By John Butler
Alchemist
Saturday, April 7, 2012
Adapted from
The Golden Revolution: How to Prepare for the Coming Global Gold Standard by John Butler.
Contrary to the conventional wisdom of the current economic mainstream that the gold standard is but a
quaint historical anachronism, there has been an unceasing effort by
prominent individuals in the US and also a handful of other countries to
try and re-establish a gold standard ever since President Nixon
abruptly ended gold convertibility in August 1971. The US came
particularly close to returning to a gold standard in the 1980s. This
was understandable following the disastrous stagflation of the 1970s and
severe recession of the early 1980s, at that time the deepest since
WWII. Indeed, Ronald Reagan campaigned on a platform that he would
seriously study the possibility of returning to gold if elected
president.
Once successfully elected, he remained true to his word and appointed
a Gold Commission to explore both whether the US should and how it
might reinstate a formal link between gold and the dollar. While the
Commission’s majority concluded that a return to gold was both
unnecessary and impractical – Fed Chairman Paul Volcker had successfully
stabilised the dollar and brought inflation down dramatically by 1982 –
a minority found in favour of gold and published their own report, The
Case for Gold, in 1982. Also around this time, in 1981, future Fed
Chairman Alan Greenspan proposed the introduction of new US Treasury
bonds backed by gold as a sensible way to nudge the US back toward an
explicit gold link for the dollar at some point in future.
In the event, the once high-profile debate in the US about whether or
not to return to gold eventually faded into relative obscurity. With
brief exceptions, consumer price inflation trended lower in the 1980s
and 1990s, restoring confidence in the fiat dollar. By the 2000s,
economists were talking about the ‘great moderation’ in both inflation
and the volatility of business cycles. The dollar had been generally
strong versus other currencies for years. ‘Maestro’ Alan Greenspan and
his colleagues at the Fed and their counterparts in many central banks
elsewhere in the world were admired for their apparent achievements.
We now know, of course, that this was all a mirage. The business
cycle has returned with a vengeance with by far the deepest global
recession since WWII, and the global financial system has been teetering
on the edge of collapse off and on for several years. While consumer
price inflation might be low in the developed economies of Europe, North
America and Japan, it has surged into the high single- or even
double-digits in much of the developing world, including in China, India
and Brazil, now amongst the largest economies in the world.
The economic mainstream continues to struggle to understand just why
they got it so wrong. They look for explanations in bank regulation and
oversight, the growth of hedge funds and the so-called ‘shadow banking
system’. They wonder how the US housing market could have possibly
crashed to an extent greater than occurred even in the Great Depression.
Some look to global capital flows for an answer, for example China’s
exchange rate policy. Where the mainstream generally fails to look,
however, is at current global monetary regime itself. Could it be that
the fiat- dollar-centred global monetary system is inherently unstable?
Is our predicament today possibly a long-term consequence of that
fateful decision to ‘close the gold window’ in 1971?
I believe that it is. But what that implies, given the damage now
done to the global financial system, is that there is no way to restore a
sufficient degree of credibility and trust in the dollar, or other
major currencies for that matter, without a return to some form of gold
standard. This may seem a rather bold prediction, but it is not. The
evidence has been accumulating for years and is now overwhelming.
Money can function as such only if there is sufficient trust in the
monetary unit as a stable store of value. Lose this trust and that form
of money will be abandoned, either suddenly in a crisis or gradually
over time in favour of something else. History is replete with examples
of ‘Gresham’s Law’, that ‘bad’ money drives ‘good’ money out of
circulation; that is, that when faith in the stability of a money is
lost, it may still be used in everyday transactions – in particular, if
it is the mandated legal tender – but not as a store of value. The
‘good’ money is therefore hoarded as the superior store of value until
such time as the ‘bad’ money finally collapses entirely and a return to
‘good’ money becomes possible. This monetary cycle, from good to bad to
good again, has been a central feature of history.
In the present instance, we find a growing number of countries
expressing concern about the stability of the dollar amid relentlessly
expansionary US monetary policy, excessive dollar reserve accumulation
and the associated surge in inflation, including China, India and
Brazil. The ‘Arab Spring’ of 2011 originated in part from soaring food
price inflation.
Concern is increasingly giving way to action. China has entered into
bilateral currency swap arrangements with Russia, Brazil, Argentina,
Japan, South Korea and Thailand as all these countries seek to reduce
their dependence on the dollar as a transactional currency. As the
dollar’s role gradually declines, global monetary arrangements are
likely to become increasingly multipolar, as there is no single currency
that can realistically replace the dollar as the pre-eminent global
monetary reserve. The euro area has major issues with unsustainable
sovereign debt burdens and an undercapitalised financial system. Japan’s
economy is too small and too weak to provide a dollar substitute. And
while China’s economy has been growing rapidly, its financial system is
not yet mature or robust enough to instil the necessary global
confidence in the yuan as the dominant reserve currency. Yet growth in
global trade continues apace, to the benefit of nearly all economies. A
global currency facilitates global trade.
It was precisely a multipolar world amid rapidly growing
international trade that ushered in the classical gold standard in the
1870s. Although gold had been in the ascendant in global monetary
affairs for several years, growing German political and economic clout
provided an important tipping point as Germany favoured gold for
settlement of international balance of payments. While the Bank of
England was the dominant central bank of its day, reflecting British
economic power, it never sought to impose a gold standard on its trading
partners. Rather, it accepted the gold standard as an international
fait accompli.
The US Federal Reserve may find it plays a similar role in the near
future. While it is certainly possible that, in order to restore
confidence and trust in the dollar, the US relinks the dollar to gold on
its own initiative, more likely is that another country, or group of
countries, where economic power is in the ascendant, where there are
large and growing current account surpluses, and where a meaningful
amount of gold has already been accumulated, will be the first movers.
All of the BRICs are potential candidates, as are certain oil-producing
countries and, possibly, Germany and Japan.
When presented with a
fait accompli, the US will have little
choice but to go along or find that the dollar not only loses reserve
currency status entirely, but also is no longer accepted for
international transactions. In the event, we believe a decision to
accept the new global gold standard will be rather easy to reach. While
it is unclear just what kind of gold standard will prevail – history
provides a range from which to choose, some of which worked better than
others – the key point is that, whatever form of standard prevails, it
must restore a sufficient degree of credibility and trust in global
monetary affairs. That requires that, simultaneously and alongside the
return to gold, there must be a dramatic deleveraging of the
undercapitalised financial system in the US, euro area, UK, Japan and
also a handful of other countries. Fortunately, this is easily
accomplished. All that is required is that the rate of gold
convertibility is set at a gold price sufficiently high to imply that
existing debt burdens, now clearly excessive, are reduced to levels that
can be credibly serviced from existing levels of national income and,
in the case of sovereign debts, from tax revenues.
However, given just how overleveraged financial systems are, and how
large sovereign debt burdens are becoming amid unprecedented peacetime
deficit spending, the rise in the price of gold will need to be an order
of magnitude higher than it is today. That may surprise some, given
that the price of gold has been rising for years. But what should really
surprise us is that the growth of money and credit has been far
greater. Simply taking the numbers as they are and allowing the gold
price to rise sufficiently to compensate for decades of cumulative,
excessive money and credit growth implies that a credible gold
conversion price in dollars would be above $10,000. The credible,
sustainable conversion prices in euros, yen, sterling and other
developed world currencies would also lie far higher than where they are
today.
From an investor’s perspective, there are far greater implications of
a return to a gold standard than merely the large rise in the gold
price. The dynamics and determinants of interest and exchange rates, and
risk premia for the entire range of assets, are going to change. For
example, for those countries that return to gold, exchange rates will
become essentially fixed. Interest rates, however, while nominally still
under the control of central banks, will need to be set at
market-determined levels, not below, or gold reserves will be depleted,
eventually leading to a funding crisis. Risk premia for most assets will
need to rise, primarily because, constrained by the gold standard, both
monetary and fiscal authorities will have less flexibility to provide
stimulus during economic downturns. As such, cyclical profit swings will
tend to be larger, as will the number of bankruptcies.
While a lack of policymaker flexibility and increased risk of
corporate bankruptcy might concern some investors, consider that it was
precisely an excess of policymaker flexibility – chronically loose
monetary and fiscal policy – which got the developed world into its
current predicament. This point is clear: poorly managed fiat currencies
and the financial systems built upon them caused the global credit
crisis, not gold. And what a world of ‘too big to fail’ needs are
reforms that indeed allow large firms to go bankrupt from time to time,
so that capitalism can in fact work as intended.
It is worth considering why bankruptcy has become such a bad word.
While no investor wants to lose money on a bankrupt enterprise, when
looking at a capitalist economy as a whole, bankruptcy is absolutely
essential to economic progress. Josef Schumpeter’s ‘creative
destruction’, unlocking resources in unproductive enterprises and moving
them to where they can be more efficiently employed, or mixed with new
technologies or business techniques, is what capitalism is all about.
Real long-term economic progress depends on it.
There are other reasons not to fear gold but rather embrace it. A
gold standard will reward savings, something that is sorely lacking in
much of the developed world. It will rationalise government finances, in
particular by making it difficult if not impossible for countries to
incur large debts and then try to pass these off on future generations,
something of dubious morality. Absent easy money, it will force
economies to become more flexible, and labour and capital to become more
mobile. By implication, financial leverage will also be limited and
‘too big to fail’ will instead become ‘too big to bail’. Indeed, absent
easy money or bailouts, the financial sector will only grow to the
extent that it actually serves the broader, productive economy. Huge
numbers of engineers and other quants who went to the City looking for
outsize bonuses will make their way back into real industries making
real things, where they will be joined by fresh graduates and lay the
groundwork for what is likely to be an era of great industrial
innovation.
Investors should not fear the golden revolution. Rather, they should
welcome it. After all, they don’t call particularly prosperous
historical episodes ‘Golden Ages’ for nothing.
Reprinted with permission. Currently serving as the Chief Investment Officer of a commodities
fund, John was previously Managing Director and Head of the Index
Strategies Group at Deutsche Bank in London, where he was responsible
for the development and marketing of proprietary, systematic
quantitative strategies for global interest rate markets.
For further reading/viewing:
"Book Review: The Golden Revolution", Keith Weiner, August 20, 2012
"Podcast #22 with John Butler",
TF Metals Report, May 25, 2012
"Beyond currency wars, the coming Global Gold Standard with John Butler" (video),
Capital Account, April 3, 2012
