrote that, back in June of 2014, that it might be controversial, but I hoped that it would eventually make sense after I finally got out what I had in mind. So now my question to you is whether or not what I wrote makes sense to you. I hope it does. Here's the part I'm referring to:
In order to see how the dollar can collapse, you need to understand how and why it is overvalued today, not just in the monetary plane with its monumental overhang of "financial savings", but also in the physical plane of production and trade. By the end of this post, you might be surprised to discover how the dollar would still collapse even if we could hypothetically erase all of the dollars and "financial wealth" that has accumulated in the system.
Also by the end of the post, I hope you will see how simple Freegold really is, but for those of you who are impatient, or don't like to read long posts, or don't care about understanding things deeply and would rather just have an abstract that can be easily dismissed so you can get back to the stuff you already know, here's the gist of it.
Freegold is all about gradual, natural and automatic adjustment mechanisms in the modern world of fiat currencies. An adjustment mechanism is quite simply anything that periodically corrects physical plane imbalances. In economics, the term "adjustment mechanism" is often used to describe the flow of gold between different countries back when gold was used as base money in those countries. But this is not at all what Freegold is about, so I am using the term in a much broader sense that applies at any scale, from the global scale on down to the individual.
Whenever you buy a gold coin, or even a coffee at Starbucks, that's an example of an adjustment mechanism at the individual level. Monetary plane balances (like "financial wealth", the "idea of long term debt being held as a money asset", or even cash in your wallet) represent physical plane imbalances. Whenever monetary balances are reduced, real world imbalances are reduced. Likewise, when monetary balances are accumulated, physical plane imbalances increase. It's a simple concept and a simple view.
The flow of money within a common currency zone, like the United States for example, is the most basic and automatic adjustment mechanism. Other adjustment mechanisms include changes in wages and in the prices of various goods and services in general, and in different locales, and the movement of people and capital from one location to another.
Wherever multiple currencies interact, like on planet Earth for example, changes in the exchange rate between them are the primary adjustment mechanism. Fixing, pegging or otherwise manipulating the exchange rate of different currencies does, in fact, preclude other adjustment mechanisms and causes imbalances to accumulate, often to the point that abrupt adjustment becomes unavoidable, economically disruptive, and financially destructive, in other words, painful.
Currency collapse and hyperinflation are natural but not gradual adjustment mechanisms, as are controlled devaluations. Floating exchange rates are a more gradual adjustment mechanism between different currency zones.
These adjustment mechanisms have always been with us, so the real change in Freegold is the "gradual, natural and automatic" part. Gradual (or ongoing) is self-explanatory, but what I mean by "natural and automatic" is that these ongoing adjustments will be allowed to happen or made by choice, not forced or induced by a central bank, because such ongoing adjustments will be in the self-interest of anyone in a position to choose, on any scale.
I'm sure that some of you are already skeptical about what I'm saying. You're probably thinking that Freegold relies somehow on gold and whether or not it's embraced by the masses. But here's another thing that will probably surprise you in the end. Gold has very little to do with "Freegold the monetary system"! Gold is not a key part of the monetary adjustment mechanisms in Freegold. The price and physical movements of gold won't even matter to the monetary system. Any movements of gold in price, ownership or location will be irrelevant to the monetary system of the future.
Freegold is the true unshackling of gold from the monetary system. In Freegold, a properly functioning monetary system requires nothing of gold. In Freegold, the international monetary system won't require gold to change price or location in order for it (the new IMFS) to function. That's why it's called Freegold. Gold is finally and truly set free from its shackles to the monetary system.
So what do you think, does it make sense?
I think MdV finally got it. On 5/3, Marion wrote:
"Foreign trade deficits would be settled in gold…assuming that no new global reserve asset emerges."
And MdV responded:
"As for trade imbalances being settled with gold, in a free floating currency regime, imbalances are ‘cured’ by a changing relative value of currencies."
Very good! See how simple it is? This was my big epiphany back in 2014, that took me a year to explain, and took a couple more years to really click for FoNoah. And here MdV just drops it in a single sentence as if it's no big deal. ;D
That post I was working on was called "Settlement" because I was trying to connect the idea of gold being settlement at the person level with it also working that way at the international level, but something about it was wrong, and FoNoah knew it.
Freegold isn't about gold settling imbalances at all levels, only at the individual saver level. At the sovereign or central bank level, it will just be a reserve, one that lies very still until it is needed in an emergency.
That's in Freegold, but first we have to get there, finish the trip, and get through the transition.
I know it's been a long one, but we're finally here, at the end. ;D
Sincerely,
FOFOA
