by Sara Eisen
A New World Currency
The most salient developments in the international monetary system for the foreseeable future will involve the decline in the status of the dollar as the world’s leading reserve currency. Decline does not mean collapse or elimination. It means a diminution in the dollar’s percentage of total global reserves, along with a diminution in the power and influence that come with being the dominant reserve currency.
In 2000, the U.S. dollar made up 71 percent of all identified foreign exchange reserves in the world.4 By the end of 2011, the U.S. dollar component of identified foreign exchange reserves had dropped to 62 percent.5 Over the same period, the absolute size of identified U.S. dollar reserves had increased from approximately $1.1 trillion to $3.4 trillion, a 300 percent increase. However, other currencies, such as the euro, yen, Swiss franc, and pound sterling, had increased even more, leading to a percentage decline in the U.S. dollar component and an increase in the others.
A simple extrapolation of these trends suggests a world in which the dollar drops below the 50 percent threshold and the euro and other currencies increase their shares until there is no dominant reserve currency, but rather a group of currencies, all vying for a place in the reserve accounts of the world’s central banks and sovereign wealth funds. This could happen in as little as 10 years, perhaps sooner.
This world of multiple reserve currencies is viewed benignly by some. It seems to take the pressure off the U.S. dollar to maintain itself as a store of value. Like a dowager who is no longer vibrant but maintains some dignity, the dollar would have an important place in world finance, but it would no longer be an instrument of a robust foreign or military policy because of the prevalence of alternatives.
The leading advocate for this outcome is Berkeley professor Barry Eichengreen, who compares it to a time in the 1920s when the dollar and the pound sterling traded places as the two leading reserve currencies, with neither one completely dominant.6 However, Eichengreen’s complacency ignores the fact that the international monetary system of the 1920s was anchored by a type of gold standard—albeit the flawed gold exchange standard devised at the Genoa Conference—and that until recently, the international monetary system was at least nominally anchored in a kind of dollar standard. A world of multiple reserve currencies without gold would leave the world with no anchor at all for the first time since the creation of the Bank of England in 1694. Far from being a resolution of the currency wars, the world of multiple reserve currencies could exacerbate them, with repeated rounds of sequential devaluation by central banks and nowhere for reserve holders to take refuge.
More likely than multiple reserve currencies is a world with a single reserve currency—but not the dollar. The new king of the hill would be the SDR issued by the IMF. The IMF has already announced plans for the emergence of the SDR as the new world reserve currency.7 These plans include an annual issuance of $200 billion equivalent in SDRs per year as well as recommendations for private SDR bond issuers, suggested SDR investors, the creation of a network of SDR dealers, and the use of SDR repo facilities and SDR derivatives for financing and hedging purposes. In short, the SDR would be endowed with all of the elements of a modern liquid bond market. It is the existence of deep liquid bond markets denominated in a particular currency that is the sine qua non of reserve currency status and distinguishes a reserve currency from the more common trade currency.
This plan will also require years to implement, but the first tentative steps are already being taken. For the first time in its history, the IMF is funding its commitments on a large scale with debt instruments rather than with equitylike member quotas. These new SDR notes are being issued to members in large quantities to fund bailouts in Europe and elsewhere. In addition, the IMF issued approximately $294 billion in new SDRs to its members in September 2009—the first such issuance since 1981 and by far the largest.8
The IMF now exhibits the combination of a leveraged balance sheet through SDR note issuance and the capacity to print money through the recent allocations of SDRs to its members. Combining an expanded balance sheet with money-printing capability makes the IMF a de facto global central bank of issue operating under G-20 auspices.
This does not mean that local currencies will perform no role or will disappear. Currencies such as the dollar will still be used for local transactions inside the United States in the same way that Turkish lira are used for transactions inside Turkey today. However, the SDR will be the exclusive unit of account for all important international transactions, such as reserve balances, balance of payments adjustments, invoicing oil and other global commodities, and the financial statements of the 1,000 or so largest global corporations.
Hoping for the Best—Thinking About the Worst
Given the weak dollar policies of the Obama administration and the Federal Reserve under Chairman Bernanke, the evolution of the international monetary system away from a dollar standard toward the new SDR standard seems inevitable, perhaps with a stop in the world of multiple reserve currencies during the transition. Given the many elements required for a true SDR-based system—bond issuers, investors, dealers, repo markets, derivatives, and so on—it seems that this transition will take at least five years and more likely ten or fifteen years to complete.
However, this process could be accelerated greatly in the event of another financial panic as bad as, or even worse than, the Panic of 2008. The world avoided an even greater collapse at that time through the creation of trillions of dollars of new money by all of the world’s major central banks, most prominently the U.S. Federal Reserve. As a result, central bank balance sheets today are overleveraged and relatively illiquid by historical standards. Even minor interest-rate increases would wipe out all central bank capital if assets were marked to market to reflect the decline in their market value as a result of such increases. In short, the ability of central banks to duplicate the flood of liquidity they created in 2008–2010 in the event of a new financial panic is severely constrained.
Instead, the next financial panic will be addressed with liquidity not from the central banks, but from the IMF in the form of massive printing of SDRs. In such a panic, the IMF will have the only unimpaired balance sheet in the world and will therefore be the sole source of new global liquidity. This flooding of the world with new SDR liquidity, perhaps on the order of $3 trillion or more, could be the catalyst that thrusts the SDR into the role of world reserve currency ahead of schedule. While panics are by their nature impossible to predict in terms of their exact timing, it does seem more likely than not that such a scenario could play out in the next several years, considering that the problems of the 2008 collapse were never fully resolved and are still with us, buried in the balance sheets of the too-big-to-fail banks.
In the event that such a dire outcome emerges, we can at least take comfort from the fact that the G-20-IMF-SDR blueprint already exists and that the plumbing has been tested over the course of 2009–2012 with modest issuance of new SDRs and SDR notes. Executive orders would replace legislative processes in extremis, and the transition away from dollars and toward SDRs could happen quite quickly. Whether citizens of the affected nations will be content with nondemocratic processes and a new form of paper money to replace the old paper money is a question looming over all such scenarios.
When all else fails, possibly including a new SDR plan, gold is always waiting in the wings as a stable, widely accepted store of value and universal money. In the end, a global struggle between gold and SDRs for supremacy as “money” may be the next great shock added to the long list of historic shocks to the international monetary system.
CHAPTER 8
A ROLE FOR GOLD
PETER BOOCKVAR
“The system should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values.”
—Robert Zoellick, former president, World Bank, November 2010
Whether it is
considered to be jewelry, money, a collectible, or just Au 79 on the periodic table, the known history of gold dates back to around 4000 BC. It’s because of this longevity and because of gold’s sustainability in many aspects of economic life all over the world that its importance and uses must be correctly understood. Of late, with the price of gold rising for 11 straight years after 20 years of falling prices and reaching record highs, its context and relevance today are again major topics of discussion and debate. Why has a metal that has very little industrial use stood the true test of time? Why has gold historically been found to form the backbone of entire currency regimes? Why has a metal that yields no interest income produced such incredible demand from people who are willing to give up income in paper money in return for a shiny artifact? Also, is gold so pretty that for thousands of years, people the world over have clamored over its visuals?
While certain pieces of gold jewelry dating back past 4000 BC have been discovered over the past 40 years, it wasn’t until around 2500 BC that goldsmiths in Mesopotamia (making up modern-day Iraq and parts of Syria) started to hone their craft. Fast-forward 1000 years, and gold was a predominant feature in the funeral mask of Tutankhamen. It was also around this time (1500 BC) that the world’s first gold standard was unofficially established in Babylon with Egyptian-sourced gold. There were no official gold coins as a method of payment for goods, but instead spiral rings of gold were used.1 It wasn’t until 564 BC that the first official gold and silver coins came into existence during the reign of King Croesus of Lydia (part of Turkey), according to the World Gold Council.
Centuries later, the once-great Roman Empire used gold and silver coins as a core element of its monetary exchange. The Romans didn’t mine the gold themselves, but rather acquired it through conquest. The span of their empire “established the first really international economy, broader even than that encompassed by today’s Euro. For the legionnaires were paid in hard cash, gold and silver coin, bearing the portrait of their emperor.”2 “The normal use of coin as a means of exchange was ubiquitous ... that is to say that coin was used both in towns and in areas of settled agriculture, and in the ‘less developed’ as well as the ‘more sophisticated’ provinces. ... Money was embedded in the structure of the economy.”3 In Pompeii alone, 13,000 gold coins were found in the aftermath of the volcanic destruction of the city.4
For centuries to come, gold and silver coins of differing forms and weights became a standard medium of exchange, with the Roman aureus, the Byzantine nomisma, the Islamic dinar, and the Venetian ducat being the most widely internationally accepted currencies. These were eventually followed by the British sovereign, which was launched in 1817.5 A corollary of the widespread expansion of coins was differing gold standards that set the price of money at various weights and values of gold and, for a while, silver. Over the last few hundred years, gold physically backed certain paper money currency regimes.
Of lesser importance to the gold market, but still representing a steady demand up to the present, is the use of gold for industrial purposes. Dentistry, electronics, and healthcare products are just some of the industries that utilize gold. The World Gold Council (WGC) estimates that for at least the past five decades, technological uses of gold have made up about 10 percent of its demand, with jewelry and investment making up the balance with about 60 percent and 30 percent, respectively.
In order to sustain any type of gold monetary exchange and standard, and also to meet the consistent jewelry and industrial demands, there has been a constant need and desire to find new gold; this quest reached the shores of the United States with a fervor during the great California gold rush, which began in 1848. Over the following few years, about 300,000 people from all over the world migrated to California in search of riches. With new mining techniques, gold exploration also flourished in other parts of the world, and production skyrocketed. However, instead of collapsing as a result of the enormous increase in supply, the price of gold remained relatively stable, as the demand for it also continued to increase, while demand for silver declined. Today there are 165,000 metric tons of gold that have been extracted from the ground, according to the WGC. That is only enough to fill two Olympic-size swimming pools, illustrating gold’s status as a precious metal.
Against the backdrop of this very brief history of gold as a valuable commodity, the main purpose of this chapter, and certainly the focus of a current topic of conversation on the worldwide monetary stage, is to discuss whether gold is money, and why, given its limited industrial use and its popularity being subject to fashion trends, this valuable resource is in such great investment demand, both from individuals and, once again, from nations. In our contemporary fiat currency world, in which money is backed by nothing more than a government’s word, it has suddenly become intriguing to look backward to past regimes that established gold standards in order to ascertain the real value of gold in our modern world.
The form of money that the world knows now is paper. While the paper itself is worth very little (unlike a gold coin, which has inherent value), the various denominations of paper currency determine its worth in terms of exchange. Until 1971, when the United States and most of the rest of the world relinquished the last vestige of a gold standard and paper money became fiat, paper money was usually backed by something. Governments promised to exchange paper money for a fixed amount of gold or silver at a time of the holder’s choosing. Thus, paper money was collateralized. This collateral imposed a sense of discipline on those countries that printed their own currency, whether by individual banks providing notes or through a central bank that printed all of a nation’s money. The amount of money printed had to have a fixed relationship with an amount of gold and/or silver held in reserve. This would prevent excessive printing of money that would inevitably devalue the stock of existing paper currency.
Even during historical periods when gold standards were in effect, they were temporarily suspended in times of war so that countries without enough tax revenue would be able to finance their military operations by printing money without restraint. The British government temporarily suspended its gold standard during the battle against Napoleon’s armies in the early part of the nineteenth century. The United States did so during its Civil War in the 1860s, and many countries did so during World War I. Because most countries quickly returned to their gold standard after a war, the inflation that had flared during the war moderated.
The most glaring example of negative consequences that resulted from suspension of a gold standard and failing to reinstate it occurred in Germany during the Weimar Republic. After World War I, the new German government, in part because of reparations payments required by the Treaty of Versailles, and also in an effort to rebuild its economy, printed and printed and printed money to make payments. The value of a German mark in early 1921 was 60 to the U.S. dollar. By the end of 1922, it was 8,000. By 1923, a pound of bread cost 3 billion marks. Inevitably, the currency was revalued with a new one that eliminated most zeros, and a new form of a gold standard was reintroduced. It was this experience with hyperinflation that has embedded within the Germans a strict and unwavering commitment to sound money policy to this day.
Most recently, hyperinflation overtook Zimbabwe, where a government-wrecked economy resorted to printing money to cover up its ills. Instead, doing so further destroyed the economy by creating an inflation rate in the millions. Rather than halting the government policy responsible for the currency debasement, the central bank of Zimbabwe kept printing more money. Eventually, Zimbabwe’s currency became wallpaper, and its economy switched to the U.S. dollar. The examples of Germany and Zimbabwe are extreme in terms of fiscal and monetary policies that led to hyperinflation, but the underlying theme of both stories is the presence of an unrestrained central bank that prints money at will, as dictated by its own opinions.
The modern-day discussion on gold really dates back to the Great Depression in the United States, when, some people believe, the gold standard
tied the hands of central banks and deterred them from increasing the money supply and liquefying the banking system, which was under major strain at the time. These people argue that easier money would have been the key to relieving the economic stresses that resulted from the constriction in bank lending caused, in part, by many banks failing. The irony in relying on the Federal Reserve to fix the ills of a lack of liquidity in the 1930s is that its easy money policy of the mid-1920s ultimately led to the bubble of the late 1920s that was followed by the stock market crash of 1929 and the consequent tribulations of the 1930s.
In 1933, looking to the Federal Reserve for monetary help, President Franklin Delano Roosevelt signed Executive Order 6102 in order to remove its gold standard anchor. It wasn’t much of an anchor, however, as James Grant once referred to the gold exchange standard of the time as being “almost as deeply flawed as the post 1971 paper dollar system,” as the quantity of money grew far above any equal backing in gold. The Executive Order forbade “the hoarding of gold coin, gold bullion, and gold certificates within the continental United States.” All citizens were thus ordered to sell their personal holdings of gold to the Federal Reserve for $20.67 per troy ounce. Imagine that! The U.S. government made it a criminal offense to own gold! In 1934, the Gold Reserve Act followed, forcing the Federal Reserve to turn over the gold it held to the U.S. Treasury, and soon thereafter, gold was revalued at $35 a troy ounce. It was a few years after this that England, where the pound had been considered the world’s reserve currency for most of the nineteenth century, sold down much of its gold holdings in preparing for World War II and faced the realization that a proper gold standard was going to be difficult to achieve, as the war effort would require the printing of more money than there was gold to back it up.