A COMMENTARY ON THE OUTLOOK FOR THE CURRENT INTERNATIONAL MONETARY SYSTEM
1. The current international monetary system is dominated by debt; private debt; and public debt. This debt is pervasive, throughout the world; most developed and developing countries have too much current, and increasing, debt. Debt involves both creditors and debtors. The moment creditors lose confidence in their prospects of repayment, trust is undermined. When the system loses trust, a state of chaos ensues.
2. The current system, in both its present, and emerging, states is unsustainable.
3. This commentary describes the progenitor of this situation, its current state, and the range of possible solutions going forward. Each potential solution has differing implications for our current living standards, our overall wealth, and general well being. Our end objective is to identify practical strategies that will preserve our individual current financial positions, in the face of potentially large changes in the relative values of assets.
4. First, we describe the background leading to the current state of the international monetary system. Next, we highlight the issues causing concern in the current state of the monetary system. This discussion will make clear why the current system, with its present design, is unsustainable in its current form. Possible changes to resolve the difficulties will then be identified. Finally, we will discuss what we can do, as individuals, to protect ourselves from the potential impending changes foreseen. Each topic is treated in turn.
5. Prior to 1933, the world was on a “gold standard”, in which each US dollar could be exchanged for $35 of gold; one US dollar bought 1/35 ounce of gold. This arrangement was revoked by the US government in 1933; they would no longer exchange US dollars for gold. Shortly thereafter, a US law was passed making it illegal for US citizens to own gold. This situation prevailed through WWII.
6. After the war, a new international monetary arrangement was established at Bretton Woods, in 1947. This new arrangement, labelled a “gold exchange standard”, specified that the US would be prepared to exchange gold for US dollars, at a price of 1/38 oz. per dollar. All other currencies were then “pegged” to the US dollar, each having a fixed rate of exchange with the US dollar.
7. The gold exchange standard worked well until the late 1960s; it facilitated substantive economic growth in the developed countries of the world. The US DOLLAR became the “reserve currency” in this system, being used to settle international trade transactions, and serving as a “standard of value” for all other assets; the relative values of assets were uniquely determined, one relative to the other, in US dollars. The system was relatively stable. The DOLLAR BECAME THE “ANCHOR” IN THE SYSTEM…..THE MECHANISM THAT GAVE ALL OTHER ASSETS A KNOWN, VISIBLE, COMPARATIVE VALUE.
8. As international trade expanded, more US dollars were needed to handle the increased volume of transactions. This increased need for US dollars, internationally, enabled the US to run balance of payments deficits, paying for the associated goods and services, with newly printed US dollars, and thereby increasing US dollars in international circulation. Such a system was resented by the likes of France (DeGaulle) who declared that this arrangement gave the US a “free ride”. As long as the number of US dollars was kept in reasonable balance to the volume of international trade, countries accepted this arrangement, even if there was an underlying resentment by some, since there was no other obvious replacement for this arrangement at the time.
9. However, when the US (Johnson) decided he could run both the war in Vietnam, and the Great Society programs (a new thrust on social programs in the US), relying on “government deficits” to finance these events, the number of US dollars circulating in the system started to increase dramatically. France, concerned about the increasing number of dollars being injected into the system, decided to exchange its US dollar holdings for gold. It looked like other countries were about to follow. If they all wanted gold, in exchange for US dollars, the US would soon run out of gold. In response, Nixon, in 1971, announced that the US would no longer exchange gold for dollars. This announcement effectively killed the “gold exchange” system. The value of the US dollar dropped, relative to gold. Other countries renounced their “fixed exchange rates, relative to the US dollar”. Currencies started to float, with no fixed ANCHOR to any stable “benchmark”. As the US dollar started to depreciate, OPEC raised oil prices, still quoted in US dollars. Inflation ensued; wage and price controls were imposed. Interest rates rose into the “mid-teens” by the end of the 1970s. The US government passed a law, allowing citizens to again own gold, starting in 1974. “Stagflation” became a reality (high inflation and slow economic growth).
10. It took some draconian steps by the new Federal Reserve Chairman, Volker, to bring down inflation and interest rates. Once some sense of stability was re-established in the early 1980s, economic growth resumed. By this time, the US was using “monetary policy” (managing the supply of money) as the primary tool to manage their economy.
11. Countries, like China and Japan, were using an “export model” to foster solid economic growth in their economies. The US provided the demand for their exports, paying for these goods and services, with newly printed US dollars. This arrangement fostered the desired growth in Japan and China, and enabled the US to live beyond its means, paying for the excess with newly printed dollars. By 2010, both China and Japan had accumulated massive US dollar reserves, and were starting to develop a concern about the ability of the US to ever honour their debts, represented by the amount of reserves held by the two central banks.
12. In 2010, China stopped accumulating US dollars in their foreign exchange reserve account. They started acquiring gold as an alternative. Other countries are starting to follow suit. Such action is starting to raise the “spectre of TRUST” in the US dollar.
13. During this period the US had its own problems. They recognized that they had to start to deal with their twin deficits of balance of payments, and fiscal imbalances. The resolution of these difficulties, theoretically, could be solved by one of the following three options: DEFAULT; INFLATION; or ECONOMIC GROWTH. Outright default is not a realistic option. A combination of inflation (resulting in a lower real debt balance) and economic growth ( increased resources to pay back existing debt) would be an effective option if they could bring these conditions about. Hence the QE (quantitative easing) program of printing money was introduced. The hope was that this approach would foster both inflation and economic growth. It has done neither. More money is being fed into the system, with the US Treasury selling more bonds, of which the Federal Reserve is now buying some 60%, paid for with newly printed money.
14. This QE program has driven interest rates down. Investors, seeking better returns, have been funneling money into developing countries. This money pushes up the exchange rates of receiving countries, negatively impacting exports. When this new money is converted into local currency, it raises the money supply, causing inflation. They then have a combination of slow economic growth and inflation, complements of the US QE program. If conditions change, there could be a rapid outflow of this “hot money”, exhausting the country’s foreign exchange reserves, and driving down their exchange rates.
15. China and Japan, and others, heavily exporting to the US, continue to accumulate US dollars. While steps are now being taken to avoid the accumulation of more dollars, the current, and still increasing, aggregate accumulation of US dollars, outside the US, is raising the “SPECTRE OF TRUST IN THE VALUE OF THE US DOLLAR. Trying to avoid the accumulation of dollars has the effect of devaluing the US dollar, putting at risk the accumulated dollar reserves these countries now have.
16. A depreciating dollar helps US exports, thereby increasing US economic growth. The depreciated dollar also reduces the amount the US owes, in real terms, to foreign entities. From the US perspective, the QE program, while not perfect, has some positive effect. HOWEVER, IT IS UNDERMINING TRUST IN THE US DOLLAR AT THE SAME TIME. The US recognizes this issue of trust, and understands that the current international monetary system, and their role as the RESERVE CURRENCY within this system, is unsustainable. THE QUESTION IS HOW DOES THE US , AND THE REST OF THE WORLD, GET OUT OF THIS SITUATION. It is to this question that we now turn.
WHAT ARE THE OPTIONS TO RESOLVE THE ABOVE DILEMNA
17. From the US perspective, if the rest of the world allowed the US dollar to depreciate, relative to other currencies, fostering increased exports and reduced imports, US economic growth would increase, helping repayment of government debt to manageable levels. The increased exports and reduced imports would also resolve their balance of payments problems, reducing the potential release of US dollars into the larger system.
18. From the perspective of other countries, such developments, described in paragraph 17 above, would reduce their own economic growth. China, for example, has needed its exports to foster its own economic growth, and help maintain social stability within its population. Other countries have similar domestic issues. THE STATUS QUO IS NOT ACCEPTABLE TO THEM.
19. Further, the ones most at risk in holding US dollars, are the foreign central banks, which have large quantities of US dollars, or their Treasury bond equivalents. US dollar devaluation reduces the value of their holdings in real terms. Large creditors will not willing accept such a reduction in the value of their dollar holdings.
20. The gold exchange standard, between 1947 and the late 1960’s worked well. But the US stood ready to exchange its dollars for gold during this period. Creditors had options. If the price of gold was unilaterally raised, in US dollar terms, and the US stood ready to exchange US dollars for gold, the system would be reset, back to a time similar to the “gold exchange standard period”. To do so, however, would mean that the gold price would have to rise substantially in dollar terms, instantly devaluing the US dollar in terms of gold, and reducing the holdings of other central bank US dollar holdings. This approach would not be acceptable to the large creditors.
21. The US is not interested in re-establishing a link between their currency and gold either. Such a link would constrain the use of monetary policy in managing their economy. This argument can be technical and complicated, but let me simplify the explanation here. The US monetary policy is run by the Federal Reserve system, which consists of 12 regional banks. The New York Federal Reserve Bank is responsible for executing monetary policy (essentially changing the amount of money, and the interest rates) through the FOMC (Federal Open Market Committee). The Bank of Canada has the same responsibilities in Canada. However, while the Bank of Canada is a “crown corporation”, the Federal Reserve Banks are “OWNED” by bank members. The New York Fed Bank is owned by a number of MAJOR PRIVATE BIG CITY MONEY BANKS IN NEW YORK. The private banks choose the Presidents of each of the Regional Federal Banks. The OPEN MARKET COMMITTEE that directs monetary policy is composed of the 7 members of the Board of Directors of the Fed (appointed by the President), and 5 Presidents of the regional Fed banks; the President of the New York Fed is always a member of the FOMC. Those who defend this arrangement, and composition of the FOMC, maintain that the mandate of the FOMC guarantees that the FOMC works in the interest of the US public. A vocal opposition maintains that while the Federal Reserve is, nominally, operating in the interests of US citizens, they are unlikely to ever institute policies that negatively impact the profits of the big, private money centre banks in New York, who are the member owners of the New York Bank.. Going back to a “gold exchange” standard would not be in the interests of these big banks because it would constrain the manipulation of interest rates in the conduct of monetary policy. Also, constraining the scope of decisions by the Federal Reserve would diminish the “importance and power” of the academic bureaucracy that controls the decisions within the Bank. The levers of control, power, and profit, will not be relinquished willingly.
22. In sum, there seems to be little incentive for the big American players to make radical changes; the big money banks are making a fortune in the present “game”. If any change involved a large, sudden change in the value of the US dollar, the large Creditors (especially China) would object. WHATEVER THE SOLUTION, IT IS GOING TO HAVE TO BE A NEGOTIATED SOLUTION BETWEEN THE MAJOR PLAYERS (creditors and debtors).
THE INTERNATIONAL MONETARY FUND ( IMF ) AND THE SDR
23. The IMF was formed at the time of Bretton Woods, in 1947. Its purpose was to be a lender of last resort to countries with international debt problems. The vehicle for debt amelioration was the SPECIAL DRAWING RIGHTS (SDR). SDRs are used to settle the accounts between countries. The public does not have access to its facilities.
24. There are 188 member countries. Policies are voted upon by the members according to a quota system. The US has the controlling quota for voting purposes, so if the US does not want a proposed policy, it does not happen. When the US had the major share of GDP in the world, this dominant position was accepted by the other countries. However, US GDP is now less than 25% of world GDP and other countries want their voices heard now.
25. The SDR was composed of a basket of “reserve currencies”( US dollar; UK pound; Euro; Swiss Franc; Japanese Yen). In 2012, the Canadian dollar and the Australian dollar were added. The SDR value is a weighted average of the exchange rates of these 7 currencies.
26. Periodically, the IMF meets to consider adding currencies to the SDR basket. Their deliberations are held in secret, but the speculation is that the Chinese Yuan will be added to the SDR basket this October, and the voting rights of the IMF may be adjusted, giving countries like China, and the developing countries, more say in the direction and policies of the IMF. If these adjustments are made, the IMF would become a natural forum in which further negotiations on the role of the dollar, and the international monetary system as a whole, could take place.
27. Introducing the Chinese Yuan into the SDR basket would give it more prominence in international trade and settlements. It will take time though for the Yuan to be a full partner in the “reserve currency” arena with the US dollar; it does not have the liquidity (availability) to be extensively used in international payment settlements. Also, China still has capital controls on its currency. And its bond market is not sufficiently large to support a prominent reserve status role. Until such restrictions are completely eliminated the Chinese Yuan cannot play a full “reserve currency role”. But China is starting to make bilateral trade agreements in which the Yuan becomes the currency of settlement. Further, a number of centres, including Canada, are offering direct foreign exchange trading, between the local currency and the Yuan, without having to use the US dollar as an intermediary. These developments will take time to gain in importance, but their increasing use will divert international settlements away from the US dollar, leading to less demand for US dollars, and its consequent devaluation.
28. Involving the IMF, and the SDR, does not fully resolve another problem; the requirement for an “anchor” for the reserve currency. The SDR, relying on the weighted average of the value of several currencies, introduces more stability into the system than just relying on the US dollar, but it does not offer the “strength of an anchor that, say, gold would offer.
29. But if gold were to be introduced as part of the payment system, it would be extremely important to get the “initial price of the gold” right. If gold was going to be a backstop for the element of “trust”, the major players would need roughly the same degree of gold holdings to have equal trust. The US and the European Union have about the same ratio of gold to GDP. China is aggressively accumulating gold, but it is felt that it will take them until about 2020 in order to achieve the same ratio of gold to GDP as the Europeans and the US now have. So we should not expect the “gold component” to be added to any re- arrangements at this time.
30. In the meantime, with the Yuan being added to the SDR basket, the US dollar should decline in importance, and value, relative to the other currencies in the basket, over the intervening period. As long as this devaluation of the US dollar proceeds at an orderly pace, China would probably accept such an arrangement, especially if it was understood that a “gold anchor” was to be introduced by 2020, say.
31. Other countries, such as Russia, who have a good inventory of gold, and are openly hostile to the current US dominance, could push hard, for faster changes. If they, and China, keep establishing bilateral trade arrangements, that exclude the US dollar, and feature their own currencies, we could see some regionalization of currency use, and the formation of “trading blocs” instead of a generalized international trading system. Such arrangements could make the prominent currency within each bloc a reserve currency (multiple reserve currencies) for that grouping of countries, with each having their own “anchor” ( the dominant trading currency in each bloc).
32. Any variation of the above developments would lead to a depreciated US dollar. If the US continues to keep running budgetary deficits, and tries to finance them through the sale of treasury bills, it may be increasingly difficult to find buyers willing to hold such investment assets. The Federal Reserve is buying some 60% of these Treasury bills at this time. If the Fed keeps buying these treasury bills and paying for them with the issue of new money, inflation will eventually ensue, and the dollar will dramatically fall in value relative to other international currencies. The US cannot let such a scenario transpire. THEY MUST NEGOTIATE ANOTHER INTERNATIONAL ARRANGEMENT WITH THEIR CREDITORS BEFORE THE SITUATION, AS DESCRIBED ABOVE, DETERIORATES FURTHER.
33. The Euro zone and Japan have debt issues equally as disturbing as the US. And China is not without its internal debt bubbles.
34. The foregoing descriptions of the international monetary system highlights that we are all sitting on a ticking time bomb. With focused determination, the involved parties can probably start to ameliorate the situation over a 5 year time period. HOWEVER, THE TICKING TIME BOMB DETONATOR IS “TRUST”. As long as events seem to be progressing positively towards an accepted negotiated solution, we might be able to hold the “TRUST ISSUE” at bay. But any BLACK SWAN (random development or miscalculated step by any of the parties) could precipitate a crisis, and chaos.
35. All of the major players in the foregoing story are all experiencing aging, falling populations. With declining labour forces, it will be very difficult for any of them to experience strong economic growth.
36. If the trend leads to regional trading blocs (a multiple reserve currency world), such a development would further dampen economic growth worldwide. Austria has just announced that it has asked England to return 63% of its gold being held in the Bank of England. The New York Fed holds 57% of the worlds’ gold reserves. When gold is transferred between countries, it is just relabelled in the vaults of the New York Fed. So seeking actual physical transfers of gold, such as in the Austrian case, is not typical. It suggests a lack of trust in the system. Such moves, if widespread, may well accelerate the movement towards regional trading blocs.
37. The US, with its expected continued emphasis on immigration, is the only major country amongst this group that can expect continued population increases. With its cultural orientation of invention and innovation, there is every expectation that in the longer term the US should do well. Their problem is short to medium term; excessive debt, and crony capitalistic institutions in need of reconstruction.
38. The implications of the foregoing description are time dependent.
a. In the short run, where the problems in Europe, Japan, and others, seem more imminent, money may well gravitate to the US in search of security; this may strengthen the dollar in the short term, but it has to be seen as a temporary development. The dollar is going to have to be devalued (or other currencies revalued) in order to fix its debt problems.
b. Analysts, such as Harry Dent, who give prominence to demographic developments, feels there is a major “crash” coming in both financial assets, and commodities (including gold) . If such developments occur within the next 2 years, as he expects, the price of gold is likely to drop from its current level. He also expects the US dollar to increase in value, driven by a flight to safety by non-American investors. Apart from a rise in the US dollar, caused by this flight to safety, his remaining expectations of significant crashes in stocks, bonds, and real estate, can be seen as compatible with our concern for the chaos that could be generated by “lack of trust” in the US dollar. Dent’s expectation derives from domestic developments, underpinned by demographics. The “lack of trust” development arises from concerns abroad, outside the US, over the concern for the US’s ability to repay its international debts. The timing, and the source of the potential chaos, differs, one domestic, the other international, but the consequences, while not identical, are projected to have similar effects.
c. What could divert such a prognosis. Any weakening in the price of gold would enable China to unload US dollars more quickly, in exchange for gold. The sooner China can build up its ratio of “Gold to GDP”, the sooner that longer term negotiations could be initiated, leading to a more stable international monetary system, including a “role for gold”. In such an arrangement, the price of gold would be paramount to its success. The current thinking is that the price of gold would have to be at least $7000 US per oz.; and maybe as high as $10,000, with the median price around $8500 per oz. Such developments would dilute Dents’ expectation of falling gold prices. It could be the catalyst for turning around other markets. However, as we have emphasized elsewhere, it may well take until 2020 for these conditions to develop. Dent expects the major downturns between now and 2017. We can see that the timing of developments, while critical, is not totally clear. But the risks are clearly on the side of chaos.
d. Another catalyst for chaos would arise if the US has difficulty selling treasury bills to finance its continuing government deficits. Interest rates would start to rise in the US. Inflation could also ensue. The US markets could be very disruptive, with significant relative changes in asset values; and bankruptcies.
e. There is a rumour that if gold was revalued excessively, the US government could confiscate the gains from people holding gold, either through a tax, or outright confiscation. This is what happened in the 1930’s when the US went off the gold standard; people were given US dollars, at the old price, for their gold, and then the government immediately after raised the price of gold.
f. The US will not willingly accede to a role for gold in any new arrangement. It would mean that financial market rates could not be as easily manipulated through monetary policy, diluting the profits of the big city banks; and diluting the bureaucratic power, and control, of the academics involved in the Fed.
39. All of the actions identified above, are being conducted in secrecy by the organizations involved. The public will not know what is going to occur until announced after the fact. But analysis and potential plans for action are going on at the present time. The recent emails, revealed in the UK, that showed that the Bank of England is engaged in war games, testing alternative scenarios, in the event of exit from the EURO, is a case in point.
WHAT SHOULD WE DO AS INDIVIDUALS
40. The underlying threat for individuals is risk. A risk free asset is one in which there is no counterparty. There are degrees of counterparty risk. Physical gold, if owned outright, and held in person, involves no counterparty risk. We are often told that gold is a poor investment as it pays neither interest nor dividends. But an investment return is comprised of two parts: a component based on a riskless return, and a risk component of return. The riskless component, today, is miniscule, so we are not giving up much return in this regard. But we have a potential return, based on risk , that may seem worthwhile to some. Gold, embodying this risk component, is what makes it an asset class worth considering.
41. Paper gold (exchange traded funds (ETFs), purporting to hold gold, involve the risk of the physical gold not being present in the fund in the amount represented by the value of the ETF. An ETF may also hold the counterparty risk of the persons, or organization, responsible for the ETF. If the party went bankrupt, we would still be at risk, even if we held the ETF.
42. Cash, held in person, is dependent upon the solvency of the government in question, and the volatility of exchange rates. Cash held in a bank account involves the counterparty risk of the bank solvency. Cypress confiscated all bank account money in excess of 100,000 euros; changed legislation in such cases illustrates another component of counterparty risk.
43. Land owned outright seems safe. However, with land we are giving up liquidity, and the tax jurisdiction within which the land resides could unilaterally raise taxes when in difficulty.
44. Commodities (hard assets) may well be good places to be, although obviously not without some risk. They also have varying degrees of liquidity which, depending on the distribution of your other assets, and income streams, may be important. The value of commodities, like oil, are also contingent upon demand in industrial use.
45. Bonds obviously hold the counterparty risk of the issuing entity. Changes to interest rates also poise an intermediate term risk, up to the term of maturity.
46. Common stock obviously involves the counterparty risk of the company whose stock one holds. The assessment of such risk is contingent upon the business prospects of the company, in the face of the degree of chaos implied in the foregoing analysis.
47. Art work, contingent upon the prominence of the artist, may be useful, if liquidity is not a serious concern.
48. IN SUM, FROM MY PERSPECTIVE, THE DOMINANT CHARACTERISTIC WE SHOULD BE LOOKING FOR, IF ADVERSE CONDITIONS PREVAIL, IS “SAFETY OF CAPITAL”, WITH ONLY SECONDARY THOUGHT BEING GIVEN TO RETURN ON INVESTMENT. Both safety of capital and rate of return on investment are contingent upon counterparty risk in most asset choices. Commodities (gold; silver; etc.) if owned outright, and held in person, eliminate counterparty risk. Other asset choices involve varying degrees of counterparty risk. Counterparty risk, and outright government confiscation (by decree or taxing authority), are the dominant potential developments against which we must protect ourselves, in seeking safety of capital.
49. The foregoing analysis suggests a high probability of market chaos in the nearer term, whether initiated by domestic catalysts, as Dent expects, or by external stimuli, arising from eroding “trust” in the US dollar.
50. The best case scenario seems to involve some form of negotiated arrangement for a new international monetary system. But such an arrangement, if it involves a role for gold, is unlikely to occur before 2020.
51. Further deterioration in the trust for the US dollar, without a negotiated settlement, could lead to multiple regional reserve currencies, based on trading blocs. If such arrangements materialize, it will mean more volatility in exchange rates, and slower economic growth for all countries involved. The world demographics already indicate slower economic growth going forward, and regional trading blocs would further reduce such growth prospects.
52. It is possible that an interim arrangement, involving only the SDR, with the Chinese Yuan added to the SDR basket of currencies, without a role for gold, could emerge as an intermediate solution. But it would likely be an unbalanced situation, awaiting a more permanent arrangement.
53. Finally, we must ask if we can imagine any other developments that will avoid all of the disruptive developments brought forth in this analysis. The only option that I could imagine is that the “trust issue” is allayed somewhat, perhaps on the promise of US changed behaviour. However, I am not optimistic in such a development.
54. A recent book, by Ian Bremmer entitled Superpower, analyses the strategic policy options that the US could realistically adopt going forward. His conclusion is that the US would be best served by focusing on its internal domestic issues, with a pull back from its role as policeman for the world. If Bremmer is right in the potential US choice, it would reinforce the multiple currency reserve system.
55. In such a multiple reserve currency world, Canada’s primary world would be found within the US sphere of influence. Our energy industry would be focused on North American energy markets.
Similarly, manufacturing and other industries would probably be focused on the North American market also. The Canadian dollar would probably correlate with the movements of the US dollar.
56. I have tried to give an even handed analysis in the foregoing text. While I will continue to search for alternative scenarios, the above text seems, to me, to be the most realistic expectation of what we might expect for the next 5 years. It does not eliminate the prospect of any BLACK SWANS, such as a Greek debt default and exit from the Euro, or a military conflagration in Eastern Europe, the South China sea, or the middle east. If any such Black Swans materialize, all the chaos implied above would release forces in an unpredictable order.
57. The dominant catalysts are “demographics” and “a failure of trust”. The demographics cannot be changed. Forces outside the US will determine when, and if, a failure in “trust” occurs. The most critical period is likely to be over the next 5 years. Our only personal recourse is to strive to protect our capital during this period.