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.
CHAPTER 9
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 t
o 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.
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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.”
The Death of Money Page 25