Chinese GPS: Payback in Full with Benefits
This sequel to The Golden Sextant offers an updated approach for a gold-based reform of the international monetary system. As used in the title, "GPS" refers to the Gold Positioning System proposed below.
Gold and to a lesser extent silver have served as permanent natural money throughout history, but the manner of their use has typically been dictated by the dominant economic power of the era. In the century prior to World War I, the British Empire took the lead in managing the classical gold standard, and even today London remains the hub of the world gold market. During the interwar years, the British had to share monetary predominance with the Americans as together they tried to make the gold exchange standard function. But the attempt to maintain the prewar parities proved unrealistic; the effort collapsed in failure, ushering in the Great Depression. See J. P. Warburg, The Money Muddle (Knopf, 1934), pp. 54-60.
Under the Bretton Woods Agreements after the Second World War, global monetary leadership passed to the United States, which until President Nixon closed the gold window in 1971 promised to redeem dollars presented by foreign monetary authorities at the rate of US$35 per ounce. Since then, all the nations of the world have for the first time in history been on a fiat standard with no official link to gold, silver or anything else of tangible value. And the result has been entirely predictable: depreciating currencies, mushrooming private and government debt, widespread major bank failures, sovereign defaults, and in the Western democracies, the poorest economic performances since the Great Depression.
In short, freed from the discipline of sound money, the modern democratic welfare state is going broke. Perhaps Margaret Thatcher put it best: "The problem with socialism is that eventually you run out of other people's money." Then the path of least political resistance is resort to the printing press, its modern equivalent being policies of so-called quantitative easing characterized by abnormally low interest rates.
By undercutting normal gold lease rates, these super low interest rates have forced central banks to reduce their lease rates to nonsensical levels in order to prevent gold futures from going into overt backwardation. Recall that GOFO, the gold forward rate, is the interest rate for a given maturity less the lease rate for that maturity, and that a negative GOFO represents backwardation. See Gold Derivatives: GLD and Ass Backwardation (5/24/2010); Gold Derivatives: The Tide Turns (5/25/2009). Passing the argument that widely reported premiums for spot physical delivery represent a form of backwardation, figures from the LBMA have now shown a negative GOFO at the shorter maturities for almost three weeks (July 8 through July 25) due to a surge in lease rates, which still remain below more normal historical levels.
Indeed, this unusual event has attracted considerable attention even from those outside the narrow world of gold. See, e.g., J. Skoyles, Backwardation, negative GOFO and the gold price, The Real Asset Co. (July 24, 2013); M. Kentz, Gold futures hiccup indicates demand outpacing supply, Reuters (July 19, 2013); G. Williams, What If, Things that Make You Go Hmmm, Mauldin Economics (July 15, 2013).
A well-functioning international monetary system is as critical to a healthy global economy as a well-functioning circulatory system is to the human body. Backwardation in gold can be compared to very high blood pressure: a sign that something is dangerously amiss and that absent prompt remedial action, a serious and quite possibly catastrophic event is imminent.
No country has a greater stake in a strong and prosperous global economy than China, the emerging economic superpower with a population of some 1.3 billion. While many of the world's major nations and some of its smaller ones have by various means tried to discourage private gold ownership, China almost alone has promoted the use of gold by its citizens. At the same time, China has aggressively added to its official gold reserves, leading some to suggest that the ultimate goal is a gold-backed yuan trading freely on international markets.
Whatever the ultimate goal, the parlous state of the global economy and the international monetary system on which it depends calls for action now, and the only country capable of imposing a useful and effective unilateral reform today is China. No option other than unilateral action exists; it is fantasy to believe that any sort of international conference could under current conditions even be assembled for this purpose, let alone reach agreement on meaningful reforms.
Ample historical precedent exists for unilateral action by a dominant monetary power to impose changes on a malfunctioning international payments system. President Roosevelt acted unilaterally to almost double the price gold and ultimately force a worldwide devaluation. President Nixon acted unilaterally to torpedo the Bretton Woods agreement and put the world on an exclusively fiat system.
Today, given its over US$3 trillion equivalent of foreign exchange reserves--most in U.S. dollars--and strong international trading position, only China possesses sufficient economic and financial clout to seize the monetary initiative as the United States did twice in the last century. What is more, China almost alone among the major nations has a political system capable of acting for the long term even at the expense of considerable short term pain. Jean-Claude Juncker, former prime minister of Luxembourg and for eight years president of the Eurogroup of finance ministers, neatly summarized the dilemma of the Western democracies: "We all know what to do, we just don't know how to get re-elected after we've done it."
What China should do is to adopt and implement a US$ denominated floor price for gold and commit to maintaining that price, which may be adjusted upward but never lowered. The well-informed will immediately recognize that this idea is borrowed from and an adaptation of the proposal that Hugo Salinas Price has made for Mexico, but with two key modifications: (1) it is based on gold, not silver; and (2) the price is stated not in the currency of the nation setting the floor but in the world's current principal reserve currency, of which China has a more than an ample supply along with the means to acquire more. See Hugo Salinas Price, How to Introduce a Silver Coin into Circulation in Mexico: The Hybrid Coin (2004); more information at www.plata.com.mx.
Gold: Money for Savings. Given the rate at which their real purchasing power depreciates, fiat currencies do not provide a good long term store of value. Supported by legal tender laws, they are useful primarily as transactional currencies. But while the monetary metals--gold and silver--provide effective stores of wealth over long time horizons, their practical use as vehicles for saving by ordinary citizens is undercut by the volatility of their prices. Indeed, exacerbating this volatility is a favored method used by governments to discourage use of gold and silver in competition with their fiat currencies.
The key insight underlying Hugo Salinas Price's proposal for silver coins as a vehicle for saving by Mexicans is the recognition that for the idea to be workable at a practical level, holders of these coins must be able to convert them into Mexican pesos--the legal tender transactional currency--on short notice, at a predictable rate, and without significant capital loss. Hence his proposal that the Mexican government stand ready on demand to repurchase the silver coins--the Libertads--in Mexican pesos at a set price that may be increased in the discretion of the government but never decreased.
The same idea is equally applicable to gold. Remove the volatility and gold becomes the preferred savings medium, subject, however, to competition from reasonably sound fiat currencies offering sufficiently attractive interest rates to draw savings away from gold. Like cash, gold held in physical form produces no yield. Governments that wish to draw gold out of savings and into productive sectors of the economy need only manage their currencies responsibly enough to invoke the operation of Gibson's paradox. See Gibson's Paradox Revisited: Professor Summers Analyzes Gold Prices.
Requiring the established floor price to move in only one direction--up--is consistent with all historical experience: over the long term all fiat currencies depreciate to zero. It is also consistent with gold normally being in contango against all currencies, i.e., its future price normally being higher than spot. Nor does the one way direction of the floor price indicate anything about the rate at which it may rise. In practice it may be expected to lag the market price, moving up only enough to eliminate the possibility of downside market action severely impacting the value of savings.
Floor Price: Mechanics and Arbitrage. Determination of the initial US$ floor price as well as any subsequent increases must be left to the discretion of the Chinese. Bearing in mind that the price may be raised but not lowered, caution suggests a conservative approach informed by recent market action. Additionally, as the world's largest gold producer, China is well-positioned to give due consideration to the current costs of new gold production and to the level of prices required to support a healthy gold mining industry.
A key initial issue for the Chinese would be whether to give some advance public notice of the possible implementation of a US$ gold floor price. Whether done by rumor, leak or establishment of a formal study commission, even broaching the idea would in all probability have an effect--quite possibly dramatic--on existing gold prices. While that market action might well be helpful in setting the initial floor price, it could also result in severe market instability should the proposal be considered but ultimately not adopted.
Mechanically, implementation of a US$ denominated gold floor price by the Chinese requires only that the People's Bank of China, or such other agents as it or the government may appoint, stand ready on request to purchase London good delivery 400 oz. bank bars from approved banks or other sellers at the floor price. There would be no need for China to deal in smaller bars or coins. When and if the market price declined to the level of the floor price, smaller transactions could be handled through arbitrage as banks and dealers developed a widely accessible network offering to pay the floor price less a modest discount. More likely, however, growing confidence in the floor price would push the market price higher as increasing monetary use of gold contributed to rising demand.
Benefits to China and the World. The benefits to China, and indeed to the rest of the world, would be the long term benefits that may be expected to flow from a reformed and more stable international monetary system linked to gold, but in a manner far more flexible than earlier versions of the gold standard. Those systems called on governments to redeem paper for gold, something they too often ran out of. The Chinese Gold Positioning System would reverse the traditional exchange, replacing the promise to redeem paper for metal at a fixed rate with a promise to purchase metal with paper at a fixed or higher price.
Some have suggested that China may have used the recent drop in gold prices to make further additions to its reserves, quite possibly with an eye to someday backing the yuan with gold. Such purchases are of little or no current benefit to the Chinese or global economies. While they may allow China to replace some dollar reserves with gold, they do nothing to stabilize the value of the dollar reserves that China continues to hold. And should the yuan in future be made redeemable in gold, China will face the same problems and constraints that have plagued past gold and quasi-gold standard regimes.
Chinese GPS would initially operate as both a tell-tale and a lever, a sort of report card, on the US$. Should the dollar be managed so recklessly as to lose its current status as the principal reserve currency, as would be indicated by a rapidly rising floor price, the Chinese would always have the option also to set a floor price in yuan, effectively replacing the dollar as the key currency. But by initially setting the floor price in US$ rather than yuan, China would be working within the current system, challenging the United States to better manage its own currency while allowing adequate opportunity for the international payments system to adjust if it does not.
What is more, any country could follow the Chinese lead and set a floor price for gold in its own currency. Indeed, it is possible to imagine a brave new monetary world where currencies compete on the basis of gold floor prices and interest rates. Under these circumstances the attractiveness of a nation's notes and bonds would be determined principally by the proximity of its floor price to market, the competitiveness of its interest rate structure, and the perceived general soundness of its monetary policy. Nations that scored well on these criteria could expect to draw savings from gold holdings; those that did not could well find themselves effectively excluded from the debt markets.
Under Chinese GPS, the gold market would become far more transparent and connected to the physical market for real metal. No longer could the gold savings of ordinary folks all over the planet be devastated by volatile downside action caused by large bullion banks trading paper gold in the New York and London futures markets, frequently with the support of central banks trying to make their own currencies look better against gold than they are.
On the contrary, central banks would no longer be at war with what has historically been their principal asset. Rather, rising gold prices would allow them to repair their own balance sheets. Those which had stupidly sold down or leased out their gold could buy more, either at market or even by setting a floor price above market, which would become the new method of devaluation.
The balance sheets of the Western democracies are simply too weak to permit an easy transition back to a sounder gold-linked international monetary system. Chinese GPS, while not pain-free, would provide a start to global monetary reform and a pathway out of the morass of floating and depreciating currencies into which the Western central banks have now led us. Just as the world had to adapt to President Nixon's closing of the gold window, it will adapt to Chinese GPS, but in this instance rather than a descent into the abyss of unlimited fiat, gold will be restored to its proven historical role as the principal global monetary numeraire.
Impact on the United States. Chinese GPS, of course, would pose a huge challenge to the United States, particularly to the Federal Reserve and the U.S. Treasury, both of which are now wedded to abnormally low interest rates with no apparent means of escape. No longer could the Fed make saving the "too big to fail, to big to sue banks" its primary objective. Rather, to save itself it would be forced to save the dollar by honest means, including higher interest rates and the possible early establishment of its own gold floor price. No longer could the Treasury assume that the Fed would always step forward as buyer of last resort for its notes and bonds, which would have to compete in the debt markets on a far more equal basis that heretofore with the notes and bonds of other governments.
Many in the United States, including pension funds, retirees and others dependent on yield from fixed income securities, would be pleased and relieved by the return to a more normal interest rate structure. So too, overseas investors in U.S. government securities, including foreign central banks and monetary authorities, would welcome the prospect of a more stable dollar. From their perspective, Chinese GPS would answer the conundrum posed by John Connally, President Nixon's Secretary of the Treasury, who in a 1971 meeting with other G-10 finance ministers stated: "The dollar is our currency, but it's your problem." At a single stroke, implementation of Chinese GPS would make the health of the dollar problem number one in Washington.
Fed Chairman Ben Bernanke may not have had prior professional exposure to the gold market comparable to that of what a Time cover story once labelled "The Committee to Save the World" (Messrs. Greenspan, Rubin and Summers, Feb. 15, 1999), but his testimony of July 18, 2013, to the Senate Banking Committee suggests an ignorance of gold and the gold market that is scarcely credible coming from a Fed chairman and illustrates why the Fed and other central banks are so paranoid on the subject.
Gold is an unusual asset. It's an asset that people hold as disaster insurance. A lot of people hold gold as an inflation hedge. But movements of gold prices don't predict inflation very well, actually. But anyway, the perception is that by holding gold you have a hard asset that will protect you in case of some kind of major problem. I suppose that one reason gold prices are lower is that people are less concerned about extreme outcomes, particularly negative outcomes and therefore they feel less need for whatever protection gold affords....
Gold price going down is not necessarily a bad thing from that perspective. It suggests people have somewhat more confidence, and are less concerned about really bad outcomes. But let me just end by saying that nobody really understands gold prices, and I don't pretend to understand them either.
Much as Mr. Bernanke might wish that the recent smash in gold prices reflected growing confidence in the Fed's policies, nobody with any real knowledge of the gold market believes that to be the case. On the contrary, all the evidence suggests that the decline was orchestrated by the Fed, almost certainly in collusion with the Bank for International Settlements and other key central banks, to bail out their agents, the large bullion banks, from untenable short positions put on not merely for profit but more importantly to silence the warning that rising gold prices give. See, e.g., I. Gordon, Who Killed the Gold Price?, The Gold Report (June 26, 2013); J. Browne, Is golds fall Feds doing?, Pittsburgh Tribune-Review (May 25, 2013); Systemic crisis 2013: with record stock exchange highs, the planets imminent plunge into recession, Global Europe Anticipation Bulletin (GEAB) N°75 (May 16, 2013); G. Arensburg, So Much for Position Limits on COMEX Gold, Got Gold Report (May 15, 2013); and numerous interviews at King World News.
Payback with Benefits. While the monetary changes wrought by the New Deal centered on gold, silver too played a critical role, not least because President Roosevelt required the political support of important senators from the silver producing states. No country was more affected by U.S. silver policy of the era than China. As the last major nation on a silver standard, its money supply was drained by increased world silver prices triggered by official American buying. This bit of monetary history is best recounted by Professor Roy W. Jastram in Silver: The Restless Metal (Wiley, 1981), pp. 98-103.
A profoundly disturbing example of how one country, for purely domestic political reasons, can devastate the economy of another country can be seen by examining the effects of U.S. silver policy on the Chinese Republic. The history of this sorry episode is replete with governmental clashes at the highest levels, Japanese skullduggery in her expansionist schemes, the collapse of trade in international markets, the ruin of countless Chinese trades people and--it is not too much to say--starvation among her peoples.
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It is sad to be reminded of popular American comments of the times. These seldom went beyond reiterating the conviction that doubling the world price of silver would double the exchange value of China's stocks of silver and thereby allow her to buy the United States out of the depression. What it did was to drag China in.
The Chinese never joined in the exhortation for higher silver. Two economists at the University of Nanking summarized the statements of many when they said, "As long as China remains on a fixed silver standard, those who advocate and work for higher silver values are unconsciously working for declining prices and depression in China."
Domestic American silver aims were, therefore, basically at variance with the economic good of China. Insofar as American business representatives argued this case, they were selfish and mistaken. Insofar as the silverites played the Chinese card, they were either naive or cynical. Both groups achieved their goal in the United States, and China went into economic confusion and depression.
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[Secretary of the Treasury] Morgenthau warned President Roosevelt that American policies, especially the increased price of silver, were giving great aid to Japan by weakening China's currency position. He was constantly embarrassed by the results of the policy he was required to carry out; as he wrote in his diary, he felt as if he might as well be in the pay of the Japanese.
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At the close of October in 1935, the Chinese had reached their limit of patience--even endurance. They proposed the sale of a huge amount of silver in preparation for putting their money on a paper basis. On November 3 they nationalized all domestic silver and ordered it exchanged for paper notes.
The silver policy of the Roosevelt administration tried to rescue the U.S. economy at the expense of certain devastation of China's. Chinese GPS would attempt to rescue China's and the world's economy while at the same time giving the United States an equal opportunity to rescue its own. President Roosevelt as good as assassinated the Chinese Republic. Chinese GPS would put the United States on the road to reducing its pretensions to empire and to restoring the dream of its founding fathers: a republic in which sound money acts as a protector of private property and a key restraint on government power. See Constitutional Money: Don't Ask, Don't Tell.
Nothing could bring more benefit to the world or more honor to China than reversing President Nixon's gravest constitutional sin. By relinking the international monetary system to gold in a flexible, practical and effective manner, Chinese GPS could spearhead a return of sanity and soundness to world finance and lay a new foundation for global growth and prosperity.
July 25, 2013