Some consideration must be given to the legal mechanism by which a new gold standard would be enforced. A legal statute might be sufficient, but statutes can be changed. A U.S. constitutional amendment might be preferable, since that is more difficult to change and could therefore inspire the most confidence.
What should the dollar price of gold be under this new standard? Choosing the wrong price was the single biggest flaw in the gold exchange standard of the 1920s. The price level of $20.67 per ounce of gold used in 1925 was highly deflationary because it failed to take into account the massive money printing that had occurred in Europe during World War I. A price of perhaps $50 per ounce or even higher in 1925 might have been mildly inflationary and might have helped to avoid some of the worst effects of the Great Depression.
Taking the above factors into account produces some startling results. Without suggesting that there is any particular “right” level, the following implied gold prices result when using the factors indicated:
In order to impose discipline on whatever regime was chosen, a free market in gold could be allowed to exist side by side with the official price. The central bank could then be required to conduct open market operations to maintain the market price at or near the official price.
Assume that the coverage ratio chosen is the one used in the United States in the 1930s, when the Fed was required to hold gold reserves equal to 40 percent of the base money supply. Using April 2011 data, that standard would cause the price of gold to be set at $3,337 per ounce. The Fed could establish a narrow band around that price of, say, 2.5 percent up or down. This means that if the market price fell 2.5 percent, to $3,254 per ounce, the Fed would be required to enter the market and buy gold until the price stabilized closer to $3,337 per ounce. Conversely, if the price rose 2.5 percent, to $3,420 per ounce, the Fed would have to enter the market as a seller until the price reverted to the $3,337 per ounce level. The Fed could maintain its freedom to adjust the money supply or to raise and lower interest rates as it saw fit, provided the coverage ratio was maintained and the free market price of gold remained stable at or near the official price.
The final issue to be considered is the degree of flexibility that should be permitted to central bankers to deviate from strict coverage ratios in cases of economic emergency. There are times, albeit rare, when a true liquidity crisis or deflationary spiral emerges and rapid money creation in excess of the money-gold coverage ratio might be desirable. This exceptional capacity would directly address the issue pertaining to gold claimed by Bernanke in his studies of monetary policy in the Great Depression. This is an extremely difficult political issue because it boils down to a question of trust between central banks and the citizens they ostensibly serve. The history of central banking in general has been one of broken promises when it comes to the convertibility of money into gold, while the history of central banking in the United States in particular has been one of promoting banking interests at the expense of the general interest. Given this history and the adversarial relationship between central banks and citizens, how can the requisite trust be engendered?
Two of the essential elements to creating confidence in a new gold-backed system have already been mentioned: a strong legal regime and mandatory open-market operations to stabilize prices. With those pillars in place, we can consider the circumstances under which the Fed could be allowed to create paper money and exceed the coverage ratio ceiling.
One approach would be to let the Fed exceed the ceiling on its own initiative with a public announcement. Presumably the Fed would do so only in extreme circumstances, such as a deflationary contraction of the kind England experienced in the 1920s. In these circumstances, the open market operations would constitute a kind of democratic referendum on the Fed’s decision. If the market concurred with the Fed’s judgment on deflation, then there should be no run on gold—in fact, the Fed might have to be a buyer of gold to maintain the price. Conversely, if the market questioned the Fed’s judgment, then a rush to redeem paper for gold might result, which would be a powerful signal to the Fed that it needed to return to the original money-gold ratio. Based on what behavioral economists and sociologists have observed about the “wisdom of crowds” as reflected in market prices, this would seem to be a more reliable guide than relying on the narrow judgment of a few lawyers and economists gathered in the Fed’s high-ceilinged boardroom.
A variation of this approach would be to allow the Fed to exceed the gold coverage ratio ceiling upon the announcement of a bona fide financial emergency by a joint declaration from the president of the United States and the speaker of the House. This would preclude the Fed from engaging in unilateral bailouts and monetary experiments and would subject it to democratic oversight if it needed to expand the money supply in case of true emergencies. This procedure would amount to a “double dose” of democracy, since elected officials would declare the original emergency and market participants would vote with their wallets to ratify the Fed’s judgment by their decision to buy gold or not.
The implications of a new gold standard for the international monetary system would need to be addressed as well. The history of CWI and CWII is that international gold standards survive only until one member of the system suffers enough economic distress, usually because of excessive debt, that it decides to seek unilateral advantage against its trading partners by breaking with gold and devaluing its currency. One solution to this pattern of unilateral breakouts would be to create a gold-backed global currency of the kind suggested by Keynes at Bretton Woods. Perhaps the name Keynes suggested, the bancor, could be revived. Bancors would not be inflatable fiat money like today’s SDRs but true money backed by gold. The bancor could be designated as the sole currency eligible to be used for international trade and the settlement of balance of payments. Domestic currencies would be pegged to the bancor, used for internal transactions and could be devalued against the bancor only with the consent of the IMF. This would make unilateral or disorderly devaluation, and therefore currency wars, impossible.
The issues involved in reestablishing a gold standard with enough flexibility to accommodate modern central banking practices deserve intensive study rather than disparagement. A technical institute created by the U.S. White House and Congress, or perhaps the G20, could be staffed with experts and tasked with developing a workable gold standard for implementation over a five-year horizon. This institute would address exactly the questions posed above with special attention paid to the appropriate price peg in order to avoid the mistakes of the 1920s.
Based on U.S. money supply and the size of the U.S. gold hoard, and using the 40 percent coverage ratio criteria, the price of gold would come out to approximately $3,500 per ounce. Given the loss of confidence by citizens in central banks and the continual experience of debasement by those banks, however, it seems likely that a broader money supply definition and higher coverage ratio might be required to secure confidence in a new gold standard. Conducting this exercise on a global basis would require even higher prices, because major economies such as China possess paper money supplies much larger than the United States and far less gold. The matter deserves extensive research, yet based on an expected need to restore confidence on a global basis, an approximate price of $7,500 per ounce would seem likely. To some observers, this may appear to be a huge change in the value of the dollar; however, the change has already occurred in substance. It simply has not been recognized by markets, central banks or economists.
The mere announcement of such an effort might have an immediate beneficial and stabilizing impact on the global economy, because markets would begin to price in future stability much as markets priced in European currency convergence years before the euro was launched. Once the appropriate price level was determined, it could be announced in advance and open market operations could commence immediately to stabilize currencies at the new gold equivalent. Finally, the currencies themselves could become pegged to gold, or a new global currency bac
ked by gold could be launched with other currencies pegged to it. At that point the world’s energies and creativity could be redirected from exploitation through fiat money manipulation toward technology, productivity improvements and other innovations. Global growth would be fueled by the creation of real rather than paper wealth.
Chaos
Perhaps the most likely outcome of the currency wars and the debasement of the dollar is a chaotic, catastrophic collapse of investor confidence resulting in emergency measures by governments to maintain some semblance of a functioning system of money, trade and investment. This would not be anyone’s intention or plan; rather it would simply happen like an avalanche brought about by the layering of one last financial snowflake on an unstable mountainside of debt.
The instability of the financial system in recent years has been dialed up through the greatly increased diversity and interconnectedness of market participants. Embedded risk has been exponentially increased through the vastly expanded scale of notional derivatives contracts and leverage in the too-big-to-fail banks. The exact array of critical thresholds of all market participants is unknowable, but the overall system is certainly closer to criticality than ever before for reasons already discussed in detail. All that is required to initiate a collapse is a suitable catalyst relative to the lowest critical thresholds. This does not have to be a momentous event. Recall that both small and large fires are caused by the same-sized bolt of lightning, and what makes for conflagrations is not the lightning but the state of the world.
The catalyst might be noteworthy in its own right, yet the link between catalyst and collapse may not immediately be apparent. Following is one scenario for the catenation of collapse.
The triggering event happens at the start of the trading day in Europe. A Spanish government bond auction fails unexpectedly and Spain is briefly unable to roll over some maturing debt despite promises from the European Central Bank and China to support the Spanish bond market. A rescue package is quickly assembled by France and Germany, but the blow to confidence is severe. On the same day an obscure but systemically important French primary bond dealer files for bankruptcy. Normally trouble in Europe is good for the dollar, but now both the dollar and the euro come under siege. The double-barreled bad news from Spain and France is enough to cause a few Dutch pension fund dollar stalwarts to change their minds in favor of gold. Although not usually active in the to-and-fro of dollar trading, the Dutch push the dollar “sell” button and some snowflakes start to slide. In Geneva, another dollar-critical threshold is crossed at a hedge fund, and that fund pushes the “sell” button too. Now the slide is noticeable; now the avalanche has begun.
The dollar quickly moves outside its previous trading range and begins to hit new lows relative to the leading indices. Traders with preassigned stop-loss limits are forced to sell as those limits are hit, and this stop-loss trading just adds to the general momentum forcing the dollar down. As losses accumulate, hedge funds caught on the wrong side of the market begin to sell U.S. stocks to raise cash to cover margin calls. Gold, silver, platinum and oil all begin to surge upward. Brazilian, Australian and Chinese stocks start to look like safe havens.
As bank and hedge fund traders perceive that a generalized dollar collapse has begun, another thought occurs to them. If an underlying security is priced in dollars and the dollar is collapsing, then the value of that security is collapsing too. At this point, stress in the foreign exchange markets immediately transfers to the dollar-based stock, bond and derivatives markets in the same way that an earthquake morphs into a tsunami. The process is no longer rational, no longer considered. There is no more time. Shouts of “Sell everything!” are heard across trading floors. Markets in the dollar and dollar-based securities collapse indiscriminately while markets in commodities and non-U.S. stocks begin to spike. Dumping of dollar-denominated bonds is causing interest rates to surge as well. This has all happened before high noon in London.
New York traders, bankers and regulators are disturbed in their sleep by frantic calls from European colleagues and counterparts. They all awake to the same sea of red and rush to get to work. The usually sleepy 6:00 a.m. suburban commuter train is standing room only; the normal “no cell phone” etiquette is abandoned. The train looks like a trading floor on wheels, which it now is. By the time the bankers arrive in midtown Manhattan and Wall Street, the dollar index has dropped 20 percent and stock futures are down 1,000 points. Gold is up $200 per ounce as investors scramble to a safe haven to preserve wealth. The contrarians and bottom-feeders are nowhere in sight; they refuse to jump in front of a runaway train. Some securities have stopped trading because there are no bids at any price. The dollar panic is now in full swing.
Certain markets, notably stock exchanges, have automatic timeouts when losses exceed a certain amount. Other markets, such as futures exchanges, give officials extraordinary powers to deal with disorderly declines, including margin increases or position limits. These rules do not automatically apply in currencies or physical gold. In order to stop a panic, central banks and governments must intervene directly to fight back the waves of private selling. In the panic situation just described, massive coordinated buying of dollars and U.S. government bonds by central banks is the first line of defense.
The Fed, the ECB and the Bank of Japan quickly organize a conference call for 10:00 a.m. New York time to discuss coordinated buying of the U.S. dollar and U.S. Treasury debt. Before the call, the central bankers consult with their finance ministries and the U.S. Treasury to get the needed approvals and parameters. The official buying campaign begins at 2:00 p.m. New York time, at which point the Fed floods the major bank trading desks with “buy” orders on the dollar and U.S. Treasuries and “sell” orders on euros, yen, sterling, Canadian dollars and Swiss francs. Before the buying begins, Fed officials leak a story to their favorite reporters that the central banks will do “whatever it takes” to support the dollar and the Fed source specifically uses the phrase “no limits” in describing the central banks’ buying power. The leaks soon hit the newswires and are seen on every trading floor around the world.
Historically, private market players begin to back off when governments intervene against them. Private investors have fewer resources than governments and are informed by the timeless admonition “Don’t fight the Fed.” At this point in most panics, traders are happy to close out their winning positions, take profits and go home. The central banks can then mop up the mess at taxpayer expense while traders live to fight another day. The panic soon runs its course.
This time, however, it’s different. Bond buying by the Fed is seen as adding fuel to the fire because the Fed prints money when it buys bonds—exactly what the market was troubled by in the first place. Moreover, the Fed has printed so much money and bought so many bonds before the panic that, for the first time, the market questions the Fed’s staying power. For once, the selling power of the panic outweighs the buying power of the Fed. Sellers don’t fear the Fed and they “hit the bid,” leaving the Fed holding a larger and larger bag of bonds. The sellers immediately dump their dollar proceeds from the bond sales and buy Canadian, Australian, Swiss and Korean currencies in addition to Asian stocks. The dollar collapse continues and U.S. interest rates spike higher. By the end of day one, the Fed is no longer spraying water on the fire—it is spraying gasoline.
Day two begins in Asia and there is no relief in sight. Even stock markets in the countries with supposedly stronger currencies, such as Australia and China, start to crash, because investors need to sell winning positions to make up for losses, and because other investors have now lost confidence in all stocks, bonds and government debt. The scramble for gold, silver, oil and farmland becomes a buying panic to match the selling panic on the side of paper assets. The price of gold has now doubled overnight. One by one officials close the Asian and European stock exchanges to give markets a chance to cool down and to give investors time to reconsider valuations. But the effect is the o
pposite of the one intended. Investors conclude that exchanges may never reopen and that their stock holdings have effectively been converted into illiquid private equity. Certain banks close their doors and some large hedge funds suspend redemptions. Many accounts cannot meet margin calls and are closed out by their brokers, but this merely shifts the bad assets to the brokers’ accounts and some now face their own insolvencies. As the panic courses through Europe for the second day, all eyes slowly turn to the White House. A dollar collapse is tantamount to a loss of faith in the United States itself. The Fed and the Treasury have been overwhelmed and now only the president of the United States can restore confidence.
Military jargon is peppered with expressions like “nuclear option” and “doomsday machine” and other similar expressions used both literally and figuratively. In international finance, the president has a little-known nuclear option of immense power. This option is called the International Emergency Economic Powers Act of 1977, known as IEEPA, passed during the Carter administration as an updated version of the 1917 Trading with the Enemy Act. President Franklin Roosevelt had used the Trading with the Enemy Act to close banks and confiscate gold in 1933. Now a new president, faced with a crisis of comparable magnitude, would use the new version of that statute to take equally extreme measures.
The use of IEEPA is subject to two preconditions. There must be a threat to the national security or the economy of the United States, and the threat must originate from abroad. There is some after-the-fact notification to Congress, but in general the president possesses near dictatorial powers to respond to a national emergency. The circumstances now unfolding meet the conditions of IEEPA. The president meets with his economic and national security advisers and speechwriters to prepare the most dramatic economic address since the Nixon Shock of 1971. At 6:00 p.m. New York time on day two of the global dollar panic, the president gives a live address to an anxious world audience and issues an executive order consisting of the following actions, all effective immediately:• The president will appoint a bipartisan commission consisting of seasoned veterans of capital markets and “eminent economists” to study the panic and make suitable recommendations for reform within thirty days.
Currency Wars: The Making of the Next Global Crisis Page 28