Peak Exorbitant Privilege

"Importing more than you export means lots of empty containers. That visual manifestation of our trade deficit is what drivers see as they pass the Port of New York and New Jersey on the New Jersey Turnpike. In the first eight months of 2010, the port saw the equivalent of 700,000 more full 20-foot containers enter than leave.

45% of containers exported from port operator APM Terminals’ Port Elizabeth facility (part of the Port of New York and New Jersey)
are empty, a reflection of the trade imbalance." Source

In the wake of WWI (1914-1918) there was an international movement in Europe to return to the stability of fixed exchange rates between national currencies. But all of them had been inflated so much during the war that reestablishing the peg to gold at the pre-war price would have implied an overvaluation of currencies that would have led inevitably to a run on all the gold in the banking system, monetary deflation and economic depression (good thing they avoided that, eh?). At the same time, they feared that raising the gold price would raise questions about the credibility of the new post-war regime, and quite possibly cause a global scramble into gold.

This "problem" with gold was viewed at the time as a "shortage" of gold. And so one of the stated goals of the effort to solve this problem was "some means of economizing the use of gold by maintaining reserves in the form of foreign balances." (Resolution 9 at the Genoa Conference, 1922) To economize means to limit or reduce, often used in conjunction with "expense" or "waste". So to "economize the use of gold" meant to limit or reduce the use of gold.

Meanwhile, the United States had emerged from the war as the major creditor to the world and the only post-war economy healthy enough to lend the financial assistance needed for rebuilding Europe. And so even though the U.S. wasn't directly involved in the European monetary negotiations that took place in Brussels in 1920 and Genoa in 1922, it was acknowledged that any new monetary order was likely to be a U.S. centered system.

The Genoa negotiations were led by the English including British Prime Minister Lloyd George and Bank of England Governor Montagu Norman who proposed a "two-tier" system especially designed to circumvent "the gold shortage". The British proposal described a group of "center countries" who would hold their reserves entirely in gold and a second tier group of (unnamed) countries who would hold reserves partly in gold and partly in short-term claims on the center countries. [1]

The proposal was named the "gold-exchange standard" (as opposed to the previous gold standard). In 1932 French economist Jacques Rueff proclaimed the gold-exchange standard that had come out of the Genoa conference a decade earlier "a conception so peculiarly Anglo-Saxon that there still is no French expression for it." [2]

The gold-exchange standard that officially came into being around 1926 (and lasted only about six years in its planned form) worked like this: The U.S. dollar was backed by and redeemable in gold at any level, even down to small gold coins. The British pound was backed by gold and dollars and redeemable in both, but for gold, only in large, expensive bars (kind of like the minimum gold redemption in PHYS is 400 oz. bars but you can redeem in dollars at any level). Other European currencies were backed by and redeemable in British pound sterling, while both dollars and pounds served as official reserves equal to gold in the international banking system. [3]

Since only the U.S. dollar was fully redeemable in gold, you might expect that gold would have immediately flowed out of the U.S. and into Europe. But as I already explained, the U.S. emerged from WWI as the world's creditor and the U.S. Treasury in 1920 held 3,679 tonnes of gold. By the beginning of the gold-exchange standard in 1926 the U.S. was up to 5,998 tonnes and by 1935 was up to 8,998 tonnes. By 1940 the U.S. Treasury held 19,543 tonnes of gold. After WWII and the start of the new Bretton Woods monetary system, official U.S. gold peaked at 20,663 tonnes in 1952 where it began its long decline. [4]

In Once Upon a Time I wrote, "Once sterilized [at the 1922 Genoa Conference], gold flowed uncontrolled into the US right up until the whole system collapsed and beyond." My point was that before the introduction of "paper gold" as official reserves in the form of dollars and pounds, the flow of physical gold in international trade settlement governed as a natural adjustment mechanism for national currencies and exerted the spur and brake forces on their economies. But after 1922, this was no longer the case.

After 1922, the U.S. provided the majority of the reserves for the international banking system in the form of printed dollars. And as the world's creditor and reserve printer, dollar reserves flowed out and gold payments flowed in. From the start of the gold-exchange standard in the mid-1920s until 1952, about 26 years, the dollar's monetary base grew from $6B to $50B while the U.S. gold stockpile grew from 6,000 tonnes to more than 20,000 tonnes. [5]

The Roaring Twenties was not just a short-lived period of superficial prosperity in America, it was also a time when a great privilege was unwittingly granted to the United States that would last for the next 90 years. And I say "unwittingly granted" because the U.S. did not even participate in the negotiations that led to its privilege. As Jacques Rueff wrote in his 1972 book, The Monetary Sin of the West:

"The situation I am going to analyze was neither brought about nor specifically wanted by the United States. It was the outcome of an unbelievable collective mistake which, when people become aware of it, will be viewed by history as an object of astonishment and scandal." [6]

I should pause here to note that gold standard advocates and hard money campers will quickly point out that the post-1922 gold-exchange standard is not what they want. They want to return to the gold standard of the 19th century, the one before WWI. But that's not my position. And anyway, it's not gonna happen and even if it would/could happen, it would not fix the fundamental problem. Just like time, we move relentlessly forward and, luckily for us, the future is much brighter than the past.

Now, back to this privilege which, in the end, may turn out to be more of a curse. In order to really understand how the gold-exchange standard and its successor systems, the Bretton Woods system and the current dollar standard system translated into a privilege for the United States, we need to understand what actually changed in the mid-20s as it fundamentally relates to how we use money. I will explain it as briefly as possible but I want to caution you to resist the temptation to make judgments about what is wrong here as you read my description. As some of you already know, I think there is only one fundamental flaw in the system and it was present even before the gold-exchange standard and the U.S. exorbitant privilege, but that's not the subject of this post.

What changed?

People and economies trade with each other using money – mainly credit, denominated in a national currency – as their primary medium of exchange so as to avoid the intractable double coincidence of wants problem with direct barter. So we trade our stuff for their stuff using bank money (aka fungible currency-denominated credit) and the prices of that stuff is how we know if there is any inequity or imbalance in the overall trade. When we periodically net out the bank transactions using the prices of the stuff we traded, we inevitably come up short on one side or the other. And so that imbalance is then settled in the currency itself.

But because different countries use different currencies, we need another level of imbalance clearing. And that international level is cleared with what we call reserves. So, in essence, we really do have two tiers in the way we use money. We have the domestic tier where everyone uses the same currency and clearing is handled at the commercial bank level with currency. And then we have the international tier where everyone doesn't use the same currency and so trade imbalances tend to aggregate and then clear with what we call "reserves" (aka international liquidity) at the national or Central Bank level.

This is built right into the very money that we use, and have used, for a very long time. To see how, we will regress conceptually back to how our bank money is initially conceived. And because most of you have at least a basic understanding of the Eurosystem's balance sheet from my quarterly RPG posts, this should be a fairly easy exercise. If not, RPG #4 might be a good place to catch up quickly.

Recall this chart from Euro Gold:

It shows the change, over time, in relative value of the two kinds of reserves held by the Eurosystem: 1. gold reserves and 2. foreign currency reserves. And in RPG #4 I explained the difference between reserves and assets on the CB balance sheet. Assets are claims against residents of your currency zone denominated mostly in your own currency. Reserves are either gold or claims against non-residents denominated in a foreign currency.

In our regression exercise we'll see the fundamental difference between reserves and assets. Reserves are the fundamental basis on which the basic money supply of a bank is borne, while assets are the balance sheet representation of the bank's extension of credit. Changes in the ratio between reserves and assets exert opposing (enabling/disabling) influences on the ability of the system to expand.

So, now, looking back at the very genesis of our money, we've all heard the stories of the gold banker who issues receipts on the gold he has in his vault, right? Well, that's basically it. Money as we know it today ultimately begins with the monetization of some gold. The Central Bank has some amount of gold in the vault which it monetizes by printing cash.

CB

Assets-------Liabilities

Gold | Cash

For the sake of this exercise, let's say that the government deposits its official gold in its newly-created CB and the CB monetizes that gold by printing cash which is now a government deposit. So let's simplify the balance sheet even more. CB = Central Bank, R = reserves, A = assets and C = cash (or also CB liabilities which are electronic obligations of the CB to print cash if necessary, so they are essentially the same thing as cash within the banking system).

CB
R|C

That's reserves (gold) on the asset side of the balance sheet and cash (the G's deposit) on the liability side. Now the G can spend that cash into the economy where it will end up at a commercial bank. Let's say COMMBANK1 = commercial bank #1, C = cash (or CB liabilities) and D = deposit.

COMMBANK1
C|D

Now that the G spent money into the economy, our first commercial bank has its own reserves and its first deposit from a government stooge who received payment from G and deposited it in COMMBANK1. In the commercial bank, cash is the reserve on the asset side of the balance sheet whereas cash is on the opposite side, the liability side, of the Central Bank's balance sheet. Also, all the cash issued by the CB remains on its balance sheet even after it has left the building and is sitting in the commercial bank (or even in a shoebox under your bed).

At this point we have a fully reserved mini-monetary system. Both the CB's and the commercial bank's liabilities are balanced with reserves. The CB's reserves are gold and the commercial bank's reserves are cash or CB liabilities. That's fully reserved. But let's say that the economy is trying to grow and the demand for bank money (credit) is both strong and credible. So now our banks can expand their balance sheets.

As credit expands, the asset side will be balanced with assets (A) rather than reserves (reserves are gold in the case of the CB and cash in the case of COMMBANK1). Also, I'm going to put the CB under the commercial banks since it is essentially the base on which the commercial bank money stands.

COMMBANK1
ACC|DDD
________________________________________
CB
AR|CC

Here we see that our CB now has an asset and a reserve. The asset is a claim denominated in its own currency against a resident of its currency zone, and the reserve is the gold. Let's say that the CB lent (and therefore created) a new C to the government. Meanwhile, our commercial bank COMMBANK1 has had two transactions. It has received the deposit from a second government stooge and it has also made a loan to a worthy entrepreneur.

So on the COMMBANK1 (commercial bank) balance sheet, the A is a claim against our entrepreneur and the two Cs are cash reserves. The first C came in when our first stooge deposited his government paycheck and the second C came in when the second stooge deposited his payment which G had borrowed (into existence) from the CB. The three Ds (deposits) belong to our two stooges and the entrepreneur.

I'm not going to go much further with this model but eventually, as the economy and bank money expands, we'll end up with something that looks more like this:

COMMBANK1
AAACC|DDDDD

COMMBANK2
AAACC|DDDDD

COMMBANK3
AAACC|DDDDD

COMMBANK4
AAACC|DDDDD

COMMBANK5
AAACC|DDDDD

________________________________________
CB
AAAAAAAAAR|CCCCCCCCCC

And here we have a simple model of our monetary system within a single currency zone. There are two observations that I want to share with you through this little exercise. The first is the tiered nature of our monetary system even within a single currency zone. And the second is the natural makeup of a Central Bank's balance sheet.

You'll notice that one thing the Central Bank and the commercial banks have in common is that the asset side of their balance sheets consist of both reserves and assets. Remember that assets are claims denominated in your currency against someone else in your currency zone. But you'll also notice that the commercial bank reserves are the same thing as the Central Bank's liabilities. So the Central Bank issues the reserves upon which bank money is issued to the economy by the commercial banks.

The fundamental take-home point here is that reserves are the base on which all bank money expands. CB money rests on CB reserves and commercial bank money rests on commercial bank reserves which are, in fact, CB money which is resting on CB reserves. So you can see that the entire money system is built up from the CB reserves.

The deposits (D) in the commercial banks are both redeemable in reserves and cleared with reserves (reserves being cash or CB liabilities). Deposits are not redeemable or cleared (settled) with assets. If a commercial bank has a healthy level of reserves it can expand its credit. But if it expands credit without sufficient reserves for its clearing and redemption needs, it must then go find reserves which it can do in a number of ways.

Notice above that we have 25 deposits at 5 commercial banks based on 10 commercial bank reserves. Those commercial bank reserves are Central Bank liabilities which are based ultimately on the original gold deposit. Before 1933, gold coins were one component of the cash, and CB liabilities were also redeemable by the commercial banks in gold coin from the CB to cover redemption needs. So the commercial banks (as well as the Fed) had to worry about having sufficient reserves of two different kinds. As you can imagine, this created another level of difficulty in clearing and especially in redemption.

Clearing and Redemption

Very quickly I want to go over clearing and redemption and how they can move reserves around in the system. Here's our simple system once again:

COMMBANK1
AAACC|DDDDD

COMMBANK2
AAACC|DDDDD

COMMBANK3
AAACC|DDDDD

COMMBANK4
AAACC|DDDDD

COMMBANK5
AAACC|DDDDD

________________________________________
CB
AAAAAAAAAR|CCCCCCCCCC

Now let's say that one of our depositors at COMMBANK5 withdrew his deposit in cash. And let's also say that another depositor at the same bank spent his money and his deposit was therefore transferred to COMMBANK4 and that transaction cleared. Here's what it would look like:

COMMBANK1
AAACC|DDDDD

COMMBANK2
AAACC|DDDDD

COMMBANK3
AAACC|DDDDD

COMMBANK4
AAACCC|DDDDDD

COMMBANK5
AAA|DDD

________________________________________
CB
AAAAAAAAAR|CCCCCCCCCC

A few quick observations. There are now only 9 Cs in the commercial banking system even though there are still 10 Cs outstanding on the CB's balance sheet. That's because one of them is now outside of the banking system as on-the-go cash in the wallet.

Also, notice that COMMBANK4 received its sixth deposit which cleared and so COMMBANK4 received the cash (C) reserve from COMMBANK5. This transaction bumped COMMBANK4 up from being 40% reserved to 50% reserved. But because COMMBANK5 had to deal with two transactions, one redemption and one cleared deposit transfer, COMMBANK5 is now out of reserves.

In this little scenario, COMMBANK4 is now extra-capable of expanding its balance sheet, while COMMBANK5 needs to forget about expanding and try to find some reserves. To obtain reserves, COMMBANK5 can call in a loan, sell an asset for cash, borrow cash temporarily while posting an asset as collateral, or simply hope that some deposits come his way very soon. But in any case, COMMBANK5's next action is, to some extent, influenced by its lack of reserve.

This is an important point: that as reserves move around, their movement exerts some influence on the activities of both the giver and the receiver of the reserves.

International Clearing

Now let's scale our model up and look at how it works in international trade. Commercial banks deal mostly in their own currency zone's currency. But in today's fast-paced and global world we have a constant flow of trade across borders, so various currencies are also flowing in all directions. Some international commercial banks handle these transactions, but as you can imagine, clearing and redemption becomes a bit more complicated.

You might have a deposit (D) at COMMBANK5 in the U.S. being spent in Europe somewhere and ending up at a European commercial bank where it is neither redeemable nor clearable as it stands (currently denominated in dollars). The U.S.-based COMMBANK5 will transfer both the C and the D to the European bank. The European deposit holder who sold his goods to the U.S. will want his bank to exchange those dollars for euros so he can pay his bills. So the European bank will look to either the foreign exchange market or to its CB to change the currency.

If trade between the two currency zones was perfectly equal at all times, there would be an equal amount of euros wanting to buy dollars and vice versa. But we don't live in a perfect world, so there's always more of one or the other which is why the exchange rates float. If, instead, we had fixed exchange rates, the CBs would be involved in equalizing the number of euros and dollars being exchanged, and then the CBs would settle up amongst themselves using their reserves, which was how it was before 1971.

But even today, with floating exchange rates, the CB's still do get involved in what we call the "dirty float" to manage the price of their currency on the international market. This is essentially the same process as during fixed exchange rates except that they don't maintain an exact peg, but instead they let it float within a range that they deem acceptable. And the way they do that is essentially the same way they did it back in the fixed exchange rate system of Bretton Woods and before. They buy up foreign currency from their commercial banks with newly printed cash.

Or, if there's a glut of their own currency in foreign lands trying to get home, then they have to buy back their own currency using up their CB reserves. Which brings us to the makeup of a CB's balance sheet, most pointedly its reserves. And the take-home point that I want to share with you here is the difference between finite and infinite from a CB's perspective.

From the perspective of a CB, its own currency is infinite while its reserves are finite. So if there's a glut of foreign currency in its zone, it has no problem buying up as much as it wants with printed cash. In fact, theoretically, a CB could buy up foreign currency that is accumulating in its zone until the cows come home. On the other hand, if there's a glut of its own currency abroad, its buy-back power is finite and limited to the amount of reserves it stockpiled earlier.

So why do it? Why does a CB spend its precious reserves buying its own currency back from foreign lands? What happens if it doesn't? Currency collapse is what happens. If there's a glut of your currency abroad and you don't buy it back, the market will take care of it for you by devaluing your currency until it becomes impossible for you to run a trade deficit. And this is a painful process when the marketplace handles it for you because it not only collapses your trade deficit to zero, it also tends to bring your domestic economy to a standstill at the same time, a double-whammy.

And this is how the monetary system above scales up to the international level. While the commercial bank reserves (Cash) are good for clearing, redemption and credit expansion within a currency zone, only the CB reserves work in a pinch on the international level. And if the CB runs out of reserves, the currency collapses due to market forces and, therefore, the commercial bank reserve (Cash) upon which commercial bank money is expanded devalues, and so bank money, too, devalues. It is all stacked upon the CB reserves from whence the first bank money was born.

And as you can see above, the natural makeup of a CB's reserves is gold. But that changed in 1922.

Now obviously there are a myriad of directions in which we could take this discussion right now. But the direction I want to keep you focused on so that I can eventually conclude this post is that when a Central Bank's finite reserves are ultimately exhausted in the international defense of its currency, its local commercial bank's reserves (Cash) are naturally devalued by the international market. And with the commercial bank reserves being what commercial bank deposits are redeemable in, so too is local money devalued.

But in 1922 they "solved" this "problem" with the introduction of theoretically infinite reserves.

As we move forward in this discussion, I want you to keep in mind my first fundamental take-home point which was that reserves are the base on which bank money expands. Commercial banks expand their bank money on a base of Central Bank-created reserves. And (as long as there is trade with the world outside of your currency zone) the Central Bank's reserves are the base on which the commercial banks' reserves stand. So the corollary I'd like to introduce here is that theoretically infinite reserves lead to theoretically infinite bank money expansion.

Of course it doesn't take a genius to figure out that infinite money expansion does not automatically translate into infinite real economic growth. And so we need to look at who, in particular, was the prime beneficiary of these newly infinite reserves.

In 1922 the Governor of the Bank of England which had around 1,000 tonnes of gold at the time (less than the Bank of France which had about 1,200 tonnes) proposed economizing the use of gold by declaring British pound sterling and U.S. dollars to be official and recognized reserves anywhere in the world. The "logic" was that dollars and pounds would be as good as gold because they would be redeemable in gold on their home turf.

Three Fair Warnings

The reason I went through this somewhat-lengthy exercise explaining the significance of reserves in our monetary and banking system was to help you understand the words of Jacques Rueff who first warned of the catastrophically dangerous flaw embedded in this new system—a flaw which continues today—way back in 1931. The term "exorbitant privilege" would not be used until 30 years later under a new system, but I hope to help you see, as I do, the common thread that ties all three systems together, the gold-exchange standard, Bretton Woods and the present dollar standard.

As we walk through this timeline together, you'll read three warnings at times of great peril to the system. The first was delivered by Rueff to the French Finance Minister in preparation for the French Prime Minister's meeting with President Hoover in Washington DC in 1931. The second was delivered to the U.S. Congress by a former Fed and IMF economist named Robert Triffin in 1960. And the third will be delivered later in this post.

To put it all in perspective, I drew this rough timeline to help you visualize my thought process while writing this post:

Those of you who have been reading my blog for a while should be aware that the U.S. has run a trade deficit every year since 1975. You should also know that, since 1971, the U.S. government has run its national debt up from $400B to $15,500B, and that foreign Central Banks buying this debt have been the primary support for both the relatively stable value of the dollar and the perpetual nature of the U.S. trade deficit.

But it wasn't always this way. Before 1971 the U.S. was running a trade surplus and the national debt level was relatively steady during both the gold-exchange standard and the Bretton Woods era. During the gold-exchange standard the national debt ranged from about $16B up to $43B. It increased a lot during WWII to about $250B, but then it remained below its $400B ceiling until 1971.

Another big difference during this timeline which I have already mentioned is the flow of gold. The U.S. experienced an uncontrolled inflow of gold from the beginning of the gold-exchange standard until 1952, and then a stunted outflow ensued until it was stopped altogether in 1971.

The point is that with such a wide array of vastly disparate circumstances, it is a bit tricky for me to explain the common thread that binds this timeline together. Very generally, let's call this common thread the monetary privilege that comes from the rest of the world voluntarily using that which comes only from your printing press as its monetary reserves. It started as a privilege, grew into an exorbitant privilege 35 years later, and then peaked 45 years later at something for which, perhaps, there is not an appropriately strong enough adjective.

Robert Triffin thought it had gone far enough to warrant warning Congress in 1960, but just wait till you see how much farther it went over the next four and a half decades. But first, let's go back to 1931.

First Warning

In his 1972 book [6], Jacques Rueff writes:

Between 1930 and 1934 I was Financial Attache in the French Embassy in London. In that capacity, I had noted day after day the dramatic sequence of events that turned the 1929 cyclical downturn into the Great Depression of 1931-1934. I knew that this tragedy was due to disruption of the international monetary system as a result of requests for reimbursement in gold of the dollar and sterling balances that had been so inconsiderately accumulated.

On 1 October 1931 I wrote a note to the Finance Minister, in preparation for talks that were to take place between the French Prime Minister, whom I was to accompany to Washington, and the President of the United States. In it I called the Government's attention to the role played by the gold-exchange standard in the Great Depression, which was already causing havoc among Western nations, in the following terms:

"There is one innovation which has materially contributed to the difficulties that are besetting the world. That is the introduction by a great many European states, under the auspices of the Financial Committee of the League of Nations, of a monetary system called the gold-exchange standard. Under this system, central banks are authorized to include in their reserves not only gold and claims denominated in the national currency, but also foreign exchange. The latter, although entered as assets of the central bank which owns it, naturally remains deposited in the country of origin.

The use of such a mechanism has the considerable drawback of damping the effects of international capital movements in the financial markets that they affect. For example, funds flowing out of the United States into a country that applies the gold-exchange standard increase by a corresponding amount the money supply in the receiving market, without reducing in any way the money supply in their market of origin. The bank of issue to which they accrue, and which enters them in its reserves, leaves them on deposit in the New York market. There they can, as previously, provide backing for the granting of credit.

Thus the gold-exchange standard considerably reduces the sensitivity of spontaneous reactions that tend to limit or correct gold movements. For this reason, in the past the gold-exchange standard has been a source of serious monetary disturbances. It was probably one cause for the long duration of the substantial credit inflation that preceded the 1929 crisis in the United States."

Then in 1932 he gave further warning in the speech at the School of Political Sciences in Paris which I wrote about in Once Upon a Time:

The gold-exchange standard is characterized by the fact that it enables the bank of issue to enter in its monetary reserves not only gold and paper in the national currency, but also claims denominated in foreign currencies, payable in gold and deposited in the country of origin. In other words, the central bank of a country that applies the gold-exchange standard can issue currency not only against gold and claims denominated in the national currency, but also against claims in dollars or sterling.

[…]

The application of the gold-exchange standard had the considerable advantage for Britain of masking its real position for many years. During the entire postwar period, Britain was able to loan to Central European countries funds that kept flowing back to Britain, since the moment they had entered the economy of the borrowing countries, they were deposited again in London. Thus, like soldiers marching across the stage in a musical comedy, they could reemerge indefinitely and enable their owners to continue making loans abroad, while in fact the inflow of foreign exchange which in the past had made such loans possible had dried up.

[…]

Funds flowing out of the United States into a gold-exchange-standard country, for instance, increase by a corresponding amount the money supply in the recipient market, while the money supply in the American market is not reduced. The bank of issue that receives the funds, while entering them directly or indirectly in its reserves, leaves them on deposit in the New York market. There they contribute, as before being transferred, to the credit base.

[…]

By the same token, the gold-exchange standard was a formidable inflation factor. Funds that flowed back to Europe remained available in the United States. They were purely and simply increased twofold, enabling the American market to buy in Europe without ceasing to do so in the United States. As a result, the gold-exchange standard was one of the major causes of the wave of speculation that culminated in the September 1929 crisis. It delayed the moment when the braking effect that would otherwise have been the result of the gold standard's coming into play would have been felt.

Are you starting to get a sense of the key issue yet? Reserves move from one bank to another to settle a transaction. When our depositor at COMMBANK5 spent his deposit and it was thereby transferred to COMMBANK4, the cash (C) reserve was also moved to COMMBANK4 to settle (or clear) the transaction. This put a certain strain on COMMBANK5 since it had also lost another reserve to redemption which forced COMMBANK5 into the action of seeking reserves.

Or when a Central Bank expends its reserves trying to remove a glut of its currency abroad so that the marketplace won't devalue (or collapse) it, that CB is generally limited to a finite amount of reserves which, once spent, are gone. So the movement of reserves serves two purposes. It is not only attained by the receiver but it is also forfeited by the giver. Both are vital to a properly functioning monetary system.

But with the system that began around 1926 and still exists today, we end up with a situation in which one currency's reserves are actually deposits in another currency zone: 

Notice that I am avoiding the use of gold in my illustration. The warnings given in 1931 and 1960 were presented in the context of a gold exchange standard of one form or another, and therefore they (of course!) heavily reference the problems as they related to ongoing gold redemption. But the real problem, as I have said, transcends the specific issues with gold at that time.

The real problem was and is the common thread I mentioned earilier: the monetary privilege that comes from the rest of the world voluntarily using that which comes only from your printing press as its monetary reserves. It was and is, as Jacques Rueff put it, "the outcome of an unbelievable collective mistake which, when people become aware of it, will be viewed by history as an object of astonishment and scandal."

Another angle which was apparent from the very beginning—because Rueff mentioned it in 1932 (as quoted above)—was that of international lending. It basically worked in the same way as the three steps above except that the net international (trade) payment was an international loan. Remember that the U.S. was the prime creditor to the world following both wars. This may partly explain the inflow of gold payments that brought the U.S. stockpile up from 3,679 tonnes in 1920 to 20,663 tonnes in 1952. A dollar loan was the same as a gold loan and was payable in dollars or gold. But as Rueff pointed out above, the lent dollars came immediately back to New York just as the pounds came back to London:

"During the entire postwar period, Britain was able to loan to Central European countries funds that kept flowing back to Britain, since the moment they had entered the economy of the borrowing countries, they were deposited again in London. Thus, like soldiers marching across the stage in a musical comedy, they could reemerge indefinitely and enable their owners to continue making loans abroad."

Now think about that for a moment. The same reserves (base money) getting lent out over and over again like a revolving door. And let's jump forward to the present for a moment to see if we can start connecting some dots between 1932 and 2012. Here's a recent comment I wrote about the revolving door of dollars today:

Hello Victor,

The point of JR's excerpts is that the real threat to the dollar lies in the physical plane (real price inflation) rather than the monetary plane (foreign exchange market). The source of the price inflation will be from abroad and it will be reflected in the exchange rate, but the price inflation, not the FX market, is the real threat.

Imagine a toy model where the entire United States (govt. + private sector) imports $100,000 worth of stuff during a period of time (T). T repeats perpetually and, just to keep it real, let's say that t = 1 second, which is pretty close to reality. So the US imports the real stuff and exports the paper dollars. But the US also exports $79,000 worth of real stuff each second. So 79,000 of those dollars come right back into the US economy in exchange for the US stuff exports.

Now, in our toy model, let's say that the US private sector is no longer expanding its aggregate level of debt. And so let's say, just for the sake of simplicity, that $79,000 worth of international trade over time period T represents the US private sector trading our stuff for their stuff. And let's say that the other $21,000 worth of imports each second is all going to the USG consumption monster.

So the USG is borrowing $21,000 **from some entity** each second and spending it on stuff from abroad. This doesn't cover the entire per-second appetite of the USG consumption monster, only the stuff from abroad. The USG also consumes another $114,000 in domestic production each second, which is all the domestic economy can handle right now without imploding, but we aren't concerned with that part yet.

Now, if the **from some entity** is our trading partner abroad, then there is no fear of real price inflation. The USG is essentially borrowing $21,000 this second -- that our trading partner received last second -- and the USG will spend it again on more foreign stuff a second from now and then borrow it again. See? No inflation! The same dollars circulate in perpetuity, the real stuff piles up in DC, and the USG debt piles up in Beijing.

But what if that **from some entity** is mostly the Fed, and has been for two years now (and they are calling it QE only to make it sound like its purpose is to assist the US private sector)? If that's the case, then the fear of real price inflation is now a clear and present danger to "national security" (aka the USG consumption monster). Not so much for the private sector which is now trading our stuff for their stuff, but mostly for the public sector which trades only $21,000 in paper nothings, per second, for their stuff.

Under this latter situation, you now have $21,000 per second piling up outside of US borders and it's not being lent back to either the USG or the US private sector (which has stopped expanding its debt). It's either going to bid for stuff outside or inside of US boundaries.

The USG budget approved by Congress does account for this $21,000 per second borrowing, but it also assumes reasonably stable prices. If the general price level starts to rise faster than Congress approves new budgets, this creates a problem for the USG. It's not as big of a problem for the US private sector, since we are trading mostly stuff for stuff. If the cost of a banana rises to $1T, it will still only cost half an apple. But if you're relying only on paper currency to pay for your monstrous needs, real price inflation is an imminent threat!

FX volatility has more to do with the changing preferences of the financial markets. It is a monetary plane phenomenon on most normal days. But it will also show up when the price of a banana starts to rise.

When the USG cuts a check, it is drafted on a Treasury account at the Fed. Sometimes those funds are all ready to go in the account. Sometimes they are pulled (momentarily) from a commercial bank into the Fed account for clearing purposes. And sometimes the Fed simply creates them, adding a Treasury IOU to its balance sheet.

This latest Executive Order paves the way for the Fed to start stacking not only Treasury IOUs, but also Commerce Dept. IOUs, Homeland Security IOUs, State Dept., Interior, Agriculture, Labor, Transportation, Energy, Housing and Urban Development, Health and Human Services, etc… IOUs. Whatever it takes to keep the real stuff flowing in! If you think the Fed's balance sheet looks like a gay rainbow now, just wait!

But from a financial perspective, if you are stuck in dollar assets when real price inflation takes hold, you are going to want out. And the quickest way out is through the currency itself. So we could see a spike (outside of the US) in the price of Realdollars even as the dollar is collapsing against the physical plane and the USG is printing like crazy to defend its own largess! How confusing will that be to all the hot "experts" on CNBC?

The financial markets can cause dramatic volatility in the FX market, and vice versa. But that's all monetary plane nonsense. A small change in the physical plane might not even register at first in the FX market, especially if a financial panic is overpowering it in the opposite direction. But even if the dollar doubles in financial product purchasing power terms (USDX to 150+), that's not going to lower the price of a banana in the physical plane while the USG is defending its consumption status quo with the printing press.

Sincerely,

FOFOA

I highlighted the part relevant to our revolving door discussion, but the whole comment is relevant to the whole of this post because I had this post in mind when I wrote the comment. Anyway, can you see any similarity between what Jacques Rueff wrote about the sterling in 1932 and what I wrote last week?

How about a difference? That's right, the U.S. is now the world's premier debtor while it was the world's creditor back in the 30s. But in both cases the dollar currency is being continuously recycled while notations recording its passage pile up as reserves on which foreign bank money is expanded while the U.S. counterpart of reserves and bank money is not reduced as a consequence of the transfer.

If you print the currency that the rest of the world uses as a reserve behind its currency, that alone enables you to run a trade deficit without ever reducing your ability to run a future trade deficit. Deficit without tears it was called. For the rest of the world, running a trade deficit has the finite limitation of the amount of reserves stored previously and/or the amount of international liquidity (reserves) your trading partner is willing to lend you.

Another thing that happens is that, as the printer of the reserve, the rest of the world actually requires you to run a balance of payments deficit or else its (the rest of the world's) reserves will have to shrink, and its currency, credit and economy consequently contract. So to avoid monetary and economic contraction, the world not only puts up with, but supports your deficit without tears. Here's a little more from Jacques Rueff:

The Secret of a Deficit Without Tears [6]

To verify that the same situation exists in 1960, mutatis mutandis, one has only to read President Kennedy's message of 6 February 1961 on the stability of the dollar.

He indicates with admirable objectivity that from 1 January 1951 to 31 December 1960, the deficit of the balance of payments of the United States had attained a total of $18.1 billion.

One could have expected that during this period the gold reserve would have declined by the same amount. Amounting to $22.8 billion on 31 December 1950, it was, against all expectations, $17.5 billion on 31 December 1960.

The reason for this was simple. During this period the banks of issue of the creditor countries, while creating, as a counterpart to the dollars they acquired through the settlement of the American deficits, the national currency they remitted to the holders of claims on the United States, had reinvested about two-thirds of these same dollars in the American market. In doing so between 1951 and 1961 the banks of issue had increased by about $13 billion their foreign holdings in dollars.

Thus, the United States did not have to settle that part of their balance-of-payments deficit with other countries. Everything took place on the monetary plane just as if the deficit had not existed.

In this way, the gold-exchange standard brought about an immense revolution and produced the secret of a deficit without tears. It allowed the countries in possession of a currency benefiting from international prestige to give without taking, to lend without borrowing, and to acquire without paying.

The discovery of this secret profoundly modified the psychology of nations. It allowed countries lucky enough to have a boomerang currency to disregard the internal consequences that would have resulted from a balance-of-payments deficit under the gold standard.

Second Warning

By the early 1960s, Jacques Rueff was not alone in speaking out against the American privilege embedded in the monetary system. Another Frenchman named Valéry Giscard d'Estaing, who was the French Finance Minister under Charles de Gaulle and would later become President himself, coined the term "exorbitant privilege". [7] Even Charles de Gaulle spoke out in 1965 and you can see a short video of that speech in my post The Long Road to Freegold.

But perhaps more significant than the obvious French disdain for the system was Robert Triffen, who stood before the U.S. Congress in 1960 and warned:

"A fundamental reform of the international monetary system has long been overdue. Its necessity and urgency are further highlighted today by the imminent threat to the once mighty U.S. dollar."

To put Triffin in the context of our previous discussion, here's what Jacques Rueff had to say about him:

"Some will no doubt be surprised that in 1961, practically alone in the world, I had the audacity to call attention to the dangers inherent in the international monetary system as it existed then.

I must, however, pay a tribute here to my friend Professor Robert Triffin of Yale University, who also diagnosed the threat of the gold-exchange standard to the stability of the Western world. But while we agreed on the diagnosis, we differed widely as to the remedy to be applied. On the other hand, the late Professor Michael Heilperin, of the Graduate Institute of International Studies in Geneva, held a position in every respect close to mine."

And here is what Wikipedia says about Robert Triffin's Congressional testimony:

"In 1960 Triffin testified before the United States Congress warning of serious flaws in the Bretton Woods system. His theory was based on observing the dollar glut, or the accumulation of the United States dollar outside of the US. Under the Bretton Woods agreement the US had pledged to convert dollars into gold, but by the early 1960s the glut had caused more dollars to be available outside the US than gold was in its Treasury. As a result the US had to run deficits on the current account of the balance of payments to supply the world with dollar reserves that kept liquidity for their increased wealth. However, running the deficit on the current account of the balance of payments in the long term would erode confidence in the dollar. He predicted the result that the system would not maintain both liquidity and confidence, a theory later to be known as the Triffin dilemma. It was largely ignored until 1971, when his hypothesis became reality, forcing US President Richard Nixon to halt convertibility of the United States dollar into gold, an event with consequences known as the Nixon Shock. It effectively ended the Bretton Woods System." [8]

(For more on the Triffin dilemma, please see my posts Dilemma and Dilemma 2 – Homeless Dollars. And for a glimpse at what I view as an even more fundamental dilemma, you'll find "FOFOA's dilemma" in my post The Return to Honest Money. )

As noted above, Triffin's prescription in the 1960s was at odds with Rueff and the French contingent. In fact, even today, the IMF refers to "Triffin's solution" as a sort of advertisement for its own product, the almighty SDR. [9] From the IMF website:

Triffin's Solution

Triffin proposed the creation of new reserve units. These units would not depend on gold or currencies, but would add to the world's total liquidity. Creating such a new reserve would allow the United States to reduce its balance of payments deficits, while still allowing for global economic expansion.

But even though Triffin proposed something like the SDR (a proposal the IMF loves on to this day), I think that actions speak louder than words.

Robert Triffin was a Belgian economist who became a U.S. citizen in 1942 after receiving his PhD from Harvard. He worked for the Federal Reserve from 1942 to 1946, the IMF from 1946 to 1948 and the precursor to the OECD from 1948 until 1951. He also taught economics at both Harvard and Yale. But in 1977 he reclaimed his Belgian citizenship, moved back to Europe, and helped develop the European Monetary System and the concept of a central bank for all of Europe which ultimately became the ECB five years after his death in 1993.

Final Warning

With the end of the Bretton Woods monetary system in 1971, three things (besides the obvious closing of the gold window) really took hold. The first was that the U.S. began running (and expanding) a blatant trade deficit. It went back and forth a couple of times before it really took hold, but starting in 1976 we have run a deficit every year since. [10]

The second thing that took hold was something FOA called "credibility inflation". You can read more about it in my aptly-titled post, Credibility Inflation. This phenomenon, at least in part, helped grow the overall level of trade between the U.S. and the rest of the world in both nominal and real terms. In inflation adjusted terms, U.S. trade with the rest of the world is up almost eightfold since 1971. [11]

The third thing was that the U.S. federal government began expanding itself in both nominal and real terms by raising the federal debt ceiling and relying more heavily on U.S. Treasury debt sales. From Credibility Inflation (quoting Bill Buckler):

Way back in March 1971, four months before Nixon closed the Gold window, the "permanent" U.S. debt ceiling had been frozen at $400 Billion. By late 1982, U.S. funded debt had tripled to about $1.25 TRILLION. But the "permanent" debt ceiling still stood at $400 Billion. All the debt ceiling rises since 1971 had been officially designated as "temporary!" In late 1982, realizing that this charade could not be continued, The U.S. Treasury eliminated the "difference" between the "temporary" and the "permanent" debt ceiling. The way was cleared for the subsequent explosion in U.S. debt. With the U.S. being the world's "reserve currency," the way was in fact cleared for a debt explosion right around the world.

Here are the debt ceilings through 2010 as found on Wikipedia:

That's all well and good, but to really see the U.S. exorbitant (is there a stronger word?) privilege of the last 40 years in stark relief, we must think about those empty containers we export from the picture at the top. Those containers come in full and leave empty, just to be refilled again overseas and brought back in. Those empty containers represent the real trade deficit, the portion of our imports that we do not pay for with exports. Those empty containers represent the portion of our imports that we pay for with nothing but book entries which are little more than lines in the sand. [12]

Here's my thesis: that the U.S. privilege which began in Genoa in 1922, and was so complicated that only one in a million could even fathom it in 1931 and 1960, became as clear as day for anyone with eyes to see after 1971. And so, to see it in real (not nominal) terms, we can very simply look at the percentage of our imports that is not paid for with exports. So simple, which might be why the government doesn't publish that number and the media doesn't talk about it. All you have to do is compare the goods and services balance (which is a negative number or a deficit every year since 1975) with the total for all goods and service imports.

That's comparing apples with apples. For example, in 1971 total imports were $60,979,000,000 and total exports were $59,677,000,000 leaving us with a trade deficit of $1,302,000,000. It doesn't matter what the price of an apple was in 1971, because whatever it was, we still imported 2.14% more stuff than we exported. 1,302 ÷ 60,979 = 2.14%.

A trade discrepancy of 2.14% in any given year would be normal under normal circumstances. You'd expect to see it alternate back and forth from deficit to surplus and back again as it actually did from 1970 through 1976. But it becomes something else entirely when you go year after year (for 36 years straight) importing more than you export. And that's why I showed that little dip in the above timeline visualization of the U.S. exorbitant privilege at 1971.

And now here's what it looks like charted out from 1970 through 2011:

Here's the data from the chart:

As you can see, the U.S. exorbitant privilege (essentially free imports) peaked in 2005 at an astounding 35.5%, or more than a third of all imports! Stop and think about that for a second. For every three containers coming in full, only two went out full. So how do we reconcile that number (35.5%) with the report at the top of this post that said 45% of containers are exported empty?

The answer is simple. The trade deficit includes both goods and services. But services are not imported in containers. In fact, the U.S. has been running a trade surplus on services every year since 1971. Imagine that! So if we look only at the portion of goods coming and going, we get an even higher percentage. So let's look at 2005 in particular.

In 2005 we imported $1.692T in goods but we exported only $911B for a goods balance of payments of negative $781B. That equates to 46% of all containers being exported empty in 2005. That goods deficit has since dropped down to around 33% for the last three years, so perhaps 45% empty containers in 2010 can be explained by the location of the Port Elizabeth facility being only 200 miles from Washington DC, consumption capital of the world.

But all of this is kind of beside the point. The point is that the U.S. exorbitant privilege peaked in 2005, for the last time, at its all-time high of a third of all imports, and soon it will go negative, where it hasn't been in a really long time.

I can say this with absolute confidence because the signs are everywhere, even if nobody is talking about them in precisely these terms. Here's one bloodhound who's at least onto the right scent (from Barrons):

But more recent Treasury data show China has been selling Treasuries outright. And while the markets have been complacent to the point of snarkiness, MacroMavens' Stephanie Pomboy thinks that's wrong. Unlike other Cassandras, she's been right in her warnings -- notably in the middle of the last decade that the U.S. financial system was dangerously exposed to a bubble in U.S. real estate. Hers was a lonely voice then because everybody knew, of course, house prices always rose.

As for the present conundrum, there's an $800 billion gap between the $1.1 trillion the Treasury is borrowing to cover the budget gap and the roughly $300 billion overseas investors are buying, Pomboy calculates.

[…]

But Pomboy has little doubt that the Fed will step in to fill the gap left by others. In other words, debt monetization, a fancy term for printing money to cover the government's debts, which in polite circles these days is called "quantitative easing."

"Having pushed interest rates to zero, launched QE1 and QE2, there's no reason to believe that the Fed is going to allow free-market forces to destroy the fragile recovery it has worked so hard to coax forth now. And make no mistake, at $800 billion, allowing the markets to resolve the shortfall in demand would send rates to levels that would absolutely quash this recovery…if not send the economy in a real depression."

But her real concern is a bigger one. "The Fed's 'need' to take on an even more active role as foreigners further slow the purchases of our paper is to put the pedal to the metal on the currency debasement race now being run in the developed world -- a race which is speeding us all toward the end of the present currency regime." That is, the dollar-centric, floating exchange-rate system of the past four decades since the end of Bretton Woods system, when the dollar's convertibility into gold was terminated.

[…]

That would leave the Federal Reserve as lender of last resort to the U.S. government to fill the gap left by its biggest creditor. Think this Zimbabwe style of central-bank monetization of an unsustainable government debt can't happen in one of the world's major industrialized democracies? [13]

That was from March 2nd. Here's another one from the same writer at Barrons just a few days ago:

Our friend, Stephanie Pomboy, who heads the MacroMavens advisory, offers some other inconvenient facts about the Treasury market: Uncle Sam is borrowing some $1.1 trillion a year, while our foreign creditors have been buying just $286 billion.

"I'm no mathematician, but that seems to leave $800 billion of 'slack' (of which the Fed graciously absorbed $650 billion last year.) Barring a desire to pay the government 1% after inflation, there is NO profit-oriented or even preservation-of-capital-oriented buyer for Treasuries," she writes in an email.

"For the life of me, I can't understand why NOBODY is talking about this???!!!"

Having known Stephanie for a few years, I can't recall her being this agitated since 2006, when she insisted the financial system's hugely leveraged exposure to residential real estate posed grave risks. She was called a Cassandra then, but both ladies' prophesies turned out to be right.

The U.S. fiscal situation hasn't mattered as long as the Treasury could readily finance its deficits at record-low interest rates. Even after the loss of America's triple-A credit rating from S&P, Treasuries rallied and yields slumped to record lows.

That's no longer happening. For what ever reason, assurances by the Fed Chairman aren't impressing the bond market. Neither is weakness in the commodity markets. Maybe Stephanie is on to something. [14]

Of course they are looking only at the monetary plane, the silly market for U.S. Treasury debt which the Fed can dominate with infinite demand. As I keep saying, the real threat to the dollar is in the physical plane: the price of all those containers being unloaded and then exported empty.

The U.S. government has grown addicted to its exorbitant privilege over the years. It is a privilege that has been supported by foreign Central Banks buying U.S. debt for the better part of the last 30 years. But as I wrote in Moneyness, and as Ms. Pomboy has noticed above, that ended a few years ago. From Moneyness, the blue that I circled below shows the Fed defending our exports **of empty containers** with nothing more than the printing press and calling it QE:

I would like you all to give this some serious thought:

1. The U.S. exorbitant privilege peaked in 2005 (before the financial crisis) and is now on the decline, meaning it is no longer supported abroad.
2. The U.S. government (with the obvious assistance of the Fed) is now in defensive mode, defending that inflow of free stuff with the printing press.
3. The U.S. federal government budget deficit (DC's "needs" minus its normal revenue) **eclipses** the trade deficit by more than a 2 to 1 margin.

So what could possibly go wrong? The recession has already contracted the U.S. economy, all except the part that resides in Washington, DC. And just to maintain its own status quo (when has it ever been happy doing only that?) our federal government needs to insure our national business of exporting empty containers at its present level.

What could go wrong? Prices! If the price of an apple doubles, what do you think happens to the price of a full container? Those of you who think we are due for some more price deflation in the stuff that the USG needs to maintain its status quo should really have your heads examined. Even Obama is winding up to pitch the whole ball of twine at the problem. He just delegated his executive power to print until the cows come home to each of his department heads. I quote from Executive Order -- National Defense Resources Preparedness :

"To ensure the supply… from high cost sources… in light of a temporary increase in transportation cost… the head of each agency… is delegated the authority… to make subsidy payments"

In case you're having difficulty connecting the dots I've laid out (not) so subtly, I'm talking about a near-term dollar super-hyperinflation that will make your hair curl and make Weimar and Zimbabwe seem like child's play in the rearview mirror. If you're new to this blog, you should know that the rate of hyperinflation does not follow the printing. An apple does not end up costing a trillion dollars because they printed enough dollars to price all apples that way. Hyperinflation comes from the margin, from the government defending its own needs, and there's never enough "money" for us mere mortals to pay the prices which are running away from everyone during hyperinflation.

Also, hyperinflation turns physical (as in physical cash) very quickly once it takes hold. So if you're expecting some sort of electronic currency hyperinflation, fuggedaboutit. If you think we're more technologically advanced than bass-ackward Zimbabwe or ancient Weimar, you are not understanding what really happens during currency hyperinflation. It cannot play out electronically all the way to the bitter end because, when prices are rising that fast, physical cash always brings a premium over electronic deposit transfers which require some amount of time (and thereby devaluation) to clear.

Here are a few of my recent posts in which I explore what little we can do to prepare for what is inevitably coming our way:

Deflation or Hyperinflation?
Big Gap in Understanding Weakens Deflationist Argument
Just Another Hyperinflation Post - Part 1
Just Another Hyperinflation Post - Part 2
Just Another Hyperinflation Post - Part 3

That's right, I saved the "crazy super-hyperinflation talk" for the tail end of a really long post. Because A) people who think they have it all figured out already tend to abandon a post once they read the word "hyperinflation", and B) the stuff in this post really happened and is still happening so it's only fair to you, the reader, to give its inevitable denouement the appropriate weight of a bold conclusion. If I didn't do that, I would not have done my job, now would I? ;)

And in case you didn't figure it out yet, this third and final warning was only for the savers who are still saving in dollars. It's way too late to fix the $IMFS.

Sincerely,

PS. Thanks to reader FreegoldTube for the custom video below! He just happened to send me the link while I was considering songs for this post. The band is Muse and the song is Uprising from their album titled The Resistance.

[1] http://mauricio.econ.ubc.ca/pdfs/kirsten.pdf
[2] The Age of Inflation –Jacques Rueff
[3] http://mises.org/money/4s3.asp
[4] http://www.gold.org/download/pub_archive/pdf/Rs23.pdf
[5] research.stlouisfed.org/publications/review/03/09/0309ra.xls
[6] http://mises.org/books/monetarysin.pdf
[7] http://en.wikipedia.org/wiki/Exorbitant_privilege
[8] http://en.wikipedia.org/wiki/Robert_Triffin
[9] www.imf.org/external/np/exr/center/mm/eng/mm_sc_03.htm
[10] www.census.gov/foreign-trade/statistics/historical/gands.txt
[11] Using data from [10] and the BLS inflation calculator at http://www.bls.gov/data/inflation_calculator.htm
[12] Lines in the sand is a reference to my Ben and Chen island analogy in Focal Point: Gold
[13] http://online.barrons.com/article/SB...5246.html
[14] http://online.barrons.com/article/SB...6544.html