The Death of Money

by James Rickards

  On this view, gold is the collateral or bond posted to ensure satisfactory performance of the money contract. If the state prints too much money, the citizen is then free to declare the money contract in default and redeem her paper money for gold at the market exchange rate. In effect, the citizen takes her collateral.

  Gold advocates suggest that the exchange rate between paper money and gold should be fixed and maintained. There is merit to this idea, but a fixed exchange rate is not essential to gold’s role in a contract money system. It is necessary only that the citizen be free to buy or sell gold at any time. Any citizen can go on a personal gold standard by buying gold with paper dollars, while anyone who does not buy gold is expressing comfort with the paper-money contract for the time being.

  The money price of gold is therefore a measure of contractual performance by the Fed and Treasury. If performance is satisfactory, gold’s price should be stable, as citizens rest easy with the paper-money deal. If performance is poor, the gold price will spike, as citizens terminate the money-debt contract and claim their collateral through gold purchases on the open market. Like any debtor, the Fed prefers that the citizen-creditors be unaware of their right to claim collateral. The Fed is betting that citizens will not claim the gold collateral en masse. This bet depends on a high degree of complacency among citizens about the nature of the money contract, the nature of gold, and their right to take collateral for nonperformance.

  This is one reason the Fed and fiat money economists use phrases like “barbarous relic” and “tradition” to describe gold and insist that gold has no role in a modern monetary system. The Fed’s view is absurd, akin to saying land and buildings have no role in a mortgage. Money is a paper debt with gold as its collateral. The collateral can be claimed by the straightforward purchase of gold.

  The Fed prefers that investors not make this connection, but one investor who did was Warren Buffett. In his case, he moved not into gold but into hard assets, and his story is revealing.

  In November 2009, not long after the depths of the market selloff resulting from the Panic of 2008, Buffett announced his acquisition of 100 percent of the Burlington Northern Santa Fe Railway. Buffett described this purchase as a “bet on the country.”

  Maybe. A railroad is the ultimate hard asset. Railroads consist of a basket of hard assets, such as rights of way, adjacent mining rights, tracks, switches, signals, yards, and rolling stock. Railroads make money by transporting other hard assets, such as wheat, steel, ore, and cattle. Railroads are hard assets that move hard assets.

  By acquiring 100 percent of the stock, Buffett effectively turned the railroad from an exchange-traded public equity into private equity. This means that if stock exchanges were closed in a financial panic, there would be no impact on Buffett’s holdings because he is not seeking liquidity. While others might be shocked by the sudden illiquidity of their holdings, Buffett would just sit tight.

  Buffett’s acquisition is best understood as getting out of paper money and into hard assets, while immunizing those assets from a stock exchange closure. It may be a “bet on the country”—but it is also a hedge against inflation and financial panic. The small investor who cannot acquire an entire railroad can make the same bet by buying gold. Buffett has been known to disparage gold, but he is the king of hard asset investing, and when it comes to the megarich, it is better to focus on their actions than on their words. Paper money is a contract collateralized by gold, the latter a hard asset nonpareil.

  ■ Debt, Deficits, and Sustainability

  The Federal Reserve is not the only government-linked debtor in the U.S. money system; in fact, it is far from the largest. The U.S. Treasury has issued over $17 trillion of debt in the form of bills, notes, and bonds, compared to about $4 trillion of debt-as-money notes issued by the Fed.

  Unlike Federal Reserve notes, Treasury notes are not thought of as money, although the most liquid instruments are often called “cash equivalents” on corporate balance sheets. Another difference between Federal Reserve notes and Treasury notes is that Treasury notes have maturity dates and pay interest. Fed notes can be issued in indefinite quantities and remain outstanding indefinitely, but Treasury notes are more subject to the discipline of bond markets, where investors trade over $500 billion in Treasury securities every day.

  Market discipline includes continual evaluation by investors as to whether the Treasury’s debt burden is sustainable. This evaluation asks whether the Treasury can pay its outstanding debts as agreed. If the answer is yes, the market will gladly accept more Treasury debt at reasonable interest rates. If the answer is no, the market will dump Treasury debt, and interest rates will skyrocket. In cases of extreme uncertainty due to lack of funds or lack of willingness to pay, government debt can become nearly worthless, as happened in the United States after the Revolutionary War and in other countries many times before and since.

  Analysis of government debt is most challenging when the answer is neither yes nor no but maybe. It is at these tipping points (which complexity theorists call phase transitions) that the bond market stands poised between confidence and panic, and debt default seems like a real possibility. European sovereign bond markets approached this point in late 2011 and remained poised on the brink until September 2012, when the European Central Bank head, Mario Draghi, offered his famous “whatever it takes” pronouncement. He meant that the ECB would substitute its money debt for sovereign debt in the quantities needed to reassure the sovereign debt holders. This reassurance worked, and European sovereign debt markets pulled back from the brink.

  In recent years, purchases of government securities with money printed by the Federal Reserve account for a high percentage of net new debt issued by the Treasury. The Fed insists that its purchases are a policy tool to ease monetary conditions and are not intended to monetize the national debt. The Treasury, at the same time, insists that it is the world’s best debtor and has no difficulty satisfying the funding requirements for the U.S. government. Still, the casual observer could be forgiven for believing that the Fed is monetizing the debt by debasing money—historically a step on the road to collapse for economic and political systems, from ancient Rome to present-day Argentina. The Fed’s great confidence game is to swap its non-interest-bearing notes for the Treasury’s interest-bearing notes, then rebate the interest earned back to the Treasury. The challenge for bond markets, and investors generally, is to decide how much Treasury note issuance is sustainable and how much substitution of Fed notes for Treasury notes is acceptable before the phase transition emerges and a collapse begins.

  The dynamics of government debt and deficits are more complicated than the conventional argument admits. Too often the debate over debt and deficits degenerates into binary choices: Is debt good or bad for an economy? Is the U.S. deficit too high, or is it affordable? Tea Party conservatives take the view that deficit spending is intrinsically bad, that a balanced budget is desirable in and of itself, and that the United States is well down the path to becoming Greece. Krugman-style liberals take the view that debt is necessary to fund certain desirable programs, and that the United States has been here before in terms of its debt-to-GDP ratio. After World War II, the U.S. debt-to-GDP ratio was 100 percent—about where it is today. The United States gradually reduced it during the 1950s and 1960s, and liberals say America can do it again with slightly more taxation.

  There are valid points in both positions, but there are also strong rebuttals to both. The policy problem is that a debate framed in this way creates false dichotomies that facilitate not resolution but rhetoric. Debt is inherently neither positive nor negative. Debt’s utility is determined by what the borrower does with the money. Debt levels are not automatically too high or too low; what matters to creditors is their trend toward sustainability.

  Debt can be ruinous if it is used to finance deficits, and with no plan for paying the debt other than through addi
tional debt. Debt can be productive if it funds projects that produce more than they cost and that pay for themselves over time. Debt-to-GDP ratios can be relatively low, but still troubling, if they are getting higher. Debt-to-GDP ratios can be relatively high and not be a cause for concern if they are getting lower.

  ■ The Debt Debate

  Framing the debt and deficit debates in these terms raises further questions. What are the proper guidelines for determining whether debt is being used for a desirable purpose and whether debt-to-GDP trends are moving in the right direction? Fortunately, both questions can be answered in a rigorous, nonideological way, without retreating to the rhetoric of conservatives or liberals.

  Debt used to finance government spending is acceptable when three conditions are met: the benefits of the spending must be greater than the costs, the government spending must be directed at projects the private sector cannot do on its own, and the overall debt level must be sustainable. These tests must be applied independently, and all must be satisfied. Even if government spending can be shown to produce net benefits, it cannot be justified if private activity can do the job better. When government spending produces net costs, it destroys the stock of wealth in society and can never be justified except in an existential crisis such as war.

  Difficulties arise when costs and benefits are not well defined and when ideology substitutes for analysis in the decision-making process. Two cases illustrate these problems—the Internet and the 2009 Obama stimulus.

  Government-spending advocates point out that the government financed the early development of the Internet. In fact, the government sponsored ARPANET, a robust message traffic system among large-scale university computers designed to facilitate research collaboration during the Cold War. However, ARPANET’s development into today’s Internet was advanced by the private sector through the creation of the World Wide Web, the Web browser, and many other innovations. This history shows that certain government spending can be highly beneficial when it jump-starts private-sector innovation. ARPANET had fairly modest ambitions by today’s standards, and it was a success. The government did not freeze ARPANET for all time; instead, it made the protocols available to private developers and got out of the way. The Internet is an example of government leaving the job to the private sector.

  An example of destructive government spending is the 2009 Obama stimulus plan. The expected benefits were based on erroneous assumptions about so-called Keynesian multipliers. In fact, the Obama stimulus was directed largely at supplementing state and local payrolls for union jobs in government and school administration, many of which are redundant, nonproductive, and wealth-destroying. Much of the rest went to inefficient, nonscalable technologies such as solar panels, wind turbines, and electric cars. Not only did this spending not produce the mythical multiplier, it did not even produce nominal growth equal to nominal spending. The Obama stimulus is an example of government spending that does not pass the cost-benefit test.

  An example of a government initiative that meets all tests for acceptable spending is the interstate highway system. In 1956 President Eisenhower championed and Congress authorized the interstate highway system, which cost about $450 billion in today’s dollars. The benefits of that system vastly exceeded $450 billion and continue to accrue to this day. It is difficult to argue that the private sector could have produced anything like this matrix of highways; at best, we would have a hodgepodge of toll roads with many areas left unserved. Only government could have completed the project on a nationwide scale, and debt-to-GDP ratios were stable at the time. Thus the interstate highway system passes the three-pronged test of efficient government spending that justifies debt.

  Today long-term interest rates are near all-time lows, and the United States could easily borrow $150 billion for seven years at 2.5 percent interest. With that money, the government could, for example, construct a new natural gas pipeline adjacent to the interstate highway system and place natural gas fueling stations at existing facilities. This interstate pipeline could be connected to large natural gas trunk pipelines at key nodes, and the government could then require a ten-year conversion of all interstate trucking from diesel to natural gas.

  With this pipeline and fueling station network in place, private companies like Chevron, ExxonMobil, and Ford would then take over the innovation and expansion of natural-gas-powered transportation, a public-to-private handoff as happened after ARPANET. The shift to natural-gas-powered trucks would facilitate the growth of natural-gas-powered automobiles. The demand for natural gas would then boost exploration and production along with related technologies in which the United States excels.

  As with the interstate highway system, the results of an interstate natural-gas-fueling system would be transformative. The boost to the economy would come immediately—not from mythical multipliers but from straightforward productive spending. Hundreds of thousands of jobs would be created in the actual pipeline construction, and more jobs would come from the conversion of vehicles from gasoline to natural gas. Dependence on foreign oil would end, and the U.S. trade deficit would evaporate, boosting growth. The environmental benefits are obvious since natural gas burns cleaner than diesel or gasoline.

  Will this happen? It is doubtful. Republicans are more focused on debt reduction than on growth, and Democrats are ideologically opposed to all carbon-based energy, including natural gas. The political stars seem aligned against this kind of out-of-the-box solution. However, it remains the case that government debt to finance spending can be acceptable if it passes the three-pronged test of positive returns, no displacement of private-sector efforts, and sustainable debt levels. The third prong is the most problematic today.

  ■ Sustainable Debt

  Another essential question must be asked: Are debt levels sustainable? That, in turn, leads to other questions: How can policy makers know if they are pushing the debt-to-GDP trend in the desired direction? What role does the Fed play in making deficits sustainable and debt affordable?

  The relation of Federal Reserve monetary policy to national debt and deficits is fraught with grave risks for the debt-as-money contract. At a primitive level, the Fed actually can monetize any amount of debt the Treasury issues, up to the point of a collapse of confidence in the dollar. The policy issue is one of rules or limitations imposed on the Fed’s money-printing ability. What are the guidelines for discretionary monetary policy?

  Historically, a gold standard was one way to limit discretion and reveal when monetary policy was off track. Under the classic gold standard, gold outflows to trading partners showed that monetary policy was too easy and tightening was required. The tightening would have a recessionary effect, lower unit labor costs, improve export competitiveness, and once again start the inward flow of physical gold. This process was as self-regulating as an automatic thermostat. The classic gold standard had its problems, but it was better than the next-best system.

  In more recent decades, the Taylor Rule—named after its creator, the economist John B. Taylor—was a practical guide for Fed monetary policy. It had the virtue of recursive functions so that data from recent events would feed back into the next policy decision, to produce what network scientists call a path-dependent outcome. The Taylor Rule was one tool in the broader sweep of the sound-dollar standard created by Paul Volcker and Ronald Reagan in the early 1980s. The sound-dollar policy was carried forward through the late 1980s and 1990s in Republican and Democratic administrations by Treasury secretaries as diverse as James Baker and Robert Rubin. If the dollar was not quite as good as gold, at least it maintained its purchasing power as measured by price indexes, and at least it served as an anchor for other countries looking for a monetary reference point.

  Today every reference point is gone. There is no gold standard, no dollar standard, and no Taylor Rule. All that remains is what financial writer James Grant calls the “Ph.D. Standard”: the conduct of policy by n
eo-Keynesian, neo-monetarist academics with Ph.D.’s granted by a small number of elite schools.

  Rules used by academic policy makers to define sustainable deficits are argued among elite economists and revealed in speeches, papers, and public comments of various kinds. In an environment of deficit spending, one of the most important tools is the primary deficit sustainability (PDS) framework. This analytic framework, which can be expressed as an equation or identity, measures whether national debt and deficits are sustainable, or conversely when the trend in deficits could cause a loss of confidence and rapidly increasing borrowing costs. PDS is a way to tell if America is becoming Greece.

  This framework has been used for decades, but its use was crystallized in the current context by economist John Makin, one of the most astute analysts of monetary policy. In 2012 Makin wrestled with the relationship of U.S. debt and deficits to gross domestic product (GDP), using the PDS framework as a guide.

  The key factors in PDS are borrowing costs (B), real output (R), inflation (I), taxes (T), and spending (S); together, the BRITS. Real output plus inflation (R + I) is the total value of goods and services produced in the U.S. economy, also called nominal gross domestic product (NGDP). Taxes minus spending (T – S) is called the primary deficit. The primary deficit is the excess of what a country spends over what it collects in taxes. In calculating the primary deficit, spending does not include interest on the national debt. This is not because interest expense does not matter; it matters a lot. In fact, the whole purpose of the PDS framework is to illuminate the extent to which the United States can afford the interest and ultimately the debt. Interest is excluded from the primary deficit calculation in order to see if the other factors combine in such a way that the interest is affordable. Interest on the debt is taken into account in the formula as B, or borrowing costs.