Once again gold has made fresh highs as the Fed prepares its second or is it the third round of quantitative easing (a.k.a. money printing) which involves buying assets (a.k.a debt) to drive down yields and hopefully stimulate more borrowing and spending. Two years after the Lehman collapse and implosion of the housing sector, the financial system is still on life support. With an anaemic domestic market of lost jobs, lost homes and lost income, the Americans, Europe and Japan are trying the familiar false remedies of subsidies and competitive devaluations to give exports a boost. And now the sovereign debt troubles of the weaker members of the euro-zone threaten to take the system down again.
Washington’s insatiable appetite for debt and taxes has become just too big. In reflating this bubble with yet another round of quantitative easing, Fed Chairman Bernanke (a.k.a. Helicopter Ben) has greatly increased the risk of a global currency war dragging down an already vulnerable banking system. Desperately the Americans and Europeans have resorted to the printing press, manipulating their currencies lower destabilizing capital flows, raising fears of an all out currency war, similar to the one that spawned the Great Depression.
Defaults aren’t new. Argentina defaulted in 2001, Mexico was in default in 1982 and Chile defaulted in the seventies. However, Iceland was the first to fall victim to the current sovereign debt crisis. Then Greece and now Ireland with fears of contagion reaching Spain, the world’s tenth largest economy. Interventions, taxpayer bailouts, rescue packages and currency crises have become regular occurrences as currencies plunge in a race to the bottom. Even Switzerland has intervened in the markets. Former Fed Chairman, Alan Greenspan called out the Fed’s policy, “as pursuing a policy of currency weakening”. Only gold has gone up.
As a result, talk of a new Plaza Accord is making the rounds. We believe QE2 will accelerate the demise of the dollar-based currency system as investors rightly fear that it will trigger inflation and more defaults. The Plaza Accord was signed by Reagan in September 1985 when France, West Germany, Japan, UK, and US devalued the dollar by almost 50 percent to solve America’s trade deficit problem. The dollar tanked, interest rates sank and the resultant liquidity spawned the 80s bull market. But alas, Japan saw the yen strengthen which wiped out its export sector, causing not one but two lost decades.
That possibility and another Plaza Accord is not lost on the Chinese, who faced with another huge US trade deficit find themselves in a similar position to Japan. This time, the Chinese are unwilling to accept America’s attempts at a new Plaza Accord or a weak dollar policy. Rejecting America’s domestic economic policies are also Germany, UK and Brazil who have accused the Fed of deliberately devaluing the dollar, rather than take the tough political measures needed to rein in spending at home. Needed of course are cuts to spending, reform the tax code and why not, a consumption tax? Why should they subsidize Americans to drive? Hike the gas tax and stop the deductions on homes and credit cards. Go beyond earmarks and do something about entitlements and the tort system – why more taxpayer bailouts? While the co-chairmen of Mr. Obama’s own blue ribbon bipartisan Debt-Reduction Commission called for tax and spending cuts to solve America’s chronic deficits, the Committee itself could not agree on a consensus and the ideas were stillborn.
Debt Atop Debt Is Not Good
The move by the US deflects attention from its two decade old policy of consumption and addiction to debt. However, instead of being financed by the traditional sources of financing, the capital markets have seen a transformation of the banking system into a “shadow banking system” whose sheer depth and variety has kept money flowing. Derivatives, the tools of the shadow banking system dominate trading from mortgages to equities to commodities and currencies, becoming the most profitable of activities for Wall Street’s giants. The notational amount of derivative contracts such as options and swaps exceeds $600 trillion. Financed by the derivatives and the subfloor plumbing of the shadow banking system, America has kept the printing presses working overtime, with an astronomical issuance of dollars to pay for debt and consumption. We believe this shadow banking system which financed a debt-based monetary system will end in an inflationary debt-default disaster so prevalent of the hyperinflations of the past.
The simple mechanics of pooling various loans and selling the cash flow to yield hungry money market and hedge funds has evolved into the securitization of opaque instruments like the discredited credit default swaps(CDS), collateralized debt obligations (CDOs), COCOs, MBSs, SIVs etc that have spread epidemic-like throughout the financial world. In an excellent paper, “The Shadow Banking System” produced by the New York Federal Reserve, the authors estimated that in early 2008, the shadow banking system peaked at $20 trillion, dwarfing the $11 trillion traditional banking system. New institutions proliferated. Today, that shadow system is at $16 trillion. Despite the crash, bailouts and the Dodd-Frank legislation, this system remains the lifeblood and the financial Achilles heel of America’s debt-ridden system.
The United States is in Deep Trouble
The real crisis in the United States then is not one of easy money or even ultra low levels of interest rates but of the diminished confidence borne of a mounting debt load due to Mr. Obama’s “big government” approach to stimulus spending, healthcare and bailouts. Americans have simply lost confidence in the ability of government to make things work, from stimulus spending to Obamacare to airport security to the task of mopping up oil in the Gulf of Mexico. His federal mandarins have too often expanded their reach. Yet, unwittingly, he has eroded the basic rules of democratic administration. Worse. America’s trading partners and its creditors have also lost confidence in America’s financial policies.
Now America’s quantitative easing and tax cut agreement will pile more debt on top of the $2 trillion of so-called assets the Fed bought during the financial crisis of 2008-09. Worse, the sovereign debt crisis threatens to suck the United States and its “too big to fail” banks into its vortex. After the war, from 1947 to 1967, federal outlays grew by 8 percent per year and federal spending as a percentage of GDP grew from 14.8 percent to 19.4 percent. And then four decades after abandoning the gold standard, federal spending has grown to some 25.4 percent of GDP with today’s deficit running at $1.3 trillion or 10 percent of GDP. America is simply spending $3.00 for every $2.00 of revenues. And while those revenues averaged 19.5 percent of GDP over recent decades, in the last two years tax revenues were only 14.9 percent of GDP, too low to support spending. Meantime, federal debt held by the public has grown to more than 62 percent, excluding entitlements with more than half of that debt held by foreign investors. The size of America’s fiscal hole just gets bigger.
Government is Part of the Problem
The root cause of America’s problem is not China, or even Wall Street. It is the expansion of the federal government. Government is as much a cause of the crisis as its cure. A few years ago the worst credit crisis in years devastated the American housing market. Wall Street was in free fall, its icons bankrupt and unemployment soared. What to do? Once elected, Mr. Obama promised to solve the problem, yet his Administration expanded government and tried to spend his way out of the Great Recession with so called TARP spending, cash for clunkers and Obamacare, all to end with a crushing debt load. The result? Ten percent of Americans are still unemployed and the country is facing trillion dollar deficits with more than 70 percent of their obligations coming due within the next five years. Between now and June, the Fed must purchase $100 billion of Treasury notes and bonds each month, adding to an already bloated balance sheet. The Fed itself has increasingly funded its long term liabilities with short term obligations, a situation not dissimilar to the condition that sank Bear Stearns or Lehman Brothers.
Today the sovereign debt problems are eerily reminiscent of 2008 when the mortgage crisis forced the Fed to come to the rescue of the banks. This time the European Central Bank (ECB) like before, in a time worn kneejerk fashion must again bailout a country and its banks. Like the sub-prime mortgage debacle, more printed money is to be the solution to stop the banks from failing, and again the supreme irony, is that heavily indebted Uncle Sam will be asked to stop this contagion with its too big to fail institutions.
Of course, America could always tighten its belt, like Greece, Iceland, or Ireland. As those indebted countries discovered, financial credibility and political stability go hand in hand. America risks turning into a third-world nation. To restore confidence in the dollar, America must stop blaming others.
Moreover, Mr. Obama has become the Jimmy Carter of American politics and today faces a gridlocked Congress. A confrontation between Congress and the President will come as early as the first quarter of next year when the statutory debt ceiling of $14.3 trillion must be increased. The federal debt has doubled over the past seven years. With the debt ceiling at $13.7 trillion and the last vote only passing by five votes, a Republican led gridlock could shutdown the government causing a legal default. The last time the government shutdown was in 1995, when Bill Clinton and Newt Gringrich fought for 21 days. This time, the market won’t be as patient.
China is Part of the Solution
One cause of the currency wars is that the US continues to print dollars, forcing excess liquidity into the system. For others, countries must import a monetary policy that is too loose. China has piled up a $2.7 trillion hoard of mostly dollars. So far, countries have resorted to rhetoric and threats, but as the Great Depression showed, capital controls, tariffs and competitive currency devaluation are next. Already the dollar’s role as a global reserve currency is unravelling in a world of competitive devaluations. The euro, the globe’s number two currency is also unravelling and the European Union itself is threatened by a tsunami of sovereign debt defaults. History shows currency wars can easily degenerate into trade wars.
China and other emerging economies have become the victims of this out-of-control printing press, accumulating a flood of newly created dollars due to their stronger economies and are left to cope with the large scale inflows of foreign capital despite attempts to keep their currencies from rising further. Of course, the inflow of international capital has also aggravated domestic inflation. The US has demonized China for its worsening global current account imbalances. But the US itself is just as guilty as it manipulates its currency down and pumps yet more dollars into the markets causing a worse imbalance, swamping economies with destabilizing capital inflows. However, such moves have failed in the past and will fail this time. China will not fall for the trap that saw Japan in the eighties acquiesce to the Americans which allowed the yen to increase. That move wiped out Japanese wealth and caused two decades of zero growth. The United States is the most indebted country in the world who depends on the trust of investors like the Chinese to finance their huge borrowing needs. Holding trillions of America debt, it is only a matter of time before the Chinese get skittish and demand higher rates which would suffocate the so-called recovery.
China Has Become More Capitalistic Than America
China, is the largest creditor to a heavily indebted US government is also ready to pick up all the marbles. China’s lightening speed industrialisation and development has resulted in an insatiable appetite for resources. As America devalues its currency, it gives China an extra edge to snap up US assets. Although China is one third the size of America, it is growing at least three times more quickly and free of fighting wars, China’s surplus savings leaves them at an advantage because America is tapped out. Ironically, China has become more capitalist than America, however with the capital. In the past, the Japanese bought Rockefeller Center, Pebble Beach and other trophy assets at their highs. This time, the Chinese are in same position as the Japanese, but rather than buy golf courses or skyscrapers, they are utilising their dollar based IOUs to feed their engine of growth. However, the value of the Chinese holdings of US Treasuries is declining, so, instead of money losing treasuries, China has diversified by buying resources, companies that produce those resources and other hard assets. China is already big in Africa and has struck energy deals in Brazil, Russia and in some cases, right in America’s backyard.
So far, China has almost 1.7 percent of its foreign currency reserves in gold, in contrast to the 10 percent average held by other major economies. The euro itself is backed by 15 percent gold. We expect China to boost its reserves beyond the tiny 1,054 tonne holding, however to get to five percent, it would need to purchase almost two years of the world’s new supply. According to state-owned China National Gold Corporation, China will produce some 320 tonnes of gold this year, first in the world for the third year in a row. Chinese imports in the first ten months of this year soared more than 200 tonnes increasing five-fold from last year reflecting strong consumer demand. Gold ownership was banned from 1945 until 2003 when China allowed citizens to own gold, and today there is even a futures market. Gold can now be added to the list of commodities where China is the world’s largest buyer. We believe that China will buy gold instead of buying more money losing Treasuries or real estate and the gold mania has just begun.
Gold Is the Default Currency
In almost four decades of fiat currencies, the International Monetary Fund (IMF) has calculated global dollar reserves at some 60 percent of America’s GDP. Because of their reserve currency status, the US government has been able to create dollars at will to meet their obligations. And to pay for those obligations in the next decade, global reserves are expected to increase to twice America’s current GDP. Therein lies the dilemma for China and others, there is insufficient backing and the Treasury liabilities will only grow. In contrast, the total of all gold ever mined is about 170,000 metric tons. The price of gold would be equivalent to about $5,000 an ounce today if the dollar liabilities were scaled to the gold supply. Reserve currency status is not a birthright. Once trust disappears, it can vanish quickly.
Gold is very different from paper money. Gold’s move to fresh highs reflects that it has become the default currency in a world of devalued currencies. Needed in this struggle is a set of rules to establish a new global financial order and a currency that nations can trust. The world is full of sick economies and sick currencies. Gold is a cure, painful but a cure.
Needed then is a return to using gold as an anchor for currency values. Needed is monetary reform. Needed are fresh ideas. We envisage a Bretton Woods II system where currencies would be linked to the value of gold rather than a fixed paper dollar system. Gold is an alternative money asset today and World Bank’s President Zoellick suggestion to use gold in a basket of multiple reserve currencies was not a call to return to a gold standard but an acknowledgement of its role as a time-tested monetary asset. After all, gold is the only commodity held by central banks.
The price of gold has increased primarily due to the loss of purchasing power of currencies, particularly the dollar. The supply of currencies seems unlimited, the supply of gold is not. Measured against a broad basket of commodities, gold is higher and rising much more quickly against all currencies. Gold’s move to fresh highs is signalling the fundamental disequilibrium in currency markets and the world economies –sort of like the canaries in the coal mine. As long as the dollar is debased, gold’s bull run will go higher. Gold’s rise is a reflection of its role as a barometer of investor anxiety. The increasing uncertainty surrounding global financial markets is currently driving the price of gold, yet in inflation adjusted terms, it remains far below its previous peak, equivalent to about $2,300 today. The canaries are chirping.
Bretton Woods II
In the Thirties, the gold standard was a fixed exchange rate system in which deficit countries were required to adjust by deflation instead of devaluing their currencies. A country’s gold stocks regulated credit. Surplus countries accumulated gold in exchange for debts. Britain then a super power was weakened because it fought and financed the war against Germany but had to pay the price by devaluing the pound and going off the gold standard in 1931 which led to the collapse of the pound. The slump of the 1930s soon followed.
For some thirty years after the Second World War, under the Bretton Woods agreement, the US dollar replaced the pound and was convertible into gold enabling the rebuilding of the major economies after World War II. The US replaced Britain as the guardian of the West and the dollar become the dominant global reserve currency. Growth averaged 4 percent a year and unemployment 4.7 percent. Consumer price inflation averaged 1.9 percent a year. Significantly, there were no global financial crises during the Bretton Woods era from 1947 to 1971. However in 1971, facing huge deficits and Vietnam war bills, President Nixon abandoned the gold standard because too many claims were made against the dollar, led by President De Gaulle who redeemed France’s dollar reserves into gold. The dollar collapsed. By 1980, gold hit an all time high of $850 an ounce. From 1971 through 2009, growth has averaged, 3 percent and unemployment 6.2 percent and the consumer price index averaged 4.4 percent. However, since 1971 we have had more than a dozen monetary crises and America’s power is diminishing in the this age of fiat money.
Gold is pegged at $42.22 an ounce on the Fed’s balance sheet. Revaluing that stockpile to $1,400 an ounce, the US holdings are worth $366 billion, insufficient to pay off their debts. However, to sovle its debt problem America could revalue that stockpile upward, and that is the lure of their gold holdings and relevancy of a gold based system.
China has the reserves to create a rival to the dollar and the internationalism of Chinese money through a convertible yuan over time is likely, starting with some sort of yuan-based basket. In 1969, the IMF created Special Drawing Rights (SDRs) backed by a basket of currencies and gold which allowed members to convert or exchange their currencies. Currently SDRs make up some 5 percent of global reserves. A possible step is to expand the monetary role of SDRs and include the yuan in its basket, but the IMF must get member approval to create additional SDR reserves, as they did to assist in the financial crisis. Alternatively, we believe a Bretton Woods II is needed with the formation of a Asian basket, a petro basket and a dollar-based basket which would augment the SDR basket as a means of rebalancing the world and reducing dependency on the dollar imposing this time, financial discipline on the global monetary system. Gold will be a good thing to have.
Whenever governments print too much money, spend too much and borrow too much, bad things can happen. We recently studied the hyperinflations of the past to give a clue of the future. We believe there are too many compelling similarities today with the past. There have been over twenty-five episodes in the last century and most major economies have had a legacy of hyperinflation. In a study for the International Monetary Fund, Stanley Fischer, Ratna Sahay and Carlo Veigh wrote about the causes of the French hyperinflation, noting, “that the link with the French revolution supports the view that hyperinflations are modern phenomena related to printing paper money in order to finance large deficits caused by wars, revolutions, the end of empires and the establishment of new states”.
Most remember the Weimar Republic. Before World War I, Germany had a gold-backed currency. To finance the war, Germany abandoned the gold backing. The US dollar was worth 4.2 marks. After World War II, Germany became the biggest debtor in the world. Germany’s debt to GDP ratio was more than 100 percent and the mark fell to 8,000 marks to the dollar. Hyperinflation followed and by 1923, the dollar was worth 4.2 trillion marks.
We also looked at the Chinese hyperinflation period from 1935 to 1947 which helped topple the Chinese leader Chiang Kai-Shek. Like other economies, the Chinese yuan was once based on a silver standard, the US was not. Indeed, the yuan is the Chinese word for a silver coin minted by the Spaniards. Consider what happened. To help out the silver producers, President Roosevelt introduced the Silver Purchase Act in 1934 which boosted the silver price. The Chinese screamed. The Americans countered that the appreciation of the yuan would benefit the Chinese by increasing their purchasing power. Of course, silver prices soared and China’s currency rose in value with an outflow of silver. China’s economy soon fell apart and despite pleas to scrap the Treasury’s silver purchase program, America refused and China was forced to abandon the silver standard in 1935. China then nationalised its banks. Chaos ensued as Chiang Kai-Shek flooded the country with paper yuan in order to pay for the war with the Japanese as well as Chairman Mao’s Communists. Hyperinflation followed. In June 1937, 3.41 yuan was worth $1.00, but by May 1944 it took 23,280,000 yuan to be worth $1. Déjà Vu?
The prospect of the US defaulting on its debt used to be unthinkable, but its most dismal state of financial affairs has made this a possibility. The Federal Reserve itself has become the most highly leveraged financial institution, since Lehman Brothers, purchasing $1.725 trillion of assets that were bought during the financial crisis of 2008-2009. The prospect of further money printing will drive the dollar down further. Policymakers have exhausted most of their options. Unfortunately the credit easing steps does nothing more but pile more debt upon more debt leaving a legacy of rising unemployment, anaemic economic growth and the threat of hyperinflation. As such, gold is the only asset class protecting investors from sovereign debt woes, the loss of purchasing power and depreciating currencies. Moreover, it appears that there are insufficient supplies to meet demand. As this contagion spreads, the markets will remain nervous and we expect increasing pressure to look for alternatives. Gold is that alternate default currency and today has no limits.