Testing the Limits of Fiat Currencies
No Free-Lunch Economics
I am a believer in the “no free-lunch” Austrian school of economics. I believe that monetary policy and credit markets have limits and that the current path is unsustainable and something has to give.
Fiat Currencies
As Voltaire warned us: “The value of paper money eventually converges to its intrinsic value: paper,” a very skeptical view of the incentives and behavior of the Governments issuing such paper.
Indeed, fiat currencies are an act of faith in the Central Bank and Government who created it. History is full of examples of Governments who tried to finance their wars and/or social programs by printing money, taking advantage of the ignorance of their people and/or assuming they had no choice. They were wrong.
The Two Sides of the Monetary Coin
Monetary policy and fiat currencies are two sides of the same coin. If we destroy one side, we will most likely destroy the other. As such, our efforts to test the limits of monetary policy translate directly into testing the limits of fiat currencies. The checkmate of this game and the channel by which Central Banks and Governments are forced to re-establish the trust, or else.
A central bank’s balance sheet is the foundation on which both money and monetary policy are built. A central bank’s liabilities define the quantity of so-called base money in circulation. And the interest rate on central bank money defines monetary policy. In that sense, central bank money and monetary policy are two sides of the same coin.
—Andy Haldane, Chief Economist, Bank of England
Needless to say, gold-backed currencies have no monetary policy or seigniorage. The duty of the Central Bank—once upon a time—was to ensure that all paper money was backed by gold. A physical feature that protected the currency from potential dilution via printing.
The decoupling of gold from money has not only opened the gate for Governments to expand and contract the monetary base to achieve its objectives of financial stability, but it has also opened the door to the dangerous slippery slope of seigniorage and monetary financing.
Easy Solution #1: Print More Money
It would be nice if we could print our way out of every problem. History is full of examples of economies, such as Argentina, Zimbabwe, or more recently Venezuela, who have tried and failed. Many other developed countries, such as Japan or Europe, are behaving similarly—if not worse—but can get away with it, for now.
I found myself doing extraordinary things that weren’t in the textbooks. Then the IMF asked the U.S. to please print money. The whole world is now practicing what they have been saying I should not. I decided that God had been on my side and had come to vindicate me.
—Gideon Gono, Former Governor, Reserve Bank Zimbabwe
Easy Solution #2: Borrow More Money
It would also be nice if we could borrow our way out every problem. Here again, many countries such as Russia, Mexico, or Greece have tried and failed. Some developed and developing countries such as Japan or China are behaving similarly—if not worse—doubling and tripling their bets with the invaluable help of their partner in crime, the Central Bank.
Gold’s Perfect Storm Investment Thesis
I first presented the Lehman Squared and Gold Perfect Storm investment thesis during the Annual LBMA Gold Conference in October 2015 that was being held in Vienna. The sentiment across market participants was extraordinarily pessimistic at the time. Gold prices were under immense pressure ahead of the much-anticipated first hike by the U.S. Federal Reserve. My investment thesis and asymmetric outlook were highly contrarian to the depressed and pessimistic consensus and positioning of the market, which only reinforced my view that gold was about to reverse course.
My Gold Perfect Storm thesis reached a global scale a few months later with the publication by the Financial Times of my article by the same name which, to my surprise and honor, was published on the front page of the written edition on June 8, 2016. An extract of the article described the investment as follows:
Gold prices have rallied over 30 percent since the lift-off in U.S. interest rates in December. A sharp reversal in pricing, sentiment, and positioning driven by a myriad of macro and micro factors and has left the gold bears and bulls as polarized as ever.
The bearish camp, which has featured prominent and respected analysts such as Goldman Sachs, tends to have a constructive view on the US dollar, the ability to raise interest rates, normalize global monetary policy, and generally a benign view on the global economy and inflationary risks.
The bullish camp, which I subscribe to, tends to have a more pessimistic view on the global economy and the unintended consequences of monetary policy without limits, and sees the recent price action as the beginning of a multiyear bull-run in gold. My view that there is a perfect storm for gold based on three closely interrelated dynamics, whereby central banks and global markets are both testing the limits of monetary policy and credit markets as well as the boundaries of fiat currencies.
Gold’s Perfect Storm investment thesis argues that gold is at the beginning of a multiyear bull market with “a few hundred dollars of downside, and a few thousand dollars of upside.” The framework is based on three phases: testing the limits of monetary policy, testing the limits of credit markets, and testing the limits of fiat currencies
Gresham’s Law: Good Money and Bad Money
I first came across Gresham’s law in Peter Bernholz’s book, “Monetary Regimes and Inflation: History, Economic and Political Relationships,” a somewhat dry but extraordinary foundation to understand the current dynamics in the global currency markets.
Gresham’s law introduces two concepts: good money and bad money, and how they interact through inflationary and hyperinflationary scenarios.
Phase 1: “Bad Money Replaces Good Money”
The concepts can be easily understood via a historical case study. It all starts with a monetary system backed by physical gold. There is paper money, but it is backed on a one-by-one basis by gold. Let’s assume, for the sake of argument, that there were 1 million currency units backed by 1 million gold units.
The Government enters into war and decides to finance its war (pay the soldiers, etc.) by printing paper. Initially, everyone assumes that the paper money is backed by gold. Nobody knows that paper is being printed. There is more paper money in circulation, but inflation is contained. Trade continues normally, but somehow paper transactions start to dominate. A few smart people prefer to pay in paper and accumulate gold, and as a result bad money (paper) starts to replace good money (gold) from transactions.
Phase 2: “Good Money Replaces Good Money”
At some point, inflation starts becoming more obvious to the public. The butcher, the baker, the smith, can feel that there seems to be more paper and goods. Trade starts to demand payment in gold instead of paper, which accelerates inflation. The soldiers and providers of the Government, aware of inflationary pressures, demand higher wages and prices, which leads to the government to accelerate the speed of money printing. The gradual loss of confidence in paper money gives way to a phase where good money (gold) replaces bad money (paper), which accelerates inflation further. At one point, inflation explodes and gets out of control.
Far from giving up easily, there are examples in history when the Government introduced death penalty for not accepting paper currencies. A good reminder to those wondering how far governments could go with their monetary policy without limits.
Eventually, and ironically, the Government demands payment of taxes in kind (corn, meat, timber, etc.) and stops accepting their own paper money. The last nail in the coffin for the paper currency.
The Government is then forced to stop the printing in an effort to re-establish the trust in their creation, their paper money. After a period of extreme volatility, the value of paper money is anchored to gold. The fair value is a function of how much money was printed. If the Government printed 9 million incremental paper units, then the new value of gold will be 10 times higher than prior to the currency crisis. I call this a monetary supercycle.
Seigniorage
Central Banks discovered very quickly the benefits of seigniorage, which is the difference between the value of money and the cost to produce it.
Seigniorage is the difference between the value of money and the cost to produce it.
In the early days of money this was done by casting coins with denominations that were greater than the value of gold required to produce it.
Today, what is the cost of issuing paper money, say a $100 note? Not much.
And the cost of issuing digital money, say a $100 book entry? Even less.
The difference is a windfall for the Government. Thank you very much. And why it is just a matter of time before they get their hands via taxation or outright prohibition of other forms of virtual money outside of Government control, such as crypto currencies.
Gresham’s law provides a clear framework of “no free-lunch economics.” The gold price must appreciate to reflect the exact amount of paper money that has been printed.
Supercyclical behavior is the norm in commodity markets. I have gone through several of them during my career and that is why the concept is very obvious and intuitive to me. At the core, the physical nature of commodities means we can’t print crude oil, or copper, or corn, or gold. A supercycle works as follows:
A typical supercycle starts with overcapacity, whereby supply is greater than demand and leads to the accumulation of inventories. This is a period of low commodity prices and poor economic returns, which discourages investment in new productive capacity and encourages demand and consumption. Demand growth starts closing the gap with supply and eventually the market rebalances and goes into a deficit, whereby inventory levels are withdrawn and could eventually run out. Prices start to go up to incentivize investment, substitution, and demand destruction. In the absence of inventories and elastic supply (it takes time to build mines, oil fields, etc.) the only way to adjust the market is by demand destruction, which explains the surge in commodity prices and the backwardation in the forward curves (premium for immediate availability). How high commodity prices spike is largely a function of the price elasticity of demand and substitution. In the case of crude oil, for example, the market was extremely inelastic: in order to destroy 2 percent of demand, oil prices had to go up by 100 percent (double). In the old days, it would take at least 10 years to develop a new oil field, which explains why the supercycles in energy have been so wild. In other markets, such as copper, it takes on average three years to develop a mine. In the case of shipping, the supply response can be less than one year.
Back to gold, we have been accumulating and issuing paper money without any tangible backing, such as gold. The value of money is an act of faith on the Government and Central Banks that created it.
Room of Mirrors
The current global currency system can be compared to a room of mirrors, where the asset and liabilities of the Central Banks balance sheets are mainly paper and government bonds, their own (which they can print) and someone else’s (which someone else can print), plus some historical legacy of gold that once-upon-a-time backed the currency.
The relative value of the main global currencies, such as the USD, EUR, or JPY is set by the free trade of their exchange rates in the markets. Some currencies, such as the CNY (Chinese Yuan aka Renminbi) or the SAR (Saudi Arabian Riyal) are pegged to the USD. A move where they give up their monetary policy in exchange for some perceived stability, which, as part of the “no free-lunch” school of economics, leads to imbalances somewhere else, in the form of inflation/deflation, accumulation of reserves, shadow banking, and other complex dynamics. A time bomb in my view.
Monetary Asset that Is No One’s Liability
In this context of global cross-holdings of currencies and government debt, gold stands out as the only asset that is no one’s liabilities.
Shadow Gold Price for USD
The size of the Central Banks balance sheets has steadily expanded over the past few decades, but has dramatically accelerated with monetary policy without limits, while Central Bank gold reserves have stayed relatively stable.
The application of Gresham’s to calculate a theoretical monetary price of gold was coined by Paul Brodsky and Lee Quaintance as shadow gold price (SGP), which extrapolates the value of gold from the end of Bretton Woods adjusted by the growth in base money versus growth in U.S. Government actual gold holdings. Assuming a reserve conversion ratio of 100 percent the gold shadow price would be 18,000 USD. And this is just for the USD, which happens to be the largest gold holder in the world.
In 1914, the Federal Reserve Act stipulated a minimum gold cover of 40 percent, which was subsequently reduced to 25 percent between 1945 and 1971, before it was completely removed with the end of Bretton Woods. Under those reserve cover ratio, the price of gold would need to be adjusted on a prorated basis.
Shadow Gold Price in Other Currencies
The SGP for the Japanese Yen is astronomical due to the combination of a high numerator (base money in local currency terms) with a small denominator (gold reserves). Japan is the 8th largest Central Bank in terms of official gold reserves with 765.2 tons, equivalent to less than 25 million ounces of gold, and valued at less than $30b at current market prices. To put in context, the official gold reserves of Japan would buy less than 5 percent of the market cap of Apple.
The SGP and other similar valuation methods are theoretical data points, not meant to be price targets, but make clear the extent of the money printing and the dilution of paper currencies versus gold reserves. A dynamic that is consistent with the view that “gold has a few hundred dollars of downside and a few thousand dollars of upside.”
Monetary Asset of Choice
I was once asked in a meeting, and why gold and not bananas? The idea behind the question was: what makes gold so unique? Should all real assets benefit in parallel from inflation and money printing?
It is true that pure parallel shift in inflation caused by money printing should inflate all assets more or less proportionally. In that sense, the price of bananas, land, crude oil, or gold, should all go up in tandem.
The monetary supercycle is not a parallel shift. It is a rebasing of the printing of monetary base versus a monetary asset of choice, which in my view is likely to be gold for a number of reasons, including its unique physical and chemical properties that make it the store or value of choice by many civilizations for over 3,000 years, and its scarcity, which prevent it from excessive dilution via mine production.
In the 17th century, Sweden introduced a copper-based monetary system that worked very well until the world copper price slumped following the discoveries of large mines in Africa and the Americas. Sweden’s daler had a much greater face value than the copper content market value and was easy to counterfeit, which resulted in the rapid loss of the seniority premium, wiping out the purchase power and savings of many people of Sweden.
In addition to its physical and chemical properties and its rarity, gold counts with the support of many influential governments. China and Russia, for example, have been steadily accumulating gold reserves over the past few years as part of a parallel battle for the reserve currency status.
The Battle for World’s Reserve Currency
The United States and the U.S. dollar have been enjoying the privileges of being the World’s Reserve Currency since the 1930s, when it took over from the Sterling Pound.
As the Reserve Currency of the World, the USD is held as the dominant share of foreign exchange reserves, serves as the base for international transactions, and is often considered a hard currency with safe-haven status, which has allowed the U.S. Government to finance itself with foreign capital in large quantities and more cheaply.
The U.S. Government is currently the largest holder of gold with 8,133 tons, with current market value circa $300 billion, which equates to less than 50 percent of Apple’s Market Cap. Not as large as one might have thought.
The Chinese Government has been a steady buyer of gold over the past few years, and has supported the trade and ownership of gold by its citizens with the development of the Shanghai Gold Exchange (SGE), which has already surpassed the almighty New York Mercantile Exchange (NYMEX) and London interbank market in terms of daily volumes. As of writing, the official Chinese gold reserves stand at 1,838 tons, approximately $70 billion, and 2 percent FX Reserves.
Central Banks will most likely continue to be net buyers of gold, led by China, Russia, and India, which will likely lead to the steady flow of gold from West to East.
The Monetary Supercycle
The Gold Perfect Storm investment thesis argues that testing the limits of monetary and credit markets will eventually also test the limits of fiat currencies. The loss of faith in paper and digital money could force the governments to anchor the value of their devalued currencies to a credible base.
The USD and gold are the best candidates to play the role of good money, but that the “USD emperor has no clothes either” and gold will eventually prevail as the monetary asset of choice. A monetary supercycle that will result in a very significant appreciation of gold against most currencies, but particularly against those that are “bad money disguised as good money,” as it is the case for the Japanese Yen, and possibly the Chinese Yuan.