The Death of Money (22 page)

■
The Island Twins

Two nations stand apart from this survey of monetary multilateralism and rising discontent
with the international monetary system: the U.K. and Japan. The U.K. is a member of
NATO and the EU, while Japan is an important and long-standing treaty ally of the
United States.

Neither nation has joined in a monetary union or spoken out vociferously against U.S.
dominance in international monetary institutions. Both Japan and the U.K. maintain
their own currencies and their own central banks; they host the respective financial
centers of Tokyo and London. The Japanese yen and the U.K. pound sterling are both
officially recognized as reserve currencies by the IMF, and both Japan and the U.K.
have the large, robust bond markets needed to support that designation.

Still, Japan and the U.K. are weak in gold reserves, with only about 25 percent of
the gold needed to equal the United States or Russia in a gold-to-GDP ratio; Japan
and the U.K. have an even lower gold-to-GDP ratio than China, which is itself short
of gold. The United States, the Eurozone, and Russia all have sufficient gold to sustain
confidence in their currencies in the event of a crisis. In contrast, Japan and the
U.K. represent the purest cases of reliance on fiat money. Both countries are out
on a limb, with printing presses, insufficient gold, no monetary allies, and no Plan
B.

Japan and the U.K. are part of a global monetary experiment orchestrated by the U.S.
Federal Reserve and articulated by former Fed chairman Ben Bernanke in two speeches,
one given in Tokyo on October 14, 2012, and one given in London on March 25, 2013.
In his 2012 Tokyo
speech, Bernanke stated that the United States would continue its loose monetary policy
through quantitative easing for the foreseeable future. Trading partners therefore
had two choices. They could peg their currencies to the dollar, which would cause
inflation—exactly what the GCC was experiencing. Or, according to Bernanke, those
trading partners could allow their currencies to appreciate—the desired outcome under
his cheap-dollar policy—in which case their exports would suffer. For trading partners
that complained that this was a Hobson’s choice between inflation and reduced exports,
Bernanke explained that if the Fed did
not
ease, the result would be even worse for them: a collapsing U.S. economy that would
hurt world demand as well as world trade and sink developed and emerging markets into
a global depression.

Despite Bernanke’s rationale, his cheap-dollar policy had the potential to ignite
beggar-thy-neighbor rounds of currency devaluations—a currency war that could lead
to a trade war, as happened in the 1930s. Bernanke addressed this concern in his 2013
London speech. One problem with the 1930s devaluations, he said, was that they were
sequential
rather than contemporaneous. Each country that devalued in the 1930s might have gained
growth and export market share, but it came at the expense of the countries that had
not devalued. The desired growth from devaluation was suboptimal because it came with
high costs. Bernanke’s solution was for
simultaneous
rather than sequential ease by the United States, Japan, the U.K., and the ECB. In
theory, this would produce stimulus in the major economies without imposing temporary
costs on trading partners:

Today most advanced industrial economies remain . . . in the grip of slow recoveries
from the Great Recession. With inflation generally contained, central banks in these
countries are providing accommodative monetary policies to support growth. Do these
policies constitute competitive devaluations? To the contrary, because monetary policy
is accommodative in the great majority of advanced industrial economies, one would
not expect large and persistent changes in . . . exchange rates among these countries.
The benefits of monetary accommodation in the advanced economies are not created in
any significant way by changes in exchange rates;
they come instead from the support for domestic aggregate demand in each country or
region. Moreover, because stronger growth in each economy confers beneficial spillovers
to trading partners, these policies are not “beggar-thy-neighbor” but rather are positive-sum,
“enrich-thy-neighbor” actions.

Bernanke’s “enrich-thy-neighbor” rhetoric ignored the neighbors in emerging markets
such as China, Korea, Brazil, Thailand, and elsewhere whose currencies would have
to appreciate (and their exports suffer) in order for Bernanke’s “stimulus” to work
in the developed economies. In other words, Japanese exports might benefit, but this
could come at the expense of Korea’s exports, and so on. It might not be a currency
war of all against all, but it was still one that pitted the United States, the U.K.,
and Japan against the remaining G20 members.

Japan and the U.K. had another reason to support the money printing and resultant
devaluation being urged by the Fed. Money printing was being done not only to promote
exports but to increase import prices. These more expensive imports would cause inflation
to offset deflation, which was a danger to the United States and the U.K. and had
long existed in Japan. In Japan’s case, inflation would come primarily through higher
prices for energy imports, and in the cases of the United States and the U.K., it
would come from higher prices for clothing, electronics, and certain raw materials
and foodstuffs.

The United States and the U.K. both have debt-to-GDP ratios of approximately 100 percent
and rising, while Japan’s debt-to-GDP ratio is over 220 percent. These levels are
historically high. The trend in these ratios is more important to investors than the
absolute levels, and the trend is worsening. All three nations are moving toward a
sovereign debt crisis if their policies cannot be adjusted to put these debt-to-GDP
ratios on a declining path.

Debt-to-GDP ratios are calculated in nominal rather than real terms. Nominal debt
needs to be repaid with nominal growth in income. Nominal growth equals real growth
plus inflation. Since real growth is anemic, the central banks
must
cause inflation to have any hope of increasing nominal growth and reducing these
debt-to-GDP ratios. When policy interest-rate cuts are no longer possible because
the rates are effectively
zero, quantitative easing, designed in part to import inflation through currency devaluation,
is the central bankers’ preferred technique.

The Bank of England (BOE) has engaged in four rounds of quantitative easing (QE),
beginning in March 2009. Subsequent rounds were launched in October 2011, February
2012, and July 2012. Increased asset purchases have ceased for the time being, but
the BOE’s near-zero-interest-rate policy has continued. The BOE is refreshingly candid
about the fact that it is targeting nominal rather than real growth, although it hopes
that real growth might be a by-product. Its official explanation on the bond purchases
to carry out QE states, “
The purpose of the purchases was and is to inject money directly into the economy
in order to boost nominal demand. Despite this different means of implementing monetary
policy, the objective remains unchanged—to meet the inflation target of 2 percent
on the CPI measure of consumer prices.”

The situation in Japan differs. Japan has been in what may be described as a long
depression since December 1989, when the 1980s stock and property bubbles collapsed.
Japan relied primarily on fiscal stimulus through the 1990s to keep its economy afloat,
but a more pernicious phase of the depression began in the late 1990s. Japan’s nominal
GDP peaked in 1997, declining almost 12 percent by 2011. The Japanese consumer price
index peaked in 1998 and has declined steadily since, with relatively few quarters
of positive CPI readings. It is a truism, if not intuitive, that an economy with declining
nominal
GDP can still have
real
growth when inflation turns to deflation. But this type of real growth does nothing
to help the government with debt, deficits, and tax collections since those functions
are based on nominal growth.

The Bank of Japan’s (BOJ) relationship to QE, inflation, and nominal GDP targeting
is more opaque than the Bank of England’s. The BOJ’s efforts at monetary ease prior
to 2001 were desultory and controversial even within the BOJ. A modest QE program
was begun in March 2001 but was too small to have much effect. A detailed IMF survey
of the impact of QE in Japan from 2001 to 2011 concluded, “
The impact on economic activity . . . was found to be limited.”

Suddenly on December 16, 2012, Japanese politics and monetary policy were transformed
with Shinzo Abe’s election as prime minister, in a landslide victory for his Liberal
Democratic Party. The election gave
Abe’s party a supermajority in the Japanese Diet that could override vetoes by the
Senate. Abe campaigned explicitly on a platform of money printing, including threats
to amend the laws governing the Bank of Japan if it failed to print. “
It’s very rare for monetary policy to be the focus of an election,” Abe said. “We
campaigned on the need to beat deflation, and our argument has won strong support.
I hope the Bank of Japan accepts the results and takes an appropriate decision.”

Even Abe’s election did not fully convince markets that the BOJ would actually take
extraordinary measures, given the bank’s indifferent approach to monetary ease for
the prior twenty years. On March 20, 2013, Abe’s handpicked candidate, Haruhiko Kuroda,
became governor of the BOJ. Within days, Kuroda persuaded the BOJ’s policy board to
implement the largest quantitative easing program the world had ever seen.
The BOJ pledged to purchase $1.4 trillion of Japanese government bonds over the two-year
period of 2013 and 2014 using printed money. Japan simultaneously announced a plan
to lengthen the maturity structure of the bonds it purchased, comparable to the Fed’s
“Operation Twist.” Relative to the size of the U.S. economy, Japan’s money-printing
program was more than twice as large as the Fed’s QE3 program, announced in 2012.
As was the case with the Bank of England, the Bank of Japan was explicit about its
goal to increase inflation in order to increase nominal, if not real, GDP: “
The Bank will achieve the . . . target of 2 percent in terms of the year-on-year rate
of change in the consumer price index . . . at the earliest possible time.”

By 2014, it was as if the Federal Reserve, the BOJ, and the BOE were in a monetary
poker game and had gone all in on their bet. All three central banks had used money
printing and near-zero rates to create inflation in order to increase nominal GDP.
Whether nominal GDP turned into real GDP was beside the point. In fact, real growth
since 2009 was on a path characteristic of depression in all three countries. Inflation
and nominal GDP were the explicit and primary goals of their respective monetary policies.

The U.S. dollar, the U.K. pound sterling, and the Japanese yen together comprise 70
percent of global allocated reserves and 65 percent of the SDR basket. If the Federal
Reserve is the keystone of the international monetary system, the Bank of Japan and
the Bank of England are
adjacent arch stones. But all three central banks, now engaged in a monetary experiment
on an unprecedented scale, face highly uncertain outcomes. Their announced goal is
not real growth but inflation and nominal growth in order to pay their debts.

Creditors and reserve holders in the BRICS, the SCO, the GCC, and other emerging markets
are watching this money-printing pageant with undisguised frustration and increasing
determination to end an international monetary system that allows such economic free-riding
at the cost of inflation, lost exports, and diminished wealth in their own countries.
It remains to be seen whether the international monetary system collapses of its own
weight or is overthrown by emerging-market losers in response to this crime of the
century being perpetrated by the U.S., U.K., and Japanese central banks.

MONEY AND WEALTH

DEBT, DEFICITS, AND THE DOLLAR

Forward guidance . . . should promise that monetary policy will not remove the punch
bowl but allow the party to continue until very late in the evening to ensure that
everyone has a good time.

Charles I. Plosser

President of the Federal Reserve Bank of Philadelphia

February 12, 2013

Adopting a nominal income . . . target is viewed as innovative only by those unfamiliar
with the debate on the design of monetary policy of the past few decades. No one has
yet designed a way to make it workable. . . . Rather, a . . . target would be perceived
as a thinly disguised way of aiming for higher inflation.

Charles Goodhart

March 18, 2013

■
The Meaning of Money

What is a dollar? This question has no easy answer. Most people respond that a dollar
is money, something they make, spend, or save. That raises another question: What
is money? Experts recite the three-part definition of money as a medium of exchange,
a store of value, and a unit of account. The
unit of account
part of the definition is useful but almost trivial. Bottle caps can be a unit of
account; so can knots on a string. A unit of account is merely a way of adding or
subtracting perceived value.
Medium of exchange
also refers indirectly to value, since each party to an exchange must perceive value
in the unit being exchanged for goods or services. Two of the three parts of the definition
implicitly reference
value. The entire standard definition can thus be collapsed into the one remaining
part, the
store of value
.

If, then, money is value, what is
value
? At this point, the analysis becomes philosophical and moral. Values can be held
by individuals yet shared within a culture or community. Values can be subjective
(as is the case with ethics) or absolute (as is the case with religion). Values can
come into conflict when competing or contiguous groups have widely varied values.

Despite this breadth in the meaning of
value,
two facets stand out. The first is the idea of a metric: that there is a way of measuring
the presence, absence, or degree of value. The second is the idea of trust: that when
one ascribes values to an individual or group, one trusts that the individual or group
will act consistently with those values. Trust embodies consistent behavior in the
form of reciprocal or altruistic acts.

At heart, a dollar is money, money is value, and value is trust consistently honored.
When one buys a bottle of Coca-Cola anywhere in the world, one trusts that the original
formula is being used, and that the contents are not adulterated; in this respect,
Coca-Cola does not disappoint. This is trust consistently honored, meaning that a
bottle of Coke has value.

When a customer buys a bottle of Coke, he hands the seller a dollar. This is not mere
barter, but rather a value exchange. What is the source of the dollar’s value? How
does it hold up as an example of trust consistently honored?

To answer that question, one needs to dig deeper. The dollar itself, whether in paper
or digital form, is a representational object. What does the dollar represent? To
whom is the trust directed? When trust is required, Ronald Reagan’s dictum applies:
Trust, but verify
. The Federal Reserve System, owned by private banks, is the issuer of the dollar.
The Fed asks for our trust, but how can one verify if the trust is being honored?

In a rule-of-law society, a customary way of verifying trust is the written contract.
A first-year law student in contracts class immediately learns to “get it in writing.”
The beliefs and expectations of the parties to a contract are written down and read
by both parties. Assuming both parties agree, the contract is signed, and from then
forward, the contract
embodies the trust. At times, disputes arise about the meaning of words in the contract
or the performance of its terms. Countries have courts to resolve those disputes.
This system of contracts, courts, and decisions guided by a constitution is what is
meant by a rule-of-law society.

How does the Federal Reserve fit into this system? On one level, the Fed follows the
written contract model. One can begin by reading the fine print on a dollar bill.
That is where one finds the written money contract. The parties to this contract are
specified as “The Federal Reserve” and “The United States of America” on behalf of
the people.

One-dollar contracts are entered into by each of the Fed’s twelve regional reserve
banks. Some of these written contracts are entered by the Dallas Fed, some by the
Philadelphia Fed, and so on. Larger denominations such as twenty-dollar contracts
are entered into by the “System.” These contracts are all signed by an agent, the
U.S. secretary of the Treasury, on behalf of the people.

The most important clause in the written dollar contract appears on the front at the
top of each bill. It is the phrase “Federal Reserve Note.” A note is an obligation,
a form of debt. Indeed, this is how the Fed reports money issued on its balance sheet.
Balance sheets show assets on the left-hand side, liabilities on the right-hand side,
and capital, which is assets minus liabilities, at the bottom. Notes issued by the
Fed are reported on the right-hand side of the balance sheet, as a liability, exactly
where one would place debt.

Fed notes are an unusual form of debt because they bear no interest and have no maturity.
Another way to describe a dollar, using the contract theory, is that it is a perpetual,
non-interest-bearing note issued by the Fed. Any borrower will attest that perpetual,
non-interest-bearing debt is the best kind of debt because one never pays it back,
and it costs nothing in the meantime. Still, it is a debt.

So the dollar is money, money is value, value is trust, trust is a contract, and the
contract is debt. By application of the transitive law of arithmetic, the dollar is
debt owed by the Fed to the people in contractual form. This view may be called
the contract theory of money, or
contractism
. As applied to the dollar, one way to understand the theory is to substitute the
word
debt
every time one sees the word
money
. Then the world looks like a different place; it is a world in debt.

This approach to money through the lens of contract is one of many monetary theories.
The most influential of these is
the quantity theory of money, or
monetarism,
advocated in the twentieth century by Irving Fisher and Milton Friedman. Monetarism
is one of the Fed’s chosen guides to money creation, although the original formulation
advocated by Friedman is no longer in vogue.

Another approach is
the state theory of money, which posits that unbacked paper money has value since
the state may demand such money as tax payments. The state may use coercion unto death
to collect taxes; therefore citizens work for and value money because it can satisfy
the state. This relationship of money and state means paper money has extrinsic value
in excess of its intrinsic value due to the medium of state power. This type of money
is known as chartal money, and
chartalism
is another name for the state theory of money. In the 1920s
John Maynard Keynes adopted chartalism in his calls for the abolition of gold standards.
More recent
acolytes of the theory of money as an arm of state power are Paul McCulley, former
executive at bond giant PIMCO, and Stephanie Kelton, economist at the University of
Missouri, who marches under the banner of modern monetary theory.

A new entrant in the money theory sweepstakes is
the quantity theory of credit. This theory, advanced by Richard Duncan, is a variant
of the quantity theory of money. Duncan proposes that credit creation has become so
prolific and pervasive that the idea of money is now subsumed in the idea of credit,
and that credit creation is the proper focus of monetary study and policy. Duncan
brings impressive statistical and forensic analyses of government data to the study
of credit expansion.
His work could properly be called
creditism,
although it is really a twenty-first-century version of a nineteenth-century view
of money called the British Banking School.

Monetarism, chartalism, and creditism all have one idea in common: a belief in
fiat
money. The word
fiat
has a Latin origin that means “let it be done.” As applied to money,
fiat
refers to the case where the state orders that a particular form of money serve as
currency and be treated as legal tender. All three theories agree that money does
not have to have intrinsic value as long as it possesses extrinsic value supplied
by the state. When fiat money opponents say money “is not backed by anything,”
these theorists answer, “So what?” In their view, money has value because the state
dictates it be so, and nothing else is required to give money its value.

A theory is useful only to the extent it accords with real-world phenomena and helps
observers to understand and anticipate events in that world. Theories of money that
rely on state power are a thin reed on which to lean because the application of state
power is changeable. In that sense, these competing theories of money may be said
to be contingent.

Returning to where we started, the contract theory of money focuses on money’s intrinsic
value. The money may be paper, but the paper has writing, and the writing is a legal
contract. A citizen may deem the contract valuable for her own reasons independent
of state dictates. The citizen may value contract performance rather than fiat. This
theory is useful for understanding not only the dollar but also whether the dollar
contract is being honored, both now and in the future.

Although the dollar as debt bears no interest and has no maturity, the dollar still
involves duties of performance on the parts of both the Fed and the Treasury, the
two named parties on the contract. This performance is made manifest in the economy.
If the economy is doing well, the dollar is useful, and contract performance is satisfactory
or valuable. If the economy is dysfunctional, performance may be thought poor to the
point of default under the contract.

A gold standard is a way to enforce the money contract. Advocates for gold insist
that all paper money has no intrinsic value, which can be supplied only by tangible
precious metal in the form of gold, or perhaps silver. This view misapprehends the
role of gold in a gold standard, but for the few who insist that coins or bullion
be the sole medium of exchange—a highly impractical state of affairs. All gold standards
involve a relationship between physical gold and paper representations of gold, whether
these representations are called notes, shares, or receipts. Once this relationship
is accepted, one is quickly back to the world of contract.

On this view, gold is the collateral or bond posted to ensure satisfactory performance
of the money contract. If the state prints too much money, the citizen is then free
to declare the money contract in default and redeem her paper money for gold at the
market exchange rate. In effect, the citizen takes her collateral.

Gold advocates suggest that the exchange rate between paper money and gold should
be fixed and maintained. There is merit to this idea, but a fixed exchange rate is
not essential to gold’s role in a contract money system. It is necessary only that
the citizen be free to buy or sell gold at any time. Any citizen can go on a personal
gold standard by buying gold with paper dollars, while anyone who does not buy gold
is expressing comfort with the paper-money contract for the time being.

The money price of gold is therefore a measure of contractual performance by the Fed
and Treasury. If performance is satisfactory, gold’s price should be stable, as citizens
rest easy with the paper-money deal. If performance is poor, the gold price will spike,
as citizens terminate the money-debt contract and claim their collateral through gold
purchases on the open market. Like any debtor, the Fed prefers that the citizen-creditors
be unaware of their right to claim collateral. The Fed is betting that citizens will
not claim the gold collateral en masse. This bet depends on a high degree of complacency
among citizens about the nature of the money contract, the nature of gold, and their
right to take collateral for nonperformance.

This is one reason the Fed and fiat money economists use phrases like “barbarous relic”
and “tradition” to describe gold and insist that gold has no role in a modern monetary
system. The Fed’s view is absurd, akin to saying land and buildings have no role in
a mortgage. Money is a paper debt with gold as its collateral. The collateral can
be claimed by the straightforward purchase of gold.

The Fed prefers that investors not make this connection, but one investor who did
was Warren Buffett. In his case, he moved not into gold but into hard assets, and
his story is revealing.

In November 2009, not long after the depths of the market selloff resulting from the
Panic of 2008, Buffett announced his acquisition of 100 percent of the Burlington
Northern Santa Fe Railway. Buffett described this purchase as a “
bet on the country.”

Maybe. A railroad is the ultimate hard asset. Railroads consist of a basket of hard
assets, such as rights of way, adjacent mining rights, tracks, switches, signals,
yards, and rolling stock. Railroads make money by transporting other hard assets,
such as wheat, steel, ore, and cattle. Railroads are hard assets that move hard assets.

By acquiring 100 percent of the stock, Buffett effectively turned the railroad from
an exchange-traded public equity into private equity. This means that if stock exchanges
were closed in a financial panic, there would be no impact on Buffett’s holdings because
he is not seeking liquidity. While others might be shocked by the sudden illiquidity
of their holdings, Buffett would just sit tight.