“We are in a world of irredeemable paper money – a state of affairs unprecedented in history.” – John Exter (1910-2006), economist and central banker
Central banks around the world have been on a gold-buying spree. Gold purchases this year have reached 673 metric tons, more than the total amount purchased in any full year since 1967. Until recently, much of the financial world regarded gold as a ‘barbaric relic” of the past.
Why the renewed interest in gold? The short answer is that the world is drowning in a sea of debt that has passed the US$300 trillion mark. Independent macroeconomists like Luke Gromen and Brent Johnson believe global debt has reached critical levels and they predict a costly and very painful financial reset.
The Exter Pyramid, named after its inventor John Exter, makes clear that global debt touches everyone. It includes pensions, social security, stocks, bank deposits, and the very solvency of nations. Governments have used their central banks to bring us to what could become the Mother of all Monetary Meltdowns.
Central banks evolved from gold shops in Europe. Goldsmiths sold gold coins and jewelry and offered their customers vault services. People deposited their gold for safekeeping, and the gold banks gave them a “banknote” as proof of ownership.
Banknotes were typically kept at home but were also used as paper money for trading goods. The holder of a banknote could buy a shipload of lumber. The seller could collect the gold from the bank with his banknote or use it for another trade.
The banknote was a way to distinguish between “what’s mine and what’s yours.” But the gold banks, sitting on idle gold deposits from their customers, started to blur the line between what was theirs and what was not theirs.
Using their reputation as guardians of gold, banks started issuing banknotes to borrowers in excess of their actual gold holdings. (Modern central banks would virtually repeat this practice and called it “fractional reserve banking.”)
A typical gold bank would own $1,000 worth of gold and have $9,000 worth of gold deposited by its customers. But it would issue banknotes with a nominal value of $100,000, 10 times their actual gold reserves. This enabled the gold banks to earn interest on an asset that didn’t exist.
These trust-busting practices would lead to the first bank runs. Rumors about an overleveraged bank would spread through the city and depositors would run to the bank to withdraw their gold before it was all gone.
When bank runs became more frequent and disruptive to society, banks pooled their resources. If a bank was subjected to a bank run, the other banks would pitch in with their gold to stop it from spreading.
A window closes
The gold shops-cum-banks were the precursors to central banks. Growing international trade required better stewardship of the financial system, and central banks were tasked with managing the monetary system.
The Bank of England was founded as early as the 17th century, but its primary function was funding the war against colonialist rival France. Britain came out on top, and the pound sterling became the currency of the British global empire.
In the 20th century, nearly every country in the world had a central bank. The US created the Federal Reserve Bank in 1913. Fort Knox, the world’s biggest vault, was built in Kentucky by the US military in 1918. The US had the world’s largest gold reserves.
Fast-forward to the Bretton Woods Agreement of 1944, which created the postwar monetary system and made the US dollar the world’s de facto reserve currency. The price of gold was set in dollars, and all other currencies were linked to the dollar at a fixed rate. With the dollar as the benchmark, all currencies were implicitly backed by gold.
Bretton Woods lasted until 1971, when US president Richard Nixon announced that the Federal Reserve would stop redeeming dollars for gold. The dollar was no longer backed by gold but by trust and by US economic power.
After the “gold window” closed, the US quickly accumulated debt. During the 1960s, when the US government spent large sums of money on “guns and butter” (the Vietnam war and poverty reduction programs). After 1971, when the US closed the gold window, deficits and the national debt gradually got out of control.
No longer constrained by the limits of its gold holdings, the US government spent liberally on everything from social programs to corporate bailouts, infrastructure, foreign wars, and frequent economic stimulus packages. The US government issues debt to finance its deficit spending. The Federal Reserve buys the debt and sells it to the public in the form of bonds or Treasury Securities. Buyers of government debt receive interest, which is paid by the government.
For decades, investors regarded bonds and Treasuries “as good as gold.” Government debt yielded moderate but stable returns. US Treasuries typically make up 40% of the portfolio of institutional investors with long-term obligations, such as pension funds.
After the financial crisis of 2008, when the US government spent hundreds of billions to bail out over-leveraged Wall Street banks, investors in Treasuries began to wonder if the US would simply issue more debt whenever a crisis occurred.
In 2020, to soften the economic impact of the Covid crisis, the US government spent $5 trillion, in real dollars more than it spent on World War II. Economists compared it to wartime finance.
It seemed there was no limit on how much the US could borrow. In the 50 years since Nixon closed the gold window, US debt increased from $371 billion (35% of gross domestic product) to $31 trillion (126% of GDP). This year, the US Congressional Budget Office projected that annual net interest costs would total $399 billion.
Apart from buying and selling debt by the government, the Federal Reserve also sets interest rates. After the 2008 financial crisis, the Fed reduced interest rates to near zero to stimulate economic recovery.
The result was a gradual inflation of asset prices, everything from real estate and stocks to collectibles such as art. Economists spoke of an “everything bubble.” They define a bubble as an instance of prices far exceeding an asset’s fundamental value.
Cheap money even pushed up the valuations of cryptocurrencies and other “digital assets.” Consumers refinanced their homes at historically low interest rates to buy Bitcoin, pushing up its price to $65,000.
Modern Monetary Theory
The US was hardly alone in accumulating historically high levels of debt. Most countries in the Group of Seven (G7) have debt-to-GDP ratios over 100%, nearly double what monetary experts consider sustainable. All of them appear to be testing the limits of Modern Monetary Theory.
Central banks create money out of thin air. When the government needs to borrow money because its revenue is insufficient for its spending, it borrows the money from the central bank. The central bank adds the debt to the asset side of its balance sheet, sells the debt as bonds or treasuries to investors, and collects interest.
The process is not much different from the old gold dealers who issued bank note for non-existing gold. Investors assume the central bank will pay the interest and return the principal when the bonds mature.
Modern Monetary Theory claims that countries able to print their own money can’t go bankrupt. They can always print more money to pay for deficit spending. If that were the case, a country with a fiat currency could simply print enough money to make all its citizens a millionaire. The theory assumes there will always be buyers for government debt.
But cracks in the system are becoming apparent. Japan has taken MMT further than any other country. Its national debt is over 300% of GDP. The BoJ is now having problems finding buyers of government debt, forcing it to keep the debt issued by the Japanese government on its own balance sheet. The balance sheet of the BoJ far exceeds the national GDP.
Britain is not faring much better. In September, the UK government proposed an increase in borrowing to pay for tax cuts for the wealthy. Investors, concerned about the ability of the government to sustain its debt, dumped government bonds (gilts), and the pound took a tumble against the dollar, the global benchmark currency.
Excessive money printing has caused monetary inflation throughout the global financial system. The Covid crisis added to the problem. The disruption of global supply chains led to price inflation. Real inflation in the US reached double digits, forcing the US to raise interest rates.
When the US raises rates to 4% while interest rates in the eurozone and Japan are near-zero, investors sell euros, pounds and yen to buy dollars. Macroeconomist Brent Johnson call it the Milkshake Theory. Dollars flood into the US economy, further fueling inflation. If inflation can’t be brought down, all fiat currencies will lose purchasing power. The US dollar is “the last man standing.”
Japan, the EU, and the UK have shown that a loss of faith in government debt can lead to a loss of faith in the currency. The recent turbulence in the US bond market suggests the US, despite being the world’s reserve currency, is not immune to the same inflationary dynamics.
If the world loses faith in the dollar, a financial reset becomes inevitable. The world would lose its financial anchor. This explains why central bankers around the world are stocking up on gold. Unlike paper money, bonds, or stocks, gold has no counter-party risk. In the words of the legendary banker J P Morgan, “Gold is money, everything else is credit.”
This is the first article in a two-part series on the global debt crisis.