The first step would be a global monetary conference, similar to Bretton Woods, where participants would agree to establish a new global monetary unit. Since the SDR already exists, it is a perfectly suitable candidate for the new global money. But this new SDR would be gold backed and freely convertible into gold or the local currency of any participant in the system. It would not be the paper SDR that exists today.
The system would also have to be two-tiered. The top tier would be the SDR, which would be defined as equal to a specified weight in gold. The second tier would consist of the individual currencies of the participating nations, such as the dollar, euro, yen, or pound sterling. Each local currency unit would be defined as a specified quantity of SDRs. Since local currency is defined in SDRs, and SDRs are defined in gold, by extension every local currency would be worth a specified weight in gold. Finally, since every local currency is in a fixed relationship to SDRs and gold, each currency would also be in a fixed relationship to one another. As an example, if SDR1.00 = €1.00, and SDR1.00 = $1.50, then €1.00 = $1.50, and so on.
In order to participate in the new gold SDR system, a member nation would have to have an open capital account, meaning that its currency would have to be freely convertible into SDRs, gold, or currencies of the other participating members. This should not be a burden for the United States, Japan, the Eurozone, or others who already maintain open capital accounts, but it could be an impediment for China, which does not. However, China may find the attractions of a nondollar, gold-backed currency such as the new SDR sufficiently enticing that it would open its capital account in order to join and allow the new system to succeed.
Participants would be encouraged to adopt the new gold SDR as a unit of account as broadly as possible. Global markets in oil and other natural resources would now be priced in SDRs rather than dollars. The financial records of the largest global corporations, such as IBM and Exxon, would be maintained in SDRs, and various economic metrics, such as global output and balance-of-payments accounts, would be computed and reported in SDRs. Finally, an SDR bond market would develop, with issuance by sovereign nations, global corporations, and regional development banks, and with purchases by sovereign wealth funds and large pension funds. It might be intermediated by the largest global banks, such as Goldman Sachs, under IMF supervision.
One of the more daunting technical issues in this potential global gold SDR system is the determination of the proper fixed rates at which currencies can convert to one another. For example, should €1.00 be equivalent to $1.30, $1.40, $1.50, or another amount? This is essentially the same issue that the founders of the euro faced after the Maastricht Treaty was signed in 1992, which committed the parties to create a single currency from diverse currencies such as the Italian lira, the German mark, and the French franc. In the euro’s case, years of technical study and economic theory developed by specialized institutions were applied to the task. Technical consideration is warranted today, too, but the best approach would be to use market signals to solve the problem. The parties in the new system could announce that the fixed rate would be determined in four years based on the weighted average of bank foreign currency transactions during the last twelve months prior to the fixing date. The four-year period would give markets sufficient time to adjust and consider the implications of the new system, and the twelve-month averaging period would smooth out short-term anomalies or market manipulation.
The most challenging issue involves the SDR’s value measured in a weight of gold, and the fractional gold reserve required to make the system viable. The problem can be reduced to a single issue: the implied, nondeflationary price of gold in a global gold-backed monetary system. Once that issue was resolved with respect to one numeraire, conversion to other units of account using fixed exchange rates would be trivial.
Initially, the new system would operate without an expansion of the global money supply. Any nation that wanted SDRs could buy them from banks or dealers, earn them in trade, or acquire them from the IMF in exchange for its own currency. Local currency delivered to the IMF in exchange for SDRs would be sterilized so the global money supply did not expand. Discretionary monetary policy would be reserved to national central banks such as the Fed and ECB, subject to the need to maintain fixed rates to gold, SDRs, and other currencies. The IMF would resort to discretionary monetary policy through the unsterilized creation of new SDRs only in extraordinary circumstances and with approval of a supermajority of IMF members participating in the new system.
Given these constraints on the creation of new SDRs, the system would launch with the SDR as an anchor and unit of account but a relatively small amount of SDRs in existence. The combined base money supplies of the participants would constitute the global money supply, as it does today, and that money supply would be the reference point for determining the appropriate price for gold.
Another key issue would be determining the amount of gold backing needed to support the global money supply. Austrian School economists insist on 100 percent backing, but this is not strictly required. In practice, the system requires only enough gold to supply anyone with a preference for physical gold over gold-backed paper money, and adequate assurance that the fixed gold price will not be changed once established. These two goals are related; the stronger the assurance of consistency, the less gold is required to maintain confidence. Historically, gold standards have operated successfully with between 20 percent and 40 percent backing relative to money supply. Given the abandonment of gold in 1914, 1931, and 1971, a high figure will be required to engender confidence by justifiably cynical citizens. For illustrative purposes, take 50 percent of money supply as the target backing; the United States, the Eurozone, China, and Japan as the participating economies; global official gold holdings as the gold supply; and M1 as the money supply. Dividing the money supply by the gold supply gives an implied, nondeflationary price for gold, under a gold-backed SDR standard, of approximately $9,000 per ounce.
The inputs in this calculation are debatable, but $9,000 per ounce is a good first approximation of the nondeflationary price of gold in a global gold-backed SDR standard. Of course, nothing moves in isolation. The world of $9,000-per-ounce gold is also the world of $600-per-barrel oil, $120-per-ounce silver, and million-dollar starter homes in mid-America. This new gold standard would not cause inflation, but it would be a candid recognition of the inflation that has already occurred in paper money since 1971. This one-time price jump would be society’s reckoning with the distortions caused by the abuse of fiat currencies in the past forty years. Participating nations would need legislation to nominally adjust fixed-income payments to the neediest in forms such as pensions, annuities, social welfare, and savings accounts up to the insured level. Nominal values of debt would be left unchanged, instantaneously solving the global-sovereign-debt-and-deleveraging conundrum. Banks and rentiers would be ruined—a healthy step toward future growth. Theft by inflation would be a thing of the past, for as long as the system was maintained. Wealth extraction would be replaced with wealth creation, and the triumph of ingenuity could commence.
Discretionary monetary policy conducted by national central banks would be preserved in this new system. Indeed, the percentage of physical gold backing the currency issues could even be increased or decreased from time to time if needed. However, central banks participating in the system would be required to maintain the fixed gold price in their currency by acting as buyers and sellers in physical gold. Any central bank perceived as too easy for too long would find citizens lined up at its doors and would be quickly stripped of its gold. IMF gold-swap lines backed by other central banks would be made available to deal with temporary adjustment requirements—an echo of the old Bretton Woods system. These gold market operations would be conducted transparently to instill confidence in the process.
Importantly, the IMF would have emergency powers to increase the SDR supply with the approval of a supermaj
ority of its members to deal with a global liquidity crisis, but SDRs and national currencies would remain freely convertible to gold at all times. If citizens had confidence in the emergency actions, the system would remain stable. If citizens perceived that money creation was occurring to rescue elites and rentiers, a run on gold would commence. These market signals would act as a brake on abuse by the IMF and the central banks. In effect, a democratic voice, mediated by market mechanisms, would be injected into global monetary affairs for the first time since the First World War.
Austrian School supporters of a traditional gold standard are unlikely to endorse this new gold standard because it has fractional, even variable gold backing. The conspiracy-minded are also unlikely to support it because it is global and has the look and feel of a new world order. Even the milder critics will point out that this system depends completely on promises by governments, and such promises have consistently been broken in the past. Yet it has the virtue of practicality; it could actually get done. It forthrightly addresses the problems of deflation that would occur if the United States took a go-it-alone approach, and it mitigates the hyperinflationary shock that would result if fractional backing were not used. The new gold standard comes close to Mundell’s prescription that the optimal currency zone is the world, and it revives a version of Keynes’s vision at Bretton Woods before the United States insisted on dollar hegemony.
Most profoundly, a new gold standard would address the three most important economic problems in the world today: the dollar’s decline, the debt overhang, and the scramble for gold. The U.S. Treasury and Federal Reserve have decided that a weak-dollar policy is the remedy for the lack of world growth. Their plan is to generate inflation, increase nominal aggregate demand, and rely on the United States to pull the global economy out of the ditch like a John Deere tractor hitched to a harvester up to its axles in mud. The problem is that the U.S. solution is designed for cyclical problems, not for the structural problems that the world currently faces. The solution to structural problems involves new structures, starting with the international monetary system.
There is no paper currency that will come close to replacing the dollar as the leading reserve currency in less than ten years. Even now the dollar is being discarded and gold remonetized at an increasing tempo—both perfectly sensible reactions to U.S. weak-dollar policies. The United States and the IMF should lead the world to the gold-backed SDR, which would satisfy Chinese and Russian interests while leaving the United States and Europe with the leading reserve positions. The world cannot wait ten years for the paper SDR, the yuan, and the euro to converge into Barry Eichengreen’s “Kumbaya” world of multiple reserve currencies. The consequences of misguided monetary leadership will be on display in far fewer than ten years.
CHAPTER 10
CROSSROADS
I’m the fellow who takes away the punch bowl just when the party is getting good.
William McChesney Martin Jr.
Chairman of the Federal Reserve Board, 1951–70
The trouble is that this is no ordinary recession, and a lot of people have not had any punch yet.
Kenneth Rogoff
June 6, 2013
Developed countries have no reason to default. They can always print money.
George Soros
April 9, 2013
■ The Inflation-Deflation Paradox
Federal Reserve policy is at a crossroads facing unpleasant paths in all directions. Monetary policy around the world has reached the point where the contradictions embedded in years of market manipulation have left no choices that do not involve either contraction or catastrophic risk. Further monetary easing may precipitate a loss of confidence in money; policy tightening will restart the collapse in asset values that began in 2007. Only structural change in the U.S. economy, something outside the Fed’s purview, can break this stalemate.
This much was clear by 2013, as weary economists and policy makers waited for the robust recovery they had eagerly anticipated since the stock market rally started in 2009. Annual GDP growth in the United States touched 4 percent in the fourth quarter of 2009, prompting talk of “green shoots” amid signs that the economy was bouncing back from the worst recession since the Great Depression. Even when growth fell to a 2.2 percent annual rate by the second quarter of 2010, the optimistic spin continued, with happy talk by Treasury secretary Timothy Geithner of a “recovery summer” in 2010. Reality slowly sank in. Annual growth was an anemic 1.8 percent in 2011 and was only slightly better at 2.2 percent in 2012. Then, despite predictions from the Fed and private analysts that 2013 would be a turnaround year, growth fell again to 1.1 percent in the first quarter of 2013, although it revived to 4.1 percent in the third quarter.
The economy was in a phase not seen in eighty years. It was neither a recession as technically defined, nor a robust recovery as widely expected. It was a depression, exactly as Keynes had defined it, “a chronic condition of sub-normal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse.” There was no cyclical recovery because the problems in the economy were not cyclical; they were structural. This depression should be expected to continue indefinitely in the absence of structural changes.
Fed forecasters and most private analysts use models based on credit and business cycles from the seventy-odd years since the end of the Second World War. Those baselines do not include any depressions. One must reach back eighty years, to the 1933–36 period, a recovery within a depression, to find a comparable phase. The Great Depression ended in 1940 with structural changes: the economy was put on a war footing. In early 2014 no war was imminent, and no structural changes were being contemplated. Instead, depressionary low growth and high unemployment have become normal in the U.S. economy.
The American Enterprise Institute’s John Makin, who has an uncanny record of accurately predicting economic cycles, pointed out that based on historical patterns, the United States might actually be headed for a recession in 2014—the second recession within a depression since 2007, an eerie replay of the Great Depression. Makin pointed out that despite below-trend growth since 2009, the expansion has lasted over four years and is approaching the average longevity for modern economic expansions in the United States. Based on duration if not strength, U.S. real growth should be expected to turn negative in the near future.
Even if the United States does not enter a technical recession in 2014, the depression will continue, the strongest evidence coming from depression-level employment data. Despite cheerleading in late 2013 about the creation of two hundred thousand new jobs per month and a declining unemployment rate, the reality behind the headline data is grim. As analyst Dan Alpert points out, almost 60 percent of jobs created in the first half of 2013 were in the lowest-wage sectors of the U.S. economy. These sectors normally account for one-third of total jobs, meaning that new job creation was disproportionately low wage by a factor of almost two to one. Low-wage jobs are positions such as the order taker at McDonald’s, the bartender at Applebee’s, and the checkout clerk at Walmart. All work has dignity, but not all work has pay that can ignite a self-sustaining economic recovery.
About 50 percent of the jobs created during the first half of 2013 were part-time, defined as jobs with thirty-five hours of work per week or less. Some part-time jobs offer as little as one hour per week. If the unemployment rate were calculated by counting those working part-time who want full-time work, and those who want a job but have given up looking, the unemployment rate in mid-2013 would be 14.3 percent instead of the officially reported 7.1 percent. The 14.3 percent figure is comparable to levels reached during the Great Depression, a level consistent with an economic depression.
New hiring since 2009 has been roughly equal to the number of new entrants into the workforce in that time period, which means that it did nothing to reduce the total number of those who b
ecame unemployed during the acute phase of the panic and downturn in 2008 and 2009. Alpert also shows that even the supposed “good news” of a declining unemployment rate is misleading because the declining rate reflects those workers dropping out of the workforce entirely rather than new job creation in an expanding labor pool. The percentage of Americans counted in the labor force had dropped from a high of 66.1 percent before the new depression to 63.5 percent by mid-2013. Even with the reduced labor force, real wage gains adjusted for inflation were not being realized, and in fact real wages have been falling for the past fifteen years.
Added to this dismal employment picture is the striking increase in dependency on government programs. By late 2013, the United States had over 50 million citizens on food stamps; over 26 million citizens unemployed, underemployed, or discouraged from looking for work; and over 11 million citizens on permanent disability, many of those because their unemployment benefits had run out. These numbers are a national disgrace. Combined with feeble growth, borderline recession conditions, and over five years of zero interest rates, these figures made talk of an economic recovery seem misplaced.
Though overall conditions suggest a new depression, one element was missing from the portrait—namely, deflation, defined as a generalized drop in consumer prices and asset values. During the darkest stage of the Great Depression, from 1930 to 1933, cumulative deflation in the United States was 26 percent, part of a broader, worldwide deflationary collapse. The United States experienced slight deflation in 2009 compared to 2008, but nothing at all comparable to the Great Depression; in fact, mild inflation has persisted in the new depression, and the official consumer price index shows a 10.6 percent increase from the beginning of 2008 to mid-2013. The contrast between the extreme deflation of the Great Depression and the mild inflation of the new depression is the most obvious difference between the two episodes and is also the source of the greatest challenge now facing the Federal Reserve. It raises the vexing question of when and how to reduce and eventually reverse money printing.
The Death of Money Page 28
