The current Euro Crisis over Greece and Club Med shows how difficult it is to create a monetary union. The European Monetary Union (EMU) that created the Euro suffers from the divorce of economic power and political power: it can cajole its members to behave well to support a single currency, but it cannot force them, nor align policies to accomplish that goal.
The Greek Tragedy got me to thinking about the calls for a new Bretton Woods and the US role as the global reserve currency. There is growing political will to change this. Sometimes this is conspiratorially described as a "secret cabal" working to get the oil trade off the US Dollar, but this is way overblown. The cabal is not so secret and the timeline is not so fast (2018, not tomorrow).
The current system gives the US an advantage of seigniorage, which in a fiat currency (as compared with specie) lets it print more Dollars than ever come back home to cause inflation, as a float must remain out of the US to be used for global trade, particularly in oil. Yet this purported advantage ends up creating a persistent trade deficit, where the gap is not really due to loss of trade but due to excess demand for Dollars. (The accounts must balance - a Dollar surplus begats a trade deficit.) It still bleeds US competitiveness, slowing weakening the dominant power. As the US reacts to support is domestic needs, its Dollar policies ratchet the global financial system.
The US can continue for a while with large trade deficits as well as deep budget deficits. At the moment the US is deleveraging faster than the Federal government is borrowing (see the first chart). We are in a deflationary environment, and the Dollar Demise is not imminent.
Thus it will be hard for our trading partners to impose on us some new gold standard. Mish does a good job of showing the impotence of the effort. Foreign Policy writes a really good piece on how hard it would be to push the US out of its hegemony. Other nations cannot easily convert out of the USD without impacting the value of the USD itself or of their own home currency. The Euro travails right now also highlight another facet of the difficulty, that the replacement may be worse.
Nonetheless, let's walk through various scenarios for a new Bretton Woods with a new global financial currency and see if there is a credible alternative to the Mighty Dollar.
Dominant Power System
The global reserve currency falls into the lap of the dominant power, and it does not leave easily. Even under the classic gold standard, it was the Bank of England that managed it, until 1914. After WWI the dominant power had moved to the US, and even then the global standard stayed in England. When the gold standard resumed in 1925, it was managed again by the Bank of England; but it had to create a bastardized standard, a gold exchange standard, where the Pound was backed by the US Dollar and the gold in the US.
Only after WWII did the standard shift to the US, under Bretton Woods. Even when the US broke with the Bretton Woods gold exchange standard, the USD has continued to reign supreme against attempts to replace it as the reserve currency.
There is a lot of myth and fluff around the gold standard. The Keynesians such as Krugman and Delong, and students of the Great Depression like Bernanke, decry the gold standard as causing the crushing deflation of the early '30s. They point to the historical fact that the countries who first went off gold and reflated their currencies suffered less and recovered more quickly than those who stayed on gold. This is compelling as far as it goes. Bernanke's papers on this also note how it wasn't gold itself which caused this problem, it was the over-reaction of central banks to the banking crisis of 1931. Rather than loosen up, they tightened and tried to preserve gold. Much of the gold flooded into the US, and under the gold standard the US should have loosened monetary policy, but instead the Fed tightened in late 1931. The US had room in 1932 to reflate even under gold, but like MIdas chose to sit on the gold.
Countries learned how to cheat on the gold standard, however, and that was its biggest weakness. They also gave a mythic quality to a mere commodity, and gave the system more significance than it deserved.
Real Bills and the Gold Standard
Gold keeps coming back however, as a small amount of gold can go a long ways - global trade in 1913 was huge, and not matched until the mid-1990s. (I know that may seem hard to believe, but things fell a long ways down due to WWI and then the Great Depression).
A small pile of gold could support a huge and growing trade system.
It was based on a 90-day instrument called a Real Bill, backed by gold held in the Bank of England. This Bills could be used to borrow against, and traded multiple times. A merchant in England contracted for cotton in the US to be shipped to a plant in China to be manufactured and shipped back to a store in London. The same, single Bill would be used at each step and often got traded or 'discounted' over 20 times. It all got cleared within 90 days and everyone paid off their debt - the many swaps down the chain simply paid off each other. (If you play with the math you can see it works.)
As long as the balance of trade of the Bank of England was even, no net gold went in or out; it simply got shuffled in the vault from one bin to another.
The Federal Reserve was supposed to be a Real Bill clearinghouse. By the time we got to Bretton Woods, the Real Bill had faded. Instead we had a system that only lasted for 25 years, and was failing badly quickly as the US expanded its domestic spending and borrowing faster than the system should have allowed.
Under Bretton Woods, the US avoided trade deficits for years due to returns on overseas investments, repatriating Dollars back home, but the debt-driven hunger of the expanding welfare state eventually overwhelmed that and threw the US into a persistent trade deficit. The expansion of government, particularly the "guns & butter" Great Society in the '60s, resulted in gold flowing out, and the US having to 'cheat' on the gold standard to stem the flows. Eventually Bretton Woods broke down, and Nixon went off gold. Memories my be short, but did you know that the US sent gunboats to South Africa around 1968 to force them to release gold they were hoarding? Such was how low we sunk, and with it the Dollar.
Floating Rate System
The floating exchange system that replaced Bretton Woods was brilliant. Rather than having fixed exchange rates and relying on the flows of gold in and out, leading to gold gamesmanship and cheating on the standard, floating rates punish poor government policies much more quickly by sinking currencies.
In contrast, within a broad currency like the Euro region, the punishment comes from the bond market, but much more slowly. We can see this drama unfold with Greece.
Here are some advantages of floating rates:
- Capital flows away from places with poor policies to those with good policies
- Floating is self-correcting: falling enhance exports, which causes it to rise again
- Floating rates act like tariffs to protect developing countries, whose cheap currencies make imports expensive, and drive the internal economy towards import-substitution and later export-expansion
It is probably lost to political memory that the Repubs used to be the party of tariffs to protect nascent industry, and the Demos the party of hard money to protect the value of King Cotton. The parties somewhat have flipped, where the Repubs support free trade, and the Demos support easy credit to pay for the welfare state; but it was Nixon who went off gold, and Clinton who pushed for NAFTA.
Floating rates, however, have one troubling flaw: with the USD as the reserve currency, US domestic policy gets exported to the rest of the world:
- Off gold in '71, we exported our inflation
- Saved by Volcker in '79, we drove too strong a currency
- Worried about Japanese imports in '86, we coordinated a devaluation of the Dollar in half (in a year!), followed was the crash of '87 and the Japanese bubble of '89,
- Solving the the S&L crisis in the '90s laid the seeds of the Greenspan Put, which created the moral hazard that we now call the Greatest Asset Bubble of All Time in the 2000s.
Compounding this flaw is the capability of mercantilist economies to peg their currencies to the Dollar and preclude the readjustment of floating rates; if they peg low enough, they have erected effective tariffs to protect their internal markets, created incentives for high savings (which are cycled back into business investment), and baked-in a competitive export advantage. In places like China, mercantilist currencies would normally have risen against the Dollar and Euro to compensate for the huge reserves they have accumulated.
The Triffin Dilemma
The Triffin dilemma, less commonly called Triffin paradox, is the fundamental problem of the United States dollar’s role as reserve currency in the Bretton Woods system, or more generally of a national currency as reserve currency. Briefly, the use of a national currency as global reserve currency leads to a tension between national monetary policy and global monetary policy. This is reflected in fundamental imbalances in the balance of payments, specifically the current account: to maintain all desired goals, dollars must both overall flow out of the United States, but must also flow in to the United States, which cannot both happen at once.The dilemma is named after Belgian-American economist Robert Triffin, who first identified the problem in 1960.
Harrison goes on to explain:
[T]he reason credit has surged dramatically over the last generation has much to do with the monetary system; unless we successfully reflate asset prices, the claims on dollar-based assets cannot be met under this jerry-rigged monetary system with the U.S. dollar at the core. I see this as a Ponzi scheme which is now in its final chapter.
He sees two ways out: follow the easy money path and keep pumping out US-denominated debt (the course we are on) until it blows up; or follow the Volcker path of backing the Dollar and risking a deflationary spiral. Neither are attractive, and neither would fix the Triffin Dilemma.
The Long-Term Problem
I have a bet that by 2020 the US Dollar will be replaced or supplemented by some form of gold-backed reserve. It would take a much more serious Dollar Crisis to get there than anything going on right now, but if you look at the long term chart of the US Debt (see chart from CBO) you will see it is complete fantasy that the US can continue with the current policies - and this chart is from late 2008; the picture is much worse today.
At some point we will face a huge Day of Reckoning. My 2020 bet looked far off when I made it a couple of years ago, but less so today.
Independent Global Currency
Let me propose a way out: an independent global currency against which all others would float. This approach can distance the rest of the world from US domestic politics, and get the US off the hook of running persistent trade deficits in order to provide persistent Dollar surpluses.
This proposal does not necessitate the classic gold standard, nor the bastardized Bretton Woods gold-exchange standard. Gold can play a role in this new global currency without going back to fixed exchange rates. Gold in effect would circulate with fiat currencies, and help keep the float honest.
It is gold which fixes the flaw in the Euro, since it removes the need for coordinated policies and at the same time makes cheating visible. Imagine a floating currency system in Europe with circulating gold. If Greece followed prudent fiscal policies, it would remain pegged to the Euro, and gold could circulate at constant value. If it tries to borrow too much or go off-balance-sheet, its currency would fall against the global "Euro" as well as gold. In either case, with Real Bills, trade can continue with Greece as if it had a stable currency over the 90-day period of the Bill.
To make the new system work, the US would have to be a major backer, and likely the Fed (or several central banks acting in concert) would have to become the lender of last resort of the world. I have thought that politically the US would oppose such a new system vigorously, down to the last ounce of value in the Dollar; in other words, we would have to be forced by our trading partners into the new system. If the global economy falls into a double-dip after the huge monetary and fiscal stimulus, the political dynamic of shock & awe in the failure of reflation & easy credit should be much more open to a new direction. Paradoxically, our potential failure leads me to have more hope in this change.
A Floating Gold Standard In the classic gold system, exchange rates were fixed and nations had to adjust their trade policy to make sure gold did not run in or out. Under a floating exchange system, the rates would adjust. Now in both systems nations could try to cheat, and did, much as the mercantilist countries like China today keep their exchange rates low by holding excessive Dollar reserves. So such a new system has to deal with the cheaters - and that is the role of gold via the Real Bill.
A Floating Gold Standard
In the classic gold system, exchange rates were fixed and nations had to adjust their trade policy to make sure gold did not run in or out. Under a floating exchange system, the rates would adjust. Now in both systems nations could try to cheat, and did, much as the mercantilist countries like China today keep their exchange rates low by holding excessive Dollar reserves. So such a new system has to deal with the cheaters - and that is the role of gold via the Real Bill.Real Bills work independently of such shenanigans. They were an emergent property of capitalism, arising early-on in the Italian city states, and hence were a very resilient system. Yet they died during WWI and have been largely lost to economic history. Instead we have commercial paper and other short-term instruments to finance trade, and are beholden to the whims and fancies of the banking sector.
If trade with Greece were done in Real Bills, the risk of the Greek floating currency collapsing would go away. During the 90-day bill period, the Greek currency might fluctuate, but the contracts would clear in the global reserve currency, backed by gold. This gives the trade system the same advantage as a single Euro currency, of stable exchange rates during the trade cycle, without the whole of Euroland importing the Greek profligacy in its fiscal policies. The Austrians never got Real Bills, and have called for a 100% reserve banking system. This would be an utter disaster. Even the normally astute Mish went into a recent rant about fractional reserve banking being fraud. He got seriously slapped down by Karl Denninger's rebuttal. A 100% reserve system would lack sufficient capital to grow; fractional reserves are a marvelous way to leverage a small amount of cash-on-hand. Anyone serious about changing the global financial system must separate: In effect we would have a floating currency system with gold. The gold would primarily back Real Bills for global trade. In order for this to work, the net gold flows in and out of central bank or clearinghouse have to balance. To remain in balance, the new system would need to handle much more than just oil purchases; it would have to set up some form of clearinghouse with relatively stable trade flows across a wide variety of trade. The central authority might be called a bank but would function more like a clearinghouse, and would be used for only part of what banks do: the commercial supply chain trade, not investment or venture finance.
If trade with Greece were done in Real Bills, the risk of the Greek floating currency collapsing would go away. During the 90-day bill period, the Greek currency might fluctuate, but the contracts would clear in the global reserve currency, backed by gold. This gives the trade system the same advantage as a single Euro currency, of stable exchange rates during the trade cycle, without the whole of Euroland importing the Greek profligacy in its fiscal policies.
The Austrians never got Real Bills, and have called for a 100% reserve banking system. This would be an utter disaster. Even the normally astute Mish went into a recent rant about fractional reserve banking being fraud. He got seriously slapped down by Karl Denninger's rebuttal. A 100% reserve system would lack sufficient capital to grow; fractional reserves are a marvelous way to leverage a small amount of cash-on-hand.
Anyone serious about changing the global financial system must separate:
In effect we would have a floating currency system with gold. The gold would primarily back Real Bills for global trade. In order for this to work, the net gold flows in and out of central bank or clearinghouse have to balance. To remain in balance, the new system would need to handle much more than just oil purchases; it would have to set up some form of clearinghouse with relatively stable trade flows across a wide variety of trade. The central authority might be called a bank but would function more like a clearinghouse, and would be used for only part of what banks do: the commercial supply chain trade, not investment or venture finance.