Feature Stories | Sep 29 2008
By Greg Peel
If you want to find a reason for the beginning of the current financial debacle, you could perhaps go back to July 2007 when the US authorities reversed the up-tick rule for short-selling, or back to 2004 when the five big US investments banks successfully pitched to have leverage limits raised from 12 times to 40 times, or back to 2001 when 9/11 led to the Fed commencing an interest rate slash towards zero, thus providing “free money”, or to 1999 when Fannie & Freddie successfully pitched to have mortgage restrictions eased.
Or you could go to 1998, when the authorities orchestrated a bail-out of the world’s largest hedge fund because it was “too big to be allowed to fail”, or to the period of 1989-95 when the Resolution Trust Corporation was created to prevent a collapse of the US financial system following the Savings & Loan crisis, which followed the invention of the “junk bond”.
But you still wouldn’t get to the heart of the problem.
You might, however, be closer to a source if you go back to 1972 – the year the world dropped the Gold Standard. There are many free marketeers who would argue long and hard on the Keynesian line that gold is a “barbarous relic”, and an anachronism from a bygone day. But it was in 1972 that the US government went broke funding the Vietnam War, and thereafter declared the new global reserve currency to be the US dollar. From that time on the world’s reserve currency was based on debt. The US dollar is no more than a perpetual IOU. In the last forty years US debt has accelerated at a breakneck pace on a parabolic upward swing, and Americans are only this week coming to realise the lolly jar is not bottomless after all.
Why was gold ever the world’s reserve currency in the first place? It provides no interest payment, you can’t eat it, and it mostly ends up simply as shiny trinkets. It is unfair that some countries (such as Australia) have large gold mines while others have none, just out of sheer luck. But the whole point of a reserve currency is to mark all value to one central, indisputable benchmark. The world agreed to a benchmark following WWII, but WWII was simply a distraction that followed the Great Depression, and the collapse of the Weimar Republic, among other “fiat” currency debacles of earlier times.
Without such a benchmark, value becomes arbitrary and beholden to a banking system which works on a principle of perpetual debt. Debt is perpetual because it simply keeps building as the world’s population grows, as that population borrows to acquire assets in exchange for future income. That asset is one day sold to another, who has also borrowed, and so the system perpetuates. Asset buyers leverage their debt in the assumption that not only is their future income secure, but it will grow over time. A mortgage is a leveraged debt – you put down 10% to borrow 100% and you spend 20 years paying the money back out of the income you derive.
This means that the amount of debt outstanding in the world is a multiple of that which is deposited, or “saved”. Debt is a multiple of equity. Were there a point at which it was decided all debt must reach maturity on the same day, then it could never be paid back. The required income is still to be earned. There is no point in suggesting debt should just be abolished (never a lender or a borrower be), for then we would all still be living in huts we built ourselves and growing our own food. An economy needs debt to “grow”, and it is through economic growth that most of us (excluding the devoutly spiritual) acquire wealth and thus gain satisfaction from life. Economic growth simply satisfies our inherent human nature.
Now consider that for “money” to be of any value it must have an asset backing, otherwise we’d all just print our own, or declare pebbles to be exchangeable currency. We’d be back in those huts again. The current system has “money” backed not by any one asset, but by the economy of the issuer. The “economy” is a somewhat arbitrary concept of the amount of “money” one country can accumulate through the activity of industry – industry which is set up to satisfy demand for goods and services, all of which cost “money”. To grow an economy you need multiply that “money”, and thus we have debt. Can you see the problem here? Round and round we go, where we stop, nobody knows.
Or maybe we’re about to find out. We certainly got a precursor last week as to what the stopping point might look like.
To stop money simply being a self-perpetuating illusion, one can use a single benchmark by which all “money” – all “currency” – is valued. Having hit a stopping point in the 1930s, the capitalist world decided that the obvious benchmark was gold. It is rare, it is heavy, it is difficult to transport, and it is actually perpetual. Virtually all the gold ever mined in the history of mankind still exists somewhere, whether in a vault, on a finger, or in a tooth. Nor can you make your own gold – as far as anyone knows alchemy has not yet proven successful.
With gold as a benchmark, between the Second World and Vietnam Wars all “money” was represented by an amount of gold. Debt clearly still existed, but the value of debt was pegged to gold and thus was contained by the amount of gold in existence. But when President Nixon found the US had spent all the money it had, as measured by gold, he simply declared an end to the Gold Standard and the beginning of the US dollar as the benchmark, “reserve” currency. The US economy was by far the world’s largest, and thus the obvious choice, but the other large economies had little choice. Germany and Japan were still paying war reparations and the UK still owed the US for saving it from the former.
Once the US dollar became the world’s reserve currency, there was no longer anything to stop the US spending everyone else’s “money”. The US economy was financed by selling bonds to the rest of the world, and the rest of the world had little choice but to buy them. The frugal Germans and Japanese thus had to lend the profligate US anything they had saved. Armed with an endless supply of money, the Americans became the world’s most wealthy nation by many quanta. There were clearly attempts to keep spending down to a sensible level so as not to overly devalue the US dollar, but the various milestones noted at the beginning of this article chronicle how such measures became more and more lax as time went on. As we are often forced to believe, gambling is a disease.
And where has this brought us to? Goodbye Bear Stearns, goodbye Lehman Bros, goodbye Merrill Lynch, AIG, IndyMac, Washington Mutual, goodbye Northern Rock, goodbye IKB Bank (goodbye Babcock & Brown?), goodbye life as some of us once knew it.
Throughout all of the period from 1972 to 2008, gold has been shunned as an old-world concept, as the “barbarous relic”. Gold shot up to US$850/oz in 1980 following the oil shocks, but that was when the new reserve currency system was still in its infancy. When we entered the twenty-first century, gold was closer to US$200/oz. Then came 9/11, and the US saw the possibility that its enemies may have this time won. So it started printing more and more money – the reserve currency – and all around the Western world money became as good as free. Only then did those old enough to remember why started buying gold again. But it still took until 2008 for gold to pass the 1980 high. It then made a new high at US$1030/oz, but that is where the music stopped once more.
If the events of last week were as calamitous as, or even more calamitous as, the events of the 1930s, and gold price had already begun to rise throughout the course of this century, why is it not even higher now?
That is the big question. There is a simple answer, a not so simple answer, and a well-supported conspiracy theory. The conspiracy theory is that the US government has been suppressing the price of gold for decades and lying about how much actual gold it has left after such suppression. The simple answer is that (a) the world is deleveraging and leveraged money was also used to buy gold and (b) the rest of the world has no choice but to support the reserve currency, to gold’s detriment.
The not so simple answer involves inflation. In its role as the reserve currency under the post-war Gold Standard, benchmarking to gold meant paper currencies could not be printed at will without hyperinflation being the result. Inflation undermines the value of money, and gold can never lose its intrinsic value (as opposed to its “dollar value”). If your own currency was in excess supply, then gold was a place in which to “store” wealth. Thus gold is a hedge against inflation, or at least was.
Gold has acted as a hedge against inflation to some degree more recently, for its rise in US dollar terms is the direct result of the US dollar’s fall in value against every other paper currency of any value. And we have had an inflation “scare” based on the runaway growth of emerging economies and their excessive demand for commodities such as oil. Commodity prices pushing and the US dollar falling equals global inflation.
But commodity prices have now bubbled and burst, and the global economy is clearly slowing. The result of this slowing, and the ongoing unwinding of leverage, should mean asset deflation. Just look at US house prices as an asset. If gold is a hedge against inflation, then a period of deflation should see its value fall.
Yet as we sit here awaiting the outcome of the US government’s Plan to save the world, we note that the US dollar has not exactly collapsed. And the Plan involves printing even more US dollars than there are already. The reason it hasn’t collapsed is because the US economy is not a closed shop. Every economy has been effected by the global credit crunch, putting every economy at risk of a recession. Currencies are only relative. Although we use the expression “buy US dollars”, we can equally say “sell Aussie dollars”, or euro, or yen. We do not actually “buy” or “sell” anything, we simply “exchange”. That’s why currencies are quoted as “exchange rates” and not “prices”.
Thus if all the world economies head into recession at the same time, their respective currencies would effectively all be worth less at the same time (as each currency is backed only by each respective economy) and thus exchange rates would not change at all. The US dollar would not “fall”. If the US dollar cannot fall, how can the price of gold go up?
We saw a taste of such relativities before this latest chapter of the credit crunch – the US dollar rose. It rose because it was deemed the economies of Europe and the UK were in even a worse state, with Japan not far behind, and even China set to slow. The Aussie dollar collapsed, and we’re the ones who are meant to be as good as immune!
It is therefore possible that if The Plan – whatever that may be – stabilises the US economy, the value of the US dollar could actually rise again while the US Treasury furiously prints more and more and more and more. If the US dollar rises, the price of gold should fall.
Could this happen?
More in Part II.
