Bernanke the Alchemist

The modern financial system is based on the idea that central bankers can perform alchemy. More specifically, that American central bankers can do so. That is because the US Dollar is the world’s reserve currency. And it can be created out of thin air.

The idea that people are willing to trade real goods and services for a piece of paper because everyone believes that piece of paper is money is, of course, the most important idea in the world fractional reserve banking. Without that idea a lot less global trade and a slot slower or lower global economic growth.

So how did the dollar come to be so central to the global system? Why is its status now in doubt? And if the dollar standard of the last 50 years falls, what will replace it and what will that mean to you as an Australian investor.

First, let’s clarify what a global dollar standard actually means. Currently, if the Chinese want to buy Middle Eastern oil, they have to buy US dollars and then buy the oil with those dollars. The same goes for other internationally traded goods. That creates an artificial and powerful demand for US dollars. If you want to buy things, you need dollars.

But why, then, is this alchemy? Under a gold standard, where gold forms a nation’s monetary reserves, any nation that prints too much money or consumes more than it produces (runs a trade deficit) will lose its gold to other nations. How exactly does that work?

In the above example, let’s say the the Chinese are trading for oil under a gold standard and not a U.S. dollar standard. To buy their oil, they would provide money backed by gold to their Middle Eastern trading partners instead of pure paper U.S. dollars. The key is that the paper money is backed by an redeemable for gold upon demand. Whomever accepts the paper can trade it for gold if they’re worried about the value of the paper (or simply more paper).

In China’s theoretical case, if China bought oil and also ran up a huge trade deficit, it would probably see a net outflow of gold from its bank vaults. Why? Debtor countries tend to pay off debts the easy way, by inflating the paper currency. Holders of the paper currency under a gold standard can prevent this effective devaluation by simply asking for gold.

In this way, during the first “golden age” of globalisation in the late 19th and early 20th century, the gold standard enforced sound fiscal and monetary policies over the world. It prevented large structural imbalances in the global economy because debtor countries always risked losing their gold if they accumulated too much debt and tried to inflate it away.

By taking the world off the gold standard and making US dollars an unbacked global reserve currency, you have a new revelation. Nations other than the US need to buy US dollars to trade. They’d agree to this (or have so far) because everyone else used the dollar to. It was convenient (liquid) and with the largest economy in the world for many years, the U.S. currency was also the most stable and reliable store of value.

The flaw in the design of the dollar standard system is that the US Federal Reserve can simply print more dollars to pay for its overseas spending sprees. This is convenient, as it costs nothing to create US dollars. The American economy cannot run out of what needs to be handed over when it runs trade deficits. It simply prints more dollars. Charles De Gaulle is said to have called this an “exorbitant privilege”.

Of course, other nations can simply create more of their currency too. But when they do, those currencies usually lose purchasing power. No one wants to own money that’s declining in value as its supply increases.

But dollars have been able to retain value despite the increasing supply because of the artificially high demand for them. They are used not just for trade in the US, but trade on international markets too. The US is not punished for printing too much money in the same way that other country’s would be.

However, that doesn’t mean that price inflation from printing US dollars doesn’t occur. All the dollars flooding the system can cause inflation of the internationally traded goods. That’s exactly what is happening now. And it’s why many commodities – especially food – are making new highs.

Crucially, then, Americans can print money without necessarily experiencing the inflation themselves. Because export economies prefer weak currencies to spur their growth, many of them offset any decline in the value of the dollar by printing their own currency. The Chinese peg their currency and are forced to print money to maintain this peg. By doing so, they fuel inflation in their own nation. They import the US’s inflation. That’s why inflation in nations other than the US continues despite attempts to slow it.

Of course, the artificial demand for US dollars as the reserve currency extends to dollar denominated assets for the same reasons. Many internationally traded goods can be paid for using US Treasuries, for example. That in turn creates an artificial demand for US Treasuries. This allows US politicians to run the deficits they do.

If you think all of this is just theoretical rambling, consider the comments made by the Chinese President Hu, as printed in the Wall Street Journal:

“The current international currency system is the product of the past,” he said, noting the primacy of the U.S. dollar as a reserve currency and its use in international trade and investment.
He said that U.S. monetary policy “has a major impact on global liquidity and capital flows and therefore, the liquidity of the U.S. dollar should be kept at a reasonable and stable level.”

The tendency for inflation to cause such tensions shows how powerful a force it is. It influences trade, fiscal balances and capital flows. That is why Austrian Economists base their explanation of the business cycle on inflation of the money supply. And it explains how poor monetary policy in the US can cause a global boom and bust.

But what if America’s control over currency reserves comes to an end, as President Hu suggests? What if the US dollar loses its reserve currency status and all this artificial demand for its money and debt disappears?

Before looking at the consequences, is there any reason to believe it might happen? Certainly. As a matter of course, empires come and go. So do their currencies. The list of examples is long.

The signs now are ominous for the US empire. The Congressional Budget Office’s more realistic projections, according to economic historian Niall Ferguson, include interest payments at 85% of government revenue in 2050. The government will barely be able to repay interest, let alone any government services.

The choices then are default, inflation or austerity. Austerity can probably be ruled out based on the projections of the CBO. Default is the best option according to Bill Bonner and Iceland’s economy is forging ahead with proof. But inflation is the likely outcome. Hence the Markets and Money’s regular mention of gold. Back to that in a moment.

How do the all too regular episodes like this usually end?

The British Pound held reserve currency status before the US dollar did, although with gold as the ultimate reserve. As the British discovered, losing this status is painful to say the least. Just Google “the winter of discontent”. Inflation, shortages, picket lines around hospitals, even grave diggers packed up their work for strikes.

Maybe the world will move from one reserve currency to another at some future political summit. More likely is that countries will turn around and demand a form of payment that cannot be printed, rather than US dollars, in their international dealings. Whoever does this first will suffer a smaller devaluation of US dollars currently held. Anyone who catches on late will be in for a surprise. So the incentive is to act. Except, of course, for the damage such a move might cause to the global economy. And you probably don’t want to be on the wrong side of an angry US President with a furious mob of voters who demand action against those trashing the dollar. Still, at some point the dollar will have to crack and someone or some country will be the first to crack it. Empires tend to end with a military conquest, which features in many sane economists’ predictions for the future.

The investment atmosphere, then, looks bleak. But it’s not all bad news. At least if you aren’t American.

If you are, consider changing your passport color. Apart from the tough times ahead for the world, things are already looking particularly troubling for those stuck in the States. You might recall the media reporting that international (read Swiss) banks were considering whether to cease serving US clients because of various new laws.

Well, now Goldman Sachs has decided to make its offering of Facebook stock unavailable to Americans! An American investment bank, an American company, but no Americans allowed. Goldman blames it on securities law. The key point is that America is falling apart law by law. Not just dollar by dollar.

Comments on you Reckoning Portfolio

Gold has taken a hit. But relative to what? Paper, or digits on a screen that represent a quantity of paper? Fiat currency will remain what it is, as will gold. Fiat turns to dust (usually in a fireplace after being used as fuel), gold does not. Even you may [may? ☺] die in the long run, but your wealth needn’t go with it. That’s why gold will continue to feature in the Markets and Money’s spotlight.

But one man seems to have stolen the show when it comes to gold. Robert Griffiths, a technical strategist with investment firm Cazenove, recently outlined his view on the metal on CNBC:

“Not owning gold is a form of insanity. It may even show unhealthy masochistic tendencies which might need medical attention.”

So there you have it. If you don’t own gold you’re crazy. And from a technical analyst!

As for the “gold bubble” commentators, they can’t even pick a bubble in their own asset classes, let alone ones they inherently don’t understand.

Anecdotal Analysis of Europe

Despite the lack of riots, strikes and protests, your editor’s trip to Europe was eventful. Let’s not go down the path of reciting travel misadventures. Instead, here is the impression a few weeks in Europe gave a former resident:

Firstly, austerity is accepted. Whether it’s students, employees or grandparents, people aren’t deluding themselves. They know the party is over and they know things will change. That doesn’t mean some fun can’t be had in the streets. The French in particular identify with strikes and riots, so that is what they will spend their time doing. But even they acknowledge that austerity is now a given.

So despite what you may see on TV, Europe’s citizens won’t be shutting up shop because their government won’t spend money on them. Then again, some will. But it won’t be due to a lack of ambition. In fact, quite the opposite. The English in particular are eyeing off Australia as a place to escape to. The opportunities are simply so much better.

Young people seem more concerned with opportunity than the cost of their education. Right now, they are getting a raw deal on both, and both thanks to the government.

The country we missed on our travels was Ireland. Friends there say times are tough. But not to worry, the money printers have been at work. You will be surprised to know that the ECB wasn’t involved. Apparently, “The Irish Independent learnt last night that the Central Bank of Ireland is financing €51bn of an emergency loan programme by printing its own money.” About 51 billion Euros!

So those economists who told you European governments gave up independent monetary policy were wrong. They kept the historically favoured tool to themselves – printing money. And the ECB isn’t bothered, as long as it is notified of the printing.

This changes the ball game dramatically, if it’s accurate. Frankly, it seems rather suspicious and mindboggling. On Wednesday morning, if you googled “Irish 51 billion” you got a bunch of obscure websites or irrelevant results. By Wednesday afternoon, the story was everywhere.

While we may be able to outline trends, and imbalances that will need correcting, the Markets and Money does not have eyes and ears amongst decision makers. Who knows what the likes of Ben Bernanke, Lloyd Blankfein and Silvio Belusconi are up to? Occasionally information will leak. None of the true stuff will be good.

As an aside, can anyone tell me if this article is satirical or not?

Nick Hubble
Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like.

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the article is satire.

Tim Flannery, Al Gore and others published books and made films. Clearly they deserve a slice of this massive victory over global warming. To them we say: “Thank you, gentlemen, you may now return to private life.”

once you get to al’s private life, you have gone from science to art.

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