The Death of Money (28 page)

During the Bretton Woods system’s early decades, from 1945 to 1965, international
monetary experts worried about a so-called dollar shortage. At that time the dollar
was the dominant global reserve currency, essential to international trade. Europe’s
and Japan’s industrial bases had been devastated during the Second World War. Both
Europe and Japan had human capital, but neither possessed the dollars or gold needed
to pay for the machinery and raw materials that could revive their manufacturing.
The dollar shortage was partly alleviated by Marshall Plan aid and Korean War spending,
but the greatest boost came from the U.S. consumer’s newfound appetite for high-quality,
inexpensive imported goods. American baby boomers, as teenagers in the 1960s, may
recall driving to the beach in a Volkswagen Beetle with a Toshiba transistor radio
in hand. By 1965, competitive export nations such as Germany and Japan were rapidly
acquiring the two principal reserve assets at the time, dollars and
gold. The United States understood that it needed to run substantial trade deficits
to supply dollars to the rest of the world and facilitate world trade.

The international monetary system soon fell victim to its own success. The dollar
shortage was replaced with a dollar glut, and trading partners became uneasy with
persistent U.S. trade deficits and potential inflation. This situation was an illustration
of Triffin’s dilemma, named after Belgian economist Robert Triffin, who first described
it in the early 1960s. Triffin pointed out that when one nation issues the global
reserve currency, it must run persistent trade deficits to supply that currency to
its trading partners; but if the deficits persist too long, confidence in the currency
will eventually be lost.

Paradoxically, both a dollar shortage
and
a dollar glut give rise to consideration of alternative reserve assets. In the case
of a dollar shortage, a new asset is sought to provide liquidity. In the case of a
dollar glut, a new asset is sought to provide substitutes for investing reserves and
to restore confidence. Either way, the IMF has long been involved in the contemplation
of alternatives to the dollar.

By the late 1960s, confidence in the dollar was collapsing due to a combination of
U.S. trade deficits, budget deficits, and inflation brought on by President Lyndon
Johnson’s “guns and butter” policies. U.S trading partners, notably France and Switzerland,
began dumping dollars for gold. A full-scale run on Fort Knox commenced, and the U.S.
gold hoard was dwindling at an alarming rate, leading to President Nixon’s decision
to end the dollar’s gold convertibility, on August 15, 1971.

As caretaker of the international monetary system, the IMF confronted collapsing confidence
in the dollar and a perceived gold shortage. The U.K. pound sterling had already devalued
in 1967 and was suffering its own crisis of confidence. German marks were considered
attractive, but German capital markets were far too small to provide global reserve
assets in sufficient quantities. The dollar was weak, gold was scarce, and no alternative
assets were available. The IMF feared that global liquidity could evaporate, triggering
a collapse of world trade and a depression, as had happened in the 1930s. In this
strained environment, the IMF decided in 1969 to create a new global reserve asset,
the SDR, from thin air.

From the start, the SDR was world fiat money. Kenneth W. Dam, a leading monetary scholar
and former senior U.S. government official who
served in the Treasury, the White House, and Department of Defense, explains in his
definitive history of the IMF:

The SDR differed from nearly all prior proposals in one crucial respect. Previously
it had been thought essential that any new international reserves created through
the Fund, and particularly any new reserve asset, be “backed” by some other asset. . . .
The SDR, in contrast, was created out of (so to speak) whole cloth. It was simply
allocated to participants in proportion to quotas, leading some to refer to the SDR
as “manna from heaven.” Thereafter it existed and was transferred without any backing
at all. . . . A ready analogy is to “fiat” money created by national governments but
not convertible into underlying assets such as gold.

Initially the SDR was valued as equivalent to 0.888671 grams of fine gold, but this
IMF gold standard was abandoned in 1973 not long after the United States itself abandoned
the gold standard with respect to the dollar. Since 1973, the SDR’s value has been
computed with reference to a reserve-currency basket. This does not mean that the
SDR is
backed
by hard currencies, as Dam points out, merely that its
value
in transactions and accounting is calculated in that manner. Today the basket consists
of dollars, euros, yen, and pounds sterling in specified weights.

SDRs have been issued to IMF members on four occasions since their creation. The first
issue was for 9.3 billion SDRs, handed out in stages from 1970 to 1972. The second
issue was for 12.1 billion SDRs, also done in stages from 1979 to 1981. There was
no SDR issuance for almost thirty years, from 1981 to 2009. This was the King Dollar
era engineered by Paul Volcker and Ronald Reagan, which continued through the Republican
and Democratic administrations of George Bush, Bill Clinton, and George W. Bush. Then
in 2009, in the wake of the financial crisis and in the depths of a new depression,
the IMF issued 161.2 billion SDRs on August 28 and 21.5 billion SDRs on September
9. The cumulative SDR issuance since their creation is 204.1 billion, worth over $300
billion at the current dollar-SDR exchange rate.

The history makes it clear that there is a close correspondence between periods of
SDR issuance and periods of collapsing confidence in the
dollar. The best index of dollar strength or weakness is
the Price-adjusted Broad Dollar Index, calculated and published by the Federal Reserve.
The Fed’s dollar index series begins in January 1973 and is based on a par value expressed
as 100.00 on the index. The first SDRs issued in 1970 to 1972 predate this index but
were linked to the dollar’s 20 percent collapse against gold at the time.

The second SDR issuance, from 1979 to 1981, immediately followed a dollar breakdown
from a Fed index level of 94.2780 in March 1977 to 84.1326 in October 1978—an 11 percent
decline in nineteen months. After the issuance, the dollar recovered its standing,
and the index hit 103.2159 in March 1982. This was the beginning of the King Dollar
period.

The third and fourth SDR issuances began in August 2009, not long after the dollar
crashed to an index level of 84.1730 in April 2008, near its level in the crisis of
1978. The lags of approximately a year between index lows and SDR issuance are a reflection
of the time it takes the IMF to obtain board approval to proceed with new issuance.

Unlike the issuance in the 1980s King Dollar period, the massive 2009 issuance did
not result in the dollar regaining its strength. In fact, the dollar index reached
an all-time low of 80.5178 in July 2011, just before gold hit an all-time high of
$1,895.00 on September 5. The difference in 2011 compared to 1982 was that the Fed
and Treasury were pursuing a weak-dollar policy, in contrast to Paul Volcker’s strong-dollar
policy. Nevertheless, the 2009 SDR issuance served its purpose, reliquefying global
financial markets after the Panic of 2008. Markets regained their footing by late
2012 with the stabilization of the European sovereign debt crisis after Mario Draghi’s
“whatever it takes” pledge on the ECB’s behalf. By 2012, global liquidity was restored,
and SDRs were once again placed on the shelf, awaiting the next global liquidity crisis.

Although the SDR is a useful tool for emergency liquidity creation, thus far the dollar
retains its status as the world’s leading reserve currency. Performing a reserve-currency
role requires more than just being money; it requires a pool of investable assets,
primarily a deep, liquid bond market. Any currency can be used in international trade
if the trading partners are willing to accept it as a medium of exchange. But a problem
arises after one trading partner has acquired large trade currency balances. That
party
needs to invest the balances in liquid assets that pay market returns and preserve
value. When the balances are large—for example, China’s $3 trillion in reserves—the
investable asset pool must be correspondingly large. Today U.S.-dollar-denominated
government bond markets are the only markets in the world large and diversified enough
to absorb the investment flows coming from surplus nations such as China, Korea, and
Taiwan. The SDR market is microscopic in comparison.

Still, the IMF makes no secret of its ambitions to transform the SDR into a reserve
currency that could replace the dollar. This was revealed in an IMF study released
in January 2011, consisting of
a multiyear, multistep plan to position the SDR as the leading global reserve asset.
The study recommends increasing the SDR supply to make them liquid and more attractive
to potential private-sector market participants such as Goldman Sachs and Citigroup.
Importantly, the study recognizes the need for natural sellers of SDR-denominated
bonds such as Volkswagen and IBM. Sovereign wealth funds are recommended as the most
likely SDR bond buyers for currency diversification reasons. The IMF study recommends
that the SDR bond market replicate the infrastructure of the U.S. Treasury market,
with hedging, financing, settlement, and clearance mechanisms substantially similar
to those used to support trading in Treasury securities today.

Beyond the SDR bond market creation, the IMF blueprint goes on to suggest that the
IMF could change the SDR basket composition to reduce the weight given to the U.S.
dollar and increase the weights of other currencies such as the Chinese yuan. This
is a stealth mechanism to enhance the yuan’s role as a reserve currency long before
China itself has created a yuan bond market or opened its capital account. If the
SDR market becomes liquid, and the yuan is included in the SDR, bank dealers will
discover ways to arbitrage one currency against the other and thereby increase the
yuan’s use and attractiveness. With regard to a future SDR bond market, the IMF study
candidly concludes, “
If there were political willingness to do so, these securities could constitute an
embryo of global currency.” This conclusion is highly significant because it is the
first time the IMF has publicly moved beyond the idea of the SDR as a liquidity supplement
and presented it as a leading form of world money.

Indeed, the IMF’s distribution of SDRs is not limited to IMF members.
Article XVII of the IMF’s governing Articles of Agreement permits SDR issuance to
“
non-members . . . and other official entities,” including the United Nations and the
Bank for International Settlements (BIS), in Basel, Switzerland.
The BIS is notorious for facilitating Nazi gold swaps while being run by an American,
Thomas McKittrick, during the Second World War, and is commonly known as the central
bank for central banks. The IMF can issue SDRs to the BIS today to finance its ongoing
gold market manipulations. Under Article XVII authority, the IMF could also issue
SDRs to the United Nations, which could put them to use for population control or
climate change regimes.

An expanded role for SDRs awaits further developments that may take years to evolve.
While the SDR is not ready to replace the dollar as the leading reserve currency,
it is moving slowly in that direction. Still, the SDR’s rapid-response role as a liquidity
source in a financial panic is well practiced. The 2009 SDR issuance can be viewed
as “test drive” prior to a much larger issuance in a future liquidity crisis.

SDRs granted to an IMF member are not always immediately useful, because that member
may need to pay debts in dollars or euros. However, SDRs can be swapped for dollars
with other members who do not mind receiving them. The IMF has an internal SDR Department
that facilitates these swaps. For example, if Austria has obligations in Swiss francs
and receives an SDR allocation, Austria can arrange to swap SDRs for dollars with
China. Austria then sells the dollars for Swiss francs and uses the francs to meet
its obligations. China will gladly take SDRs for dollars as a way to diversify its
reserves out of dollars. In actual swaps,
China had acquired the equivalent of $1.24 billion in SDRs above its formal allocations
by April 30, 2012. IMF deputy managing director Min Zhu cryptically summarized the
SDR’s liquidity role when he stated, “
They are fake money, but they are a kind of fake money that can be real money.”

The IMF is transparent when it comes to the purpose of SDR issuance. The entire Bretton
Woods architecture, which gave rise to the IMF, was a reaction to the 1930s Depression
and deflation. The IMF Articles of Agreement address this issue explicitly:

In all its decisions with respect to the allocation . . . of special drawing rights
the Fund shall seek to meet the long-term global
need, as and when it arises, to supplement existing reserve assets in such manner
as will . . . avoid . . . deflation.

Deflation is every central bank’s nemesis because it is difficult to reverse, impossible
to tax, and makes sovereign debt unpayable by increasing the real value of debt. By
explicitly acknowledging its mission to prevent deflation, the IMF’s actions are consistent
with the aims of other central banks.

With its diverse leadership, leveraged balance sheet, and the SDR, the IMF is poised
to realize its one-world, one-bank, one-currency vision and exercise its intended
role as Central Bank of the World. The next global liquidity crisis will shake the
stability of the international monetary system to its core; it may also be the catalyst
for the realization of the IMF’s vision. The SDR is the preferred pretender to the
dollar’s throne.

GOLD REDUX

Gold and silver are the only substances, which have been, and continue to be, the
universal currency of civilized nations. It is not necessary to enumerate the well-known
properties which rendered them best fitted for a general medium of exchange. They
were used . . . from the earliest times. . . . And when we see that nations, differing
in language, religion, habits, and on almost every subject susceptible of doubt, have,
during a period of near four thousand years, agreed in one respect; and that gold
and silver have, uninterruptedly to this day, continued to be the universal currency
of the commercial and civilized world, it may safely be inferred, that they have also
been found superior to any other substance in that permanency of value.

Albert Gallatin

Longest-serving Treasury secretary (1801–1814)

1831

If a gold standard is going to be effective, you’ve got to fix the price of gold and
you’ve got to really stick to it. . . . To get on a gold standard technically now,
an old-fashioned gold standard, and you had to replace all the dollars out there in
foreign hands with gold, God, the price . . . of gold would have to be enormous.

Paul Volcker

Former chairman of the board of governors of the Federal Reserve System

October 15, 2012

Money is gold, and nothing else.

J. P. Morgan, 1912

■
Gold Realities, Gold Myths

Thoughtful discussion of gold is as rare as the metal itself. The topic seems too
infused with emotion to admit of much rational discourse. On the one hand, opponents
of a role for gold in the international monetary system are as likely to resort to
ad hominem attacks as to economic analysis in their efforts to ridicule and marginalize
the topic. A 2013 column by a well-known economist used the words
paranoid, fear-based, far-right fringe,
and
fanatics
to describe gold investors, while flitting through a shopworn list of supposed objections
that do not hold up to serious scrutiny.

On the other hand, many so-called gold bugs are no more nuanced, with their charges
that the vaults in Fort Knox are empty, the gold having been long ago shipped to bullion
banks like JPMorgan Chase and replaced with tungsten-filled look-alikes. This fraud
is alleged to be part of a massive, multidecade price suppression scheme to deprive
gold investors of the profits of their prescience and to deny gold its proper place
in the monetary cosmos.

Legitimate concerns about gold’s use in conjunction with discretionary monetary policy
do exist, of course, and there’s evidence of government intervention in gold markets.
Both argue for an examination of the issue that sorts fact from fantasy. Understanding
gold’s real role in the monetary system requires reliance on history, not histrionics;
analysis should be based on demonstrable data and reasonable inference rather than
accusation and speculation. When a refined view is taken on the subject of gold, the
truth turns out to be more interesting than either the gold haters or the gold bugs
might lead one to believe.

*  *  *

Lord Nathan Rothschild, bullion broker to the Bank of England and head of the legendary
London bank N. M. Rothschild & Sons, is said to have remarked, “
I only know of two men who really understand the value of gold—an obscure clerk in
the basement vault of the Banque de Paris and one of the directors of the Bank of
England. Unfortunately, they disagree.” This comment captures the paucity of well-founded
views and the opacity that infuses discussion of gold.

At the most basic level, gold is an element, atomic number 79, found in ore, sometimes
nuggets, in scarce quantities, in or on the earth’s crust. The fact that gold is an
element is important because that means pure gold is of uniform grade and quality
at all times and in all places. Many commodities such as oil, corn, or wheat come
in various grades with greater or lesser impurities, which are reflected in the price.
Leaving aside alloys and unrefined products, pure gold is the same everywhere.

Because of its purity, uniformity, scarcity, and malleability, gold is money nonpareil.
Gold has been money for at least four thousand years, perhaps much longer. Genesis
describes the Patriarch Abraham as “very rich in livestock, gold and silver.” King
Croesus minted the first gold coins in Lydia, modern-day Turkey, in the sixth century
B.C
. The 1792 U.S. Coinage Act, passed just three years after the U.S. Constitution went
into effect, authorized the newly established Mint to produce pure gold coins called
eagles, half eagles, and quarter eagles. Gold’s long history does not mean that it
must be used as money today. It does mean that anyone who rejects gold as money must
feel possessed of greater wisdom than the Bible, antiquity, and the Founding Fathers
combined.

To understand gold, it is useful to know what gold is
not
.

Gold is not a derivative.
A gold exchange-traded fund listed on the New York Stock Exchange is not gold. A gold
futures contract traded on the CME Group’s COMEX is not gold. A forward contract offered
by a London Bullion Market Association bank is not gold. These financial instruments,
and many others, are contracts that offer price exposure to gold and are part of a
system that has physical gold associated with it, but they are contracts, not gold.

Contracts based on gold have many risks that are not intrinsic to gold itself, starting
with the possibility that counterparties may default on their obligations. Exchanges
where the gold contracts are listed may be closed as a result of panics, wars, acts
of terror, storms, and other acts of God. Hurricane Sandy in 2012 and the 9/11 attack
on the World Trade Center are two recent cases in which the New York Stock Exchange
closed. Exchange rules may also be abruptly changed, as happened on the COMEX in 1980
during the Hunt brothers’ attempted silver market corner. Banks may claim force majeure
to terminate contacts and settle in cash rather than bullion. In addition, governments
may use executive
orders to abrogate outstanding contracts. Power outages and Internet backbone collapses
may result in an inability to close out or settle exchange-traded contracts. Changes
in exchange-margin requirements may prompt forced liquidations that cascade into panic
selling. None of these occurrences affects the physical gold bullion holder.

Outright physical gold ownership, without pledges or liens, stored outside the banking
system, is the only form of gold that is true money, since every other form is a mere
conditional claim on gold.

Gold is not a commodity
. The reason is that it is not consumed or converted to anything else; it is just
gold. It is traded on commodity exchanges and is thought of as a commodity by many
market participants, but it is distinct. Economists as diverse as Adam Smith and Karl
Marx defined commodities generally as undifferentiated goods produced to satisfy various
needs or wants. Oil, wheat, corn, aluminum, copper, and countless other true commodities
satisfy this definition. Commodities are consumed as food or energy, or else they
serve as inputs to other goods that are demanded for consumption. In contrast, gold
has almost no industrial uses and is not food or energy in any form. It is true that
gold is desired by almost all of mankind, but it is desired as money in its store-of-value
role, not for any other purpose. Even jewelry is not a consumption item, although
it is accounted as such, because gold jewelry is ornamental wealth, a form of money
that can be worn.

Gold is not an investment
. An investment involves converting money into an instrument that entails both risk
and return. True money, such as gold, has no return because it has no risk. The easiest
way to understand this idea is to remove a dollar bill from a wallet or purse and
look at it. The dollar bill has no return. In order to get a return, one must convert
the money to an investment and take a risk. An investor who takes her dollar bills
to the bank and deposits them can earn a return, but it is not a return on money;
it is a return on a bank deposit. Bank deposit risks may be quite low, but they are
not zero. There is maturity risk if the deposit is for a fixed term. There is credit
risk if the bank fails. Bank deposit insurance may mitigate bank failure risk, but
there is a chance the insurance fund will become insolvent. Those who believe that
bank deposit risk is a thing of the past should consider the case of Cyprus in March
2013, when certain bank deposits were forcibly converted into bank stock
after an earlier scheme to confiscate the deposits by taxation was rejected. This
conversion of deposits to equity in order to bail out insolvent banks was looked upon
favorably in Europe and the United States as a template for future bank crisis management.

There are innumerable ways to earn a return by taking risk. Stocks, bonds, real estate,
hedge funds, and many other types of pooled vehicles are all investments that include
both risk and return. An entire branch of economic science, particularly options pricing
theory, was based on the flawed assumption that a short-term Treasury bill is a “risk-free”
investment. In fact, recent U.S. credit downgrades below the AAA level, a rising U.S.
debt-to-GDP ratio, and continuing congressional dysfunction about debt-ceiling legislation
have all shown the “risk-free” label to be a myth.

Gold involves none of the risks inherent in these investments. It has no maturity
risk since there is no future date when gold will mature into gold; it is gold in
the first place. Gold has no counterparty risk because it is an asset to the holder,
but it is not anyone else’s liability. No one “issues” gold the way a note is issued;
it is just gold. Once gold is in your possession, it has no risks related to clearance
or settlement. Banks may fail, exchanges may close, and the peace may be lost, but
these events have no impact on the intrinsic value of gold. This is why gold is the
true risk-free asset.

Confusion about the role of gold arises because it usually treated as an investment
and is reported as such in financial media. Not a day goes by without a financial
reporter informing her audience that gold is “up” or “down” on the day, and in terms
of gold’s dollar price per ounce, this is literally true. But is gold fluctuating,
or is it the dollar? On a day that gold is reported to be “up” 3.3 percent, from $1,500
per ounce to $1,550 per ounce, it would be just as accurate to treat gold as a constant
and report that the dollar is “down” from 1/1,500th of an ounce of gold to 1/1,550th
of an ounce. In other words, one dollar buys you less gold, so the dollar is down.
This highlights the role of the
numeraire,
or the unit of account, which is part of the standard definition of money. If gold
is the
numeraire,
then it is more accurate to think of dollars or other currencies as the fluctuating
assets, not gold.

This
numeraire
question can also be illustrated by the following example involving currencies. Assume
that on a given trading day, gold’s
dollar price moves from $1,500 per ounce to $1,495 per ounce, a 0.3 percent
decline,
and on the same day the yen exchange rate to one dollar moves from 100 yen to 101
yen. Converting dollars to yen, it is seen that gold’s price in yen moved from ¥150,000
($1,500 X 100) to ¥150,995 ($1,495 X 101), a 0.6 percent
increase
. On the
same
trading day, gold was
down
0.3 percent in dollars but
up
0.6 percent in yen. Did gold go up or down? If one views the dollar as the only form
of money in the world, then gold declined, but if one views gold as the
numeraire
, or monetary standard, then it is more accurate to say that gold was constant, that
the dollar rose against gold and the yen fell against gold. This unified statement
resolves the contradiction of whether gold went up or down. It did neither; instead,
the currencies fluctuated. This also illustrates the fact that gold’s value is intrinsic
and not a mere function of global currency values. It is the currencies that are volatile
and that lack intrinsic value.

If gold is not a derivative, a commodity, or an investment, then
what is it
?
Legendary banker J. P. Morgan said it best: “
Money is gold, and nothing else.”

While money was gold for J. P. Morgan—and everybody else—for four thousand years,
money suddenly ceased to be gold in 1974, at least according to the IMF.
President Nixon ended U.S. dollar convertibility into gold by foreign central banks
in 1971, but it was not until 1974 that an IMF special reform committee, at the insistence
of the United States, officially recommended gold’s demonetization and the SDR’s elevation
in the workings of the international monetary system. From 1975 to 1980, the United
States worked strenuously to diminish gold’s monetary role, conducting massive gold
auctions from official U.S. stocks. As late as 1979,
the United States dumped 412 tonnes of gold on the market in an effort to suppress
the price and deemphasize gold’s importance. These efforts ultimately failed. Gold’s
market price briefly spiked to $800 per ounce in January 1980. There have been no
significant official U.S. gold sales since then.

The demotion of gold as a monetary asset by the United States and the IMF in the late
1970s means that the economics curricula of leading universities have not seriously
studied gold for almost two generations. Gold might be taught in certain history classes,
and there are many gold experts who are self-taught, but any economist born since
1952 almost
certainly has no formal training in the monetary uses of gold. The result has been
an accretion of myths about gold in place of serious analysis.

The first myth is that gold cannot form the basis of a modern monetary system because
there’s
not enough gold
to support the requirements of world trade and finance
.
This myth is transparently false, but it is cited so often that its falsity merits
rebuttal.