Gold, the SDR and BRICS

Alasdair Macleod
23 April 2015

Last Monday there was a meeting in Washington hosted by the Official Monetary and Financial Institutions Forum (OMFIF) to discuss the future relationship, if any, of gold with the Special Drawing Rights[1] (SDR). Also on the agenda was the inclusion of the Chinese renminbi, which seems certain to be included in the SDR basket in this year’s revision, assuming that the United States doesn’t try to block it.

This is not the first time the subject has come up. OMFIF’s chairman, Lord Desai wrote a paper about it after the last Washington meeting on gold and the SDR exactly four years ago. The inclusion of the renminbi in the SDR was rejected in 2010 because of inadequate liquidity and is due to be reconsidered this year.

Desai pointed out in his paper that there are difficulties when it comes to including gold, because (and I think this is what he was trying to say) none of the SDR’s paper constituents are convertible into gold, but gold’s inclusion in the SDR would make them convertible through the back door. However, Desai seemed keen to re-examine the case for gold.

It should be pointed out that if gold is included in SDRs the arrangement cannot be long-lasting so long as the major central banks insist on printing money as an economic cure-all. However, China’s position with respect to gold and her own currency could be a different matter.

The Chinese government has almost certainly accumulated large amounts of gold yet to be included in her reserves, and she has also encouraged her own citizens to own gold as well. We can therefore be certain that China sees a monetary role for gold while at the same time she is pushing for the renminbi to be included in the SDR basket. There is no doubt, if you read the IMF papers from the last SDR review in 2010 that the renminbi does now fulfil the criteria for inclusion today. So the question then is will the advanced nations, which dominate the IMF’s membership, permit the renminbi’s inclusion, and will the US, which has dragged its heels on giving China and the other BRICS nations a greater shareholding in the IMF, relent and permit these reforms, which were accepted by the other members back in 2010?

The Americans’ blocking of reform signals her desire to preserve the dollar’s hegemony; but given she lost out spectacularly over the creation of the Asian Infrastructure Investment Bank, IMF reform could become the next serious threat to the dollar’s dominance. And if America does not back down over the IMF and the SDR, she will have no fall-back position; China on the other hand still has some aces up her sleeve.

One of them is gold, and another is her role in a rival organisation established by the BRICS. The New Development Bank (NDB) is in the final stages of being set up, driven by frustration at America’s attempts to protect the dollar’s role and to keep the IMF as an exclusive club for advanced nations. Instead, the NDB could easily issue its own version of the SDR with the gold lining Desai referred to in his original paper.

The reason this would work is very simple. The BRICS members, unencumbered by the cost burden of modern welfare states could exercise the monetary restraint required to tie their currencies to gold, perhaps running a Bretton-Woods-style[2] gold-exchange arrangement between member central banks to stabilise their currencies.

However, the NDB would almost certainly want to see the gold price considerably higher if it is to play any part in a new rival to the SDR. Other BRICS members would be encouraged to make sure they have sufficient gold on board by selling US dollar reserves to buy gold, ahead of any decision to go ahead with a new super-currency.

It would appear the era of the dollar’s global domination as a reserve currency is coming to an end, and the stage is now being set for gold to be officially accepted as the ultimate reserve money once again, this time by the next generation of advanced nations.

[1] The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member countries’ official reserves. Its value is based on a basket of four key international currencies, and SDRs can be exchanged for freely usable currencies. As of March 17, 2015, 204 billion SDRs were created and allocated to members (equivalent to about $280 billion).

[2] A now defunct system of monetary management that established the rules for commercial and financial relations among the world’s major industrial states. In 1971, the United States unilaterally terminated convertibility of the US dollar to gold, effectively bringing the Bretton Woods system to an end and rendering the dollar a fiat currency; many fixed currencies (such as the pound sterling, for example), also became free-floating at the same time.

The over-valued dollar

Alasdair Macleod

16 April 2015

There are two connected reasons usually cited for the current dollar strength: the US economy is performing better than all the others, leading towards relatively higher US dollar interest rates, and that this is triggering a scramble for dollars by foreign corporations with uncovered USD liabilities. There is growing evidence that the first of these reasons is no longer true, in which case the pressure to buy dollars should lessen considerably.

In coming to this conclusion we must be careful not to limit our thinking to the dollar rate against other currencies. They are arguably in an even worse position, with active Quantitative Easing in both Japan and the Eurozone failing to resuscitate industrial life, while the UK is in the middle of a heated election campaign. Instead we should think primarily in terms of the dollar’s purchasing power for goods and services, and here the market is already skewed to one side: the public prefers to hold dollars and reduce debt rather than spend freely, because everyone knows that prices of consumer goods are not rising and, so the logic goes, inflation is dead and buried.

Such unanimity is always dangerous and the mainstream fails to notice that far from an inflationless recovery, the US economy appears to be stalling badly. This is hardly surprising since private sector credit is still tight. Depending whose figures you use, total US debt is estimated to be in the region of $57 trillion, an increase of about $4 trillion since the banking crisis in 2008. However, government and state debt held by the public has risen by $6.7 trillion and large corporations have borrowed a further $2.3 trillion to buy back shares. Meanwhile financial debt, which includes asset backed securitisations of consumer debt, has fallen by about $4 trillion, while consumer debt directly held has declined slightly. These rough figures suggest that credit for households and smaller businesses remains constrained.

Since mid-2014 markets have undergone a sea-change, with the dollar strengthening sharply against the other major currencies and the oil price collapsing along with a number of key industrial commodities. The Baltic Dry Index, a measure of shipping demand, has recently fallen to the lowest level ever recorded. Admittedly there is a glut of ore carriers helping to drive shipping rates down, but there can be no doubt that trade volumes are down as well; and there has also been hard evidence with China’s imports and exports having declined sharply.

Common sense says that from the middle of 2014 the world ex-America entered the early stages of an economic slump. Common sense obviously took time to catch up with the U S, and it is only in the last month or so that mainstream economists have begun to cautiously down-grade their GDP forecasts. It is now impossible to ignore the confirmations which are coming thick and fast. This week alone has seen inventories stuck on the shelves, small business optimism declining and the National Association of Credit Managers reporting serious financial stress; and that was only Monday and Tuesday. This is the background against which we must assess future dollar-denominated prices.

Conventional wisdom would have us believe that an economic slump leads to an increased demand for cash as businesses are forced to pay down their debt: this is essentially the Irving Fisher debt-deflation theory from the 1930s. It is for this reason that modern central banks exist and they stand ready to create as much money as may be required to prevent this happening. Let us assume they succeed. We then have to consider another factor, and that is the progress of monetary hyperinflation, for this becomes the underlying condition driving dollar prices.

Central banks can nearly always debauch their currencies with impunity. People automatically think that money is stable and do not generally draw the conclusion that a rise in the level of prices is connected to an expansion in the quantity of money or credit. While they often admit that money buys less today than it did thirty or forty years ago, and they are aware of the consumer price index trend, they may fail to appreciate  that money can and does change its purchasing power from day to day. The result is they attach changes in prices not to money but to factors affecting individual goods.

There are several factors that affect prices, one of which is an increase in the quantity of money when that new money is spent on the goods being considered. Obviously, if the new money is not spent on consumer goods, but hoarded or spent on something else, an increase in the quantity of money will not lead to higher prices for items in a consumer price index. But more importantly, prices are inherently subjective, which is why we cannot forecast tomorrow’s prices. If you find this hard to accept, just look at the average stock trader’s record: if he is very good he might have a 10% edge, but even then he cannot tell you tomorrow’s stock prices.

Subjectivity of prices is the consequence of changing preferences for money relative to individual goods. In the current economic climate with its restricted credit people are understandably cautious about spending, which means their preference for money is relatively high. But not everyone shares the same preferences, and they are likely to be different across different classes of goods as well, with commodities and raw material prices behaving differently from the prices of finished goods, even though they are linked.

So far price rises due to monetary inflation have been generally restricted to financial markets and associated activities. Early speculators have done very well, with today’s buyers being forced to pay considerably higher prices for the same investments. Despite this obvious phenomenon, speculators do not usually understand it is the swing in preference from money towards financial instruments that is behind the rise in prices.

But what if this relative preference starts to swing in favour of commodities? The swing in preference has meant the price of oil in dollars has already risen 25% in recent weeks, or alternatively, we can say the purchasing power of the dollar has fallen by that amount. Copper, the commodity that should be collapsing as we go into a slump, has also risen, this time by 15% over the last two months.

Commodity traders who look at the charts will tell you that these are normal corrections in a bear market for the commodities involved. But how can this be, when we are entering a deflationary slump? The answer is simple: there has been a change of preferences with respect to oil, where buyers value oil more than dollars, and also for copper. This should not be confused with an increased desire to own oil and copper; rather it is a reduced desire to hold dollars relative to these two commodities.

If the idea the dollar is weakening spreads from selected but economically important commodities it could begin to alter the balance of preferences more generally, for which almost everyone is ill-prepared. How long the process takes we cannot know until it happens; but if the general public realises it is the dollar’s purchasing power going down instead of goods prices rising, it will be very difficult to stop its purchasing power from collapsing entirely.

Confusion over US unemployment

Unemployment is the one statistic that one would have thought is easy to define: just total up the number of people on unemployment benefit and there’s your answer.

It is however much more complex, particularly in a large country like the United States, whose potential labour force is estimated to be 250,080,000 across all 50 states plus Washington DC. Of this total 101,479,000 are not currently employed, a ratio of over 40%, and of these only 8,575,000 are deemed to be actually unemployed. The relevant figures are here.

The reason this matters is unemployment is one of the three key variables macroeconomists use to formulate policy, the other two being GDP and the rate of price inflation. Indeed, the Fed’s Open Market Committee has set the Continue reading Confusion over US unemployment

Valuing gold – USD FMQ Update

There is only one way to value gold, and that is to quantify the expansion of the fiat currency in which it is priced.

That is the sole purpose of the Fiat Money Quantity (FMQ), which since I last wrote about it five months ago has increased by $375bn to $13.7 trillion. This is despite the end of quantitative easing, which had been tapered down before being abandoned altogether. The long-term chart of FMQ is shown below.

FMQ chart

Continue reading Valuing gold – USD FMQ Update

Central banks paralysed at the zero bound

Though the Fed would deny it, it is clear from the minutes of the last Federal Open Market Committee (FOMC) meeting that a rise in interest rates has been put off indefinitely.

The subsequent rally in the price of gold and the sudden fall in the dollar tend to confirm this conclusion.

The Fed Funds Rate, which is the interest rate the Fed targets to set all other rates, has now been less than 0.25% for six and a quarter years, gradually declining from roughly 0.15% to about 0.10% today. It was set at a target range of between zero and 0.25% in December 2008 Continue reading Central banks paralysed at the zero bound