The global gold-to-GDP ratio of 2.2 percent reveals that the global economy is leveraged to real money at a 45-to-1 ratio but with a significant skew in favor of the United States, the Eurozone, and Russia. Those three economies have ratios above the global average; the Eurozone’s ratio at 4.6 percent is more than double the global average. The United States and Russia are in strategic gold parity, the result of Russia’s 65 percent increase in its gold reserves since 2009. This dynamic is an eerie echo of the early 1960s “missile gap,” from a time when Russia and the United States competed for supremacy in nuclear weapons. That competition was deemed unstable and resulted in strategic arms limitations agreements in the 1970s, which have maintained nuclear stability in the forty years since. Russia has now closed the “gold gap” and stands on a par with the United States.
The conspicuous weak links are China, the U.K., and Japan, each with a 0.7 percent ratio, less than one-third the U.S.-Russia ratio and far smaller than that of the Eurozone. Other major economies, such as Brazil and Australia, stand even lower, while Canada’s gold hoard is trivial compared to the size of its economy.
If gold is not money, these ratios are unimportant. If, however, there were a collapse of confidence in fiat money and a return to gold-backed money, either by design or on an emergency basis, these ratios would determine who would have the most influence in IMF or G20 negotiations to reform the international monetary system. On current form, Russia, Germany, and the United States would dominate those discussions.
■ China’s Gold Deception
Once again we find ourselves looking at China. It seems absurd to posit that the international monetary system could be reformed without major participation by China, the world’s second-largest economy (third if the Eurozone is viewed as a single entity). It is known, but not publicly disclosed, that China has far greater gold reserves than it states officially. If Table 2 is restated to show China with an estimated—but more accurate—4,200 tonnes of gold, then the change in ratios is dramatic.
In this revised alignment, the global ratio increases slightly from 2.2 percent to 2.5 percent, putting global gold leverage at 40 to 1. More important, China would now join the “gold club” with a 2.7 percent ratio, equivalent to Russia and the United States and comfortably above the global average.
Table 3. Impact of Chinese Stealth Acquisition on Gold-to-GDP Ratios
Although it is rarely discussed publicly by monetary elites, the increase of China’s gold ratio from 0.7 percent toward 2.7 percent, as shown in the comparison of Table 2 and Table 3, has actually been occurring in recent years. When this gold rebalancing is complete, the international monetary system could move to a new equilibrium gold price without China being left behind with only paper money. The increase in China’s gold reserves is designed to give China gold parity with Russia, the United States, and the Eurozone and to rebalance global gold reserves.
This rebalancing paves the way for either global inflation or gold’s emergency use as a reserve currency, but the path has been complicated for China. When Europe and Japan emerged from the ashes of the Second World War, they were able to acquire gold by redeeming their dollar trade surpluses, since the dollar was freely convertible at a fixed price. U.S. gold reserves declined by 11,000 tonnes from 1950 to 1970 as Europe and Japan redeemed dollars for gold. Thirty years later China was the dominant trading nation, earning large dollar surpluses. But the gold window had been closed since 1971, and China could not swap dollars for U.S. gold at a fixed price. As a result, China was forced to acquire its gold reserves on the open market and through its domestic mines.
This market-based gold acquisition posed three dangers for China and the world. The first was that the market impact of such huge purchases meant that gold’s price might skyrocket before China could complete the rebalancing. The second was that China’s economy was growing so quickly that the amount of gold needed to reach strategic parity was a moving target. The third was that China could not dump its dollar reserves to buy gold because it would burden the United States with higher interest rates, which would hurt China’s economy if U.S. consumers stopped buying Chinese goods in response.
The greatest risk to China in the near future is that inflation will emerge in the United States before China obtains all the gold it needs. In that case, the combination of China’s faster growth and higher gold prices will make it costly to maintain its gold-to-GDP ratio. However, once China does acquire sufficient bullion, it will have a hedged position because whatever is lost to inflation will be gained in higher gold prices. At that point, China can give a green light to U.S. inflation. This move toward evenly distributed gold reserves also explains central bank efforts at price manipulation, as the United States and China have a shared interest in keeping the gold price low until China acquires its gold. The solution is for the United States and China to coordinate gold price suppression through swaps, leases, and futures. Once the rebalancing is complete, probably in 2015, there will be less reason to suppress gold’s price because China will not be disadvantaged in the event of a price spike.
Evidence that the United States is accommodating China’s gold reserve acquisition is not difficult to find. The most intriguing comment comes from Min Zhu, the IMF’s deputy managing director. In response to a recent question concerning China’s gold acquisition, he replied, “China’s acquisition of gold makes sense because most global reserves have some credit element to them; they’re paper money. It’s a good idea to have part of your reserves in something real.” The use of the term credit to describe reserves is consistent with the reality that all paper money is a central bank liability and therefore a form of debt. Treasury bonds purchased with paper money are likewise a form of debt. Min Zhu’s distinction between credit reserves and real reserves highlights precisely the role of gold as true base money, or M-Subzero.
The reaction within the U.S. national security community to China’s gold rebalancing is nonchalance. When asked about Chinese gold acquisitions, one of the highest-ranking U.S. intelligence officials shrugged and said, “Somebody’s got to own it,” as if gold reserves were part of a global garage sale. A senior official in the office of the secretary of defense expressed concern about the strategic implications of China’s gold rebalancing but then went on to say, “The Treasury really doesn’t like it when we talk about the dollar.”
The Pentagon and CIA routinely defer to the Fed and the U.S. Treasury when the subject turns to gold and dollars, while Congress is mostly in the dark on this subject. Congressman James Himes, one of only four members of either party with a seat on both the House Financial Services Committee and the House Permanent Select Committee on Intelligence, said, “I never hear any discussion of gold reserve acquisition.” With the military, intelligence agencies, and Congress all unconcerned or uninformed about China’s acquisition of gold, the Treasury and Fed have a free hand to help the Chinese until the rebalancing is a fait accompli.
Despite the discreet and delicate handling of the global gold rebalancing, there are increasing signs that the international monetary system may collapse before a transition to gold or SDRs is complete. In the argot of chaos theorists, the system is going wobbly. Almost every “paper gold” contract has the capacity to be turned into a physical delivery through a notice and conversion provision. The vast majority of all futures contracts are rolled over into more distant settlement periods, or are closed out through an offsetting contract. But buyers of gold futures contracts have the right to request physical delivery of metal by providing notice and arranging to take delivery from designated warehouses. A gold lease can be terminated by the lessor at the end of its term. So-called unallocated gold can be turned into allocated bars, typically by paying additional fees, and the allocated gold can then be delivered to the owner on demand. Certain large gold exchange-traded fund (ETF) holders can convert to physical gold by redeeming the shares and taking gold from the ETF warehouse.
The potentially destabilizing factor is that the amount of gold subject to paper contracts is one hundred times the amount of physical gold backing those contracts. As long as holders remain in paper contracts, the system is in equilibrium. If holders in large numbers were to demand physical delivery, they could be snowflakes on an unstable mountain of paper gold. When other holders realize that the physical gold will run out before they can redeem their contracts for bullion, the slide can cascade into an avalanche, a de facto bank run, except the banks in this case are the gold warehouses that support the exchanges and ETFs. This is what happened in 1969 as European trading partners of the United States began cashing in dollars for physical gold. President Nixon shut the window on these redemptions in August 1971. If he had not done so, the U.S. gold vaults at Fort Knox would have been stripped bare by the late 1970s.
A similar dynamic commenced on October 4, 2012, when spot gold prices hit an interim peak of $1,790 per ounce. From there, gold fell over 12 percent in the next six months. Then gold crashed an additional 23.5 percent, falling to $1,200 per ounce by late June. Far from scaring off buyers, the gold crash made gold look cheap to millions of individual buyers around the world. They lined up at banks and boutiques, quickly stripping supplies. Buyers of standard 400-ounce and 1-kilo bars found there were no sellers; they had to wait almost thirty days for new bars to be produced by the refineries. The Swiss refineries Argor-Heraeus and Pamp moved to around-the-clock shifts to keep up with gold demand. Massive redemptions took place in gold ETFs, not because all investors were bearish on gold but because some wanted to obtain bullion from the ETF warehouses. COMEX warehouses holding gold for futures contract settlements saw inventories drawn down to levels last seen in the Panic of 2008. Gold futures contracts went into backwardation, a highly unusual condition in which gold for spot delivery is more expensive than gold for forward delivery; the opposite usually prevails because the forward seller has to pay for storage and insurance. This was another sign of acute physical shortages and high demand for immediate access to physical gold.
If a gold-buying panic were to break out today, there is no single gold window for the president to close. Instead, a multitude of contractual clauses, in fine print rarely studied by gold buyers, would be called into play. Gold futures exchanges have the ability to convert contracts to cash liquidation only and to shut off the physical delivery channels. Gold bullion banks can also settle gold forward contracts for cash and deny buyers the ability to convert to allocated gold. The “early termination” and force majeure clauses buried in contracts could be used by banks that sold more gold than they had on hand. The result would be that investors would receive a cash settlement up to the contract termination date, but not more. Investors would get some cash but no bullion and would miss the price surge sure to follow.
While physical gold was in short supply and high demand by early 2014, this did not necessarily mean that a superspike in gold prices was imminent. Not every snowslide turns into an avalanche; at times the avalanche awaits different initial conditions. Central banks still have enormous resources, including potential physical sales with which to suppress gold prices in the short run. Still, an alarm has gone off. The central banks’ ability to keep a lid on gold prices has been challenged, and a new willingness of paper gold buyers to demand physical gold has emerged. As China’s gold-buying operations continue apace, the entire international monetary system is tottering on the knife-edge of China’s aspirations and the global demand for physical gold.
While the gold price oscillates between the forces of physical demand and central bank manipulation, another greater catastrophe is looming: the Federal Reserve is on the brink of insolvency, if not already over the brink. This conclusion comes not from a Fed critic but from Frederic S. Mishkin, one of the most eminent monetary economists in the world and mentor to Ben Bernanke and other Fed governors and economists. In his February 2013 paper “Crunch Time: Fiscal Crises and the Role of Monetary Policy,” written with several colleagues, Mishkin warns that the Fed is dangerously close to the point where its independence is fatally compromised and its sole remaining purpose is to monetize deficit spending by causing inflation.
Mishkin and his coauthors make better use of complexity theory and recursive functions in their analysis than any of their peers. They point out the feedback loop in sovereign finance among larger deficits, followed by higher borrowing costs, which cause even larger deficits and still higher borrowing costs, and so on, until a death spiral begins. At that point, countries are faced with the unpalatable choice of either reducing deficits through so-called austerity measures or defaulting on the debts. Mishkin argues that austerity can hurt nominal growth, worsening the debt-to-GDP ratio, and possibly causing a debt default in the course of trying to stop one.
The alternative, in Mishkin’s view, is for a central bank to keep interest rates under control by engaging in monetary ease, while politicians enact long-term deficit solutions. In the meantime, short-term deficits can be tolerated to avoid the austerity curse. Short-term monetary and fiscal ease work in tandem to keep an economy growing, while long-term fiscal reform reverses the death spiral.
Mishkin says this approach works fine in theory, but he brings us back to the real world of dysfunctional political systems that have come to rely on monetary ease to avoid hard choices on the fiscal side. Mishkin calls this condition “fiscal dominance.” His paper describes the resulting crisis:
In the extreme, unsustainable fiscal policy means that the government’s intertemporal budget constraint will have to be satisfied by issuing monetary liabilities, which is known as fiscal dominance, or, alternatively, by a default on the government debt. Fiscal dominance forces the central bank to pursue inflationary monetary policy even if it has a strong commitment to control inflation, say with an inflation target. . . . Fiscal dominance at some point in the future forces the central bank to monetize the debt, so that despite tight monetary policy in the present, inflation will increase. . . .
Ultimately, the central bank is without power to avoid the consequences of an unsustainable fiscal policy. . . . If the central bank is paying for its open-market purchases of long-term government debt with newly created reserves, . . . then ultimately all the open-market purchase does is exchange long-term government debt (in the form of the initial Treasury debt) for overnight government debt (in the form of interest-bearing reserves). It is well understood . . . that any swap of long-term for short-term debt in fact makes the government more vulnerable to . . . a self-fulfilling flight from government debt, or in the case of the U.S., to a self-fulfilling flight from the dollar. . . .
Fiscal dominance puts a central bank between a rock and a hard place. If the central bank does not monetize the debt, then interest rates on the government debt will rise sharply. . . . Hence, the central bank will in effect have little choice and will be forced to purchase the government debt and monetize it, eventually leading to a surge in inflation.
Mishkin and his coauthors point to another collapse in the making, independent of debt monetization and inflation. As the Fed buys longer-term debt with newly printed money, its balance sheet incurs large mark-to-market losses as interest rates rise. The Fed does not disclose these losses until it actually sells the bonds as part of an exit strategy, although independent analysts can estimate the size of the losses from information that is publicly available.
Monetization of debt leaves the Fed with a Hobson’s choice. If the United States tips into deflation, the debt-to-GDP ratio will worsen because there is insufficient nominal growth. If the United States tips into inflation, the debt-to-GDP ratio will worsen due to higher interest rates on U.S. debt. If the Fed fights inflation by selling assets, it will recognize losses on the bond sales, and its insolvency will become apparent. This insolvency can erode confidence and cause higher interest rates on its own. Fed bond losses will also worsen the debt-to-GDP ratio since the Fed
can no longer remit profits to the Treasury, which increases the deficit. There appears to be no way out of a sovereign debt crisis for the United States; the paths are all blocked. The Fed avoided a measure of pain in 2009 with its monetary exertions and market manipulations, but the pain was stored up for another day. That day is here.
Global monetary elites and the Fed, the IMF, and the BIS are playing for time. They need time for the United States to achieve long-term fiscal reform. They need time to create the global SDR market. They need time to facilitate China’s acquisition of gold. The problem is that no time remains. A run on gold has begun before China has what it needs. The collapse of confidence in the dollar has begun before the SDR is ready to take its place. The Fed’s insolvency is looming. As the dollar’s 9/11 moment approaches, the system is blinking red.
CONCLUSION
In finance, there is no crystal ball for predicting one outcome, then proceeding on a single path. Still, it is possible to describe multiple paths and the mileposts along each one. Intelligence analysts call these mileposts “indications and warnings.” Once the indications and warnings are specified, events must be observed closely, not as a passing parade of superficial headlines but as part of a dynamic systems analysis.
Investor Mohamed El-Erian of bond giant PIMCO popularized the phrase “new normal” to describe the global economy after the 2008 financial crisis. He is half right. The old normal is gone, but the new normal has not yet arrived. The global economy has fallen out of its old equilibrium but has not stabilized in a new one. The economy is in a phase transition from one state to another.
This is illustrated by applying heat to a pot of water until it boils. Water and steam are both steady states, albeit with different dynamics. In between water and steam is a stage where the water’s surface is turbulent with bubbles rising, then falling back. Water is the old normal; steam is the new normal. Right now the world economy is neither—it is the turbulent surface deciding whether to fall back to water or rise to steam. Monetary policy is a matter of turning up the heat.
The Death of Money Page 33
