Currency Wars: The Making of the Next Global Crisis (36 page)

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Authors: James Rickards

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The second flaw in the IMF’s plan involves the role of the United States. The United States has enough voting power in the IMF to stop the SDR plan in its tracks. The expansion of SDR printing and borrowing since 2009 has been accomplished with U.S. agreement, in keeping with the Obama administration’s preference for multilateral rather than unilateral solutions to global issues. A new U.S. administration in 2012 might take a different view, and there is room for the IMF’s dollar replacement strategy to emerge as a 2012 campaign issue. But for now, the SDR is alive and well and a strong entrant in the global currency sweepstakes.
Return to the Gold Standard
 
Gold generates more impassioned advocacy, both for and against, than any other subject in international finance. Opponents of a gold standard are quick to pull out the old Keynes quote that gold is a “barbarous relic.” Legendary investor Warren Buffett points out that all the gold in the world put in one place would just be a large block of shiny metal with no yield nor income-producing potential. Establishment figure Robert Zoellick caused elite fainting spells in November 2010 by merely mentioning the world “gold” in a speech, although he stopped far short of calling for a gold standard. Among elites in general, advocacy for gold is considered a trait of the dim, the slow-witted, those who do not appreciate the benefits of a “flexible” and “expanding” modern money supply.
Gold advocates are no less rigid in their view of modern central bankers as sorcerers who produce money from thin air in order to dilute the hard-earned savings of the working class. It is difficult to think of another financial issue on which there is less common ground between the opposing sides.
Unfortunately, the entrenched positions, pro and con, stand in the way of new thinking about how gold might work in a twenty-first-century monetary system. There is an unwillingness, rooted in ideology, to explore ways to reconcile the demonstrated stability of gold with the necessity for some degrees of freedom in the management of the money supply to respond to crises and correct mistakes. A reconciliation is overdue.
Gold is not a commodity. Gold is not an investment. Gold is money par excellence. It is truly scarce—all the gold ever produced in history would fit in a cube of twenty meters (about sixty feet) on each side, approximately the size of a small suburban office building. The supply of gold from new mining expands at a fairly slow and predictable pace—about 1.5 percent per year. This is far too slow to permit much inflation; in fact, a mild persistent deflation would be the most likely outcome under a gold standard. Gold has a high density; a considerable amount of weight is compressed into a small space relative to other metals that could be used as a monetary base. Gold is also of uniform grade, an element with fixed properties, atomic number 79 in the periodic table. Commodities such as oil or wheat that might be used to support a money supply come in many different grades, making their use far more complicated. Gold does not rust or tarnish and is practically impossible to destroy, except with special acids or explosives. It is malleable and therefore easily shaped into coins and bars. Finally, it has a longer track record as money—over five thousand years—than any rival, which shows its utility to many civilizations and cultures in varied circumstances.
Given these properties of scarcity, durability, uniformity and the rest, the case for gold as money seems strong. Yet modern central bankers and economists do not take gold seriously as a form of money. The reasons go back to CWI and CWII, to the causes of the Great Depression and the crack-up of Bretton Woods. A leading scholar of the Great Depression, Ben Bernanke, now the chairman of the Federal Reserve, is one of the most powerful intellectual opponents of gold as a monetary standard. His arguments need to be considered by advocates for gold, and ultimately refuted, if the debate is to move forward.
Bernanke’s work on gold and the Great Depression draws in the first instance on a large body of work by Peter Temin, one of the leading scholars of the Great Depression, Barry Eichengreen and others that showed the linkages between the operation of the gold exchange standard from 1924 to 1936 and the world economy as a whole. Bernanke summarizes this work as follows:
Countries that left gold were able to reflate their money supplies and price levels, and did so after some delay; countries remaining on gold were forced into further deflation. To an overwhelming degree, the evidence shows that countries that left the gold standard recovered from the Depression more quickly than countries that remained on gold. Indeed, no country exhibited significant economic recovery while remaining on the gold standard.
 
Empirical evidence bears out Bernanke’s conclusions, but that evidence is just illustrative of the beggar-thy-neighbor dynamic at the heart of all currency wars. It is no different than saying if one country invades and loots another, it will be richer and the victim poorer—something that is also true. The question is whether it is a desirable economic model.
If France had gone off the gold standard in 1931 at the same time as England, the English advantage relative to France would have been negated. In fact, France waited until 1936 to devalue, allowing England to steal growth from France in the meantime. There is nothing remarkable about that result—in fact, it should be expected.
Today, under Bernanke’s guidance, the United States is trying to do what England did in 1931—devalue. Bernanke has succeeded in devaluing the dollar on an absolute basis, as evidenced by the multiyear rise in the price of gold. Yet his effort to devalue the dollar on a relative basis against other currencies has been more protracted. The dollar fluctuates against other currencies but has not devalued significantly and consistently against all of them. What is happening instead is that all the major currencies are devaluing against gold at once. The result is global commodity inflation, so that beggar-thy-neighbor has been replaced with beggar-the-world.
In support of his thesis that gold is in part to blame for the severity and protracted nature of the Great Depression, Bernanke developed a useful six-factor model showing the relationships among a country’s monetary base created by the central bank, the larger money supply created by the banking system, gold reserves broken down by quantity and price, and foreign exchange reserves.
Bernanke’s model works like an upside-down pyramid, with some gold and foreign exchange on the bottom, money created by the Fed on top of the gold, and even more money created by banks on top of that. The trick is to have enough gold so the upside-down pyramid does not topple over. Until 1968, U.S. law required a minimum amount of gold at the bottom of the pyramid. At the time of the Great Depression the value of gold at a fixed price had to be at least 40 percent of the amount of Fed money. However,
there was no maximum
. This meant that the Fed money supply could contract
even if the gold supply was increasing
. This happened when bankers were reducing their leverage.
Bernanke observes:
The money supplies of gold-standard countries—far from equaling the value of monetary gold, as might be suggested by a naive view of the gold standard—were often large multiples of the value of gold reserves. Total stocks of monetary gold continued to grow through the 1930s; hence, the observed sharp declines in . . . money supplies must be attributed entirely to contractions in the average money-gold ratio.
 
Bernanke gives two reasons for these contractions in money supply even in the presence of ample gold. The first reason involves policy choices of central bankers and the second involves the preferences of depositors and private bankers in response to banking panics. Based on these choices, Bernanke concludes that under the gold exchange standard there exist two money supply equilibria. One equilibrium exists where confidence is high and the leverage ratios are expanded. The other exists where confidence is low and the leverage ratios contract. Where a lack of confidence causes a contraction in money through deleveraging, that process can depress confidence, leading to a further contraction of bank balance sheets and declines in spending and investment. Bernanke concludes, “In its vulnerability to self-confirming expectations, the gold standard appears to have borne a strong analogy to a . . . banking system in the absence of deposit insurance.” Here was Merton’s self-fulfilling prophecy again.
For Bernanke, Eichengreen, Krugman and a generation of scholars who came into their own since the 1980s, this was the smoking gun. Gold was at the base of the money supply; therefore gold was the limiting factor on the expansion of money at a time when more money was needed. Here was analytic and historic evidence, backed up by Eichengreen’s empirical evidence and Bernanke’s model, that gold was a significant contributing factor to the Great Depression. In their minds, the evidence showed that gold had helped to cause the Great Depression and those who abandoned gold first recovered first. Gold has been discredited as a monetary instrument ever since. Case closed.
Despite the near unanimity on this point, the academic case against gold has one enormous flaw. The argument against gold has nothing to do with gold per se; it has to do with policy. One can see this by accepting Bernanke’s model and then considering alternative scenarios in the context of the Great Depression.
For example, Bernanke points to the ratio of base money to total reserves of gold and foreign exchange, sometimes called the coverage ratio. As gold flowed into the United States during the early 1930s, the Federal Reserve could have allowed the base money supply to expand by up to 2.5 times the value of the gold. The Fed failed to do so and actually reduced money supply, in part to neutralize the expansionary impact of the gold inflows. So this was a policy
choice
by the Fed. Reducing money supply below what could otherwise be achieved can happen with or without gold and is a policy choice independent of the gold supply. It is historically and analytically false to blame gold for this money supply contraction.
Bernanke points to the banking panics of the early 1930s and the preference of banks and depositors to reduce the ratio of the broad money supply to the monetary base. In turn, bankers expressed a preference for gold over foreign exchange in the composition of their reserves. Both observations are historically correct but have no necessary relationship to gold. The reduction in the ratio of broad money supply to narrow money supply need not involve gold at all and can happen at any time—it has in fact been happening in the aftermath of the Panic of 2008. The substitution of gold for foreign exchange by central banks involves gold but represents yet another policy choice by the central banks. Those banks could just as easily have expressed the opposite preference and actually increased reserves.
In addition to this refutation of Bernanke’s particular historical analysis, there are a number of actions central bankers could have taken in the 1930s to alleviate the tight money situation unconstrained by gold. The Fed could have purchased foreign exchange with newly printed dollars, an operation comparable to modern central bank currency swap lines, thereby expanding both U.S. and foreign reserve positions that could have supported even more money creation. SDRs were created in the 1960s to solve exactly this problem of inadequate reserves encountered in the 1930s. Were a 1930s-style global liquidity crisis to arise again, SDRs could be issued to provide the foreign exchange base from which money creation and trade finance could flow—exactly as they were in 2009. This would be done to head off a global contraction in world trade and a global depression. Again, this kind of money creation can take place without reference to gold at all. Any failure to do so is not a failure of gold; it is a failure of policy.
Central bankers in the 1930s, especially the Fed and the Banque de France, failed to expand the money supply as much as possible even under the gold exchange standard. This was one of the primary causes of the Great Depression; however, the limiting factor was not gold but rather the lack of foresight and imagination on the part of central banks.
One suspects that Bernanke’s real objection to gold today is not that it was an actual constraint on increasing the money supply in the 1930s but that it
could become so at some point today
. There was a failure to use all of the money creation capacity that bankers had in the Great Depression, yet that capacity was never unlimited. Bernanke may want to preserve the ability of central bankers to create potentially unlimited amounts of money, which does require the abandonment of gold. Since 2009, Bernanke and the Fed have been able to test their policy of unlimited money creation in real-world conditions.
Blaming the Great Depression on gold is like blaming a bank robbery on the teller. The teller may have been present when the robbery took place,
but she did not commit the crime.
In the case of the Great Depression, the crime of tight money was not committed by gold but by the central bankers who engaged in a long series of avoidable policy blunders. In international finance, gold is not a policy; it is an instrument. Laying the tragedy of the Great Depression at the feet of the gold standard has been highly convenient for central bankers who seek unlimited money printing capacity. Central bankers, not gold, were responsible for the Great Depression and economists who continue to blame gold are merely looking for an excuse to justify fiat money without bounds.
If gold is rehabilitated from the false accusation of having caused the Great Depression, can it play a constructive role today? What would a gold standard for the twenty-first century look like?

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