I know I promised to give UR readers a break this week, but the ongoing degringolade of our financial system is just too exciting to ignore.
This post is about the mechanics of returning to what people used to call hard money. This is a very difficult problem for which there is no good solution. However, as we’ll see, some solutions are worse than others. If you need a celebrity endorsement, or quasi-endorsement, Brad Setser says: “if nothing else, your plan is creative.” Indeed.
I will not be discussing the question of why the gold standard should be restored. I assume you either believe this is a good idea, or you don’t. If you don’t, perhaps you don’t care. (Perhaps you haven’t looked at the news lately?) Please feel free to come back next week.
First, let’s face it: the dollar is about as far from being “as good as gold” as Hillary Clinton is from being “a major-league hottie.” She needs a lot of work, and I mean a lot. Restoring the gold standard is about as easy as restoring a ’57 Chevy that has been in the same barn since ’68. Assuming of course that the world has been taken over by zombies, and your only tools are a chainsaw, a hammer, and a case of cheap brandy.
On the other hand, just pushing the Chevy down the road into zombie land isn’t going to work too well, either. So why not at least think about trying it? And that, I promise, is the last I will say on the subject. At least for now.
First: there is a simple plan for successfully restoring the gold standard, which any sovereign can apply at any time for any reason, and which will always succeed.
Let’s call it “Plan X.” To restore the gold standard via Plan X, you need exactly two facts: the face value of valid fiat currency you have outstanding, and the grams of gold in your treasury. (If you do not have this information, you are beyond the reach of accounting. Your country is probably about to be overrun by savage tribes. You should be looking for a seaworthy vessel, not trying to fix your monetary system.)
Let’s call the first quantity F and the second quantity G. The new gold price, Pnew, the price of a gram of gold, in cowries or strips of leather or wood chips or whatever your people are putting out these days, is F/G. At least, it is at least F/G. At your discretion, Sublime Pasha, it may be greater. I don’t think I have to point out the advantages of this option.
What makes a Plan X restoration slightly tricky is that whatever Pnew is, there is also a Pold – the present price of a gram of gold. Since Pnew has to exceed Pold or no one can possibly care, and since it offends the Pasha’s dignity for the Armenians to front-run his ass down in the bazaar, Plan X depends on the element of surprise. While it shares this with all monetary policy, the amount of loot a leak can extract in a Plan X gold restoration is effectively infinite and untraceable. Problem.
Thus it is very difficult for an inefficient bureaucratic state, which is indiscreet by definition, to even consider Plan X as a viable policy option. Since an efficiently managed state would never have left the gold standard in the first place, this problem is unsolvable. Moreover, the same problem holds for all feasible restoration plans. The option of just letting Pnew equal Pold is not physically tractable without some serious alien technology. There is not enough gold on Planet Three. You would need to go in for asteroid mining, or something.
Since this problem is not solvable, we will ignore it. Often people are faced with multiple contradictory problems. I’ll bet a lot of them are working 100-hour weeks right now. To even start to deal with a situation like the present financial crisis, you have to at least know why all your impossible courses of action are just as impossible as they seem.
But there is a second problem with Plan X, which is that it is not politically feasible. Ie, if you just apply Plan X, it will leave a very large number of people hatin’ life, and hating you as well. This is not conducive to a successful career in public service. And this is why, I think, people shrink so instinctively from the very thought of restoring the gold standard. They associate it with Plan X, which is too hateful even to mention. In fact, while moral judgments are not my specialty, I don’t think it’s going too far to describe Plan X as outright unethical.
Here is the problem with Plan X.
The monetary base of the United States today – the number of dollars outstanding in the strict legal sense of the word dollar – is about $800 billion. The monetary base is physical currency, plus the balances of member banks at the Fed. (In case you are unfamiliar with the actual structure of the Fed, think of it as a secret uber-bank at which only banks have bank accounts.)
US gold reserves are about 8000 metric tons. Ergo, F/G is about $100 million per metric ton, or $100K per kilogram, or $100 per gram. Since gold today is around $30 a gram, this represents a Pnew/Pold ratio of about 3. (Obviously, all these values are constantly changing.)
So Plan X, if applied to the dollar, would triple the gold price overnight. This seems rather extreme. It suggests that Pnew is way too high. Perhaps, but it’s also way too low. Did I say this would be easy? If restoring the gold standard was easy, someone would have done it already.
The problem is that the monetary base (M0, or F above) is not a particularly important or useful number. It is not in fact a good representation of “the number of dollars in the world.” This is well-known. And there are a variety of other monetary indicators, with snappy little numbers attached, like M1, M2, etc. In Britain they even have M4, which I was sure was a motorway. In any case, none of these numbers is of much interest either. They are all the result of subjective decisions, littered with constants pulled out of thin air, etc, etc. This again is quite well known. No one has done anything about it, because no one can do anything about it.
(The idea that monetary policy can be managed by mathematical models is, in fact, madness. The experiment is neither deductively understood nor scientifically controlled. Fitting models to the past is no substitute: it will always produce a “data mining” effect. If one of these models somehow turned out to be correct, you would have no way of knowing which one it was.)
Why is it impossible to measure the quantity of dollars in the world? Especially in a modern country which is not about to be overrun by savage tribes, and really does keep a handle on its monetary base? A fascinating question, folks.
We can start to see the answer by looking, within the monetary base, at the difference between electronic dollars at the Fed and actual physical bills. These objects could not be more different – one is a magnetic mark on a hard disk, the other is a piece of paper. Why do we lump them together and treat them as the same thing?
They are equivalent because either form is convertible to the other. Any bank can take a bundle of bills to the Fed and exchange it for electronic credits. Any bank can also draw down its electronic balance in the form of print jobs. Both these rights are protected by law, and there is no conceivable scenario on which the Fed runs out of either disk space or paper.
You’ll sometimes hear dollars in the monetary base called “high-powered,” an incredibly weird and confusing locution. Let’s just call them formal dollars. Since these dollars are all valid at present, they are formal current dollars.
The reason it’s impossible to measure the quantity of dollars in the world is that a formal current dollar is only one point in a vector space. Formality and maturity are both variables. Worse, the latter is quantifiable but the former is not. So we are trying to describe an unquantifiable two-dimensional vector as a precise scalar (our F). If this isn’t mathematical malpractice, I don’t know what is.
How do we solve this problem? As usual, by trying to understand it.
Let’s deal with maturity first. Imagine that every dollar bill had a “not valid before” date on it, like a postdated check. Maturity is simply the difference between now and that time. For example, a zero-coupon Treasury bond which matures in 10 years could be defined as a dollar bill which is not valid until 2018. We can call these dollars not current but latent.
Formality is the extent to which an instrument is guaranteed, in practice, by the Fed. A Federal Reserve Note (“dollar bill”) is perfectly formal. A piece of paper which says “Mencius Moldbug promises to pay the bearer one (1) dollar” is perfectly informal. Between these lies a wide range, which cannot be measured or quantified, but is no less important for that.
A Treasury bond is almost perfectly formal – but not quite, since the Fed and Treasury are at least in different buildings. In practice, the financial markets treat Treasury obligations as perfectly formal or “risk-free.” It is probably best to describe them as negligibly informal.
“Agency” bonds – those written not by Treasury, but nominally private companies (GSEs) such as the infamous Fannie and Freddie – are mildly, but not negligibly, informal. The bond market puts a small premium on agency bonds over T-bonds (typically a quarter point or so), showing that they have a small chance of defaulting. This is essentially a political calculation, and financial markets do not hesitate before making political guesses – which is not to say that they are always right. (Note that we cannot use the GSE spreads as quantifications of formality, because there is another variable in the equation – the actual default risk.)
But the most famous kind of informal dollars are the negligibly-informal current dollars we call “checking deposits.” While checking accounts are not as financially important as they once were, most people have one and most everyone understands them.
A checking deposit is actually a loan from you to your bank. This loan has a zero maturity and is continuously rolled over. If you find this hard to grasp, imagine the loan term was one minute. Every minute, the bank automatically returns your money to you, and you automatically lend it back to the bank. If you show up at the ATM and want to withdraw it, you have to wait until the minute is over. Replace a minute with zero, and you have the “demand deposit.”
It would sort of defeat the purpose, but imagine that your checking-account dollars were not electronic entries, but physical bills. They look just like regular dollar bills, except that they are blue, not green, and they have your bank’s name instead of the Fed’s – eg, “Wells Fargo Note.”
A dollar in a checking account is informal because it is a debt, and the debtor is not the mighty Fed but a sordid, corporate bank. The Fed will not just take a blue dollar and convert it to a green dollar. Your bank has to do that, and your bank has to have its own green dollar to exchange for your blue dollar. If it’s out, the Fed will not just give it more.
However, like the Treasury bonds, blue dollars are negligibly informal. Your bank is “insured” by something called the FDIC. This so-called “deposit insurance” is in fact a sham, because the risk of a bank run is not in any way, shape or form an insurable risk. Nor does the FDIC have anywhere near enough green dollars to exchange for all the blue ones. However, although the Fed is not legally obligated to back up the FDIC – just as it is not legally obligated to back up the Treasury – it is a political certainty that it will do so.
We can think of informal instruments, like agency bonds or blue dollars, as an inseparable combination of two instruments: a private debt (eg, your bank’s debt to you, as represented by the blue dollar), and an option written by the Fed. The option pays off if the debt does not – unless, of course, the Fed’s informal loan guarantee turns out to be not just informal, but actually nonexistent.
We are now in a position to understand the horrendous destruction that Plan X would unleash upon society. Since Plan X does not recognize the existence of informal dollars, applying it is equivalent to destroying them, or more precisely destroying their informal Fed option halves. The debt from the bank to you still exists. But will it be paid? Um…
Plan X is easier if we think of it in two phases. In the first phase, we destroy the informal options and set F to the monetary base M0. In the second phase, we exchange every formal current dollar for F/G grams of gold, courtesy of Fort Knox. (There are no formal latent dollars – the Fed issues no such thing.) After we perform the first phase, we can perform the second at any time, so we can analyze them separately.
All the destruction in Plan X comes from the first phase. Call it Plan X(1). Another way to think of Plan X(1) is that (after printing the entire monetary base), we destroy the Fed’s printing press. No new dollars can be created, ever. If this reminds you of the breaking of the assignat plates, you’re not alone:
This system in finance was accompanied by a system in politics no less startling, and each system tended to aggravate the other. The wild radicals, having sent to the guillotine first all the Royalists and next all the leading Republicans they could entrap, the various factions began sending each other to the same destination: Hébertists, Dantonists, with various other factions and groups, and, finally, the Robespierrists, followed each other in rapid succession. After these declaimers and phrase-mongers had thus disappeared there came to power, in October, 1795, a new government, – mainly a survival of the more scoundrelly, – the Directory. It found the country utterly impoverished and its only resource at first was to print more paper and to issue even while wet from the press. These new issues were made at last by the two great committees, with or without warrant of law, and in greater sums than ever. Complaints were made that the army of engravers and printers at the mint could not meet the demand for assignats – that they could produce only from sixty to seventy millions per day and that the government was spending daily from eighty to ninety millions. Four thousand millions of francs were issued during one month, a little later three thousand millions, a little later four thousand millions, until there had been put forth over thirty-five thousand millions. The purchasing power of this paper having now become almost nothing, it was decreed, on the 22nd of December, 1795, that the whole amount issued should be limited to forty thousand millions, including all that had previously been put forth and that when this had been done the copper plates should be broken. Even in spite of this, additional issues were made amounting to about ten thousand millions. But on the 18th of February, 1796, at nine o’clock in the morning, in the presence of a great crowd, the machinery, plates and paper for printing assignats were brought to the Place Vendome and there, on the spot where the Napoleon Column now stands, these were solemnly broken and burned.
Well, it certainly sounds like the right move at the right time. And who can’t resist the idea of sending a few phrase-mongers, not to mention Republicans, to the guillotine?
But the good news is that we are not in a state of revolutionary hyperinflation. At least, not yet. The bad news is that the result of Plan X(1) would be an episode of economic destruction that would make the Great Depression look like a panty raid.
The informal loan guarantees we destroyed may have been informal. But they existed. And people relied on them – just as if they were formal.
For example, by breaking the plates, we eliminated the Fed’s informal guarantee of Treasury debt. Surprise! Over the next 30 years, Treasury is now obligated to fork over ten times as much gold as now exists in the United States – since the Treasury’s debt is about ten times the monetary base.
What do you think is the chance that this will actually happen? Fairly small, I would say. I suspect long-term interest rates, at least as measured by Treasury bonds (which is how they’re measured now) would go from about 5% to more like 50%. If not 500%. The good news is that you could actually buy that house you’ve been saving for.
The bad news is that your savings probably won’t be there. Because they are probably in blue dollars, or something like them. Those debts from various financial entities to you still exist. But the various financial entities don’t. They will instantly face the mother of all bank runs as people with blue dollars rush to exchange them for green.
The Fed’s loan guarantees, it turns out, have been serving an essential structural purpose in our economy. They have been making term transformation stable. The interaction between term transformation and fiat loan guarantees deserves its own Nitropian analogy, but what we do know is that term transformation is not stable without them. Ergo, since it is not stable, it will collapse. The good news is that you might be able to buy a hamburger for ten cents again. The bad news is that you might not have ten cents.
So our definition of F as the monetary base has a great flaw, which is that it does not account for the informal loan guarantees, which are legally meaningless but economically important. As a result, we are simply destroying a large quantity of money – the monetary equivalent of filling your gas tank with molasses. Woops.
There is only one way fix this. Our new plan, Plan Y, has to include informally guaranteed instruments as well. Furthermore, because it includes informal instruments, it has to deal not just with current dollars but with latent dollars (such as Treasury bonds).
How does Plan Y deal with informal dollars? Very simply. It creates formal dollars, and exchanges them for the informal dollars. So, for example, the Fed can buy all the checking deposits that it has guaranteed. Your checking account becomes a green-dollar account at the Fed. The debt from your bank to you is now a debt from your bank to the Fed.
Alternatively, the Fed could just buy your bank at the present market value – ie, nationalize it. This is less financially elegant, but it may be simpler in practice. It also has another advantage, which is that it wraps up the maturity mismatch on the bank’s books. Your bank is almost certainly backing its short-term obligations with long-term receivables. If the Fed refuses to renew the rolling loans that used to be everyone’s checking deposits, the banks will fail. If it lets them roll on for ever, it might as well cancel them. Either way the result is ugly.
There are two ways for Plan Y to deal with latent informal dollars. One is to exchange them for latent formal dollars. The other is to exchange them for current formal dollars.
Perhaps the former could be made to work, but the latter is probably superior. The trouble is that in a world with protected term transformation, we really have no idea what the maturity preferences of investors are. If we assume that they correspond to their current holdings, we run the risk of considerable economic disruption.
The people who have been buying 30-year T-bonds are not, in general, people who are genuinely willing to exchange current dollars for dollars which are not valid before 2038. In fact, considering that we have a system in which maturity transformation is ubiquitous, there are probably a lot of financial players who own dollars which are not valid before 2038, but have contracted to deliver valid dollars in, say, March.
We do not actually know where supply and demand would set the 30-year interest rate. It could be anything. If we assume that it has any relation to the present rate, we will, again, create disruption. If we wanted disruption, Plan X would do just fine.
What we see is that Plan Y is essentially a bailout of the entire dollar financial system. The informal guarantees have spread very far and wide. Our goal, in the first (formalization) phase of the plan, is to find them all and use formal dollars to buy them all out at the present market price. One of the largest sets of informal guarantees is the set of promises the US government has made to itself in the form of Medicare and Social Security, which may give you some idea of the kind of numbers we’re looking at. (Fortunately, entitlement payments are not securitized and thus are not on the balance sheets of term transformers, which means they can be exchanged for latent dollars.)
When Plan Y(1) is complete, everyone’s monthly portfolio statement should show more or less the same number that it did before, and the Fed will enjoy managing many fascinating new assets. F, the final monetary base, will be a precise measure of the number of dollars in the world. And we are free to go through with Plan Y(2), which is precisely the same as Plan X(2): redeeming all dollars for gold.
However, we are no longer increasing the gold price by a factor of 3. The factor is now more like 300. This does not require any more or less secrecy or surprise than increasing it by 3 – in both cases, discipline must be absolute. But it does make us think a little.
Not all the gold in the world is in Fort Knox. If you increase the gold price by two orders of magnitude, you are making anyone who now owns gold extremely wealthy. This happens – people make money, and they make money by being right when everyone else is wrong. Predicting that paper money was unsustainable and the gold standard would live again was not exactly a conformist investment. If you restore the gold standard, you have validated it.
Also, you can tax the hell out of these people. Any restoration of the gold standard should be associated with a high direct tax on gold ownership. If the tax is too high, it will pass the Laffer peak and favor the really crazy antigovernment types who keep their Krugerrands in their flowerpots. 80 or 90%, for example, is probably too high. But 60% probably isn’t.
The new gold zillionaires will certainly compete in some markets and drive up some prices, but it is hard to see how they will much inflate the price of, say, crude oil, or wheat. It’s also worth noting that a lot of the world’s gold, especially the gold that hasn’t been mined yet, is in places like India and Africa, which could sure use a little money. And while no increase in the gold price will produce a giant flood of newly mined gold – people have been trying very hard for a very long time to get gold out of the Earth’s crust – two orders of magnitude will certainly create a lot of jobs, not all of which are menial. Perhaps some of our financial engineers could go back to school and study geology.
On the other hand: once we have executed Plan Y(1), do we really need Plan Y(2)?
After all, our goal in restoring the gold standard is hard money: a completely neutral monetary system, which is not subject to manias and panics, and does not bollix economic prediction by exerting a chaotic, exogeneous, politically charged effect on price levels or business activity. In other words, our goal is to never have to deal with this kind of BS again. Condy Raguet put it well when he said:
Such being the theory of this branch of my subject, I have the satisfaction to state in regard of the practice under it, upon the testimony of a respectable American merchant, who resided and carried on extensive operations for near twenty years at Gibraltar, where there has never been any but a metallic currency, that he never knew during that whole period, such a thing as a general pressure for money. He has known individuals to fail from incautious speculation, or indiscreet advances, or expensive living; but he never saw a time that money was not readily available, at the ordinary rate of interest, by any merchant in good credit. He assured me, that no such thing as a general rise or fall in the prices of commodities, or property was known there; and that so satisfied were the inhabitants of the advantages they enjoyed from a metallic currency, although attended by the inconvenience of keeping in iron chests, and of counting large sums in Spanish dollars and doubloons, that several attempts to establish a bank there were put down by almost common consent.
This is not the only historical example of the delights of monetary predictability. And there is nothing more predictable than a constant. Suppose that, after formalizing the dollar base, we just leave it at that? Why do we need the gold standard? Can’t we just fix the number of dollars in the world, and call it a day?
We can. But we may not want to.
Gold makes a good currency for several reasons. First, because it has some intrinsic uses, it is self-bootstrapping in the classic Mengerian sense. But the dollar is already a currency, so bootstrapping is not a concern. From an economic perspective, fiat currencies work fine. Second, after a few millennia of mining, new gold is extremely hard to come by, so the supply is quite inelastic. (The present gold supply dilutes at well under 2% per year.) Inelastic is almost constant. But constant is even more constant.
So a fixed, formalized dollar supply would create a currency that was actually harder than gold – at least, in a strictly economic sense. The dollar would not be “as good as gold.” It would be better. (If only we could do the same for Hillary.)
This course of action would also have the effect, surely delicious in some peoples’ minds, of sending the gold price back down into double digits. People who hold gold (such as myself) are, in general, holding it as money. If you fix the fiat currency system permanently, you destroy the entire monetary premium on gold. If this course is taken, perhaps its architects could have some pity on us poor economic royalists, and print a little extra to buy back our Krugerrands.
The only problem with a fixed-supply fiat currency is that it has been tried before. It’s one thing to limit the number of dollars in the world. It is quite another to enforce that limit. Congress can pass a law prohibiting the Fed from printing new money. But will it? And next time there is a war, a flood, an indoor rainforest in Iowa, or some other budgetary emergency, won’t it just unpass it? Our F might quite easily become like the Federal debt limit, which is routinely increased. A better idea might be to put it in a Constitutional amendment. But even these can be repealed, or still worse judicially ignored.
As Alan Greenspan once explained, gold as a monetary standard succeeds because it is self-enforcing. The Fed cannot print gold. Congress cannot pass a law which creates it. If the gold standard is really brutally abused, as it was in the 1920s and ’30s, it will turn on its abusers with a vengeance. This is not a bug, but a feature. Gold works because it keeps the government honest. And surely anyone of any political persuasion can agree that honest government beats the converse.
Of course, the main problem with Plan Y, gold or no gold, is that it can’t possibly happen. It is impossible to imagine Washington executing any plan anywhere near this unusual and aggressive. Moreover, the first step is always to admit that you have a problem. Picture that press conference! I can’t, which is why I can’t see this happening.