GaveKal: The world is reverting to the gold standard

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Macro Afternoon

Via the always provocative GaveKal:

Throughout my career, I have always found that it pays to bear in mind Jacques Rueff ’s notion of US “imperial privilege.” Put succinctly: the US has long been the only country able to settle its current account deficits in its own currency. So, when the US runs a current account deficit, it pumps large quantities of US dollars abroad, many of which flow into the foreign exchange reserves of countries running current account surpluses. These countries then take these dollars and buy US treasuries, which are held in custody for them by the Federal Reserve. In effect, the US current account deficit finances the US budget deficit.

For years, the system worked like a dream. Historically, around one-third of the dollars exported via the US current account deficit came back to the US as foreign exchange reserves, with the bulk of the rest likely being used by the private sector to fund purchases of US assets and as working capital to finance international trade.

But in recent years, I have found myself scratching my head. The US has continued to run enormous current account deficits, but the reserves of foreign central banks held in custody at the Fed have fallen steeply. As the chart overleaf illustrates, over the last seven years, something over US$1trn has gone “missing” in this fashion, as shown by the divergence between the blue and red lines.

Now, admittedly US$1trn isn’t what it used to be, but it is still a tidy sum of money. The discrepancy is far too big to be explained away by a simple dollar deleveraging movement, such as we saw in the early 2000s. Something else must be going on.

I think I may have an idea what. And—no surprise—it has something to do with the future of the US dollar as a reserve currency.

The US has continued to run large current account deficits, but these are no longer being recycled into US treasuries to the same extent.

In the past, reserves held in custody at the Fed for foreign central banks benefited from a double guarantee: (i) they could always be drawn down at any time should the country that owned them find itself facing a balance of payments crisis, and (ii) they were implicitly backed by the large gold holdings of the US Treasury.

The first of these guarantees began to look dubious when the US government decided to weaponize the US dollar (see BNP, Big Brother And The US Dollar). And the second guarantee diminished greatly over the years, as the value of the US gold inventory fell from more than 100% of the foreign central bank reserves deposited at the Fed to bottom out at less than 10%.

Foreign central banks no longer enjoy the implicit guarantee of US gold holdings.

Foreign central banks don’t mind that their reserves at the Fed are not backed by gold as long as the US pursues a “responsible” monetary policy. But if the Fed begins to follow a reckless “Keynesian” monetary policy (see Managing Money In A Keynesian Environment), it is another matter entirely. Foreign central bank reserve managers are the ultimate rentier. So, they can hardly be expected to sit back contentedly and do nothing should the US in its wisdom decide to proceed to the euthanasia of the rentier.

The probability is that foreign central banks have taken their excess dollars and have started to buy gold (or in the case of China, rather than buying dollars from the state-owned banks, the central bank has ordered them to use the dollars to buy gold on its behalf, which amounts to the same thing).

If this is correct, and non-US central banks have bought some US$1trn in gold in the last few years, it implies that slightly more than 10% of the world’s stock of gold has changed hands, going from private hands into central bank vaults—whence it will not return.

This is troubling, not least because in the current environment, the private sector players who are monetizing their holdings of gold are likely doing so out of desperation in order to service bad debts. And because so many debts are bad, commercial bank lenders will not take any money recouped on them and lend it back to the real economy. Instead they will hold it as reserves.

The result is that the banking multiplier outside the US collapses, and the international velocity of money collapses. In short, in order not to be euthanized by the Keynesian policies of the Fed, the central banks of the world’s current account surplus countries are being forced to accumulate gold to sterilize the excess savings produced by their own economies. In effect, non-US central banks are now in the business of sterilizing the stimulative effect that the US current account usually has on growth in the rest of the world, with all the deleterious effects that implies.

If all this sounds far-fetched, it shouldn’t. It’s what France did in the late 1920s and early 1930s under the gold standard, running an undervalued currency and using the resulting current account surpluses to accumulate large amounts of gold, which vanished into the Banque de France’s vaults.

France’s actions then were one of the main causes of the Great Depression. I fear something similar now.

On the upside for investors, if central banks continue to run down their US dollar reserves and accumulate gold until the coverage ratio for their dollar reserves at the Fed is a more comfortable 50%, it implies a tripling in the gold price from its current level.

This may be a small consolation, however, as it becomes increasingly clear the world monetary order is reverting to a gold standard. I once asked Milton Friedman what was wrong with the gold standard, and he answered, “Oh, nothing. But we can do much better.”

It seems we failed.

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