(republished from “A View from the Trenches“)
Please, click here to read this article in pdf format:Â October 21 2012
Today we retake the discussion left two weeks ago, on a return to the gold standard. We had divided the discussion in two parts: The first part (here) was based on an historical perspective. Today, we will deal with the technical one.
As a summary of the first part, we left with two important conclusions: a) A gold standard will fail if the banking system is allowed to survive with a reserve requirement below 100%, and b) Establishing a gold standard does not require that gold be confiscated. The question before us today is: How do we transition from this:
Note that the in the second chart, there is no central bank. And note that in none of the charts, we make reference to the shadow banking structure that exists and is well alive today. While including it makes matters more complicated, excluding it does not affect the analysis at all. We will write why this is so, further below.
In the first chart, we see a stylized version of the consolidated balance sheets of a central bank, commercial banks and their relation to the money stock. The reserve ratio is the ratio of demand deposits to reserves. If this ratio was 100%, no loans would be made from demand deposits. In this case, we would have a system with noÂ aggregateÂ leverage. Leverage, at the firm or individual level would still be possible. However, for someone to raise debt, there would have to be someone else saving no less than the same amount.
From the first chart too, it is clear that it is not only the private sector that has leverage. The leverage of the public sector is very significant, since all the liabilities of the central bank (reserves and currency) are fully backed by sovereign debt (US Treasuries). The first chart is reproduced from Laura Davidsonâ€™s â€œThe Causes of Price Inflation and Deflationâ€, 2011.
In what follows, we will examine the adjustment process necessary to shift from a system with fiat money and a reserve ratio below 1 (reserve requirement under 100%). Letâ€™s begin clarifying that this proposed delevering process is an ideal situation, applicable if one had the luxury of planning the shift. There is not always time to do so and, if we ever had any, weâ€™re running out of it pretty fast.
The adjustment process below could only be done very gradually, by adjusting the reserve requirement and gold holdings by the central bank a few bps every year (say 200bps).Â The ultra-necessary condition here is that the nation undergoing this process be able to generate an equivalent fiscal surplus, in percentage terms.Â For instance, the process could demand to cover 2% per year of the gap in the reserve ratio to reach 1 (50 years long!!!). This means that if the reserve ratio is 10%, the gap is 90% and narrowing it over 50 years would require to increase reserves by 1.8% every year (90%/50).
Because the delevering process should be accompanied by a pari passu reduction in the fiscal deficit and sovereign debt, that 2% annual adjustment, inÂ the USÂ this would require a surplus of $324BN every year, over 50 years ($16.2 trillion in national debt x 2%). In 2012 terms, spending would have to be cut by $1.52 trillion ($324 billion + $1.2 trillion annual deficit), if the numbers we have are correct. We suspect they are not: The situation is even worse. But, the bottom line is that, once you see these numbers, you realize that going back to a world of no leverage is politically impossible. Even though it is technically feasible, just like the European Monetary Union was planned and built over decades, it is still politically impossible.
(If you are still interested in the mechanics of this fictional process, you are welcome to keep reading. Otherwise, please, accept our apologies for the time we took from you. But if you ask us, learning how fiction works, in the end, always helps to cope with reality)
Now, if the delevering cannot be planned, and if the amounts involved are so colossal, you can have a very good picture of how painful it will be when liquidation eventually happens and how overvalued the US dollar is today. Below, we present you the aggregate, sectorial, balance sheets represented in the first chart:
t is completely out of the question that to delever the public sector, the private sector must generate equal savings, and they would have to come from exports. This would require political stability, capitalism, free trade and privatization of public services, among other things.Â In this rare context, this is what the accounting side of the story would look like:
Deleverage of the public sector
Above, we show one of the two delevering processes required to transition to a commodity-based standard, with a 100% reserve requirement: That of the public sector.
In step 1 we see the generation of savings that is needed to pay off the sovereign debt. Assets produced by the private sector are sold to the rest of the world in exchange of foreign currency. In step 2, the private sector sells the foreign exchange to the central bank, for currency. In step 3, the private sector uses that currency to cancel taxes due to the public sector and to purchase government-owned assets, via privatizations. In step 4, the government applies the currency received from the private sector to repay debt (i.e. Treasuries). In this last transaction, the currency that was initially issued against foreign exchange is withdrawn by the central bank, leaving the monetary base unchanged, but backed by foreign exchange. This is, of course, preferable toÂ allowing the government to cancel its debt with the central bank. Initially, it is more painful, but the result is more desirableâ€¦
Deleverage of the private sector
Simultaneously with the delevering of the public sector, the leverage ex-nihilo in the private sector has to be eliminated, to slowly reduce the risk of further systemic liquidity runs. To reach a reserve ratio of 1, the loans from demand deposits must be cancelled. Just like the deleverage of the public sector, this would have to be done over 50 years (yes, yes, we knowâ€¦but note that the European Monetary Union took about thirty years and it was way more complex than this simple rule of increasing reserves by 2% every January 1stÂ ). The chart below shows how it would be accounted for:
Once again, the source of savings for this delevering process will stem from exports. In step 1, we show the assets produced by the private sector, which are sold to the rest of the world in exchange of foreign currency. In step 2, the private sector sells the foreign exchange to the central bank, for currency. In step 3, the private sector uses the currency to repay the loans originated from demand deposits (2% of total, every year). In step 4, the banks apply that currency to reserves at the central bank.Â The result is an increase in the level of reserves and, pari passu, of the monetary base. This marginal change is entirely backed by foreign exchange.
Commoditization of the monetary base
Â Simultaneous with the delevering of the public and private sectors, the central bank should every year, convert 2% of the foreign exchange holdings into gold. This transaction is represented below:
The immediate result is a devaluation of theÂ foreign exchangeÂ vs. gold. As the local currency is incrementally backed by gold, it appreciates vs. the foreign exchange held by the central bank, albeit at a lower pace.
This appreciation would generate a virtuous cycle, because based on the expectations of a 2% annual commoditization of the local currency, foreign savings would fund local investments and real interest rates would slowly decrease to aÂ Wicksellian, natural level. This is counterintuitive to Keynesians. Keynesians would maintain that this steady appreciation of the currency would damage the local competitiveness and exports. However, IF THE PUBLIC SECTOR HONOURS ITS DELEVERING GOAL, the rest of the world will export capital to the country, lowering real rates and financing growth (i.e. productivity gains). If the public sector does not honour its delivering targets, the whole exercise will have been utterly useless.
Aggregated balance sheets at the end
Once the two delevering processes and the commoditization of the monetary base are finalized, in the new system loans will only be made from time deposits (i.e. real savings) and demand deposits will be fully backed by reserves. The public sector will have no debt and the non-financial private sector will have realized capital gains from the privatized assets and productivity increases.
Restructuring of the financial system:
Only at this stage one could restructure the financial system. Banks could spin-off themselves into gold-backed note-issuing banks and investment banks. As the central bank is unwound, the note banks will need to join a clearinghouse to minimizeÂ counterpartÂ risk, with all notes denominated in gold (i.e. interchangeable). The market will sort out which ones are the most liquid, based on the liquidity services provided by the each bank, rather than repayment risk. Further below, we show the possible revenue model for such banks.
Some would argue that this revenue model is not viable and that these banks would not be profitable. We disagree, although we can only speculate here. For the City of Amsterdam, the Bank of Amsterdam of the 17thÂ century was profitable and in general, senioriage, has been a good business. Even more so under a 100% reserve ratio, because it is stable and grows in volume with time. Cash management and fx services would naturally be ancillary businesses for these institutions. The resulting investment banks would be simple brokers between those interested in saving in credit products and those raising funds via debt. The net interest income would be their main revenue driver.
Revenue sources of a note bank
As we mentioned in the beginning, we have not considered the role of shadow banking in our discussion. Why not? Simply because the whole structure, since it is levered, also rests upon the existence of a central bank as lender of last resort. Otherwise, these players would be swallowed either by the investment banks that we just described or by the public debt market.
If thereÂ wasn’tÂ a central bank (i.e. lender of last resort), re-hypothecation would not be tolerated and economies of scale would dictate that only the investment banks end up capturing savings, along with the private and public equity and debt markets. But this, of course, is pure speculation and at this time, is nothing else than an intellectual exercise of dubious utility. Hence, we leave the matter asideâ€¦
Ron Paulâ€™s Proposal
What we just described is not the only transition possible. Since 2010, Ron Paul has been publicly suggesting that a transition to gold-backed money be simply enabled by allowing gold to be used as money (i.e. capital gains not taxed). In other words, Ron Paul suggested what the US Constitution clearly dictates:Â â€¦No State shall (â€¦) coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debtsâ€¦â€ (Section 10 – Powers prohibited of States).
We commented about this idea in our â€œOpen Letter to Ron Paulâ€ (Dec/10).Â We still think that this proposal would unnecessarily lead to hyperinflation and the discredit of the libertarian movement, without solving anything and giving others the excuse to return to the status quo.
Revolutions usually start in the least likely of all places
If the transitions we described today or the one proposed by Ron Paul are not politically possible, are there any chances that we may ever see a system without aggregate leverage? Such a system would have to challenge the financial establishment of the currency zone where it wants to blossom. Perhaps then, the best environment for its development is a place where any potential opposition is weak: A nation without capital markets or an established banking system. There are many examples of such places today: Argentina,Bolivia,Paraguay, in South America; a multitude more in Northern Africa andÂ the MiddleÂ East.
Does this make sense? We think it does. There are parallels in history that wonâ€™t disappoint you: Protestantism would have never flown inÂ Rome orÂ Spain. Those who opposed the status quo were expeditiously eliminated. However, when Protestantism surged in the Alps, far from the center of power, it was underestimated and allowed to flourish. By the time the status quo sought to quench it, it was too late. The same occurred with the liberal revolutions of the 18thÂ century. When the Americans declared their rebellion, they were underestimated. They were far from the centres of power. When the French declared theirs, they were suppressed. When communism beganÂ in RussiaÂ it was unchallenged. When it tried to growÂ in BritainÂ orÂ the UnitedÂ States, it was immediately repelled. Revolutions then, apparently survive when they start in the backyard, rather than the front yard.