The Death of Money (32 page)

Given these constraints on the creation of new SDRs, the system would launch with
the SDR as an anchor and unit of account but a relatively small amount of SDRs in
existence. The combined base money supplies of the participants would constitute the
global money supply, as it does today, and that money supply would be the reference
point for determining the appropriate price for gold.

Another key issue would be determining the amount of gold backing needed to support
the global money supply. Austrian School economists insist on 100 percent backing,
but this is not strictly required. In practice, the system requires only enough gold
to supply anyone with a preference for physical gold over gold-backed paper money,
and adequate assurance that the fixed gold price will not be changed once established.
These two goals are related; the stronger the assurance of consistency, the less gold
is required to maintain confidence. Historically, gold standards have operated successfully
with between 20 percent and 40 percent backing relative to money supply. Given the
abandonment of gold in 1914, 1931, and 1971, a high figure will be required to engender
confidence by justifiably cynical citizens. For illustrative purposes, take 50 percent
of money supply as the target backing; the United States, the Eurozone, China, and
Japan as the participating economies; global official gold holdings as the gold supply;
and M1 as the money supply. Dividing the money supply by the gold supply gives an
implied, nondeflationary price for gold, under a gold-backed SDR standard, of approximately
$9,000 per ounce.

The inputs in this calculation are debatable, but $9,000 per ounce is a good first
approximation of the nondeflationary price of gold in a global gold-backed SDR standard.
Of course, nothing moves in isolation. The world of $9,000-per-ounce gold is also
the world of $600-per-barrel oil, $120-per-ounce silver, and million-dollar starter
homes in mid-America. This new gold standard would not cause inflation, but it would
be a candid recognition of the inflation that has already occurred in paper money
since 1971. This one-time price jump would be society’s reckoning with the distortions
caused by the abuse of fiat currencies in the past forty years. Participating nations
would need legislation to nominally adjust fixed-income payments to the neediest in
forms such as pensions, annuities, social welfare, and savings accounts up to the
insured level. Nominal values of debt would be left unchanged, instantaneously solving
the global-sovereign-debt-and-deleveraging conundrum. Banks and rentiers would be
ruined—a healthy step toward future growth. Theft by inflation would be a thing of
the past, for as long as the system was maintained. Wealth extraction would be replaced
with wealth creation, and the triumph of ingenuity could commence.

Discretionary monetary policy conducted by national central banks would be preserved
in this new system. Indeed, the percentage of physical gold backing the currency issues
could even be increased or decreased from time to time if needed. However, central
banks participating in the system would be required to
maintain the fixed gold price
in their currency by acting as buyers and sellers in physical gold. Any central bank
perceived as too easy for too long would find citizens lined up at its doors and would
be quickly stripped of its gold. IMF gold-swap lines backed by other central banks
would be made available to deal with temporary adjustment requirements—an echo of
the old Bretton Woods system. These gold market operations would be conducted transparently
to instill confidence in the process.

Importantly, the IMF would have emergency powers to increase the SDR supply with the
approval of a supermajority of its members to deal
with a global liquidity crisis, but SDRs and national currencies would remain freely
convertible to gold at all times. If citizens had confidence in the emergency actions,
the system would remain stable. If citizens perceived that money creation was occurring
to rescue elites and rentiers, a run on gold would commence. These market signals
would act as a brake on abuse by the IMF and the central banks. In effect, a democratic
voice, mediated by market mechanisms, would be injected into global monetary affairs
for the first time since the First World War.

Austrian School supporters of a traditional gold standard are unlikely to endorse
this new gold standard because it has fractional, even variable gold backing. The
conspiracy-minded are also unlikely to support it because it is global and has the
look and feel of a new world order. Even the milder critics will point out that this
system depends completely on promises by governments, and such promises have consistently
been broken in the past. Yet it has the virtue of practicality; it could actually
get done. It forthrightly addresses the problems of deflation that would occur if
the United States took a go-it-alone approach, and it mitigates the hyperinflationary
shock that would result if fractional backing were not used. The new gold standard
comes close to Mundell’s prescription that the optimal currency zone is the world,
and it revives a version of Keynes’s vision at Bretton Woods before the United States
insisted on dollar hegemony.

Most profoundly, a new gold standard would address the three most important economic
problems in the world today: the dollar’s decline, the debt overhang, and the scramble
for gold. The U.S. Treasury and Federal Reserve have decided that a weak-dollar policy
is the remedy for the lack of world growth. Their plan is to generate inflation, increase
nominal aggregate demand, and rely on the United States to pull the global economy
out of the ditch like a John Deere tractor hitched to a harvester up to its axles
in mud. The problem is that the U.S. solution is designed for cyclical problems, not
for the structural problems that the world currently faces. The solution to structural
problems involves new structures, starting with the international monetary system.

There is no paper currency that will come close to replacing the dollar as the leading
reserve currency in less than ten years. Even now the dollar is being discarded and
gold remonetized at an increasing tempo—both
perfectly sensible reactions to U.S. weak-dollar policies. The United States and the
IMF should lead the world to the gold-backed SDR, which would satisfy Chinese and
Russian interests while leaving the United States and Europe with the leading reserve
positions. The world cannot wait ten years for the paper SDR, the yuan, and the euro
to converge into Barry Eichengreen’s “Kumbaya” world of multiple reserve currencies.
The consequences of misguided monetary leadership will be on display in far fewer
than ten years.

CROSSROADS

I’m the fellow who takes away the punch bowl just when the party is getting good.

William McChesney Martin Jr.

Chairman of the Federal Reserve Board, 1951–70

The trouble is that this is no ordinary recession, and a lot of people have not had
any punch yet.

Kenneth Rogoff

June 6, 2013

Developed countries have no reason to default. They can always print money.

George Soros

April 9, 2013

■
The Inflation-Deflation Paradox

Federal Reserve policy is at a crossroads facing unpleasant paths in all directions.
Monetary policy around the world has reached the point where the contradictions embedded
in years of market manipulation have left no choices that do not involve either contraction
or catastrophic risk. Further monetary easing may precipitate a loss of confidence
in money; policy tightening will restart the collapse in asset values that began in
2007. Only structural change in the U.S. economy, something outside the Fed’s purview,
can break this stalemate.

This much was clear by 2013, as weary economists and policy makers waited for the
robust recovery they had eagerly anticipated since the stock
market rally started in 2009. Annual GDP growth in the United States touched 4 percent
in the fourth quarter of 2009, prompting talk of “green shoots” amid signs that the
economy was bouncing back from the worst recession since the Great Depression. Even
when growth fell to a 2.2 percent annual rate by the second quarter of 2010, the optimistic
spin continued, with happy talk by Treasury secretary Timothy Geithner of a “recovery
summer” in 2010. Reality slowly sank in. Annual growth was an anemic 1.8 percent in
2011 and was only slightly better at 2.2 percent in 2012. Then, despite predictions
from the Fed and private analysts that 2013 would be a turnaround year, growth fell
again to 1.1 percent in the first quarter of 2013, although it revived to 4.1 percent
in the third quarter.

The economy was in a phase not seen in eighty years. It was neither a recession as
technically defined, nor a robust recovery as widely expected. It was a depression,
exactly as Keynes had defined it, “
a chronic condition of sub-normal activity for a considerable period without any marked
tendency either towards recovery or towards complete collapse.” There was no cyclical
recovery because the problems in the economy were not cyclical; they were structural.
This depression should be expected to continue indefinitely in the absence of structural
changes.

Fed forecasters and most private analysts use models based on credit and business
cycles from the seventy-odd years since the end of the Second World War. Those baselines
do not include any depressions. One must reach back eighty years, to the 1933–36 period,
a recovery within a depression, to find a comparable phase. The Great Depression ended
in 1940 with structural changes: the economy was put on a war footing. In early 2014
no war was imminent, and no structural changes were being contemplated. Instead, depressionary
low growth and high unemployment have become normal in the U.S. economy.

The American Enterprise Institute’s John Makin, who has an uncanny record of accurately
predicting economic cycles, pointed out that based on historical patterns, the United
States might actually be headed for a recession in 2014—the second recession within
a depression since 2007, an eerie replay of the Great Depression. Makin pointed out
that despite below-trend growth since 2009, the expansion has lasted over four years
and is approaching the average longevity for modern economic
expansions in the United States.
Based on duration if not strength, U.S. real growth should be expected to turn negative
in the near future.

Even if the United States does not enter a technical recession in 2014, the depression
will continue, the strongest evidence coming from depression-level employment data.
Despite cheerleading in late 2013 about the creation of two hundred thousand new jobs
per month and a declining unemployment rate, the reality behind the headline data
is grim. As analyst Dan Alpert points out, almost 60 percent of jobs created in the
first half of 2013 were in the lowest-wage sectors of the U.S. economy. These sectors
normally account for one-third of total jobs, meaning that new job creation was disproportionately
low wage by a factor of almost two to one. Low-wage jobs are positions such as the
order taker at McDonald’s, the bartender at Applebee’s, and the checkout clerk at
Walmart. All work has dignity, but not all work has pay that can ignite a self-sustaining
economic recovery.

About 50 percent of the jobs created during the first half of 2013 were part-time,
defined as jobs with thirty-five hours of work per week or less. Some part-time jobs
offer as little as one hour per week. If the unemployment rate were calculated by
counting those working part-time who want full-time work, and those who want a job
but have given up looking, the unemployment rate in mid-2013 would be 14.3 percent
instead of the officially reported 7.1 percent. The 14.3 percent figure is comparable
to levels reached during the Great Depression, a level consistent with an economic
depression.

New hiring since 2009 has been roughly equal to the number of new entrants into the
workforce in that time period, which means that it did nothing to reduce the total
number of those who became unemployed during the acute phase of the panic and downturn
in 2008 and 2009. Alpert also shows that even the supposed “good news” of a declining
unemployment rate is misleading because the declining rate reflects those workers
dropping out of the workforce entirely rather than new job creation in an expanding
labor pool. The percentage of Americans counted in the labor force had dropped from
a high of 66.1 percent before the new depression to 63.5 percent by mid-2013. Even
with the reduced labor force, real wage gains adjusted for inflation were not being
realized, and in fact real wages have been falling for the past fifteen years.

Added to this dismal employment picture is the striking increase in dependency on
government programs. By late 2013, the United States had over 50 million citizens
on food stamps; over 26 million citizens unemployed, underemployed, or discouraged
from looking for work; and over 11 million citizens on permanent disability, many
of those because their unemployment benefits had run out. These numbers are a national
disgrace. Combined with feeble growth, borderline recession conditions, and over five
years of zero interest rates, these figures made talk of an economic recovery seem
misplaced.

Though overall conditions suggest a new depression, one element was missing from the
portrait—namely, deflation, defined as a generalized drop in consumer prices and asset
values. During the darkest stage of the Great Depression, from 1930 to 1933, cumulative
deflation in the United States was 26 percent, part of a broader, worldwide deflationary
collapse. The United States experienced slight deflation in 2009 compared to 2008,
but nothing at all comparable to the Great Depression; in fact, mild inflation has
persisted in the new depression, and the official consumer price index shows a 10.6
percent increase from the beginning of 2008 to mid-2013. The contrast between the
extreme deflation of the Great Depression and the mild inflation of the new depression
is the most obvious difference between the two episodes and is also the source of
the greatest challenge now facing the Federal Reserve. It raises the vexing question
of when and how to reduce and eventually reverse money printing.

A depression’s natural state is deflation. Businesses faced with declining revenue
and individuals faced with unemployment will rapidly sell assets to reduce debt, a
process known as deleveraging. As asset sales continue and as spending declines, prices
decline further, which is deflation’s immediate cause. Those price declines then add
further economic stress, leading to additional asset sales, more unemployment, and
so on in a feedback loop. In deflation, the real value of cash increases, so individuals
and businesses hoard cash instead of spending it or investing in new land, plant,
and equipment.

This entire process of asset sales, hoarding, and price declines is called a liquidity
trap, famously described by Irving Fisher in his 1933 work
The Debt-Deflation Theory of Great Depressions
and by John Maynard Keynes in his most influential work,
The General Theory of
Employment, Interest and Money.
In a liquidity trap, the response to money printing is generally weak, and from a
Keynesian perspective, fiscal policy is the preferred medicine.

While the response to money printing may be weak, it is not nil. Working against potential
deflation has been a massive money-printing operation by the Federal Reserve. In the
six years from 2008 to 2014, the Federal Reserve has increased base money from about
$800 billion to over $4 trillion, a more than 400 percent increase. While the turnover
or velocity of money has been in sharp decline, the quantity of money has skyrocketed,
helping to offset the slower pace of spending. The combination of massive money printing
and zero interest rates has also propped up asset prices, leading to a stock market
rally and a strong recovery in housing prices since 2009. But asset values are being
inflated from other sources too.

■
Tuition Tally

Another reason deflation has not prevailed over inflation, despite faint economic
growth, is that the U.S. Treasury has promoted a new cash injection into the economy,
larger than subprime housing finance in the 2002–7 period. This injection is in the
form of student loans.

Student loans are the new subprime mortgages: another government-subsidized bubble
about to burst. Students have a high propensity to spend, whether on tuition itself
or on books, apartments, furniture, and beer. If you give students money, they will
spend it; there is little danger that they will buy gold or otherwise hoard the money
as savings. Tuition payments financed by student loans are a mere conduit since the
payments are passed along as union faculty salaries or university overhead. Loan proceeds
remaining after tuition are spent directly by the students.

Annual borrowing in all undergraduate and graduate student loan programs surged to
over $100 billion per year in 2012, up from about $65 billion per year at the start
of the 2007 depression.
By August 2013, total student loans backed by the U.S. government exceeded $1 trillion,
an amount that has doubled since 2009. A provision
contained in the 2010 Obamacare legislation provided the U.S. Treasury with a near
monopoly on student loan origination and sidelined most private lenders who formerly
participated in this market. This meant that the Treasury could relax lending standards
to continue the flow of easy money.

The student loan market is politically untouchable because higher education historically
produces citizens with added skills who repay the loans and earn higher incomes over
time. No member of Congress wants to support legislation that would crimp Johnnie
or Susie’s ability to afford college. But the program has morphed into direct government
pump priming, in the same manner that historically productive home lending programs
morphed into a housing bubble between 1994 and 2007. In the mortgage market, Fannie
Mae and Freddie Mac used government subsidies to push home ownership beyond levels
that buyers could afford, giving rise to subprime mortgages without documentation
or down payments. The mortgage market crashed in 2007, marking the start of the depression.

Student loans now pose a similar dynamic. Most of the loans are sound and will be
repaid as agreed. But many borrowers will default because the students did not acquire
needed skills and cannot find jobs in a listless economy. Those defaults will make
federal budget deficits worse, a development not fully reflected in official budget
projections. In effect, student loans are being pumped out by the U.S. Treasury and
directed to borrowers with a high propensity to spend and limited ability to repay.

These monies have helped prop up the U.S. economy, but the flow of tuition dollars
isn’t sustainable. It is economically no different than the Chinese building ghost
cities with borrowed money that cannot be repaid. Chinese ghost cities and U.S. diplomas
are real, but productivity increases and the ability to repay the borrowings are not.

While student loans may provide a short-term lift to discretionary spending, the long-term
effects of excessive debt combined with the absence of jobs are another encumbrance
on the economy. A record 21 million young adults between ages eighteen and thirty-one
are living with their parents. Many of these stay-at-homes are recent graduates who
cannot pay rent or afford down payments on homes because of student loans. For now,
student loan cash flows and spending have helped to defer the
deflation threat, but the student loan bubble will burst in the years ahead, making
the debt and deficit crises worse.

■
The Inflation Conundrum

Former Fed chairman Bernanke once said that the Federal Reserve could combat deflation
by throwing money from helicopters. His metaphor assumed that people would gladly
pick up the money and spend it. In the real world, however, picking up the money means
going into debt in the form of business loans, mortgages, or credit cards. Businesses
and individuals are unwilling to go into debt because of policy uncertainty and the
threat of even more deflation.

Going back to 2009, Bernanke’s critics have claimed that quantitative easing would
lead to unacceptably high inflation, even imminent hyperinflation. These critics focused
exclusively on money printing, failing to perceive that inflation is only partially
a function of money supply. The other key factor is behavior in the form of lending
and spending. Underlying weakness in the economy, and extreme uncertainty about policies
on taxes, health care, environmental regulation, and other business cost determinants,
resulted in stagnation both in consumer spending and in business investment, two main
drivers of economic growth.