by Sara Eisen
Whatever benefits FDR and his administration were trying to achieve with this newfound freedom to lift the U.S. economy from the depths of the Depression in 1933, the reality is that it wasn’t until at least 12 years later, after the end of World War II, that the U.S. economy finally got back on a firm footing. At this point, of course, industrial competition from Europe and Japan had disappeared, and U.S. business and Washington, DC, had finally made peace after FDR had vilified American industrialists during the 1930s.
John Maynard Keynes, one of the preeminent economists of the time, had influenced FDR’s economic policies, promoting the theory that inflation was needed both to pay off excessive debts with devalued dollars and to raise employment. Unrestrained printing of money was certainly not free, however. Although Keynes’s economic philosophies are still widely followed and implemented politically today, the results can be specious. Keynes himself said the following in his 1919 book, The Economic Consequences of the Peace, on the subject of a central bank free from the shackles of a gold standard:
Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. ... Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.6
Notwithstanding this realization, Keynes termed gold a “barbarous relic” in 1923, because of his belief that the gold standard was dead after World War I. In his mind, it was good riddance. He wanted countries to have the ability to print money at will in order to foster growth, irrespective of the inflationary pressures that would follow. Nominal (real 1 inflation) GDP growth was his preferred cure for economic recessions.
While he acknowledged the evils of currency debasement and inflation, Keynes was more focused on the short-term economic consequences of economic downturns. He favored both using interventionist fiscal and monetary policies to lift aggregate demand and depreciating one’s currency to boost trade. While these measures would foster economic growth in the short term, the long-term consequences and “payback” were not his focus.
The wartime period during which many countries remained off the gold standard lasted until 1944, when the final remnant of a gold standard was codified in the Bretton Woods Agreement in 1944, just as World War II was nearing its end. The purpose of the Bretton Woods Agreement was to establish the U.S. dollar as the global reserve currency, enabling foreign countries to sell their dollars at will for a fixed amount of gold, since the U.S. dollar was backed by gold. The goal of this fixed currency regime was to provide stability for those countries that chose to tie and fix their currencies to the value of the U.S. dollar, this would assure a necessary degree of certainty as economic globalization started to regenerate after the war.
This attempt at an international financial system was meant to break down barriers to trade and provide the basis for a healthier and freer global economic backdrop, which would benefit all those who took part. Also, utilizing the U.S. dollar as the center of this new system would prevent other countries from manipulating their currencies at will, since at the same time that participating countries fixed their currencies to the U.S. dollar, the U.S. dollar was fixed at a value of $35 per troy ounce of gold. The Bretton Woods Agreement produced a new financial system that represented the first international agreement on monetary policy of the modern age. It remained in effect until August 1971, when President Nixon unilaterally ended this pseudo-gold standard and declared that currencies were now meant to float, without the constraint of any ties to gold. Because many nations had pegged their own currencies to the U.S. dollar, which was now no longer linked to gold, a global freely floating currency regime was, in essence, created.
A new fiat currency regime was established because the United States found it increasingly difficult to sustain a peg to gold, in part because of fiscal policies used to finance the Vietnam War and the Great Society spending initiatives of the 1960s. These had included the use of borrowed money instead of tax revenue for funding. Foreigners, seeing the flood of U.S. dollars, wanted gold instead, forcing Nixon to eventually put a stop to the convertibility of the U.S. dollar into gold. This allowed gold itself to start to trade, and it flew upward from the $35 level.
With currencies now floating freely in relation to one another without the anchor of gold, it was left to the fiscal and monetary policies of individual nations to determine the value of their currency in the internationally traded markets. What soon followed, as the decade of the 1970s progressed, was a major inflation problem, with the rate of consumer price inflation in the United States in particular reaching 13.5 percent year over year in 1980. Gold topped out at $850 per troy ounce in 1980, when the U.S. Federal Reserve finally used the lever of interest rates to tighten money to such an extent that it quelled the inflation of money creation. The immediate slowdown in economic activity that resulted led to a sharp fall in the rate of change in consumer prices over the subsequent years.
The much more benign growth in the rate of inflation that lasted over the next 20 years ultimately led the price of gold to fall to as low as $250 per troy ounce in 1999. The purchasing power of the dollars in your pocket still went down, but at a pace that was dramatically lower than that seen in the 1970s. U.S. central bankers had succeeded in creating their own “gold standard” by implementing policies that provided price stability; it seemed as though they had created a basis for healthy, unrestrained economic growth. And so they believed.
Any discussion of gold and its proper worth cannot be detached from a study of the actions of the U.S. Federal Reserve and other central banks in the world, such as the European Central Bank, the Bank of England, and the Bank of Japan. As gold is a currency and not a commodity, its value is directly related to the market’s perception of its competition with paper currencies, whose supply is dictated by central banks and the fiscal policies of individual governments. The value of a currency is very simply determined by the supply of it relative to the demand. Economics 101 taught some of us that a greater supply of a good compared with the demand for it would result in a lower price, and vice versa. Every day, $4 trillion worth of foreign currencies are traded, and market participants’ opinions of supply and demand are put to the test. The supply of gold, however, is not determined by the whims of politicians and central bankers. Its supply is determined solely by the ability to mine it from the ground. Thus its price is determined strictly by its availability from mines and the desire to sell it at a profit. Consequently, it is this independence from politics and government intervention in the marketplace that has set gold in its place as a valuation benchmark for fiat currencies.
To visualize monetary policy without the constraints of a gold standard, one must realize that in the short term, the cost of money is determined by men and women seated around large tables in their respective central bank conference rooms. Using econometric models and forecasts, they are all trying to pick the “right” interest rate. That “right” rate, of course, varies based on the individual circumstances of each of their countries, but my point is that this arbitrary conduct of policy is prone to danger. Compare this scenario to the setting of interest rates in the marketplace, where millions of participants decide at what price they want to lend money, and others decide at what price they are willing to borrow. The market gets it wrong sometimes, but the beauty of the market is that it quickly readjusts when it goes wrong. Bureaucrats in elaborate offices aren’t that quick to adjust, and they often purposely choose to manipulate the cost of money to achieve a particular level of economic performance that they are determined
to achieve.
We need look no further than the U.S. economy over the past 10 years and the actions of our central bank to see what can go wrong when one ignores the price of gold, and instead has too much faith in a crystal ball. Following the easy money–induced stock market bubble in the United States in the late 1990s, which resulted in a major bust, Alan Greenspan, Ben Bernanke, and Co. cut the fed funds rate from 6.5 percent to 1 percent and maintained that level for years, irrespective of the rising level of inflation, because they wanted to juice economic growth through the extension of credit.
This cheapening of money led to the greatest credit bubble this world has ever seen, and we’re currently still dealing with the aftermath. The Bernanke-led Fed embarked on multiple rounds of interest-rate cuts and money printing, known as quantitative easing (QE), in order to price-fix the cost of money lower. But instead of facilitating years of needed deleveraging, the Fed has been trying to put Humpty Dumpty back together again, and, in the process, has tried to repair an economy that is characterized by too much personal borrowing, too little saving, and too much spending. I emphasize this because it directly relates to the value of gold, as the Fed is creating money out of thin air in order to achieve its monetary goals. It thus goes back to Economics 101, where we learned that too great a supply of currency relative to the demand for it cheapens the currency, and inversely, that is increasingly seen in the price of gold. The price level of gold is the best measure of this imbalance, as the supply of gold can’t be created by the Fed.
Over the past few years, attempts to inflate one’s way out of an overindebted economy have occurred in England, Japan, and most of Europe. Switzerland has taken part in its own form of money printing; however, this has been more focused on fixing the value of the Swiss franc to the euro. Most of the Western world is suffering from a lack of growth and extraordinary levels of debt. Instead of encouraging healthy growth through long-term policies and debt paydown and writedown, central banks are trying to prevent, at all costs, any sort of needed adjustments by employing massive liquidity steps, resulting in a debasement of currencies as the creation of money is inflated on a grand scale.
Figures 8-1 to 8-3 show the respective balance sheets of the European Central Bank, the Fed, and the Bank of England.
Figure 8-1 ECB in Euros
Figure 8-2 Federal Reserve in U.S. Dollars
Figure 8-3 Bank of England in pounds
Ironically, it is the central banks in developing countries that have added to their gold reserves in order to protect themselves and their U.S. dollar, euro, and yen holdings from debasement. According to the World Gold Council, in the first three months of 2011, central banks bought a net 350 tons of gold, and 148.4 tons in the third quarter alone. This compares to a net 180 tons bought in 1988, the last time central banks were net buyers. While there is no official breakdown of which countries bought gold, Russia, Thailand, Bolivia, Brazil, and Mexico have publicly stated that they have added to their holdings. These central banks are not speculating on higher prices; they are structurally changing the asset mix of their reserve holdings.
In the absence of any type of restraint, whether political or through a gold standard or something similar to it, unelected central bankers have run rampant over an international economic system that was once dependent on the free flow of goods and services, with the cost of money being determined mostly by the marketplace at a level above the rate of inflation. As in any bubble, a misallocation of capital results from a muddying of the price discovery of goods and services that follows an inaccurate measure of the pricing of credit. For example, artificially cheap money created by the Fed in the mid-2000s led to excessive credit demand that manifested itself in the housing market, creating a level of housing prices that was, in turn, artificial. Rising prices attracted even more capital, and the obvious bubble resulted. If there is any indictment of central bank policy, specifically that of the U.S. Federal Reserve, it is the current economic malaise, the debt overhang, and the price of gold. The price of gold is directly tied to the value of the alternative fiat currencies, and the 11-year bull market in gold to an all-time record high in August of 2011 fully expressed the market’s view of the reckless fiscal and monetary policy being conducted by our elected and unelected officials and their impact on paper money.
Figure 8-4 is a chart of the Consumer Price Index, in which we can see a notable increase beginning in 1971, just as the handcuffs of a gold standard were lifted from central bankers. Price stability this is not—and it’s the standard of living of the middle class that gets destroyed. The purchasing power of the U.S. dollar has declined 82.5 percent since 1971 and 94 percent since 1934, when FDR altered its value versus gold. Income inequality is now a huge debate, but where is the criticism of the Fed for perpetuating it? One of the Fed’s publicly stated goals is a rise in asset prices as a result of its policies, but only half of Americans own assets. Inflation is the Fed’s unspoken goal—but many people can’t handle it because their wages can’t keep up. Gold was once a check on the behavior of central bankers, but fortunately (and unfortunately), we are now gaining a body of evidence concerning the damage that is done when the discipline is not there. Some examples are reflected in Figures 8-4 and 8-5, the cost of living (CPI) and the amount of debt the U.S. federal government (not even including state and local debt) has accumulated over the years.
Figure 8-4 Consumer Price Index
Figure 8-5 U.S. Total Treasury Public Debt Outstanding
While gold may not mean much to those who don’t wear it as jewelry or use it for some industrial purpose, it has a history of serving as a form of money, a means of exchange, and a store of value for thousands of years. Its price is determined solely by the supply of it that has been taken out of the ground relative to the demand for it, and more and more of the demand for gold over the past 10 years has been from investors. Every single central banker should ask himself (or herself), “Why on earth would an investor buy a metal that yields nothing and can’t be used as a form of exchange to buy even a pack of gum at the local convenience store?” What they don’t realize is that gold represents a form of protection: protection of the value of one’s hard-earned income, protection against inflation, and thus protection against the incompetence of a set of men and women who are wrongly entrusted with picking the right borrowing rate and protection against elected officials who spend money that they don’t have and never plan to repay with currency with the same value as that which was borrowed.
Congressman Ron Paul once asked Ben Bernanke whether gold was money, and the chairman of our Federal Reserve responded, “No.” Coming from a supposed historian of economics, that should alarm the rest of us who understand gold’s place in history. Gold is not held because of longstanding tradition, as Bernanke believes; ironically, it’s held as a form of self-defense against policy makers such as him. We are fast approaching another form of a gold standard, whether backed by gold itself or by silver or a basket of commodities. The bond market in Europe has revolted against excessive debt caused by reckless spending and anemic growth, and it is naïve to think that this trend won’t make its way to Japan, the United Kingdom, and eventually the shores of the United States, as all suffer from the same characteristics. Not until the printing press is finally taken away from the Fed and other central bankers the world over will the economies of the developed world be back on a stable, less leveraged foundation.
In the current state of currencies that float freely against one another, gold will be the last man standing in terms of a store of value and the maintenance of purchasing power that is derived from this. No central banker can create it or print it, as its supply is limited to what can be found in the ground. We have all seen firsthand what unrestrained central bankers can do to their currency and their economy. Irrespective of their good intentions, central bank policies create booms and busts, with economic repercussions that damage the lives of many. Also, the constant reduction of the purchasing power of
paper currencies via inflation as a result of excessive money printing reduces the standard of living of those who can least afford it.
Free markets don’t need fine tuning of monetary policy to create a temporary, yet false, sense of security; they can adjust on their own to the inevitable dislocations that always occur and that are healthy in cleansing the economic system of any excess. Gold, and a currency standard backed by it or something like it, puts handcuffs on central bankers and creates a certain level of restraint in their actions that limits their constant intervention in a free-market economy, the clear repercussions of which are distortion, manipulation, currency debasement, and asset bubbles and crashes.
CHAPTER 9
CHINA
ROBERT JOHNSON
“When large economies with undervalued exchange rates act to keep the currency from appreciating, that encourages other countries to do the same. This sets off a dangerous dynamic.”
—Tim Geithner, October 2010
Currency imbalances in the global economy played an integral part in creating the 2008 financial crisis. The old Bretton Woods system devised after World War II, which broke down in 1971, has not been replaced by a monetary system that is capable of dealing with the problems of today’s volatile currency markets and trade imbalances. Given this, China’s unilateral currency peg will not work going forward. China is simply too large a country to continue on the mercantilist path of export-led growth. Threats of protectionism, a paradox of risk aversion, and the specter of a worldwide recession will loom as long as China continues in this direction. If the world’s leading nations, now including China, are unable to collectively find a way forward, the future of the world economy looks dim. There are strong financial interests on all sides, domestic and international. The outcome of their struggles will determine what comes next. This article examines the present imbalances that have resulted from China’s peg and suggests possible futures for its currency policy as it relates to both domestic issues and foreign policy.