John Butler gave a great presentation in Auckland last week, it was only a shame more people weren’t there to see him. Particularly from the institutional investment community, as his message is very accessible and not full of hyperbole or grand assumptions.
As he said right at the start, his aim is to use theory and history to try and make the controversial case as to why a remonetisation of gold is inevitable and why we may have a full return to gold backed money at least as an international money for solving balance of payment transactions.
Or put another way; where the ultimate response to the current situation where policy makers are deliberately trying to create inflation to stimulate growth and get us out of the current mess, will be a remonitisation of gold. Where we see gold again being used to settle balance of payments transactions internationally. To follow is an expansion of the notes we took where he makes very compellingly his case.
He began with a bit of theory.
There are 3 traditional properties of money:
- Medium of exchange – to allow us to move beyond barter
- Unit of account – to denominate economic activities and keep the books in some unit of account
- Store a value – something which is stable over time, otherwise no one would use it if it was such a moving target. Ultimately, if it lost enough of its value no one would accept it. They simply wouldn’t have confidence in it having a store of value.
It is this 3rd measure where we have the problem today. The US dollar has been the dominant form of money globally since the 1920’s. A role which was enhanced by the interwar years.
Post war 50% of global production took place within the USA due to destruction of factories etc across much of the rest of the world.
So as the war was coming to an end, with the USA the dominant player internationally, the Bretton Woods agreement was reached where dollar was at the centre but backed by gold.
The supply of the dollar was meant to be fairly fixed. Even in the 50’s the dollar supply was growing. But in the 60’s it really picked up with Vietnam war, US interstate highway construction and expansion of welfare state.
Charles de Gaul decided the USA was behaving irresponsibly and made a famous speech in February 1965. Stating the USA was abusing its “exorbitant privilege”.[Below is a video of de Gaul’s speech if you have yet to see it]
Then roughly once a year there was a run on the US gold reserves where investors and governments such as Spain, Netherlands and even great Britain were exchanging dollars for gold.
This led Nixon in August 1971 to “temporarily” (for 40 years!) suspend the convertibility of the dollar to gold. So that was the beginning of the floating fiat reserve standard we have today.
Here’s Nixons “temporarily suspend the convertibility of the dollar” speech too:
Fast forward to today where “The global financial crisis has critically undermined the equilibrium that holds this dollar reserve standard together”.
Funny how history repeats or rhymes at least.
The run on the dollar in 79 and 80 actually inspired a Hollywood film – “Rollover” starring Jane Fonda and Kris Kristofferson.
A key scene showed a senior financier who sees the oil producing nations swapping all their dollar reserves for gold but trying to keep it quiet. He has a conversation with a young protege who thinks they should warn the government. Everything will be okay and the dollar will hold as long as no one panics. It’s a confidence game is effectively the point he makes.
The film ends with a massive financial crisis, riots in the streets and not a pretty picture. While he’s not suggesting this will happen today, the fact of the matter is the world today also finds itself in a similar crisis of confidence.
This is due to the dollar reserve base growing exponentially over the last 4 decades as the US followed an irresponsibly loose monetary policy particularly in the 2000’s. Which as we know, resulted in bail outs and bank guarantees to hold things together but only with more money and credit growth. Which continues to inflate asset prices to this very day as seen for example in property prices here in New Zealand.
But countries are increasingly concerned about the instability being caused.
As far back as October 2009 veteran Journalist Robert Fisk reported while writing for the well known paper The Independent of “The Demise of the Dollar”.
This piece mentioned secret negotiations taking place between China, between oil producers to construct an international monetary arrangement that will reduce the need for the dollar.
In fact not only that these discussions were underway but it made specific reference to using gold as some part of this new arrangement.
Today we’ve come a long way since the Bretton Woods agreement, whereby the BRIC nations share of global GDP is now greater than the USA. So we are seeing the end of the USD hegemony.
Robert Mundell, Nobel laureate in economics, said in a 31 March 2011 speech at a G20 economic seminar:
“7 problems of the present international monetary system are all related to the change in the role of the dollar”
And as far back as 1997 he said:
“We can look upon the gold standard as being a period that was unique in history when there was a balance among the powers and no single super power dominated.”
The world is moving towards a more multi polar structure so it’s logical that it would move towards a more multi polar monetary system.
But how do you organise this?
Consider Professor Giulio Gallarotti – an authority on the gold standard. In 2010 he said:
“To the extent that they fail to correct for the negative effects of power, governments choose foreign policy strategies that are ultimately self defeating.”
So declining powers sometimes do things that are counter productive in the long run e.g. The US in pursuing an internally focused policy of trying to reflate its economy, is currently undermining the dollars global reserve role without necessarily really realising it.
“The gold standard showed very little co-operation among national governments in the process of formal regime building. The rise of the gold standard can be seen more as a case of a regime emerging from the failure to co-operate.”
John commented that many of us in the room might have noticed that today there is more competition and conflict in international economics and monetary matters.
In a BRIC summit in April 2010 the statement said in strong language that sounded a bit like Charles de Gaul:
“that the International financial crisis has exposed the inadequacies and defences of the existing international monetary and financial system. We support the reform and improvement of that system with a board based int reserve currency system providing stability and certainty.”
Then in their 2012 Summit the statement showed the BRIC nations don’t all see eye to eye on all foreign policy matters.
So there is some rivalry taking place even amongst themselves. So they are getting themselves organised given the of lack of co-operation and the conflict that exists currently.
Then he went back to another movie example, discussing a particular scene in the hollywood movie A Beautiful Mind, starring Russell Crowe, about mathematician John Nash.
A blonde came into a bar that Nash and all his mates fancied the look of. But Nash realised if they all tried to chat her up then the other girls in her group would be upset, she’d be overwhelmed and they’d all lose. Instead they should do what wasn’t any of their first choices and talk to all the other girls in the group while ignoring the blonde altogether.
Here’s the scene:
The point was that players recognise interests and strategies of other players are changing and that Nash’s equilibrium game theory shows that “what seems sub optimal to one player may be the optimal response to the other players strategies.”
So why was John Butler talking about Nash’s Equilibrium?
If you’re going to move away from the dollar and put your own currency forward as a superior store of value, you have to maintain a harder currency policy. But all governments want to inflate as this is the easy option. But in a multi polar world without a hegemony where everyone still wants to trade, who will trust each other if everyone thinks everyone else is going to inflate? A currency war will be the result and that could then lead to a trade war. Bad news all round for all players – just like the Nash’s theory in the movie scene if they all “go for the blonde”.
So instead if all parties agree to simultaneously move to maintain more stable currencies you could reach a new equilibrium.
They would agree to put all their currencies forward as part of a new system.
Because while no one trusts the US no one can trust anyone else either.
So if everyone wants their currency to be used in international trade they’re going to have to start backing it with gold since that restores credibility and doesn’t rely upon trust.
And what do you know? China, India, Russia, and Brazil are all accumulating gold. So the world is starting to act like we are moving to a new equilibrium where gold will be used to settle international balance of trade.
Currently US treasury assets are concentrated in relatively few hands globally.
Game theory shows that in situations like this where there are only a few major players left in a game, and where the interests of just one player shifts, you can’t hold the equilibrium together and it collapses.
So while there is a 1st mover penalty for revaluing because it could destabilise things temporarily, it is dwarfed by the last mover penalty. Because no one wants to be the last one holding these reserves as the world moves away as they will be sharply devalued in the process.
Further evidence that gold is slowly being remonetised, is the change mooted in the Basel banking regulations to allow gold as Tier one capital. This would give banks more flexibility to hold gold as collateral and is being driven by weaker European countries whose banks are no longer able to hold their nations sovereign debt ascit is now no longer of Tier One calibre.
If real interest rates are zero then the opportunity cost of holding gold is zero. So the price of gold rises.
Further backing comes from a Financial Times article from April 2012 headlined “The unwitting move towards a global gold standard”
“Hence, the great corollary of over indebtedness is the relative scarcity of good collateral to support the debt load outstanding. This imbalance of debt to collateral is impacting the ability of banks to make loans to their customers, for central banks to make loans to commercial banks, and for shadow banks to be funded by the overnight Repo market. Hence the growth of gold as a collateral asset to debt heavy markets is inevitably in the cards and is de facto occurring. Gold is stepping up to the plate as “good” collateral in a world of bad collateral.”
But if the world is remonetizing gold, then this will only happen if the dollar devalues versus gold.
Otherwise it won’t work and the price of gold is going to rise but by how much?
Ideally countries would repeg to gold at a price that would not impose further deflationary pressure on the global financial system.
So if we did return to gold being used to settle international transactions and if a country runs a net import position (like the USA does) then the gold price would need to rise to:
- $10,000 if backing gold base money supply, or
- $15,000 if 40% backing of broad money like the Fed was historically required to do.
So if gold is returning to the centre of the monetary system what does this mean to the value of other currencies?
Key factors in which currencies would strengthen and weaken in relative terms in a global move back toward a gold standard are:
- Potential growth rate
- Export/resource competitive (positive factor)
- Size of accumulated debt burden (negative factor)
- Accumulated gold reserves (positive factor)
In the US case 3 out of 4 are bad. Lower growth, higher debt and lower exports compared to imports.
At current gold prices US could only cover about 10 months of net imports with it’s gold reserves. So…
Winners: Swiss Franc, Russia, China
Losers: US, Great Britain, much of Europe.
Another outcome of a return to gold.
Interest rates will be relatively low without monetary inflation to price in. Real and nominal interest rates will merge. So we will see a flatter yield curve that just reflects the time value of money not inflation like they do currently. Rates will also be less volatile.
But Central Banks won’t be able to bail the system out. So some countries will have to fail and risk premium will rise for private assets. So equities would likely be valued lower in the shorter term. So we’d see Price/Earnings ratios of 10/15 like in the Bretton Woods era and gold standard era.
And this is not really a bad thing in the long run. Creative destruction can be beneficial in an economy and lead to higher growth rates like 19th and early 20th century.
Q & A Session:
Luckily there was quite a bit of time for some questions at the conclusion of the presentation…
Q. Do you see China as thwarting the progress to a gold standard until they have consumed their USD foreign reserves?
A . It would be in their interests to:
- Gather as many real assets as possible
- In regions where you think property rights will be recognised
- Have a strong military to defend these property rights
- Seek out common allies
And China is doing all this.
Q. But all that takes time though?
A. Yes it does. It appears that there is quite a deliberate progress amongst the BRIC nations. Some others are even more extreme. South Korea has completely changed the way it manages its reserves and its sovereign wealth fund. But these have non-linear effects in terms of time so you never know how close you are to the tipping point.
Q. Why has gold just been wandering along?
A. In 2011 it seemed a lot of late bull market speculators had come into the market. So that came off really hard – a classic indication of speculative excess. Been in a bear market since then and that became really acute early this year. A number of marginally profitable gold miners were forced into some distressed hedging at this time. This could be as plausible an explanation as any.
Q. How does the individual navigate what’s coming? Such as avoiding a windfall profits tax or confiscation.
A. Rise in risk premium for financial assets. But when it comes to gold itself it has always been a store of value and that remains the case today. But it’s also an insurance policy and 2008 taught us this lesson that insurance is needed.
Forms of gold which more or less exist outside of the financial system. Don’t rely on derivative paper instruments of gold for insurance. Fine for speculation but not insurance. You want physical gold outside the banking system which hopefully would not be subject to confiscation. He hopes property rights are maintained because if they are not then we will need a lot more than insurance. Could consider holding gold in multiple jurisdictions and do your homework.
Q. If things play out as you suspect what would you avoid and what industries would you look to?
A. Financial sector remans excessively large with respect to the rest of the economy. At its peak $1 in $5 was moving money from one place to another. That can’t be healthy. Whereas a long term history it is only 5% or $1 in every $20 moving from one place to another. So the financial sector will do poorly if he is right about gold being remonetised. Look for value, dividends, cash generation. Look for companies holding infrastructure or bottle neck resources with strong pricing power.
Q. Interest rates are artificially suppressed. How much longer can this last? Are we near or at the bottom?
A. It really depends what policy makers choose to do. Once a upon a time they left interest rates to the market. In theory once a central bank wants to control interest rates they can do whatever they want with the yield curve and just cap interest rates at a given level. As the US did on treasuries until 1954 at 2.5% to pay off the war debt. However, you can set interest rates where you want but you can’t set the price of your currency. Because if international investors don’t think you offer a fair rate of return on bond denominated in your currency they will sell your currency. And if central banks let them do that it will become very inflationary. And if you let it go long enough you will hyperinflate.
When the Fed notices that the dollar is under real selling pressure that is when the game is up and they will have to let the market do what it wants.
Q. Do you agree with Ray Dalio and Bill Gross on low interest rates for a couple of decades?
A. We’re seeing the beginnings of it now. History suggests excessive debts are worked off either by default or by devaluation. If the central bank won’t allow default then its by devaluation through unfair interest rates forcing markets to sell your currency and hence devaluation occurs.
He agrees with them in part. But he disagrees with Ray Dalio that it can be done in an orderly fashion that doesn’t have other nasty side effects. He believes in free markets so he believes in a free market for money. And when you muck around with interest rates you distort the critical signals that should be allocating resources in time and place. You don’t allow economies to allocate capital and labour to where they are best used. So the idea that financial repression can be carried out without causing damage over time – he doesn’t buy it.
Q. If one of the triggers for the revaluation of gold is a dollar crisis and if all other CB are printing too – will that dollar crisis ever occur?
A. In short “I don’t know” was his answer. However if you look at the end of the 1970’s that was a dollar crisis- there was “a run on the dollar”. In fact in 1980 when gold was trading at $850 the entire US money supply was backed by gold.
Greenspan wrote an opinion piece in 1981 in the Wall Street Journal advocating that the US pay treasury coupons in gold. Overtime the entire US treasury stock would be these gold backed bonds and so overtime you would claw yourself back onto a gold standard.
But no one wants a crisis to happen and would like to carry on as we are. But too many interests are conflicting and cooperation is breaking down. It’s comparable to a war. No one wants one but it happens when the interests of the players come under such severe conflict with one another that the perceived costs of going to war are less than the perceived benefits. So a dollar crisis could emerge from an unstable equilibrium where a handful of actors decide that the perceived cost of not initiating action exceed the perceived benefits. And while there could be a 1st mover penalty of taking action and causing a crisis, there is a massive last mover disadvantage if you don’t prepare for it. Fine line between preparation and the crisis itself.