Currency Wars: The Making of the Next Global Crisis (37 page)

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Authors: James Rickards

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Some of the most vociferous advocates for a gold standard on the ubiquitous blogs and chat rooms are unable to explain exactly what they mean by it. The general sense that money should be linked to something tangible and that central banks should not be able to create money without limit is clear. Turning that sentiment into a concrete monetary system that can deal with the periodic challenges of panic and depression is far more difficult.
The simplest kind of gold standard—call it the
pure
gold standard—is one in which the dollar is defined as a specific quantity of gold and the agency that issues dollars has enough gold to redeem the dollars outstanding on a one-for-one basis at the specified price. In this type of system, a paper dollar is really a warehouse receipt for a quantity of gold kept in trust for the holder of the dollar and redeemable at will. Under this pure gold standard, it is impossible to expand the money supply without expanding the gold supply through new mining output or other purchases. This system would inject a mild deflationary bias into the economy since global gold supply increases about 1.5 percent per year whereas the real economy seems capable of consistent 3.5 percent growth under ideal conditions. All things equal, prices would have to fall about 2 percent per year to equilibrate 3.5 percent real growth with a 1.5 percent increase in the money supply, and this deflation might discourage borrowing at the margin. The pure gold standard would allow for the creation of credit and debt through the exchange of money for notes, but it would not allow for the creation of money beyond the amount of gold on deposit. Such debt instruments might function in the economy as money substitutes or near-money, but they would not be money in the narrow sense.
All other forms of gold standard involve some form of leverage off the existing gold stock, and this can take two forms. The first involves the issuance of money in excess of the stock of gold. The second involves the use of gold substitutes, such as foreign exchange or SDRs, in the gold pool on which the money is based. These two forms of leverage can be used separately or in tandem. This type of gold standard—call it a
flexible
gold standard—requires consideration of a number of design questions. What is the minimum percentage of the money supply that must be in gold? Is 20 percent comfortable? Is 40 percent needed to instill confidence? Historically the Federal Reserve maintained about a 40 percent partial gold reserve against the base money supply. In early April 2011 that ratio was still about 17.5 percent. Although the United States had long since gone off a formal gold standard, a kind of shadow gold standard remained in the ratio of gold to base money, even in the early twenty-first century.
Other issues include the definition of money for purposes of calculating the money-gold ratio. There are different definitions of “money” in the banking system depending on the availability and liquidity of the instruments being counted. So-called base money, or M0, consists of notes and coins in circulation plus the reserves that banks have on deposit at the Fed. A broader definition of money is M1, which includes checking accounts and traveler’s checks, but does not count bank reserves. The Fed also calculates M2, which is the same as M1 except that savings accounts and some time deposits are also included. Similar definitions are used by foreign central banks. In April 2011, U.S. M1 was about $1.9 trillion and M2 was about $8.9 trillion. Because M2 is so much larger than M1, the selection of a particular definition of “money” will have a large impact on the implied price of gold when calculating the ratio of gold to money.
Similar issues arise when deciding how much gold should be counted in the calculation. Should only official gold be counted for this purpose, or should gold held by private citizens be included? Should the calculation be done solely with reference to the United States, or should some effort be made to institute this standard using gold held by all major economies?
Some consideration must be given to the legal mechanism by which a new gold standard would be enforced. A legal statute might be sufficient, but statutes can be changed. A U.S. constitutional amendment might be preferable, since that is more difficult to change and could therefore inspire the most confidence.
What should the dollar price of gold be under this new standard? Choosing the wrong price was the single biggest flaw in the gold exchange standard of the 1920s. The price level of $20.67 per ounce of gold used in 1925 was highly deflationary because it failed to take into account the massive money printing that had occurred in Europe during World War I. A price of perhaps $50 per ounce or even higher in 1925 might have been mildly inflationary and might have helped to avoid some of the worst effects of the Great Depression.
Taking the above factors into account produces some startling results. Without suggesting that there is any particular “right” level, the following implied gold prices result when using the factors indicated:
 
In order to impose discipline on whatever regime was chosen, a free market in gold could be allowed to exist side by side with the official price. The central bank could then be required to conduct open market operations to maintain the market price at or near the official price.
Assume that the coverage ratio chosen is the one used in the United States in the 1930s, when the Fed was required to hold gold reserves equal to 40 percent of the base money supply. Using April 2011 data, that standard would cause the price of gold to be set at $3,337 per ounce. The Fed could establish a narrow band around that price of, say, 2.5 percent up or down. This means that if the market price fell 2.5 percent, to $3,254 per ounce, the Fed would be required to enter the market and buy gold until the price stabilized closer to $3,337 per ounce. Conversely, if the price rose 2.5 percent, to $3,420 per ounce, the Fed would have to enter the market as a seller until the price reverted to the $3,337 per ounce level. The Fed could maintain its freedom to adjust the money supply or to raise and lower interest rates as it saw fit, provided the coverage ratio was maintained and the free market price of gold remained stable at or near the official price.
The final issue to be considered is the degree of flexibility that should be permitted to central bankers to deviate from strict coverage ratios in cases of economic emergency. There are times, albeit rare, when a true liquidity crisis or deflationary spiral emerges and rapid money creation in excess of the money-gold coverage ratio might be desirable. This exceptional capacity would directly address the issue pertaining to gold claimed by Bernanke in his studies of monetary policy in the Great Depression. This is an extremely difficult political issue because it boils down to a question of trust between central banks and the citizens they ostensibly serve. The history of central banking in general has been one of broken promises when it comes to the convertibility of money into gold, while the history of central banking in the United States in particular has been one of promoting banking interests at the expense of the general interest. Given this history and the adversarial relationship between central banks and citizens, how can the requisite trust be engendered?
Two of the essential elements to creating confidence in a new gold-backed system have already been mentioned: a strong legal regime and mandatory open-market operations to stabilize prices. With those pillars in place, we can consider the circumstances under which the Fed could be allowed to create paper money and exceed the coverage ratio ceiling.
One approach would be to let the Fed exceed the ceiling on its own initiative with a public announcement. Presumably the Fed would do so only in extreme circumstances, such as a deflationary contraction of the kind England experienced in the 1920s. In these circumstances, the open market operations would constitute a kind of democratic referendum on the Fed’s decision. If the market concurred with the Fed’s judgment on deflation, then there should be no run on gold—in fact, the Fed might have to be a buyer of gold to maintain the price. Conversely, if the market questioned the Fed’s judgment, then a rush to redeem paper for gold might result, which would be a powerful signal to the Fed that it needed to return to the original money-gold ratio. Based on what behavioral economists and sociologists have observed about the “wisdom of crowds” as reflected in market prices, this would seem to be a more reliable guide than relying on the narrow judgment of a few lawyers and economists gathered in the Fed’s high-ceilinged boardroom.
A variation of this approach would be to allow the Fed to exceed the gold coverage ratio ceiling upon the announcement of a bona fide financial emergency by a joint declaration from the president of the United States and the speaker of the House. This would preclude the Fed from engaging in unilateral bailouts and monetary experiments and would subject it to democratic oversight if it needed to expand the money supply in case of true emergencies. This procedure would amount to a “double dose” of democracy, since elected officials would declare the original emergency and market participants would vote with their wallets to ratify the Fed’s judgment by their decision to buy gold or not.
The implications of a new gold standard for the international monetary system would need to be addressed as well. The history of CWI and CWII is that international gold standards survive only until one member of the system suffers enough economic distress, usually because of excessive debt, that it decides to seek unilateral advantage against its trading partners by breaking with gold and devaluing its currency. One solution to this pattern of unilateral breakouts would be to create a gold-backed global currency of the kind suggested by Keynes at Bretton Woods. Perhaps the name Keynes suggested, the bancor, could be revived. Bancors would not be inflatable fiat money like today’s SDRs but true money backed by gold. The bancor could be designated as the sole currency eligible to be used for international trade and the settlement of balance of payments. Domestic currencies would be pegged to the bancor, used for internal transactions and could be devalued against the bancor only with the consent of the IMF. This would make unilateral or disorderly devaluation, and therefore currency wars, impossible.
The issues involved in reestablishing a gold standard with enough flexibility to accommodate modern central banking practices deserve intensive study rather than disparagement. A technical institute created by the U.S. White House and Congress, or perhaps the G20, could be staffed with experts and tasked with developing a workable gold standard for implementation over a five-year horizon. This institute would address exactly the questions posed above with special attention paid to the appropriate price peg in order to avoid the mistakes of the 1920s.
Based on U.S. money supply and the size of the U.S. gold hoard, and using the 40 percent coverage ratio criteria, the price of gold would come out to approximately $3,500 per ounce. Given the loss of confidence by citizens in central banks and the continual experience of debasement by those banks, however, it seems likely that a broader money supply definition and higher coverage ratio might be required to secure confidence in a new gold standard. Conducting this exercise on a global basis would require even higher prices, because major economies such as China possess paper money supplies much larger than the United States and far less gold. The matter deserves extensive research, yet based on an expected need to restore confidence on a global basis, an approximate price of $7,500 per ounce would seem likely. To some observers, this may appear to be a huge change in the value of the dollar; however, the change has already occurred in substance. It simply has not been recognized by markets, central banks or economists.
The mere announcement of such an effort might have an immediate beneficial and stabilizing impact on the global economy, because markets would begin to price in future stability much as markets priced in European currency convergence years before the euro was launched. Once the appropriate price level was determined, it could be announced in advance and open market operations could commence immediately to stabilize currencies at the new gold equivalent. Finally, the currencies themselves could become pegged to gold, or a new global currency backed by gold could be launched with other currencies pegged to it. At that point the world’s energies and creativity could be redirected from exploitation through fiat money manipulation toward technology, productivity improvements and other innovations. Global growth would be fueled by the creation of real rather than paper wealth.
Chaos
 
Perhaps the most likely outcome of the currency wars and the debasement of the dollar is a chaotic, catastrophic collapse of investor confidence resulting in emergency measures by governments to maintain some semblance of a functioning system of money, trade and investment. This would not be anyone’s intention or plan; rather it would simply happen like an avalanche brought about by the layering of one last financial snowflake on an unstable mountainside of debt.

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