Category Archives: reserve currency

The World Bank’s “new gold standard”–what’s that about?

November 9, 2010 By in China, economics, Gold, Recent Market Action, reserve currency Tags: , , , , , , , , Leave a comment

Robert Zoellick, an American who’s head of the World Bank, has recently called, in an op-ed piece in the Financial Times, for the nations of the world to agree to a new framework of international economic cooperation that would be tied together using gold as a “reference point” for value.  “…markets are using gold as an alternative monetary assets today,” he writes.  Gold shot up on this news.  There’s also been an outpouring of nasty comments by professional economists deriding the idea as nonsense.  What is this about?

gold (my view, anyway)

I’ve come to realize that–contrary to my conscious belief that I don’t care that much one way or the other about gold–that I actually do have deep-seated convictions about gold.  Unlike some of my other beliefs, they’re not simply plucked out of the blue, but derive from my having spent close to ten years analyzing natural resources industries, especially metal miners.  This was at a time when, having virtually bankrupted themselves developing massive deposits of base metals, miners were concentrating on gold. (That’s because gold deposits offer high value in small deposits, making them faster and cheaper to develop.)  At the same time, I was also studying the developing countries that are the main sources of demand for the yellow metal (you can find more under the “gold” tab on my blog).  I have three basic conclusions.

1.  Gold is not some sort of proto-money, Ur-money or the “essence” of money.  It’s a metal that used to act as money, but doesn’t in most places any more.  Its virtues are that a small weight/volume contains a lot of value.  You can wear it.  You can break off little pieces to buy stuff.  And, if you want, you can bury it in the back yard so no one–especially the government–knows you have it.  It’s also great if you don’t trust the banks to give back the money you have on deposit.

If you don’t need these attributes, gold is a waste of effort.  You have to safeguard it.  You have to assay it all the time in significant transactions.  And you have to deal with a potentially large bid-asked spread.

2.  Gold doesn’t give inflation protection.  Yes, it has gone up a lot during the past decade.  But that’s not the same as protecting against inflation.  Since 2000, the price level in the US has risen by about 25%.  Gold is up by 450% during the same period.  Not a great match.

From 1980 to 2000, the domestic price level rose by about 80%.  The gold price fell by over 50% during those two decades.

3.  The more you look, the less historical evidence there is for any of the gold bugs claims.  Maybe this is #2 all over again.  But, for example, during the early days of the nineteenth century, metal coins were used as a common medium of exchange in the US.  But they were silver, not gold.  And Spanish coins were preferred to ones from the US, because of their higher purity.

a “true” gold standard

In its purest and simplest form, this means that the money that circulates is either itself gold or is exchangeable into a specified amount of gold on demand.

I don’t think any serious student of economics or history advocates a gold standard in this sense, despite its two positive points:

1.  Governments can’t just print money, willy nilly, to pay for stuff.  No extra gold means no extra money.

2.  Countries have to watch their foreign exchange positions carefully.  A trade deficit is extremely dangerous.  If a creditor nation were to exchange its holdings of a deficit country’s currency for gold, instead of putting the money into the latter country’s government bonds, it would shrink the money supply of the deficit country–causing a recession.

The negatives of such a system outweigh the positives, however.   First of all, the two positives are themselves two-edged swords.  The first would likely prevent a government from taking counter-cyclical economic measures, subjecting it to periodic very violent economic downturns.  The second potentially turns commerce into a political/military battleground, where it is possible to inflict terrible economic damage on a country by redeeming its currency.

Then, of course, there are issues related to the world’s physical supply of gold.

–It is often pointed out that a static, or very slowly growing supply of gold would mean similar limits on world economic growth.

–One might also look back to the effects of the mid-nineteenth century California gold rush, which made millionaires of many Westerners, including the maker of Levi’s jeans, but unleashed a horrible wave of inflation at the same time that destroyed the real value of the savings of just about everyone else.

–Then, of course, there’s my favorite worry.  It’s that a real-life Goldfinger might steal the gold reserves of a given country (likely a small one), thereby rendering its money worthless and stopping its economy in its tracks.

so, what is Mr. Zoellick after?

He knows all this.   In fact, in any proposal over the years that advocates a return to gold, if you read carefully (or read at all), what’s being said has virtually nothing to do with gold per se.  the “gold” part only provides political cover for countries to agree to a course of action which may imply that they’ve been negligent or imprudent in the past, but doesn’t require that they admit it.  And it allows politicians to deflect blame from themselves if an agreement requires painful measures in the future.  After all, it’s not as if they would be choosing to inflict pain.  Gold is forcing them to.

In this case, the issues are obvious.  Politicians in Washington, and in many capitals in Europe, have been stunningly incompetent in managing economic affairs for a long time.  The Great Recession is only one manifestation of this.  China has reached the point where export-oriented emerging economies have always faced their most difficult challenge–persuading the powerful beneficiaries of the status quo that the country must turn away from exports and toward developing the domestic economy.  All sides realize it is likely political suicide to be seen to be “giving in” to the other.

In this case, popular myths about gold can be made to serve a useful purpose.  Maybe I’ve got to warm up to gold, in this sense at least, after all.

 

 

Martin Wolf: the ants and the grasshoppers

May 28, 2010 By in Asian economic development, Balance of Payments, China, currency effects, economics, Hong Kong, Japanese development, reserve currency, Strategy Tags: , , , , , , , , , Leave a comment

Martin Wolf, one of my favorite economic commentators, recently wrote an update of the fable of the ant and the grasshopper (actually a cicada, but…) in the Financial Times.

Aesop

In the original story, attributed to Aesop, the ant works all summer to store up food for the winter while the grasshopper plays.  When the weather turns bad, the grasshopper asks the ant for aid.  He is rebuked for his idleness and left to die.

Wolf

In the Wolf version, there are industrious “ant” countries (China, Germany and Japan), which produce goods and export them to lazy “grasshopper” countries (like the US, UK and the PIGS) who dabble in activities like real estate, which by and large generate no economic return.  (that is:  if you build a factory, you can make stuff in it that you can sell at a profit.  If you build a beach house, it just sits there.  It’s like buying a very expensive home entertainment system.)

The grasshoppers get the money to do this by borrowing from the ants’ banks, using their real estate as collateral.

At some point, the ants figure out what’s going on and realize they’ve made a very bad deal.  The grasshoppers are never going to repay and the collateral is not particularly useful.  On occasion, the grasshopper economies weaken as real estate prices wobble and then fall.  Does the grasshopper government learn the folly of its ways?  No.  It simply lowers interest rates and borrows more from the ants to pump up the real estate market and keep the party going a while longer.

The ants help out because they don’t want to admit that they’ve made all these horrible loans.  So they end up throwing good money after bad.

In the Wolf fable, there are two sets of ants/grasshoppers:  Germany/rest of the EU, and China/EU + US.

me

I think the grasshopper/ant metaphor is a very useful way of framing the structural problems that the US and Europe face today.  In particular, it highlights the fact the Europe is in double trouble:  it’s China’s largest trading partner, and the EU faces the internal Germany/Greece dilemma as well.

I think the story needs a couple of nuances to make it a better reflection of today’s global economic situation, though.  For instance:

a post-WWII phenomenon

The first “grasshopper” was the US and the first “ants” were Japan and Europe.   The original relationship benefitted the US, of course, but it was also essential in enabling the rest of the developed world to rebuild after the destruction of their industrial infrastructure during WWII.  Two of todays ants were the initiators of this devastation.

After the fall of the Berlin Wall and the reunion of the two Germanys, that country faced enormous economic difficulties:  the west’s outdated plant and high-cost labor, the pitiful state of the east after almost a half-century of Soviet rule, and the consequences of the inflated exchange rate at which the merger was done.  So Germany really needed grasshopper counterparts to alleviate what would otherwise have been a decade of even greater misery.

not just good and evil

There’s a wider point.  Like the sadist and the masochist (maybe not the best analogy, but the only one I can come up with at the moment), the relationship may not be healthy but both sides do get something out of it.  The ants get technology transfer and the opportunity to radically raise their standard of living.  The grasshoppers get a chance to invest directly in the fast-growing ant economy.  They also get cheaper foreign-made goods.

China is a very unusual ant

For one thing, it’s much larger than any of the others.

It also doesn’t have the hangups of its fellow ants:  Germany’s commitment to make the one-Europe project work, and Japan’s history of extreme deference to the wishes of the US as a result of having lost WWII.

China gets what’s going on.

To me, it gives every indication that it thinks it has gotten all the value it can out of the grasshopper/ant dynamic and is determined to move on.  It has already started to convert its dollar foreign currency reserves into physical assets through foreign acquisitions by state-controlled companies.  Unlike Japan, which has never wanted the yen to be a world currency, China is taking steps to make the renminbi a vehicle of exchange among emerging countries.  It is also trying to grow its way out of its grasshopper problem by strengthening economic ties with other emerging nations.  China won’t thereby reduce the size of its problem of being a creditor to grasshoppers, but it may be able to reduce the significance of these liabilities if it can expand its trade in a healthier way with non-grasshopper nations.

The mess in Greece–any silver linings?

May 2, 2010 By in Balance of Payments, economics, emerging markets, government debt trap, reserve currency Tags: , , , , 2 Comments

the mess

When Greece was admitted into the EU about a decade ago, there were suspicions that the country had fudged its economic numbers a bit to meet the minimum criteria for entry. But the EU chose to look the other way.  In the middle of the decade, more evidence of cheating was uncovered, but again the EU chose to look the other way.

the discovery

Last year, after a change of government, the new administration confirmed that Greece had indeed been cooking the books in its reports to the EU , to its citizens and to the outside world, in a major way for years.

With a lag of some months, these revelations have sparked the currency and bond crisis, akin to the Asian developing market worries of 1997, that we are in now.

positives?

We all know the negatives.  Are there any positives to be taken from the situation?  I think so.  Specifically,

1.  Better now than a year ago, when the whole world was falling apart.

2.  It appears that the EU is finally going to address the Greece issue instead of papering it over.  Germany, ever the economic policeman of Europe, seems unwilling to move down a slippery slope of denial and compromise. And even if it were, world government bond markets will no longer allow that to happen.  It’s unclear what the ultimate outcome for Greece will be—the two polar cases are its leaving the EU and and an IMF-led policy overhaul—but some thing definitive will happen.

3.  The Greece situation probably puts an end for a long while to the idea that the euro can replace the dollar as the world’s reserve currency, or even serve as a viable second team substitute.  This probably buys some time for the US to get its own fiscal house in order, but I think that’s a mixed blessing.

The implication for China, which is already offloading dollars through acquisitions and foreign aid as fast as it can, of the unsuitability of the euro as a home for its foreign currency reserves is to push harder to advance the renminbi as a medium for inernational trade.

3.  Germany vs. Greece can easily be seen as the pattern for the way a possible confrontation years down the road between China and the US might develop.   As such, it may serve as a salutary warning to the US.  I would particularly note that the Greek crisis came out of nowhere but quickly developed a savage intensity.  Scary.  And hopefully motivation to avoid the Greek outcome through sensible economic policy at any cost.

(On the other hand, given the strange (to me) way Washington operates, politicians could easily regard the real failing of Greece to be ruling out devaluation as an option by entering the EU.  This would imply that Congress and the sitting administration should set the inflationary ball rolling sooner rather than later.  Not good.  Also not a silver lining, and therefore a topic for another day.

US dollar as the world’s reserve currency–potential problem for the US(II)–today

August 21, 2009 By in Asian economic development, China, economics, reserve currency Tags: , , Leave a comment

From Bretton Woods…

It has been almost 40 years since the Bretton Woods fixed exchange rate agreement that served the world well in the years immediately after WWII fell apart.  What’s different today?

–to a new world order

1.  The US is no longer the dominant economic force in the world.

a.  Germany, Japan, and to a lesser extent the UK, have returned to their former great power status.

b.  The major countries of Europe have formed the EU, a loose economic and political confederation aimed at counterbalancing US might and which has encouraged the development of large, multinational firms headquartered there.

c.  China and India have emerged as world economic powers, by some measures bigger than all other countries save the US and Japan.  Brazil is not far behind.  And Russia is reestablishing a more prominent place in the world order.

2.  Periodic crises like the collapse of the European Exchange Rate Mechanism in the early Nineties or the Asian crisis in the second half of that decade have shown that fixed currency regimes without sound economic policies underpinning them are a recipe for disaster.  It has also become clear that the central banks of even the largest economies have much less power in the currency markets than the international commercial banks.  So intervention in the currency markets in pursuit of a national objective have by and large become a thing of the past. Therefore,

3.  Ensuring currency stability has become a function of international coordination of sound money and fiscal regimes.  This has taken on increasing importance as global growth has been more and more driven by world trade.

4.  Currencies are now by and large fiat currencies, no longer convertible into gold or silver, but deriving their value from the economic soundness of the issuer.

5.  The universal good will toward the US stemming from its behavior during and after WWII–which, after all, ended almost 65 years ago–and which permeated the Bretton Woods era, is gone.  A new generation of leaders, none of whom experienced the war itself or the reconstruction period immediately following, is in charge in most countries, including the US.  These leaders, justifiably, see no reason there should be one set of rules of conduct for the US and another for the rest of the world.

Still, the US dollar rules

Nevertheless, Continue reading →

US dollar as the world’s reserve currency: what it means and why it’s a potential problem for the US (I) Bretton Woods

August 19, 2009 By in economics, reserve currency Tags: , , , Leave a comment

Two posts

This topic will be in two posts.  In this one, I’ll try to sketch how the post-WWII currency system was set up and why it eventually broke apart.  In the second post, I’ll talk about how I think the present situation compares with that time and how our current federal budget deficit poses a serious threat to US economic power similar to that of the Sixties.

Foreign exchange

In even the simplest world where there are a number of different countries, each with its own currency, but all wanting to trade with one another, the issue of foreign exchange comes up.  The grower of American corn, for example, probably wants to be paid in dollars.  The maker of German printing presses expects to be paid in marks (or, in today’s world, in euros).  The Mexican buyer of either not only wants to know the peso price of each, he needs to have a currency market where he can exchange his pesos for the appropriate foreign currency.

Previous, unofficial, reserve currencies

There have been times in the past when one country has held a leading position in wealth, culture, prestige, military power or something else that has resulted in its currency being used in other countries as well.  In the 18th and 19th centuries, for example, the Spanish real de a ocho (dollar, or piece of eight) was an accepted medium of exchange in large parts of the world.  In the US it was preferred for its greater purity to the output of our own government mints.  During the same period, Spanish gold often formed the basis for many countries’ official foreign currency reserves.

Bretton Woods makes the US dollar the first explicit reserve currency

The idea of using an individual country’s currency as a standard for transactions in many countries took a quantum leap forward after the World War II.  Large portions of the industrial bases of most major combatants had been destroyed in the course of the fighting.  National treasuries were severely depleted by the cost of waging the war, as well.  The United States, however, had emerged from the conflict relatively unscathed and had become, by default if nothing else, by far the most powerful industrial country on earth.

The Bretton Woods agreements ratified shortly after the end of the war established a new world monetary system.   The US volunteered to stand squarely at its center.  The signatories agreed to establish the value of their own currencies in terms of  US dollars at a pre-determined, fixed, exchange rate.  The US, which at that time held over half the world’s official gold reserves, pledged to act as the central currency in the system and provide liquidity to the rest of the world.  It also agreed to anchor the accords to gold, by committing itself to exchange dollars for gold a the fixed rate of $35 per ounce.  In effect, the US became the central banker for the world.

The Bretton Woods collapse

The Bretton Woods arrangement lasted over twenty years before collapsing in 1971, when in the face of sharply depleted gold reserves, the US declared it would no longer exchange dollars for gold at $35 an ounce.

Why the change of heart?–or, the better question, what strains in the fixed rate system caused its collapse?

There were two key ones:

1.  The initial exchange rates had been fixed at a relatively high rate for the dollar, as a way of trying to stimulate growth of export-oriented manufacturing in the countries ravaged by the war.  Twenty years later, thanks in part to the Marshall Plan and other US aid programs, Europe and Japan had reindustrialized.  Their plants were brand-new, and more efficient than the US industrial base, which, was still using, for example, blast furnaces for steel built in the 1800s.  Their countries were growing more rapidly than the US.  In 1970, the exchange rates fixed in the late Forties were no longer appropriate and would have to change.

2.  Since everything in the system was explicitly or implicitly priced in dollars, the US had volunteered to provide enough dollars to the rest of the world to allow world trade to grow.  This outflow of dollars was not necessarily the best thing for the long-term health of the domestic American economy.

More important, Washington soon figured out that its central position gave it an unparalleled opportunity to “game” the system.  If the budget didn’t balance, why raise taxes or cut out some pork barrel projects.  Instead, use our position as the world’s banker to print up a few more dollars to cover the shortfall.  Who would notice?

At first no one did–or grateful for the generosity of the US in helping the world rebuild after the war, they pretended not to notice and just absorbed the “extra” Treasury bonds as part of their national foreign currency reserves.  But by the mid-Sixties, the US government was financing the ambitious social programs of the War on Poverty as well as the war against North Vietnam (as part of the larger Cold War), not by raising the necessary taxes or trimming expense, but by printing a lot more dollars than the system needed or wanted.

As US debts to the rest of the world mounted, foreign governments eventually showed their displeasure at US economic and foreign policy in the only way they could.  They began to liquidate their holdings of US government bonds by cashing them in for gold.

By 1971, this pressure was great enough that the Bretton Woods system fell apart.

Transition to a new order

What took its place?  The outlines of the currency situation we have now.

–US remained the dominant–though no longer the sole–economic power in the world, so the dollar retained its key role in world commerce.

–But the link to the gold price was gone.

–Currency prices were no longer officially fixed, but were allowed to fluctuate based on supply and demand.  –Initially, governments attempted to nudge currencies in the direction they preferred.  But as time passed, the trading desks of large commercial banks grew to dwarf the power of individual government treasurers. As a result, government attempts to set currency policy by establishing a specified rate of exchange in the market began to disappear.

In my next post:  where we are now.