Thursday, 3 May 2012
Submitted by Jeff Snider, President and CIO of Atlantic Capital Management
*The Real Debate On Gold And Money*
Monetary adjustments, heavy as they have been in these past four years, will remain a permanent part of our economic landscape so long as central banks remain committed to their current course. Now that the annual excitation of economists and their dreams of recovery are waning, and the “unexpected” decline in the economy has returned right on schedule, the discussion needs to turn toward those monetary interventions. I have had many discussions with clients and members of the general public on the topic of the gold standard over the past few years, especially in the past several weeks as Chairman Bernanke deliberately broadcasts his specific problems with it from the perspective of a central banker tasked with “saving” the economy. Even getting past the glaze of apparent anachronism, largely that something so archaic seems utterly incompatible with our modern electronic society, the persistent, and otherwise extremely healthy, mistrust of banks prevents a further discussion of how the gold standard really works. For those that actually know the US paper dollar was primarily issued by banks prior to 1913 in the form of deposit claims on “reserve” assets, it is simply asserted that the principle of “universal currency” issued by the government, with its full faith and credit backing it, is a better fit, a more complete system befitting our digital age. This simple line of thinking confuses the needs for clearing money imbalances with money itself, more than anything, but it also misses the central transformation of the 20th century.
If the greatest trick the devil ever pulled was convincing the world he didn’t exist, the greatest trick our central bank ever pulled was convincing the world we couldn’t live without it. For most of that past twenty years, that PR campaign has been centered on the Great “Moderation”, so called because it apparently represented the full embodiment of economic management – a period of unparalleled prosperity, a Golden Age of soft economic central planning. Give the central bank enough “flexibility” and it will produce unmatched economic and financial satisfaction.
In 2012, as the illusion and luster of the Great Moderation fades into the realization of the unthinkably high cost by which it was all purchased, soft central planning is no longer unchallenged by general apathy. Into that breach the topic of “flexibility” flows, a battle that has profound implications for the future, especially the longer term. Chairman Bernanke wants at least to maintain his flexibility, preferring to expand it as much as possible. But as we face continued and mysterious economic headwinds that are fully unexpected by the sophisticated and elegant math of economic practitioners, engaged observers who otherwise were content with that central bank apathy awake to the possibility that flexibility for the Federal Reserve comes at the price of individual flexibility. More power for Chairman Bernanke necessarily means less power for you and me.
If the topic of the Great Moderation is open for re-examination as nothing more than asset inflation disguising recklessness and poorly conceived and constructed theory (often shockingly simplistic, it is hard to believe sometimes that the mathematical models that rule the economic world encompass so many simple assumptions and just ignore any other parameters that cannot be statistically fit into them), the idea of central bank/universal currency should also be addressed. The Great Moderation itself (the asset bubbles, credit production and, above all, interest rate targeting) would never have been possible without central bankers controlling not only the supply of money, but also its very definition.
A gold standard in whatever form represents a decentralized paradigm of monetary control, the true expression of the free-est marketplace. You may argue that such a paradigm is ultimately economic suicide, a pro-cyclical monetary drag on economic affairs during dislocations, but you cannot argue that the ultimate decision for that drag lies with individual persons, not central bankers. A true gold standard, one where banks may only issue “dollars” that are convertible into some specified physical quantity of gold, means that control of the money supply rests entirely within the willingness of individual economic actors to exchange real money (gold) for paper dollars (currency). That is the ultimate monetary power.
An individual bank operating under this paradigm would actually care about public perceptions of its risk profile and ability to successfully carry out its role as an intermediary of credit. Since the stock of money is exogenously controlled by the general public, individual banks would actually compete with each other to maintain some real standard (as opposed to an ephemeral accounting notion) of sanity and reserve, so much so that the very idea of intentional complexity and opacity would be harmful to its own prospects. Profits are driven by the careful elucidation of true intermediation since the scarcity of reserves reinforces the public’s general skepticism of the potential for banking mischief. As is often the case with banks as businesses, the alignment of a bank’s ultimate goal (profits) with depositors’ collective desires for safekeeping rarely coincide. A bank seeks to grow its profits through some degree of informed speculation (the very definition of intermediation), taking on some degree of financial risk that without a doubt exceeds the level of risk a depositor would deem appropriate. So the dance within the financial system of deposits of real money is one where the bank will always try to push the boundary of “appropriate”, and depositors will restrain that boundary through marginal withdrawals of real money.
If the bank expands its boundary too far, the amount of deposits that flee exceeds the ability of the bank to replace them, meaning bankruptcy. In the true gold standard system, there are no alternatives to this course – it is the brutal realization of market discipline. Market discipline, for its part, systemically keeps other banks in check as a reminder to remain aware of the exogenous level of appropriate credit creation. Scarcity enforces a true standard of credit creation, ultimately set by the (admittedly imperfect) perceptions of individuals as they carry out actions in the real economy.
The great trick, then, was the transformation of the banking system, first away from real reserves, and then the displacement of the marginal authority of depositors altogether. As early as 1865 in the United States, in Jay Cooke’s pamphlet, elite opinion first sought to equalize precious metals and government bonds as bank reserves, which was eventually realized. Then came physical Federal Reserve Notes, backed by tax collection powers rather than scarce real money. Then came ledger money and the rise of accounting – the beginnings of a cashless society. The slow transformation of the monetary system, and central bank realization of a level of flexibility on par with economic control was finished with the adoption of equity capital rules (Basel) and the supremacy of interbank wholesale money markets. Depositors were shoved out of the monetary equation, and with them, the primary considerations for and ties to the real economy.
In our current central bank standard, particularly as central banks adhere to both interest rate targeting and monetary elasticity, the level of deposits of “money” (whatever that means today) has little bearing on a bank’s survivability, at least anything approaching a systemic counterbalance. Sure, IndyMac failed because $1 billion in deposits of digital dollars were adjusted off its accounting ledger (especially after Senator Schumer’s letter), but IndyMac’s real restraint was financial collateral. That has many implications (as we have observed the growing shortage of collateral for funding operations), but it also means that the ultimate source and arbiter of bank funding is not deposits.
As long as a bank can pledge some kind of financial collateral with a central bank, that bank will remain in business, regardless of how its depositors (the public) feel about its recklessness. Indeed, most of the credit production accomplished during the past thirty years (encompassing the whole of the Great Moderation) was done by banks that have no depositors whatsoever. The Great Moderation would be more appropriately called the Great Financialization, where securities overtook the role of “reserves”, and central banks committed to unlimited funding of those reserves (to achieve a specified interest rate target, meaning a zero or near-zero interest rate target can lead to the possibility of unlimited reserve creation, but, again, the effective restraint being the supply of “quality” collateral, as defined by central banks themselves).
Under these terms, it is easy to see why Chairman Bernanke decries the role of a gold standard. The current interest rate targeting/quality collateral reserve standard is almost completely at his whim. In practical application, the only restraint on his control of the money supply is the political willingness of governments to issue debt. Yet, far from being the opposite of the rigid gold standard, we see instead rigidity reappear in other places.
The unending string of bailouts of systemically “important” institutions is the prime example of this new rigidity. The fact that there even exists the notion of systemically important institutions belies the fact that the “flexible” system has improved at all upon the gold standard. The myth has been propagated that it was the gold standard in the early 1930’s that transmitted the monetary collapse throughout the world, a conduit for the collapse in money to transmit into the global real economy. Even if we accept that explanation and interpretation, how is the current state of affairs any different? In 2008, the systemically important banks transmitted the same kind of monetary contagion far and wide through the rigidity and weaknesses of the same interbank money markets that were supposed to be such a marked improvement. Even in the nearly four years since that time, central bankers are still wrestling with bypassing their own interbank creations due to persistent dysfunction, with the system rigidly locked in a perpetual state of crisis. This more than suggests that not only does rigidity remain in the system, it continues to grow worse, hardly an improvement on the gold standard (and the gold standard in the 1920’s was nothing like the classical gold standard, it was a gold exchange standard that permitted central bank sterilization, the first widespread uses of central bank flexibility).
Part of this new strain of rigidity stems from a stark perversion of the meaning of intermediation. During the Great Financialization, the banking system itself transformed from its traditional method of increasing the productivity of money and the general pool of savings into a system of transmitting monetary policies regardless of market conditions. Instead of reactive to marketplaces, the banking system would subsume and set markets on orders from central planners. Owing to the growing acceptance of the rational expectations theory, central banks began to view credit and credit producers as tools of psychological manipulation. It was the simultaneous application of both increasing the stock of money and enticing monetary actors to increase its circulation that led to the supposed golden age of central banks. Debt-fueled consumption and the “wealth” effect were the realized supremacy of all the economic theories that worship at the altar of aggregate demand.
Unfortunately, as a tool of central banks, with the promise of liquidity and uninterrupted profit expansion, banks began to lose and discard the idea of intermediation altogether. The whole of financial innovation during this period was not directed toward real economy productivity nor even monetary productivity, it was directed toward maximizing the new rigid rules of the monetary regime. Banks, instead of worrying about various obligors’ ability to repay loans, instead set themselves to creating profits regardless of any ability to repay. Accounting rules were invented (gain-on-sale being the most notorious), as were new methods of attracting these new bank reserves for the sake of attracting new bank reserves. Quality collateral could be synthesized out of nothing; the real economy was not even needed (see synthetic CDO’s and interest rate swaps).
Essentially, central bank flexibility has bastardized intermediation, as liquidity and scale became the sole determinants of financial profitability. Traditional depository banks could no longer compete, as was designed. So long as aggregate demand was meeting some mathematical target, central bank planners cared little about this growing process of de-intermediation. Banks, for their part, only cared about buying and holding whatever obligation got them funding, even if that obligation would be deemed unworthy under regular means of intermediation. This de-intermediation of banks applies not only to the current circumstance of hundreds of billions of PIIGS debt issued in the past few years, it equally applied to subprime mortgages that were packaged and securitized, forming the initial basis of the financial-collateral-as-bank-reserves monetary pyramid. The repo market and interbank wholesale markets reached their apex in the 2000’s, but made their first marginal impacts as early as the 1970’s. Even by the mid-1980’s, repos were causing problems, as bad repo trades led to the first few failures of what would become the S&L crisis.
The question of the gold standard is a question of what kind of banking system do we desire. Do we accept a bank-first approach to the economy, where we also accept the central bank dogma that the banking system and the real economy are one and inseparable? If we view the banking system through the lens of true capitalism, the bank-first approach reverses the accepted notion that intermediation exists as a tool for increasing productivity and production in the real economy. That scarcely describes the system we have right now, or have had for forty-five years (particularly the last twenty-five), where banks exist to serve themselves, where financial firms scarcely pay lip service to aligning their goals with their liability-holders (or clients). Nor is it compatible with the basic, simple idea of productivity: those with bad ideas are eliminated. Instead, intermediation now means those with every bad idea possible are given funding because profits have little to do with real economic success. The financial economy really has become a game that simply seeks to transfer “money” from one perception to another. How it goes about that transference, nobody really cares anymore as long as some type, any type, of economic activity appears at the margins.
Given the dramatic rise of derivative contracts, especially synthetic bond creation through interest rate swaps, the banking system at the top really doesn’t even need the real economy to function on any scale. In fact, in this system of unlimited reserves and central bank flexibility, the real economy has become a hindrance to the banking system’s all-consuming quest for profit and growth. Intermediation in the real economy is far less attractive, on a profitability basis, than pure financial speculation with the blank check of digital dollars conferred by the definition of modern bank money: financial collateral. Italy can guarantee the debt of banks that it itself depends on for “money”, all so those same banks can access the ECB and serve as a means to transfer that “money” back to Italy. This is not intermediation, and it has, right now, subsumed the whole of the bloated financial economy.
Until QE 2.0, 99.999% of the public (including 99.999% of economists) would never have guessed it was collateral and accounting notions of balance sheet equity, both of which are eminently fudge-able at will, that actually governed the global banking system. That kind of flexibility, which brought about the overgrown financial economy and this pitiful diminishment of intermediation, is an anathema to a free economy and polity. The decentralized opinions of markets, the collective will of individual acts of free expression and movement, have been sacrificed unto the deity of the philosopher kings of elite opinion. Our intellectual betters can scarcely be expected to allow the uneducated common man to chart the collective economic course, let alone define the rules of the game. Markets no longer serve as a roadmap to the effective and efficient use of scarce real resources, they are tools of psychological manipulation to fulfill the religion of aggregate demand, soft central planning’s answer to the five-year plan. It all started the moment the gold standard was softened, conferring the ability of central banks to redefine money unto themselves. What was the ultimate monetary authority in the hands of the people was redefined into the hands of elite opinion. Flexibility can only visit one side of that equation.
The collective will of the people is certainly far from perfect. There is no question that the public succumbs to irrational fear and prejudice, and that power that rests in the hands of the temporarily unwise leads to real problems, but in a nominal system of freemen we would certainly be far wiser to maintain decentralized control and instead exerting our considerable collective efforts to mitigating the inevitable fits of irrationality. But even those fits of irrationality perform a vital function, a process intentionally disabled by central bank flexibility. Fear and prejudice that leads to financial distress, and even economic distress, is a self-correction mechanism of the real economy to clear out bad ideas and bad growth (any and all economic activity is not preferable, the real economy absolutely needs the right mix of economic activity to prosper in the long run). Creative destruction is just as much a part of free market capitalism as decentralized authority, and creative destruction has been circumvented and disabled numerous times by the illusion of prosperity that is this bank-first, credit-first monetary system.
With that in mind, the question of exogenous money and central bank flexibility comes down to a simple question: would you rather have had 2008 in 1990 or 2008? Or, even better, 1971? At what point would it have been best to reinstate exogenous money creation and let creative destruction carry out its vital function? Politicians would have protested and Fed Chairmen would have vociferously decried their lack of flexibility, but we would have been better off maintaining our own flexibility by exercising the ultimate measure of monetary control. We were in far better shape long ago to weather this storm of imbalance before the economy was distorted away from its productive foundation (described by real money) into a consumptive economy (run on figments of political flexibility and expedience). The transformation and distortion in the real economy that took hold in the late 1970’s, “perfected” in the 1990’s, was based entirely within the philosophy of money.
That is the final judgment of monetary standards. Chairman Bernanke decries the gold standard, but his institution’s record is far worse. Not only in terms of alternate standards (the current system is just as rigid and susceptible to global contagion, if not more so) but the utter corruption that the financial economy system has undergone strongly disfavors central bank supremacy. Some of that damage will likely be permanent; at the very least it will damage the real economy for generations as we attempt to unwind financial incentives that placed unproductive speculation at the forefront, far above incentives for productive work. Investors’ expectations, for example, even after twelve years of a bear market, remain elevated by an asset price system devoid of true price discovery. Far too many people still seek the easy lure of asset inflation, and that destruction of patience and care in the investment class will be a drag on the whole system for a long time. More than a generation’s (possibly as many as three) worth of knowledge and competence has been displaced by easy money. I fail to see how any of this is better than a gold standard. Gold is, again, far from perfect, but, in the end analysis, it may be the least objectionable.
The definition of money is really a political consideration. The slow relegation of monetary power to the Federal Reserve is a concentration of economic authority that is wholly incompatible with a free market, free society. To paraphrase Abraham Lincoln, our economic system cannot remain both free and centrally planned, a market economy divided against itself cannot stand - we must become all one thing or all the other. There are no perfect answers; there are only hard choices to make. Perhaps that is the most loathsome and destructive aspect of the current standard of central bank flexibility, an aspect that I believe renders full judgment in favor of restoring decentralized power. Central banks and their economic dogma essentially try to convince the public that there are no hard choices. The entire welfare society system that this central bank regime was created to serve is built on that notion, that wealth is easily conjured and transferred, if only money could prove as flexible as the diktats of imposed political will. Nothing so far in human history has been so thoroughly and unambiguously repudiated by the empirical evidence of human history itself. By exposing that lie we can put to rest the notion that the real economy cannot function without the financial economy. This bank-first approach to monetary policy is just a mislabeled effort to maintain and expand the current strain of central planning; there is no mistake about which direction central banks want to take if we are, indeed, fated to become all one thing.
The discussion of the gold standard is nothing more than politics of eliminating the PhD class’ flexibility. In that respect, I care little about the mechanics of whatever means is used to impart central bank confinement. It could be nothing more than a narrowly defined, transparently monitored and completely predictable restriction on the growth of bank reserves. It could be a gold price rule. Whatever means might effectively remove “discretion” from the vocabulary of central bankers should be included in all discussions. Given an extremely limited role, central banks can actually be useful, particularly if they are reduced to nothing more than rigid clearinghouses of fiscal and financial imbalances (no, the ECB is not performing this job particularly well at the moment since it is busy trying to keep the monetarist side of the economic house from ruin and discredit).
Gold, itself has a definable tradition, a tradition that is readily accepted in many parts of the world, so it may yet be ahead of the game in that regard – certainly not what Chairman Bernanke had in mind when he derided precious metals’ “tradition” in front of Congress last year. In the ultimate fit of irony, perhaps it would be most fitting that owing solely to that tradition gold restores the proper balance of flexibility in the monetary system and the financial economy. Less flexibility for Bernanke will mean more for you and me. This restraint will finally define the devilish allure of the seemingly easy answers and illusory prosperity of central banks and conventional economics as nothing more than anesthesia. However, once you turn over ultimate monetary authority to the central bank and give them the flexibility to define money, as we are finding out, it is far more difficult to recover it. To paraphrase Rahm Emanuel, we should not waste the re-occurrence of crisis to take it all back.