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The velocity myth

Alasdair Macleod – 03 October 2014

If there is one concept that illustrates the difference between a top-down macro-economic approach and the reality of everyday life it is the velocity of circulation of money.

Compare the following statements:

“The collapse in velocity is testament to the substantial misallocation of capital brought about by the easy money regimes of the past 20 years.” Broker’s research note issued September 2014; and

“The mathematical economists refuse to start from the various individuals’ demand for and supply of money. They introduce instead the spurious notion of velocity of circulation according to the pattern of mechanics.” Ludwig von Mises, Human Action.

This article’s objective is not to disagree with the broker’s conclusion; rather it is to examine the basis upon which it is made.

The idea of velocity of circulation referred to arose from the quantity theory of money, which links changes in the quantity of money to changes in the general level of prices. This is set out in the equation of exchange. The basic elements are money, velocity and total spending, or GDP. The following is the simplest of a number of ways it has been expressed:

Amount of Money x Velocity of Circulation = Total Spending (or GDP)

Assuming we can quantify both money and total spending, we end up with velocity. But this does not tell us why velocity might vary: all we know is that it must vary in order to balance the equation. You could equally state that two completely unrelated quantities can be put into a mathematical equation, so long as a variable is included whose only function is to always make the equation balance. In other words the equation of exchange actually tells us nothing per se.

This gives analysts a problem, not resolved by the modern reliance on statistics and computer models. The dubious gift to us from statisticians is their so-called progress made in quantifying the economy, so much so that at the London School of Economics a machine called MONIAC (monetary national income analogue computer) used fluid mechanics to model the UK’s economy. This and other more recent computer models give unwarranted credence to the idea that the economy can be modelled, derivations such as velocity explained, and valid conclusions drawn.

Von Mises’s criticism is based on the philosopher’s logic that economics is a social and not a physical science. Therefore, mathematical relationships must be strictly confined to accounting and not be confused with economics, or as he put it human action. Unfortunately we now have the concept of velocity so ingrained in our thinking that this vital point usually escapes us. Indeed, the same is true of GDP, or the right hand side of the equation of exchange.

GDP is only an accounting identity: no more than that. It ranks gin with golf-balls by reducing them both to a monetary value. Statisticians select what’s included so it is biased in favour of consumer goods and against capital investment. Crucially it does not tell us about an ever-changing economy comprised of successes, failures, and hard-to-predict human needs and wants, which taken all together is economic progress. And because it is biased in its composition and says nothing about progress the value of this statistic is grossly exaggerated.

The only apparent certainty in the equation of exchange is the quantity of money, assuming it is all recorded. No one seems to allow for unrecorded money such as shadow banking, but we shall let that pass. If the money is sound, as it was when the quantity theory of money was devised, one could assume that an increase in its quantity would tend to raise prices. This was experienced following Spain’s importation of gold and silver from the new world in the sixteenth century, and following the gold mining booms in California and South Africa. But relating an increase in the quantity of gold to prices in general is at best a summary of a number of various factors that drive the price relationship between money and goods.

Today we no longer have sound money, whose purchasing power was regulated by human preferences across national boundaries. Instead we have fiat currencies whose purchasing power is formalised in foreign exchanges. When the Icelandic krona on 8th October 2008 halved in value, it had nothing to do with changes in the quantity of money or Iceland’s GDP. Yet if we try to interpret velocity in this case, we will find ourselves pleading a special case to explain its substantial increase as domestic prices absorbed the shock imparted through the foreign exchanges.

Iceland’s currency collapse is not an isolated event. The purchasing power of a fiat currency varies constantly, even to the point of losing it altogether. The truth of the matter is the utility of a fiat currency is entirely dependent on the subjective opinions of individuals expressed through markets, and has nothing to do with a mechanical quantity relationship. In this respect, merely the potential for unlimited currency issuance or a change in perceptions of the issuer’s financial stability, as Iceland discovered, can be enough to destabilise it.

According to the equation of exchange, this is not how things should work. The order of events is first you have an increase in the quantity of money and then prices rise, because monetarist logic states that prices rise as a result of the extra money being spent, not as a result of money yet to be spent. With a mechanical theory there can be no room for subjectivity.

It is therefore nonsense to conclude that velocity is a vital signal of some sort. Monetarism is at the very least still work-in-progress until monetarists finally discover velocity is no more than a factor to make their equation balance. The broker’s analyst quoted above would have been better to confine his statement to the easy money regimes of the past 20 years being responsible for the substantial misallocation of capital, and leaving out the bit about velocity entirely.

A small slip perhaps on the way to a sensible conclusion; but it is indicative of the false mechanisation of human behaviour by modern macro-economists. However it should also be noted that is impossible to square the concept of velocity of circulation with one simple fact of everyday life: we earn our salaries once and we dispose of it. That’s a constant velocity of roughly one.

Valuing gold and turkey-farming

Alasdair Macleod – 26 September 2014

Today’s financial markets are built on the sand of unsound currencies. Consequently brokers, banks and investors are wedded to monetary inflation and have lost both the desire and ability to understand gold and properly value it.

Furthermore governments and central banks in welfare-driven states see markets themselves as the biggest threat to their successful management of the economy, a threat that needs to be tamed. This is the backdrop to the outlook for the price of gold today and of the forces an investor in gold is pitted against.

At the heart of market control is the substitution of unsound currency for sound money, which historically has been gold. Increasing the quantity of currency and encouraging banks to increase credit out of thin air is the principal means by which central banks operate. No matter that adulterating the currency impoverishes the majority of the population: central banks are working from the Keynesian and monetarist manual of how to manage markets.

In this environment an investor risks all he possesses if he insists on fighting the system; and nowhere is this truer than with gold. Gold is not about conventional investing in this world of fiat currencies, it is about insurance against the financial system collapsing under the weight of its own delusions. Regarded as an insurance premium against this risk, gold is common sense; and there are times when it is worth increasing your insurance. In taking that decision, an individual must be able to evaluate three things: the relative quantities of currency to gold, the likelihood of a systemic crisis and the true cost of insuring against it. We shall consider each of these in turn.

The relationship of currency to gold

Not only has the quantity of global currency and bank credit expanded dramatically since the Lehman crisis, it is clear that this is a trend that cannot now be reversed without triggering financial chaos. In other words we are already committed to monetary hyperinflation. Just look at the chart of the quantity of US dollar fiat money and note its dramatic growth since the Lehman crisis in 2008.

FMQ 26092014

Meanwhile, the quantity of above-ground stocks of gold is growing at less than 2% annually. Gold is therefore getting cheaper relative to the dollar by the day. [Note: FMQ is the sum of all fiat money created both on the Fed's balance sheet and in the commercial banks. [See here for a full description]

Increasing likelihood of a systemic crisis

Ask yourself a question: how much would interest rates have to rise before a systemic crisis is triggered? The clue to the answer is illustrated in the chart below which shows how lower interest rate peaks have triggered successive recessions (blue shaded areas are official recessions).

Effective Fed Funds 26092014

The reason is simple: it is the accumulating burden of debt. The sum of US federal and private sector debt stands at about$30 trillion, so a one per cent rise in interest rates and bond yields will simplistically cost $300bn annually. The increase in interest rates during the 2004-07 credit boom added annual interest rate costs of a little over double that, precipitating the Lehman crisis the following year. And while the US this time might possibly weather a two to three per cent rise in improving economic conditions, much less would be required to tip other G8 economies into financial and economic chaos.

The real cost of insurance

By this we mean the real price of gold, adjusted by the rapid expansion of fiat currency. One approach is to adjust the nominal price by the ratio of US dollars in circulation to US gold reserves. This raises two problems: which measure of money supply should be used, and given the Fed has never been audited, are the official gold reserves as reported to be trusted?

The best option is to adjust the gold price by the growth in the quantity of fiat money (FMQ) relative to the growth in above-ground stocks of gold. FMQ is constructed so as to capture the reversal of gold’s demonetisation. This is shown in the chart below of both the adjusted and nominal dollar price of gold.

Gold USD 26092014

Taken from the month before the Lehman collapse, the real price of gold adjusted in this way is $550 today, based on a nominal price of $1220. So in real terms, gold has fallen 40% from its pre-Lehman level of $920, and has roughly halved from its adjusted high in 2011.

So to summarise:

• We already have monetary hyperinflation, defined as an accelerating debasement of the dollar. And so for that matter all other currencies that are referenced to it are on a similar course, a condition which is unlikely to be halted except by a final systemic and currency crisis.
• Attempts to stabilise the purchasing power of currencies by raising interest rates will very quickly develop into financial and economic chaos.
• The insurance cost of owning gold is anomalously low, being considerably less than at the time of the Lehman crisis, which was the first inkling of systemic risk for many people.

So how is the global economy playing out?

If the economy starts to grow again a small rise in interest rates would collapse bond markets and bankrupt over-indebted businesses and over-geared banks. Alternatively a contracting economy will increase the debt burden in real terms, again threatening its implosion. So the last thing central banks will welcome is change in the global economic outlook.

Falling commodity prices and a flight from other currencies into the dollar appear to be signalling the greater risk is that we are sliding into a global slump. Even though large financial speculators appear to be driving commodity and energy prices lower, the fact remains that the global economy is being undermined by diminishing affordability for goods and services. In other words, the debt burden is already too large for the private sector to bear, despite a prolonged period of zero official interest rates.

A slump was halted when prices collapsed after Lehman went bust; that time it was the creation of unlimited money and credit by the Fed that saved the day. Preventing a slump is the central banker’s raison d’être. It is why Ben Bernanke wrote about distributing money by helicopter as the final solution. It is why we have had zero interest rates for six years.

In 2008 gold and oil prices fell heavily until it became clear that monetary stimulus would prevail. Equities also fell with the S&P 500 Index down 60% from its October 2007 high, but this index was already 24% down by the time Lehman failed.

The precedent for unlimited creation of cash and credit has been set and is undisputed. The markets are buoyed up by a sea of post-Lehman liquidity, are not discounting any trouble, and are ignoring the signals from commodity prices. If the economic downturn shows any further signs of accelerating the adjustment is likely to be brutal, involving a complete and sudden reassessment of financial risk.

This time gold has been in a bear market ahead of the event. This time the consensus is that insurance against financial and systemic risk is wholly unnecessary. This time China, Russia and the rest of Asia are buying out physical bullion liquidated by western investors.

We are being regularly advised by analysts working at investment banks to sell gold. But bear in mind that the investment industry is driven by trend-chasing recommendations, because that is what investors demand. Expecting analysts to value gold properly is as unlikely as farmers telling turkeys the truth about Thanksgiving.

The end of tapering and government funding

Alasdair Macleod – 19 September 2014

Last year markets behaved nervously on rumours that QE3 would be tapered; this year we have lived with the fact. It turned out that there has been little or no damage to markets, with bond yields at historic lows and equity markets hitting new highs.

This contrasts with the ending of QE1 and QE2, which were marked by falls in the S&P 500 Index of 9% and 11.6% respectively. Presumably the introduction of twist followed by QE3 was designed at least in part to return financial assets to a rising price trend, and tapering has been consistent with this strategy.

From a monetary point of view there is only a loose correlation between the growth of fiat money as measured by the Fiat Money Quantity, and monthly bond-buying by the Fed. FMQ is unique in that it specifically seeks to measure the quantity of fiat money created on the back of gold originally given to the commercial banks by our forebears in return for money substitutes and deposit guarantees. This gold, in the case of Americans’ forebears, was then handed to the Fed by these commercial banks after the Federal Reserve System was created. Subsequently gold has always been acquired by the Fed in return for fiat dollars. FMQ is therefore the sum of cash plus instant access bank accounts and commercial bank assets held at the Fed.

The chart below shows monthly increases in the Fed’s asset purchases and of changes in FMQ.

Fed Asset Purchase

The reason I take twice the monthly Fed purchases is that they are recorded twice in FMQ. The chart shows that the creation of fiat money continues without QE. That being the case, QE has less to do with stimulating the economy (which it has failed to do) and is more about funding government borrowing.

Thanks to the Fed’s monetary policies, which have encouraged an increase in demand for US Treasuries, the Federal government no longer has a problem funding its deficit. QE is therefore redundant, and has been since tapering was first mooted. This does not mean that QE is going to be abandoned forever: its re-introduction will depend on the relationship between the government’s borrowing needs and market demand for its debt.

This analysis is confirmed by Japan’s current situation. There, QE coincides with an economy that is deteriorating by the day. One cannot argue that QE has been good for the Japanese economy. The reality behind “abenomics” is that Japan’s government is funding a massive deficit at the same time as savers are drawing down capital to cover their day-to-day living requirements. In short, the funding gap is being covered by printing money. And now the collapsing yen, which is the inevitable consequence of monetary inflation, threatens to expose this folly.

On a final note, there appears to be complacency in capital markets about government deficits. A correction in bond markets will inevitably occur at some point and severely disrupt government fund-raising. If and when this occurs, and given that it is now obvious to everyone that QE does nothing for economic growth, it will be hard to re-introduce it as a disguised funding mechanism for governments without undermining market confidence.

Currency turbulence

Alasdair Macleod – 12 September 2014

You’d think that the US dollar has suddenly become strong, and the chart below of the other three major currencies confirms it.


The US dollar is the risk-free currency for international accounting, because it is the currency on which all the others are based. And it is clear that three months ago dollar exchange rates against the three currencies shown began to strengthen notably.

However, each of the currencies in the chart has its own specific problems driving it weaker. The yen is the embodiment of financial kamikaze, with the Abe government destroying it through debasement as a cover-up for a budget deficit that is beyond its control. The pound is being poleaxed by a campaign to keep Scotland in the union which has backfired, plus a deferral of interest rate expectations.
And the euro sports negative deposit rates in the belief they will cure the Eurozone’s gathering slump, which if it develops unchecked will threaten the stability of Europe’s banks.

So far this has been mainly a race to the bottom, with the dollar on the side-lines. The US economy, which is officially due to recover (as it has been expected to every year from 2008) looks like it’s still going nowhere. Indeed, if you apply a more realistic deflator than the one that is officially calculated, there is a strong argument that the US has never recovered since the Lehman crisis.

This is the context in which we must judge what currencies are doing. And there is an interpretation which is very worrying: we may be seeing the beginnings of a major flight out of other currencies into the dollar. This is a risk because the global currency complex is based on a floating dollar standard and has been since President Nixon ended the Bretton Woods agreement in 1971. It has led to a growing accumulation of currency and credit everywhere that ultimately could become unstable. The relationship between the dollar and other currencies is captured vividly in the illustration below.

TotalWorldMoney 12092014
The gearing of total world money and credit on today’s monetary base is forty times, but this is after a rapid expansion of the Fed’s balance sheet in recent years. Compared with the Fed’s monetary base before the Lehman crisis, world money is now nearly 180 times geared, which leaves very little room for continuing stability.

It may be too early to say this inverse pyramid is toppling over, because it is not yet fully confirmed by money flows between bond markets. However in the last few days Eurozone government bond yields have started rising. So far it can be argued that they have been over-valued and a correction is overdue. But if this new trend is fuelled by international banks liquidating non-US bond positions we will certainly have a problem.

We can be sure that central bankers are following the situation closely. Nearly all economic and monetary theorists since the 1930s have been preoccupied with preventing self-feeding monetary contractions, which in current times will be signalled by a flight into the dollar. The cure when this happens is obvious to them: just issue more dollars. This can be easily done by extending currency swaps between central banks and by coordinating currency intervention, rather than new rounds of plain old QE.

So far market traders appear to have been assuming the dollar is strong for less defined reasons, marking down key commodities and gold as a result. However, the relationship between the dollar, currencies and bond yields needs watching as they may be beginning to signal something more serious is afoot.

A difficult question

Alasdair Macleod – 05 September 2014

In a radio interview recently* I was asked a question to which I could not easily give a satisfactory reply: if the gold market is rigged, why does it matter?

I have no problem delivering a comprehensive answer based on a sound aprioristic analysis of how rigging markets distorts the basis of economic calculation and why a properly functioning gold market is central to all other financial prices. The difficulty is in answering the question in terms the listeners understand, bearing in mind I was told to assume they have very little comprehension of finance or economics.

I did not as they say, want to go there. But it behoves those of us who argue the economics of sound money to try to make the answer as intelligible as possible without sounding like a committed capitalist and a conspiracy theorist to boot, so here goes.

Manipulating the price of gold ultimately destabilises the financial system because it is the highest form of money. This is why nearly all central banks retain a holding. The fact we don’t use it as money in our daily business does not invalidate its status. Rather, gold is subject to Gresham’s Law, which famously states bad money drives out the good. We would rather pay for things in government-issue paper currency and hang on to gold for a rainy day.

As money, it is on the other side of all asset prices. In other words stocks, bonds and property prices can be expected to rise measured in gold when the gold price falls and vice-versa. This relationship is often muddled by other factors, the most obvious one being changing levels of confidence in paper currencies against which gold is normally priced. However, with bond yields today at record lows and equities at record highs this relationship is apparent today.

Another way to describe this relationship is in terms of risk. Banks which dominate asset markets become complacent about risk because they are greedy for profit. This leads to banks competing with one another until they end up ignoring risk entirely. It happened very obviously with the American banking crisis six years ago until house prices suddenly collapsed, threatening to take the whole financial system down. In common with all financial bubbles everyone ignored risk. History provides many other examples.

Therefore, gold is unlike other assets because a rising gold price reflects an increasing perception of general financial risk, ensuring downward pressure on other financial asset prices. So while the big banks are making easy money ignoring risks in equity and bond markets, they will not want their party spoiled by warning signs from a rising gold price.

This is a long way from proof that the gold market is manipulated. But the big banks, and we must include central banks which are obviously keen to maintain financial confidence, have the motive and the means. And if they have these they can be expected to take the opportunity.

So why does it matter if the gold price is rigged? A freely-determined gold price is central to ensuring that reality and not financial bubbles guides us in our financial and economic activities. Suppressing the gold price is rather like turning off a fire alarm because you can’t stand the noise.

*File on 4: BBC Radio4 due to be broadcast on 23 September at 8.00pm UK-time and repeated on 28 September at 5.00pm.

3 reasons to invest on gold

The Matterhorn London Interviews – Aug 2014

In this 2nd of a series of London interviews that Lars Schall conducted for Matterhorn Asset Management this summer, Lars has a City of London streetside conversation with Alasdair Macleod right outside the Dutch reform Church in Austin Friars near the Bank of England. Together they talked about, inter alia: the challenges for The London Bullion Market Association (LBMA); China’s appetite for gold; the Shanghai Cooperation Organization as THE future player in the gold market; and the problems related to Germany’s gold at the New York Fed.

Watch the full interview here.

The wages-fuel-demand fallacy

Alasdair Macleod – 29 August 2014

In recent months talking heads, disappointed with the lack of economic recovery, have turned their attention to wages. If only wages could grow, they say, there would be more demand for goods and services: without wage growth, economies will continue to stagnate.

It amounts to a non-specific call to stimulate aggregate demand by continuing with or even accelerating the expansion of money supply. The thinking is the same as that behind Bernanke’s monetary distribution by helicopter. Unfortunately for these wishful-thinkers the disciplines of the markets cannot be bypassed. If you give everyone more money without a balancing increase in the supply of goods, there is no surer way of stimulating price inflation, collapsing a currency’s purchasing power and losing all control of interest rates.

The underlying error is to fail to understand that economising individuals make things in order to be able to buy things. That is the order of events, earn it first and spend it second. No amount of monetary shenanigans can change this basic fact. Instead, expanding the quantity of money will always end up devaluing the wealth and earning-power of ordinary people, the same people that are being encouraged to spend, and destroying genuine economic activity in the process.

This is the reason monetary stimulation never works, except for a short period if and when the public are fooled by the process. Businesses – owned and managed by ordinary people – are not fooled by it any more: they are buying in their equity instead of investing in new production because they know that investing in production doesn’t earn a return. This is the logical response by businesses to the destruction of their customers’ wealth through currency debasement.

Let me sum up currency debasement with an aphorism:

“You print some money to rob the wealth of ordinary people
to give to the banks to lend to business
to make their products
for customers to buy with money devalued by printing.”

It is as ridiculous a circular proposition as perpetual motion, yet central banks never seem to question it. Monetary stimulus fails with every credit cycle when the destruction of wealth is exposed by rising prices. But in this credit cycle the deception was so obvious to the general public that it failed from the outset.

The last five years have seen all beliefs in the manageability of aggregate demand comprehensively demolished by experience. The unfortunate result of this failure is that central bankers now see no alternative to maintaining things as they are, because the financial system has become horribly over-geared and probably wouldn’t survive the rise in interest rates a genuine economic recovery entails anyway. Price inflation would almost certainly rise well above the 2% target forcing central banks to raise interest rates, throwing bonds and stocks into a severe bear market, and imperilling government finances. The financial system is simply too highly geared to survive a credit-driven recovery.

Japan, which has accelerated monetary debasement of the yen at an unprecedented rate, finds itself in this trap. If anything, the pace of its economic deterioration is increasing. The explanation is simple and confirms the obvious: monetary debasement impoverishes ordinary people. Far from boosting the economy it is rapidly driving us into a global slump.

The solution is not higher wages.

Sprott’s Thoughts with Alasdair Macleod: What if China, Russia Succeed in Going off the Dollar?

21 August 2014

Besides what the Fed is doing by printing money, there is another big threat to the dollar, said Alasdair. Countries in Asia are banding together in order to rid themselves of using the dollar in international trade.

Read the full interview at Sprott Global

SCO and Mackinder’s prophecy

Alasdair Macleod – 22 August 2014

There will be a defining geopolitical event next month when India, Pakistan, Iran and Mongolia become full members of the Shanghai Cooperation Organisation (SCO). This will increase the population of SCO members to an estimated 3.05 billion. We should care about this because it is the intention of the SCO to do away with the US dollar for trade settlement.

The nations joining in September are currently designated as Observer States and the only one left will be Afghanistan, which will presumably join when it can untie itself from NATO. Dialog Partners, defined as states which share the goals and principals of the SCO and wish to develop mutually beneficial relations, include Belarus Sri Lanka and Turkey. Turkey is of special interest because it has been a long-standing NATO member. It had hoped to join the EU but it became clear that this was never going to happen. Instead under the leadership of Recep Erdoğan Turkey is moving towards the SCO.

Erdoğan was re-elected earlier this month by a comfortable majority and it will be interesting to see how quickly Turkey’s new alignment evolves. Erdoğan must be aware that Asia is on the up while the EU declines, in which case Turkey as a front-line state is better off joining the SCO.

The SCO’s influence extends beyond its boundaries, with China and India’s diasporas populating much of the rest of south-east Asia. SCO members, particularly China and India, are also the largest consumers of Middle Eastern energy. And because they write the biggest cheques they have primacy over the west; so the swing away from the petro-dollar towards Asia is in the making. China also has sub-Saharan Africa sewn up, securing vital minerals such as copper from Zambia.

We must also consider why Russia is aggressively driving the pace of the SCO’s development, and it’s not just to escape the west’s economic sanctions as many observers think. Fundamentally the SCO is about resources and the production of goods: Russia controls Asia’s resources and China turns them into goods.

One of the first persons to identify the geopolitical importance of Russia’s resources was Halford Mackinder in a paper for the Royal Geographical Society in 1904. He later developed it into his Heartland Theory. Mackinder argued that control of the Heartland, which stretched from the Volga to the Yangtze, would control the “World-Island”, which was his term for Europe, Asia and Africa. Over a century later, Mackinder’s theory resonates with the SCO.

The underlying point is that North and South America, Britain, Japan and Australasia in the final analysis are less important than Mackinder’s World-Island. There was a time when British and then American primacy outweighed its importance, but this is no longer true. If Mackinder’s theory is right about the overriding importance of undeveloped resources, Russia with the backing of the SCO’s members is positioned to become the most powerful nation on earth.

The SCO is the greatest challenge yet mounted to American economic power, and Russia and China are clearly determined to ditch the dollar. We don’t yet know what will replace it. However, the fact that the Central Bank of Russia and nearly all the other central banks and governments in the SCO have been increasing their gold reserves could be an important clue as to how the representatives of 3 billion Euro-Asians see the future of trans-Asian money.

No escape from the dollar as the currency standard

Alasdair Macleod – 15 August 2014

All commodities and near-commodities are priced internationally in dollars, and the dollar is used for over 80% of cross-border trade settlements. Consequently the dollar is the base currency for all countries’ foreign reserves, giving it its reserve status. However, there are now challenges to the dollar’s hegemony, with Russia, China as well as the other members, dialog-partners and associates of the Shanghai Cooperation Organisation (SCO), taking deliberate steps towards doing away with the dollar entirely for pan-Asian trade. Recent developments setting up a rival to the IMF by the BRICS nations is part of this challenge.

If you follow the geopolitics, you might reasonably conclude that the dollar’s dominance has peaked and is now declining. The SCO appears to believe there can be a transition away from the dollar, an idea that could turn out to be dangerously wrong at a time of great but generally unrecognised currency fragility. At the heart of the issue there is a worrying lack of distinction between the dollar’s reserve function and its function as the monetary standard from when it replaced gold in 1971. To fully appreciate the importance of the dollar as the standard for all other currencies, we must review the monetary history behind how and why the dollar replaced gold, and the implications for today.

The US dollar progressively broke its relationship with the gold standard from 1933 onwards, when gold ownership by US citizens was unexpectedly banned. The Bretton Woods Agreement after 1944 then defined the gold-based monetary order until the Nixon Shock in 1971. President Nixon ended Bretton Woods and all rights to dollar conversion into gold. By default, all other national currencies went on a US dollar standard, albeit a floating one. Crucially, the confidence in the purchasing power of all fiat currencies became vested in an underlying confidence in the purchasing power of the US dollar. This is a separate monetary function from the dollar’s reserve status, though the two functions are intertwined and may be difficult to separate in practice.

There are obviously differences in the way the gold standard operated compared with the dollar standard of today, but the function is the same. Before the Nixon Shock, the relationship between the gold standard and the US dollar was illustrated famously by John Exter, who showed gold at the apex of an inverse pyramid, supporting ever-increasing categories and quantities of dollars and dollar liabilities. Between 1932 and 1971 the quantity of money and bank credit expanded, and this is shown in the graphic below, based on Exter’s illustration, but with a pure monetary emphasis.

USD Monetary Pyramid

In 1932 when gold officially exchanged at $20.67 per ounce the relationship with the monetary base was by today’s standards very conservative. However, the fractional-reserve credit expansion at an additional 9.3 times (note that M3 includes the monetary base) was a threat to the entire US banking system when the banks were facing escalating bad debts because of the economic depression. And since the dollar was technically a money-substitute (with gold being the freely-exchangable underlying money), the dollar risked being exposed as over-issued and therefore valueless. For this reason, President Roosevelt’s Executive Order forcing American residents to surrender their gold and rescinding all rights to exchange their dollars for gold, was the only feasible option open to his government, the alternative being the collapse of the banking system. In January 1934 he revalued gold to $35 per ounce, making the Exter pyramid relationships more sustainable.

In 1944, the Bretton Woods Agreement formalised arrangements for central banks to fix their currencies to the dollar and for them to continue to have the right to exchange dollars at the Fed for gold at $35 per ounce. So central banks while originating their own currencies were still on a gold standard, through the US dollar. By 1971, when President Nixon ended this limited gold convertibility, the Fed’s monetary base and broad M3 money had become exceedingly stretched at nearly seven times and 72 times respectively.

The alternative would have been to revalue gold from $35 to a level where the US would suffer no more outflows, taking a leaf out of President Roosevelt’s book. Revaluation of gold was ruled out and rigorous attempts were made to discredit gold instead. The dollar therefore replaced gold as the de facto standard for all currencies. Freed from the discipline of gold, the Fed was able to continue to expand its monetary base and US banks their bank credit, while growing foreign demand for dollars to purchase energy, other commodities and for trade-finance, underwrote its purchasing power. And because the demise of Bretton Woods led to the end of fixed exchange rates, the expansion of US dollar quantities was mirrored by the expansion of cash and credit in other currencies as well, as non-US central banks managed their currency rates vis-à-vis the dollar base.

The next pyramid shows the relationship not only between US dollar quantities but also includes an estimate of the dollar equivalent of global broad money supply, and a new feature that did not noticeably exist in 1971: shadow banking. This quantifies the relationship between dollar money and the quantity of money in other currencies, with the dollar as the new currency standard.

Total Global Money 15082014

In 2013 the relationship of US bank deposits relative to the Fed’s monetary base was only 2.4 times. This was due to the rapid expansion of the Fed’s balance sheet since mid-2008, having increased to 4.7 times the Pre-Lehman Monetary Base. The world’s broad money at $168.5 trillion is geared nearly 40 times, including the Financial Stability Board’s estimate of off-balance sheet shadow banking. To put it mildly, even after the rapid expansion of the Fed’s Monetary Base, which dramatically lowered the broader money ratios from what they would otherwise have been, the international monetary situation is still dangerously geared.

The risk of a new currency crisis has been dramatically increased by the major central banks acting to maintain financial asset values, particularly in bond and stock markets. This transfers risk from investment assets into the currencies themselves, something that is certain to become evident in the event of a rise in interest rates. For example a 10% fall in over-valued sovereign bond prices could easily threaten the survival of some systemically important banks, triggering a new financial crisis. Obviously, this cannot be allowed to occur and there can be little doubt that the central bank response will be to flood the financial system with yet more money.

Alternatively, the global banking system is too highly geared to survive an economic slump, which is an increasing risk in both the Eurozone and Japan and may well spread elsewhere. Remember that the dollar M3-to-gold ratio of 11 times in 1933 was enough to force a system reset; today the global ratio is nearly 40 times, on an admittedly flexible dollar. Again, the solution will be to flood the financial system with yet more money.

So either way, recovery or slump, price inflation or deflation, the current currency equilibrium with its dangerously high monetary gearing is unlikely to continue for long. And as if this is not enough the major emerging and Asian economies are proposing a monetary schism, breaking half the world’s population away from the dollar. The yuan, rouble, rupee and all the other Asian and emerging-economy currencies involved may be able to trade between themselves without the dollar, but they will be unable to ditch it as a back-up monetary standard. They will still remain on a dollar standard.

This is why despite determined efforts to do without the dollar nobody in Asia has come close to proposing a realistic alternative. Let us hope the powers-that-be in the Shanghai Cooperation Organisation understand the important difference between a reserve currency used for trade settlement and a currency standard; otherwise by bringing into the open the fundamental question about the dollar’s suitability as a monetary standard, they could end up undermining the dollar and with it an extremely fragile global monetary system.