The reason has to do with the concept of marginal propensity to consume, or MPC. The concept is simple. If you give a billionaire a thousand dollars, she will probably spend none of it because she already has everything she wants and has no need to spend more. If you give someone below the poverty line a thousand dollars, he will probably spend all of it on food, rent, repairs, gas for the car, and other necessities of life. In technical terms, the MPC of the billionaire is 0 percent (she spends nothing), while the MPC of the poverty-level person is 100 percent (he spends it all). It’s the act of spending and the resulting increase in the velocity or turnover of money that gives inflation a jolt.
The increased money velocity resulting from a PSE or GBI program will crash headlong into the real-growth constraints theorized by Reinhart and Rogoff. Higher money velocity increases nominal GDP. Meanwhile growth in real GDP is constrained by debt. If nominal GDP rises faster than real GDP, the difference is inflation, pure and simple. Progressive politicians may accomplish in the next two years what central bankers have been unable to accomplish in the past two decades—higher inflation. Central bankers who have been hoping for inflation should be careful what they wish for. They may get it, in the words of H. L. Mencken, “good and hard.”
Investment Secret #5: Low productivity may mean inflation … or deflation.
How does an investor prepare for a world that could be inflationary or deflationary?
The solution is called the barbell portfolio. On one side of the barbell you have inflation protection consisting of gold, silver, land, and other hard assets. On the other side of the barbell you have deflation protection consisting of 10-year Treasury notes, utility stocks, and technology companies that continually reduce costs. Connecting the two sides of the barbell is an allocation of cash. The cash reduces the overall volatility of the portfolio and provides optionality to pivot toward inflation or deflation protection if either becomes dominant.
Today’s debt-and-growth trap is the continuation of the crisis that began in 2007. It’s the slow-motion phase of the ongoing crisis, but it could turn into a bang point any time. It could also lead to a whimper consisting of decades of slow growth.
Regardless of the outcome, investors are not helpless. The barbell portfolio offers a way to preserve wealth in all states of the world.
CHAPTER SIX
The Mar-a-Lago Accord
How often do we hear references to the notion that we live in a rules-based global trading system?1 … In January 2017, British Prime Minister Theresa May praised liberalism, free trade, and globalization as “the forces that underpin the rules-based international system.” … Chinese President Xi Jinping likewise extolled the virtues of a rules-based economic order at Davos …. But could someone please explain: What exactly are those rules?
—Judy Shelton, “The Case for a New International Monetary System” (2018)
Collaboration or Chaos?
It has been over thirty years since the last major international monetary conference, at the Louvre in Paris on February 22, 1987. The conference included the finance ministers and central bank heads of the United States, United Kingdom, France, West Germany, Canada, and Japan. A new international monetary conference will be needed soon to restore order to an incoherent system. A conference could produce another monetary “reform and evolution,” in the classic formulation of scholar Kenneth W. Dam, or a “global monetary reset,” in the newer formulation of casual observers. For over a century, the elite catchphrase for the world’s monetary workings has been “the rules of the game.” Whatever tag attaches, a new regime is coming. The unknown is whether this conference is launched in an orderly way by a convening power or in the midst of chaos in response to a new financial crisis. The former is preferable; the latter more likely.
International monetary conferences were rare before the 1920s. The international monetary system as it existed prior to the First World War was the product of evolution, not design. Gold had long been the leading form of money. Central banking only began with the creation of the Sveriges Riksbank in Sweden in 1668 and the Bank of England in 1694. Those and other central banks issued banknotes backed by gold, although redemption into gold was suspended on occasion during times of war.
When two currencies are pegged to gold they are also pegged to each other by the transitive law. As individual national gold standards spread in the nineteenth century, a global system of fixed exchange rates emerged spontaneously. For example, from 1900 to 1914, the official price of gold in the United Kingdom was £4.25 per ounce, and the official price in the United States was $20.67 per ounce. Using an ounce of gold as the common denominator meant that £1 sterling expressed in dollars was worth $4.87. There was no treaty or other agreement between the United Kingdom and the United States to fix this cross-exchange rate; it was simply the mathematical result of each nation fixing its own currency to gold. A lively physical gold trade between private banks in London and New York, led by the House of Morgan on the U.S. side, maintained the $4.87 sterling/dollar parity through arbitrage, taking into account transportation and insurance costs, relative interest rates, and the time value of money. These non-gold factors were called “gold points.” When the points made gold “cheap” on one side of the ocean, a bank would buy gold, ship it to the other money center, and sell it in local currency, pocketing a nearly risk-free profit. These transactions were conducted using then new telephone technology. There was no top-down or centralized enforcement mechanism; this was the free market at its best.
Between 1870 and 1914, widespread adoption of individual national gold standards led to the emergence of an international system of fixed exchange rates despite the absence of a treaty or an institution resembling the International Monetary Fund. The United States was one of the last major trading nations to formally adopt a gold standard under the Gold Standard Act of 1900, although the Coinage Act of 1873 allowed redemption of banknotes for gold at a fixed rate at the option of the noteholder. A global gold standard and system of fixed exchange rates simply emerged by common consent, without direction or treaty.
The classic gold standard collapsed catastrophically in August 1914, the advent of the First World War. Belligerent nations suspended citizens’ gold redemption of banknotes, either de jure or de facto. The United States, a neutral party until 1917, remained on a gold standard and became a magnet for much of the world’s official gold as the United States exported arms and agricultural produce to embattled trading partners, principally the United Kingdom and France, and settled the resulting balance of payments surplus in gold.
The difficulty after the First World War was how and when to resume a gold standard. War reparations imposed on Germany by the Treaty of Versailles combined with war debts incurred by the United Kingdom, France, and Belgium, among others, left those developed economies awash in unpayable debt after the war. Gold shipments to the United States for war matériel left insufficient gold in Europe to reconstitute the prewar system. The adversaries had greatly expanded their money supplies to finance the war effort. Excessive debt, excessive money printing, and an acute gold shortage made the return to a true gold standard problematic at best. The question was ripe for a multilateral solution. The age of the international monetary conference was born.
The first formal meeting was the Genoa Economic and Financial Conference of 1922. Thirty-four nations participated in the conclave held in the Palazzo di San Giorgio in Genoa, Italy. The agenda for the Genoa Conference was far broader than just the gold standard and included economic reconstruction in Europe, the status of reparations, and relations with the relatively new Soviet Russian regime that replaced the Russian Empire. An objective to return to the gold standard was expressed, with implementation left to individual sovereign participants. The gold shortage was addressed in part by schemes to conserve on the amount of gold needed to support the money supply. These schemes included removing gold coins from circulation, melting the coins and recasting them as 400-ounce bars kept
in vaults. This made the physical exchange of gold impractical and caused citizens to become accustomed to paper money, with a vague if misplaced belief that there was sufficient gold behind the paper. Participants also agreed to accept major currencies such as French francs and pounds sterling in settlement of their balance of payments. This meant that foreign exchange was held as reserves in addition to physical gold.
This gold-exchange standard exhibited signs of failure almost from the start. The United Kingdom, France, and Belgium returned to gold over the course of 1925 through1926. France and Belgium returned at greatly devalued rates compared to the prewar parity. The United Kingdom, led by then Chancellor of the Exchequer Winston Churchill, took the opposite course and returned to gold at the prewar parity of £4.25 per ounce. This required a drastic reduction in the money supply to maintain the old parity, which proved deflationary and plunged the United Kingdom into depression several years before the world at large was affected in 1928–1929. The system then broke down completely with successive devaluations by the United Kingdom (1931), the United States (1933), and the United Kingdom and France combined (1936), before gold shipments and convertibility were once again suspended with the outbreak of the Second World War in 1939.
The next major international monetary conference was the most meaningful—the July 1944 United Nations Monetary and Financial Conference of forty-four nations held at the Mount Washington Hotel in Bretton Woods, New Hampshire. Bretton Woods featured a struggle between two principal plans. John Maynard Keynes, representing the United Kingdom, advanced a plan to establish a gold-backed form of world money called the bancor as the primary reserve currency to be issued by an international monetary fund and used to settle the balance of payments among nations. Harry Dexter White, representing the United States, advanced a plan that would establish the U.S. dollar, valued at one thirty-fifth of an ounce of gold, as the primary reserve currency. Other currencies were pegged to the dollar and only indirectly pegged to gold. Devaluation of other currencies against the dollar was possible under agreed procedures, while the dollar itself was firmly fixed to gold. Given U.S. dominance in geopolitics, commerce, and finance in the final days of the Second World War, it was not surprising that the U.S. plan carried the day despite Keynes’s best efforts. Ironically, Harry Dexter White was a Stalinist agent inside the U.S. Treasury, whose hidden agenda was to hasten the demise of the British Empire by marginalizing sterling and highlighting the U.K.’s gold shortage. White’s plan succeeded brilliantly as U.K. decolonization from 1947 to 1964 amply illustrates.
President Nixon’s August 15, 1971, decision to “temporarily” suspend redemption of dollars for gold bullion by U.S. trading partners was not intended at the time as the end of the Bretton Woods system. It was intended as a kind of time-out, during which a new international monetary conference would be convened to devalue the dollar against gold, realign fixed exchange rates, and relaunch the old system at the new valuations. The conference called to implement these changes met at the Smithsonian Institution in Washington, D.C., in December 1971, the third great international monetary conference of the twentieth century. A Group of Ten (G10) nations consisting of the United States, the United Kingdom, France, West Germany, Sweden, Italy, the Netherlands, Belgium, Canada, and Japan signed the Smithsonian Agreement, which devalued the dollar by raising the price of gold from $35.00 per ounce to $38.00 per ounce and revaluing exchange rates of the currencies of the other signatories from 7.5 percent to 17 percent each. The Smithsonian Agreement failed even faster than the gold-exchange standard of the Genoa Conference. The dollar was devalued by an additional 10 percent on February 14, 1973, before eventually settling at today’s official value of $42.22 per ounce of gold. One by one, major trading nations abandoned both the gold standard and fixed exchange rates and adopted floating exchange rates determined by the marketplace. Gold still existed in central bank vaults, yet no longer played a role in establishing the value of currencies.
Floating exchange rates were favored by academic economists at the time, most famously Milton Friedman, because they allowed nations to smoothly and continuously adjust unit labor costs and maintain favorable terms of trade without the devaluation shocks and foreign exchange crises that characterized the later years of the Bretton Woods system. As usual, the academics’ pet theories ignored the hidden costs of floating exchange rates, including increased uncertainty on the future value of foreign direct investment, hedging costs, unrealistic pegs, market manipulation, and currency wars. These flaws came to the fore in the volatile years following the final demise of the Bretton Woods system and abandonment of the Smithsonian Agreement in 1973.
The Smithsonian Agreement was not the last landmark international monetary conference. Despite the rise of floating exchange rates after 1973, it was still possible to target if not precisely peg cross exchange rates through concerted market interventions by the major trading powers. For this purpose, a meeting of the G5 finance ministers representing the United States, the United Kingdom, France, West Germany, and Japan was convened at the Plaza Hotel in New York City in September 1985. The dollar had appreciated 50 percent between 1980 and 1985 due to Fed chair Paul Volcker’s high-interest-rate policies and President Ronald Reagan’s fiscal stimulus. U.S. exporters from the agricultural and manufacturing sectors were suffering from the Volcker-Reagan “King Dollar” policy. Rather than act in a unilateral or confrontational manner, the United States, led by Treasury secretary James Baker, convened the G5 at the Plaza Hotel to reach a consensus on dollar devaluation enforced through coordinated currency interventions by the G5 central banks and finance ministries.
The resulting Plaza Accord signed on September 22, 1985, was too successful. The desired dollar decline began almost immediately, and by early 1987 started to become disorderly. A new international monetary conference was convened in Paris in February 1987 to agree on steps to halt the dollar decline and stabilize exchange rates at mutually agreed levels. The Paris group included the Plaza Accord’s G5, plus Canada. This new G6 signed the Louvre Accord in Paris on February 22, 1987, stabilizing the dollar against the currencies of major U.S. trading partners. This stability lasted until the 2008 global financial crisis and the start of a new currency war in 2010.
The 105-year era since the collapse of the classic gold standard in 1914 witnessed five major international monetary conferences: Genoa (1922), Bretton Woods (1944), Washington (1971), New York (1985), and Paris (1987). That’s an average of one conference every twenty-one years, although the chronology is not evenly spaced. The last major conference was thirty-two years ago. There were important multilateral meetings to address international monetary issues in the meantime. However, none of these meetings resulted in fundamental changes to the rules of the game as seen in the five landmark conferences. On form, the world is overdue for a new international monetary conference to implement a true global monetary reset. The most pressing question for monetary elites is whether a conference is convened proactively with a view to creating a coherent system, or convened reactively in the midst of a new global financial crisis likely to produce a draconian response. A crucial moment in monetary history has arrived. A unique opening has been offered to President Donald J. Trump.
Former Fed chair Alan Greenspan made these remarks, comparing the current unanchored system with the benefits of the former gold standard, in a February 2017 interview with Gold Investor magazine:
I view gold as the primary global currency.2 It is the only currency, along with silver, that does not require a counterparty signature. Gold, however, has always been far more valuable per ounce than silver. No one refuses gold as payment to discharge an obligation. Credit instruments and fiat currency depend on the creditworthiness of counterparty. Gold, along with silver, is one of the only currencies that has an intrinsic value. It has always been that way. No one questions its value, and it has always been a valuable commodity, first coined in Asia Minor in 600 BC …. Today, going back onto the gold standard
would be perceived as an act of desperation. But if the gold standard were in place today we would not have reached the situation in which we now find ourselves. We cannot afford to spend on infrastructure in the way that we should …. We would never have reached this position of extreme indebtedness were we on the gold standard, because the gold standard is a way of ensuring that fiscal policy never gets out of line.
The current managing director of the International Monetary Fund, Christine Lagarde, issued this warning at the 2018 Spring Meeting of the IMF:
Global debt is at an all-time high.3 It stands at $164 trillion, which is 225 percent of GDP …. Public debt in advanced economies is at levels not seen since World War II. And in low-income countries, if recent trends continue, many, not all, will face unsustainable debt burdens …. Financial vulnerabilities have increased due to high debt, rising financial market volatility, and elevated asset prices. A sudden tightening of financial conditions could lead to market corrections, unsustainable debt, and capital flow reversals.
Aftermath Page 21