The IMF Unravels the Global Monetary Order

On August 28^th, the International Monetary Fund quietly made history.

The IMF was a product of the Bretton Woods summit of economists that created the post-war global monetary order of the same name. The IMF was envisioned as a global central bank, that would act as a lender of last resort to countries facing balance-of-payments crises. The IMF has traditionally lent by raising funds among the wealthy nations, but in 1969 it created a special kind of currency, called the Special Drawing Right. SDRs aren’t used as a means of payment anywhere in the world; SDRs are used as an accounting device between countries for international settlements. Perhaps SDRs were created in the hope that one day the IMF may be able to issue its own fiat currency, a step toward a global ‘super-currency’. If so, that day has arrived.

The IMF announced on August 28^th that it would create $283 bil worth of SDRs, and distribute them to member countries. I know of no other instance of fiat currency being issued by a non-governmental organization that has no economy behind it. Countries can exchange their SDRs for one of the four hard currencies that underlie the SDR’s value (the US dollar, the pound sterling, the euro, and the yen). The US will receive one-sixth of the new SDRs, worth about $47 bil. Small change next to the magnitude of the deficits, but every billion helps.

What’s the game here? The US desperately needs to fill the hole caused by continuing trade and budget deficits and is increasingly sensitive to the criticism (made by many world leaders and central bankers) that it plans to do so by printing dollars. Could this be a sneaky move where the US receives the benefit of free money but sticks the IMF with the bill? It won’t work, of course, as global markets will simply respond by increasing prices. Increasing the money supply without increasing the supply of goods will always create inflation.

The global recession was caused by reckless money creation, which inflated the value of assets from stocks to commodities to real estate, while encouraging astounding degrees of leverage. The financial house of cards was simply not built to last, and pumping more fake money into the deflating credit bubble won’t work. Debt leverage isn’t available like it was in the past, and even if it were, a more important illusion has been punctured, namely that all this risk was essentially free. Risk always comes with a price tag, and the sooner that price is accurate, the better for the global economy.

What Will It Take to Pay Off the Federal Debt of the US?

The US is awash in debt on every level: Federal, state, local, as well as households and businesses. But for the private part of the economy, there is a different consequence for bankruptcy than for the public side. If a private individual or business goes under and fails to pay their bills, the creditors lose money, of course. But when a government goes under, it tends to go under in a way that inevitably affects everyone, for it devalues the currency.

Of course no government destroys its own currency with malice aforethought, but the pressures that come to bear on governments are such that destroying the currency seems at the time to be the right thing to do, given other options. Circumstances are already headed in that direction now, and pressure on the dollar continues to build in the face of rapidly expanding Federal debt.

The current Federal debt is $11,659 bil, and with the stimulus and other unfunded expansions in Federal spending, it’s widely believed to expand by at least another $1,800 bil in the next year alone, and to nearly double in ten years. It’s an open question as to how the Federal government expects to get the funding for that level of debt, as our foreign creditors are already reducing their purchases and seeking to ‘diversify’ their assets. China is inking trade agreements with Brazil and Argentina to conduct trade in the Renmimbi rather than in dollars. China is also channeling more of its massive currency hoard into durable commodities like copper, gold, and oil. Every day it seems, the discussion of the status of the dollar becomes a bit more open, a bit more honest, as countries seem to feel increasingly free to point out that the dollar’s days as the reserve currency of the world are numbered. Dollar-denominated Treasury debt is like a game of musical chairs: in the end, not everyone will get a seat.

In the past, the US has relied on economic growth to reduce its debt. Is that possible now? Total Federal government revenue was $2,554 bil in 2008. Let’s say that average rates of US growth resume immediately (3% per year) and continue indefinitely. Say that Federal revenue increases at the same pace. Say we immediately run surpluses, so that we can pay the interest on the debt plus an additional 1% of Federal revenue to pay the principle. (In 2008, that combination would cost $451 bil in interest plus $25 bil in principle, instead of the $458 bil deficit that actually occurred). Even with these rosy assumptions, it would take about 90 years to pay back the debt. Ninety years of solid economic growth and perfectly balanced budgets (plus the 1% surplus). No government on earth has such a record. (This analysis doesn’t include all the unseen obligations the US government has, such as Social security and Medicare, which add up to trillions more).

It seems likely that at some point, the United States’ largest creditors will demand repayment in some other form than dollars. Perhaps they would demand payment in their own currency, but that seems unlikely. The traditional asset for international settlements is gold, so gold is the most likely candidate, especially given that our two largest creditors, China and Japan, have relatively low gold reserves, while the US has the largest gold hoard in the world.

Let’s consider what would happen if the debt would have to be paid off in gold. According to the US Treasury (www.fms.treas.gov), the US government is in possession of 261,498,899 Troy ounces (8,133 tonnes) of gold, which at a gold price of $964, is worth $252 bil. The US gold stock is unaudited, and since it is also routinely leased to other parties, how much of it is owned free and clear by the government is unclear. The way that gold is leased is through a kind of repurchase agreement called a gold swap, which gives the US Treasury cash in exchange for a firm commitment to buy back the gold at a specified point in the future. For example, Goldman Sachs may give the US Treasury $1 bil today, using the gold as collateral, to receive $1.05 bil in one year, whereupon the gold reverts to the Treasury’s possession, though the gold has never left the vault. While 5% isn’t a great return, I’d say that Goldman can use the contract as an asset, since it’s backed by gold and the full faith of the US Treasury, which allows Goldman to obtain a risk-free return on the $1 bil, and still put the money to work in other ways to obtain returns.

The Gold Anti-Trust Action Committee (GATA) has estimated that the total amount of gold that is leased through gold swaps is between 12,000 and 15,000 tonnes, about half the total of all gold held by central banks. Individual nations don’t publish the extent of their gold swaps, but let’s say that half of the US Treasury’s gold has been leased, meaning that the gold is no longer an asset, but rather an obligation. If the Treasury really owns just half the gold in its possession, then it has about 131 mil Troy ounces of gold, worth $126 bil.

Now let’s imagine that a few of the large holders of US Treasury debt were to demand that the debt be repaid in gold rather than in dollars. The US Treasury holds its gold at a book value of $42.222 per Troy ounce, rather far below market prices. (If only one could buy a few ounces at that price!) Say that China and Japan (which own $1,477 bil) demand repayment in gold. Of course, these countries wouldn’t be so unreasonable as to ask for all the money all at once; let’s say they simply stop buying new debt, and ask for the interest on the debt outstanding to be paid in gold. If any large buyers were to stop or even slow their buying, yields would rise. Let’s say the yield rises only to the historical mean of about 6.5% (an event like this would probably push the yield far higher). At that yield, the interest would come to $96 bil a year, which would quickly drain the US Treasury’s entire gold stock. In fact, it would be gone in less than 18 months. If China and Japan started asking for gold, other countries would no doubt follow, as would large domestic holders, both institutional and individual. If the entire interest bill had to be paid in gold, it would come to $63 bil per month, and the Treasury would be out of gold in two months.

Now if there are no new buyers for Treasury debt, either the Federal government must immediately balance the budget, which seems unlikely, to put it mildly. More likely the Fed will step in and buy the debt directly, with money it conjures out of thin air. This leads to further depreciation of the dollar against gold, and would probably lead to a lot more demands for payment in gold, as creditors realize that their dollars will get less gold than before.

So we can’t grow our way out, and we can’t fall back on gold. The only other possible avenue is to depreciate the dollar. But how much depreciation would it take to reach the equilibrium that markets demand? If the situation arises where gold is sought for repayment rather than dollars, the question is, at what price? The US government will have give up the accounting fiction that the gold is worth $42.22 an ounce, and set an exchange rate between the dollar and gold. The rate chosen will not be below the market price, it will be well above the market price. How high is anyone’s guess—I’ll say $10,000 an ounce just to get the guessing started. This option allows the US to service its debt without the humiliation of an outright default, though it will still probably result in chaos, just as it did when the US last tried it, in 1933. It also creates a de facto gold standard. With gold at $10,000, the Treasury’s gold is worth $1,310 bil, and can now be used to pay the interest on the debt!

Where things go next is hard to foresee. But it’s clear that the debt is far too large to pay off, and that the United States’ creditors will demand payment in an asset that the US government can’t depreciate at will. The signal to investors is pretty clear: get out of Treasury debt and into gold. One way or another, the US will repudiate its debt. The other lesson is equally clear: the inevitable depreciation of the dollar simply follows the logic of the market, and cannot be denied by either money creation or fiscal stimulus.

Ah, Krugman!

To sum up: A few months ago the U.S. economy was in danger of falling into depression. Aggressive monetary policy and deficit spending have, for the time being, averted that danger. And suddenly critics are demanding that we call the whole thing off, and revert to business as usual.

The above is a quote from the marvelous Paul Krugman. I love him; and yet, he's so wrong right now.

Let's be clear: aggressive monetary and fiscal policy have not averted any danger to the economy. The danger is not inflation, nor is it deflation. The danger is economic distortions. That is, massive investment in unproductive economic activity (retail, advertising, finance, etc.). This kind of economic activity does not produce anything, and hence it is the major threat to the economy.

Why are there economic distortions? Why should it be the case that the market, which often gets things right, ought to be disastrously wrong? What causes the distortions is the massive inflation of the money supply. That may lead to inflation or it may even lead to stable prices, even deflation for a time. It all depends on how the extra dollars are used. If they are saved, no inflation in consumer prices. If dollars are spent elsewhere in the world, no inflation (at least in the US). If those extra dollars are spent in the US, expect to see some inflation.

Rising or falling prices is not the danger. The danger is that there is a prolonged period of confusion: what are my assets worth? Is my business viable? Should I start this business? What is the market saying?

If the answers to these questions are unusually obscure for a long period of time, the result will be stagnation, low growth, and unemployment. This is the danger. And it's in full bloom now. More aggressive monetary and fiscal policy will worsen the situation, not make it better.

Inflation Coming Soon

Wow. Greg Mankiw has written an unusually provocative argument in favor of inflation, even outright monetary destruction. Addressing the problem that the Fed can only push rates to zero, (and if that doesn't stimulate lending, what will?) he writes:

Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.

I am shocked by how reckless his proposal is. Unbelievable. The way out of the financial collapse is to basically render useless one-tenth our money. (As Mankiw no doubt realizes, in practical terms this wouldn't work, since the overwhelming portion of the money supply is not attached to paper notes. Only about $800 bil of the money supply is paper currency, while M3, the broad measure of the money supply, is nearly $15 tril)

Imagine if stimulating the economy were as easy as Mankiw suggests. If destroying 10% of our money is this good, why not destroy 50%? Why not simply build immense fires and burn all our paper Federal Reserve notes that we call money? What a fantastic stimulus that would be.

Destroying money through inflation will not cause a stimulus of any kind, it will cause chaos. Inflation introduces distortions into the economy. Businesses cannot easily calculate future returns; inflation transfers money from worker to employer, from saver to borrower, from the poor who tend to be far away from the money-generating mechanism, to the wealthy and well-connected, who tend to be nearer to the source, and hence can spend their income before prices rise.

Because Greg Mankiw is a towering figure in the economics establishment (professor at Harvard, chair of the Council of Economic Advisors under Bush, influential blogger and textbook author), and because this interesting article appears in the NY Times, (where it is immediately heralded by Paul Krugman) I suggest that Mankiw is striking a chord that will resonate with the central banking and political establishment, which no doubt sees the logic of inflation.

Though the CPI indicates that deflation has been our recent history, that will not last under a determined attempt to produce inflation. Remember, the Fed can print money and drop it from Helicopters. The Fed can write the US government a check for a trillion dollars. (The Fed can even write me a check for a trillion dollars, but I'm afraid I will not stop blogging.) If the Fed wants inflation, the Fed will get inflation. Mankiw simply says what needs to be said to ease the way toward that inflation.

By the way, it is completely wrong to say that inflation will stimulate bank lending. Banks are extremely reluctant to lend under inflationary conditions, unless interest rates are fully flexible, indexed to inflation and all other relevant conditions. Does that sound familiar? That is what an adjustable rate mortgage is all about. But even if rates are fully adjustable, there are two additional problems:

1) what if raising the rate high enough to cover the bank and ensure that the loan is profitable destroys the borrower?

2) how many borrowers are willing to borrow with such uncertain costs of borrowing?

If inflation was such a reliable way to stimulate bank lending, Zimbabwe would've become the world's banker, instead of the world's most recent example of the failure of central banking.

Within a year, we'll see double-digit inflation rates.

Did the Gold Standard Cause the Great Depression?

(I'll be out of town until 4/12, so I won't be blogging. Can you live without me?)

A fascinating 1997 paper by Barry Eichengreen and Peter Temin argues that the gold standard caused the Great Depression. (Well, at least that the gold standard 'mentalite' was part of a set of factors that caused the Depression.) Eichengreen (UC Berkeley) and Temin (MIT) are top-notch economists; each has published a slew of articles on economic history. They represent the mainstream orthodox neoclassical-Keynesian synthesis on this point.

In this view, which is really more Keynesian than classical, sound money tends to tie the hands of government during a recession. Sound money is 'inelastic', you see, and cannot be made to do what government officials want it to do. The government often wants the impossible: lots of spending, while at the same time cutting taxes.

Eichengreen and Temin's paper is good to read alongside Murray Rothbard's America's Great Depression. (Freely available in its entirety at the previous link). Rothbard essentially argues the opposite: it was the rapid expansion of bank credit during the 1920s which caused the inevitable contraction in the money supply as banks rushed to cover; the government's response in the form of stimulus made things far worse by lengthening the time of adjustment.

Fed "Quarterbacking"

If you want something that will turn you against the study of monetary economics forever, read a series of experts debating what the Fed should've done and how what they did affected the economy. For example, The Wall Street Journal's recent symposium, Did Alan Greenspan Cause the Housing Bubble?

What a tiresome parade of simplistic reasoning and confusion, with the exception of Judy Shelton's piece, "Loose Money and the Derivative Bubble." (She has another great article published on 2/11 called Capitalism Needs a Sound-Money Foundation. (Ms. Shelton is the author of Money Meltdown, which I confess I have not yet read.)

To blame the Chair of the Fed for supposedly disastrous Fed policies is "quarterbacking", as in, how might have that game played out if the quarterback had acted differently? A speculative exercise at best, quarterbacking ignores the interconnected nature of events, supposing that we could go back in time and change one thing, leaving all other things unchanged.

The other problem with Fed quarterbacking is that the Fed is in an impossible position. The Fed's stated mission is to maintain price stability, full employment, and financial stability. Each of these is a sham. Price stability? The Fed issues a fiat currency, and has recently increased the number of Federal Reserve Notes (aka dollars) by several trillion (most of it in electronic form). The Fed is the primary engine of inflation, not price stability.

That the Fed can use wise monetary stimulus to ensure full employment is Keynesian dogma, and it's more or less true during the credit-fueled boom. But when that boom ends, as it must, the Fed becomes ineffective, for the contraction in bank lending tends to counteract the Fed's lowering of the interbank lending rate. This is where we are now, and the Fed's efforts to re-inflate the bubble are likely to create inflation, which will surely interfere with the economic adjustments necessary to begin recovery.

As for financial stability, the Fed presides over a fractional reserve banking system, which is inherently unstable. Like building on a river delta, a flood will periodically come and wash out the banking system, causing banking failures and bank runs, which the system cannot endure.

The housing bubble isn't Alan Greenspan's fault. But it is the fault of the Fed system, which generates credit bubbles which must inevitably pop. Greenspan should've known better. He has long advocated the gold standard. But he just did what everyone wanted him to do: he spiked the punch so we could all get drunk at a decades-long party. Now we're sobering up and cursing the man who sold us the drinks we demanded.