A Not-So Modest Proposal

Paul Brodsky & Lee Quaintance run QB Partners, a private macro-oriented investment fund based in New York.”

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In our sparsely populated office – a beacon of both waste and hope – hangs a framed poster of Albert
Einstein and his quote: “imagination is more important than knowledge.” The poster is different from
the other “art” hanging on our walls – not because of its cheesy cheapness or because it makes an
otherwise stark white wall only slightly more interesting. (That is common in our office, where
taciturn riveters laze on I-Beams perched 800 feet above what would become Rockefeller Plaza.).
No, the Einstein poster is different because its simple declarative is neither ironic nor banal. The
most brilliant man of his time noted the importance of imagination, which we’re sure was an
acknowledgement of its scarcity.

Maybe Einstein recognized early something the rest of us just confirmed? Senators McCain and
Obama spent two years competing to convince us that each was more naturally at ease with political
dynamism and that change was the secret sauce to fix a world where US democracy- and wealth-
spreading machines had run into a ditch. People didn’t need convincing. The wars became pointless
to most Americans and the economy became more important to most people than merely glancing at
the closing level of the Dow Jones Industrial Average. Within this context, electing Obama would be
a rational choice – not because his ideology was necessarily better for the times but because the
country’s economic situation had no precedent from which age or experience would add any value.
Change seemed like a reasonable priority and Americans voted for the candidate they felt could
execute it best – the one with the better imagination.

There are no formal elections held on Wall Street, where daily money flows are the only votes cast.
Such a free-market approach should, theoretically, reflect (or guide) confidence levels as well as the
speed and quality of capital formation and regulation. But it isn’t that easy. The markets are
comprised and dominated by dedicated investors – institutions that must allocate all their money into
markets no matter what the outlook, and by extrapolators – Pavlovian sages who can recite
conditional responses chapter and verse – why the market or economy should go in a certain
direction because “eight out of the last ten times this did that, then…” and who shame their flocks
(usually with a chuckle and wink) “not to buy into the notion that this time is different!”

Well, this time is different. You know that and we know that, but an expert can’t be an expert if he
doesn’t have expertise (real or perceived) and expertise regarding the current economic situation
can’t be extrapolated. It must be game-theoried and theoretically applied. It must be imagined, the
way a German patent clerk did while global academic institutional extrapolators did not.

There is no greater time for imagination than during periods of adversity or when old methods just
won’t do anymore. The post World War II agreement among global powers reached in Bretton Woods,
New Hampshire in 1944 provided the free world with a necessary roadmap for terms of trade and
global monetary exchange following World War II. Old, combative ways were abandoned and new,
inclusive ways were adopted. Re-working that arrangement after almost 65 years has become, well,
unimaginable. But it is time.

President Bush’s recent invitation to gather the G20 on November 15 – ostensibly to update the
Bretton Woods Agreement – is the perfect opportunity for President-elect Obama to begin
encouraging the crafting of a new financial world order built for the twenty-first century. Merely
enacting new economic and market oversight policies – as is currently being hinted by the US – would
be insufficient. European and Asian leaders have already suggested that significant change is
necessary. The US, as the remaining superpower and the administrator of the world’s reserve
currency, should lead this change. Vastly improving the current terms of global monetary and trade
policy is a moral and practical imperative.

The recent bursting of the credit bubble in the US and Europe is quickly spreading economic
disruption throughout all global economies. At its core, the credit bubble was the result of an
unsustainable currency bubble. Credit is simply claims on future money that must be earned or
created in the future. The unlikelihood of being able to earn or create about $75 trillion in new
dollars to satisfy outstanding US credit claims was the nexus – and justification – for the credit
unwinding we are now experiencing.

While strengthening global banking oversight might help forestall a repeat of current problems, it
would fall far short of a fundamental solution. Perhaps it is time for the US to help design and
construct a fairer, more equitable mechanism for the world’s economies to do business, to compete,
and to allocate resources? US policy makers should consider leading the world in forming a new
financial monetary order. It’s time for a little imagination.

***

The Bretton Woods agreement in 1944 provided, among other things, that the US dollar would be
exchangeable into gold bullion at $35 per ounce and that other major currencies would be
exchangeable into US dollars at fixed exchange rates. Provisions were included that allowed policy
makers to tinker with these rates as capital flows between nations warranted. It was a predictable
and adaptable global monetary model. Despite temporary “cheating” among economies, global trade
flourished with this underpinning of rationality.

The gold standard was formally abandoned in 1971 when President Nixon closed the gold window
after receiving pressure from European nations to exchange their weakening US dollar reserves for
gold. (The US dollar’s value had been declining versus other currencies because the US had been
diluting the dollar to fund deficit spending from the Vietnam War.) With a stroke of the pen, US

dollars and all global currencies implicitly tied to it were no longer pegged to gold. The modern era of
fiat (un-backed) currencies was born. Paper ruled and the dollar was the new “gold”.

The fiat monetary system is currently showing its glaring and predictable weakness – the propensity
to blow asset bubbles that result in long periods of societal hardship. Fiat money is created by
central banking systems, which ensures the system will be highly susceptible to political pressures to
postpone economic adversity. Where there are no periods of economic digestion there can only be
false and synthesized asset values and rising debt loads to sustain them.

Indeed the notion of multiple subjective global monetary policies managed by unitary policy makers
seems anachronistic. Fiat currencies allow sovereign governments and their central banks to issue
as much paper currency as they wish, as long as merchants, consumers and trading partners are
willing to accept that paper in return for goods, services and assets. Because various nations have
different growth rates, as well as differing social, economic and political agendas, it follows that
subjective domestic monetary policies and the absolute and relative purchasing powers of their
attendant currencies are highly unstable and, in many instances, inordinately unfair.

Maybe the US dollar – or whatever form of money the world chooses to have as its reserve currency
in the twenty-first century – should revert back to the gold standard? A gold standard is a quaint idea
inasmuch as the theory of relativity is a quaint idea. Nothing has changed in the current global
economic environment that argues against the legitimacy, flexibility and practicality of re-adopting a
currency anchor – not the size, divergent interests or sophistication of global economies, banking
systems and capital markets.

The common fear that banking systems could extend only limited credit under a gold regime is
fallacious. There is plenty of gold – at the right gold price – to peg paper money to it. As long as

fractional reserve banking systems exist, money and credit growth would be limited only by natural
economic forces – not by rigid formulae. Neither is re-anchoring currencies to gold a partisan issue,
as is so often thought. The healthy tension surrounding free market control and the distribution of
wealth would remain in the political sphere, to be argued by liberals and conservatives.

Within all nations, it is the peoples’ collective wealth – earned from innovation, natural resources,
labor and productivity – that their central banks attempt to optimize. Central banks throughout history
have spotty records of doing this. Politicians across the political spectrum are equally critical of the
limitations of a subjective central banking system capable of promoting violent economic booms and
busts, which may threaten the very viability of their nation. The question of fairness within an
economy – the manner in which collective wealth is concentrated, distributed or re-distributed – is a
separate matter with a different pathology from employing a gold peg.

Gold-backed currencies require fiscal and trade discipline among all constituent economies – not
necessarily rigid mandated controls. A nation that runs a persistent trade deficit, for example, would
find gold leaving its vaults for those of net-exporting nations. This would prompt one of two
responses by the indulgent nation: 1) tighten domestic monetary policy which, all else equal, would
lessen demand for imports and lead to a rebalancing of accounts or, 2) adjust its fixed exchange rate
downward, which would hinder its relative terms of trade with other nations (the overly indulgent
nation’s exports would become relatively cheaper while goods it had been importing would become
more expensive). These disciplinary dynamics work naturally to rebalance trade and capital flows and
to encourage domestic economic sustainability and fairness among trading partners. This is timeless
theory (straight from Adam Smith) and would be very practical today.

***

The fiat monetary system was undeniably a boon for the US. All the new money and credit creation
funded investments in capital producing businesses, which broadened and raised the level of
employment and diversified the US economy (from an emphasis on goods production to more service-
oriented commerce). It also increased the size and strength of the US military, funded an arms race
that some would argue may have eventually bankrupted the Soviet Union, and increased the stature
and power of the US globally. Monetary inflation has been very good for the US.

The US specifically benefited because the US dollar held global reserve currency status. In effect,
the US dollar became the world’s “gold standard” in 1971 (even though the Fed had no limitations on
how much “gold” it could print). Since then, the Fed has issued increasing US dollar bank reserves
that have, through the US fractional reserve banking system, led to ever increasing flows of dollar-
based credit. Generally easy money combined with low bank reserve requirements and lax regulatory
oversight helped swell the global (dollar-linked) money stock and credit claims derived from it.

As we are now beginning to see, however, decades of monetary inflation have a dark side. The
money that was created out of thin air by all US Administrations, Congresses and Fed boards since
1971, along with ever-larger credit lines being rolled over each day by the Fed to the US banking
system (and then redistributed through the capital markets to homeowners, credit card users,
international banks etc.), built a dangerously leveraged and unsustainable global economy. [A gold-
pegged dollar would have stopped money and credit growth much sooner, which would have greatly
mitigated the slowdown (or even contractionary period) the world is beginning to experience.]

What has emerged in the US and much of Europe are finance based economies in which copious
funding ultimately became mistaken for wealth, and in which money ultimately became mistaken for
investment capital. In recent years the US economy has had lots of money and what seemed like
boundless funding with which it was creating diminishing capital and sustainable resources. One
dollar of US debt in the early eighties produced over three times as much output growth as it did in
the last few years. The credit/debt build up that emanated from an undisciplined currency regime has
had diminishing marginal returns and embedded structural risk to US output growth and the dollar.

The US has not pursued such an undisciplined monetary policy in a vacuum. Due to its status as the
world’s reserve currency, foreign central banks have been forced to follow the same monetary
policies, more or less, that the US dictates regardless of their organic economic growth profiles. US
trading partners inflated their currencies along with the US to maintain a semblance of their implicit
US dollar peg. Large and small emerging economies with much higher natural growth rates had to
inflate their sovereign currencies even more to maintain terms of trade that allowed them to
profitably export goods and services.

Money and credit growth eventually spun out of control. The US stopped publishing its broadest
measure of monetary growth in 2006 (M3, which included repurchase agreements – the primary tool
that enabled Wall Street banks to lever their balance sheets as much as 35 to 1). Prior to the recent
credit crisis, independent researchers such as Shadow Government Statistics estimated US money
and credit grew upwards of 15% annually. That growth rate is now “unlimited,” as the government
pledges to replace market losses with new currency or claims on it (credit).

No amount of new money and credit that Treasury, Congress and the Fed create and deliver into the
banking system or the housing market will save the US dollar. Indeed these actions will only destroy
its absolute value faster. The money and credit that US policy makers are now synthesizing to
counteract deflating asset prices (a.k.a. the credit crisis) are reducing the inflation-adjusted value of
all US dollar-denominated assets. When investors liquidate propped-up assets, each dollar they
receive in proceeds will likely buy less at the grocery store. Global wealth (deferred purchasing
power) is being destroyed as money and credit are being created.

***

It may be surprising to many that Americans are currently positioned to benefit from inflation.
Printing new money and credit inflates away current public and private sector debt burdens (the more
dollars in circulation, the easier it is to pay down the relatively constant principal value of debt). It
would be brilliant strategy for policy makers to execute now when the US is so deeply in debt and
has a negative savings rate. And so we are convinced this is current monetary policy – inflate,
inflate, inflate. Meanwhile though, merchants, investors and central banks residing in less indebted
nations that have been using the US dollar as its “gold peg” are beginning to ask “why should we
continue to hold US dollar reserves?” The global drumbeat for change has already begun.

Within this context, global acceptance of a new gold-backed monetary order would have two main
positive outcomes. First, it would promote global foreign exchange market stability. This would be a
multilateral win for global trade, as it would be an implicit source of price stability. Business
managers in international markets would have much more pricing certainty when developing business
plans. Second, it would promote the free-market ideal of Ricardian comparative advantage. Countries
generally seek to produce goods and services that they can bring to market most efficiently (i.e., in a
cost-effective manner). The ideal of comparative advantage in global trade to the betterment of all is
nearly universally accepted.

***

Mechanically, reverting back to a global gold standard would be straightforward. First, an intrinsic
global value of gold would have to be defined in order to convert various paper currencies. If the
original Bretton Woods agreement were to be used as a model, we first divide the respective sizes of
each central bank balance sheet by its corresponding official gold holdings. For example;

• The Fed reports official US gold holdings to be roughly 8,100 tonnes, which equates to a US
dollar value (at $800/oz) of approximately $230 billion.

• The US Federal Reserve’s balance sheet liabilities (private banking system reserves) are
approximately $1.75 trillion.

• Therefore, the US dollar would have to be pegged to gold at somewhere around $6,100/ounce.

Aggregating the gold holdings of the ECB and the legacy central banks that comprise the Eurozone
would imply a $6,300 gold price, which would require a “slight tweak” in the Euro / US Dollar
exchange rate from about 1.35 currently to 1.30. Again using the Bretton Woods system as a model,
the US dollar and Euro might be designated as “global reserve currencies” because they could most
easily be converted to gold. The remainder of participating global currencies could then be made
exchangeable into US Dollars/Euros at fixed, but amendable rates (floating foreign exchange rates).

The trickier part of converting paper currencies to a global gold standard would be persuading
economies with high paper currency-to-gold ratios. Their paper currencies would suffer devaluations
versus currencies with higher gold reserves. For example, the Japanese Yen’s gold price equilibrium
would equate to nearly $40,000/ounce when calculated against the Bank of Japan’s gold holdings and
the Chinese Renminbi’s gold price equilibrium would equate to about $117,000/ounce when
calculated against the People’s Bank of China’s published gold holdings.

A theoretical official global currency peg at, say, $6,200/ounce – while justified by the size of Fed
and Eurozone central bank balance sheets – would clearly create tension among the world’s
economies. Such a peg would imply substantial currency devaluations for Japan, China and most
other paper currencies. But this doesn’t mean doing so would be impossible or even unlikely.

Consider that while it appears to be unequivocally true that major exporting economies would lose
the majority of value held in US and Euro currencies and bonds, we believe, (as we suspect
policymakers in Asia must already know) that this pool of US dollar- and Euro-based savings is
doomed to devaluation under any circumstances. Devaluation is certain by either coordinated decree
or, left to free market devices, via organic price inflation. Much like an investor who holds 30% of a
company’s stock, major holders of Dollars, Euros and their sovereign debt could not liquidate their
holdings without negatively impacting their valuations.

Should this pool of savings come out of its sterilized hole to be spent, the effective float of these
currencies would rise dramatically and set ablaze global demand for all things US dollar- or Euro-
denominated (these savings are sterilized in the sense that they are parked away in US and
European sovereign debt instruments). In this event, the Fed and ECB would likely inflate
aggressively to beat those Asian dollars to market (as they are doing now?).
We suspect there would be an ugly race to the bottom as a currency crisis would accelerate and all
sides would lose. Surely global policy makers understand this dilemma and we think that they would
rather manage such devaluation than allow a potential cruel and destabilizing free market outcome.
Both sides have proverbial guns pointed at each other’s heads.

Creditor nations (like China and Japan) would likely accrue gold as long as they remain net
exporters. The “win” for these nations is that they would work and export in exchange for real money
today and real goods and services for their efforts tomorrow. Currently, they are saturated with paper
claims that will have very uncertain purchasing power when eventually brought to the market for
goods, services and assets denominated in US dollars. (Clearly US equity and private credit markets
must look attractive to them at the moment.)

Global trade would not likely be materially affected under a gold-backed global currency regime. Net
importing nations (e.g. the US) would likely continue to be net importers and net exporting nations
(e.g. China) would likely to continue to be net exporters. Under a Bretton Woods-type regime, net
importing nations would tender currency backed by gold for their imports (not limitlessly-produced
and un-backed fiat currency). Those economies that run trade deficits would see their gold holdings
flow to economies that run trade surpluses. This would put a natural boundary on imports and be a
motivation to promote exports of goods and services. On the other hand, as gold would flow to
exporting nations who, not coincidentally, seem to have relative deficits of gold, the gold backing of
their respective currencies would be enhanced toward parity with those of more advanced nations.

Over the longer term, two unequivocally stabilizing and positive outcomes would accrue to global
traders: 1) large net importers would be motivated to expand their exports and thus grow their
economies and, 2) the currencies of developing economies (usually net exporters) would ultimately
reach parity (in gold terms) with those of developed economies. Policy makers could tweak the
foreign exchange fixes as necessary during this slow and steady migration.

The reluctance of Americans and Europeans to sign on to such a global currency regime would be
understandable. The US has been printing and exporting dollars (inflation) while receiving goods and
cheap investment “capital” in return. This policy has allowed the Fed to inflate the money supply and
promote credit growth aggressively without driving up domestic price inflation (CPI, PPI, etc.). In
fact, much of the price inflation generated over this period has, fortuitously for the US, been
expressed in US asset prices. It’s been a win-win for the aggregate US economy and balance sheet.

As homeowners, investors and policy makers are currently concluding, however, much of that asset
price appreciation was not real (once adjusted for dollar-dilutive global monetary inflation). Asset
prices are now reverting to more sustainable levels. While the US enjoyed two and a half decades of
general asset price appreciation driven by credit creation and debt assumption, it is now in the
process of reducing that leverage and asset values are falling in both nominal and real terms.
Converting to a gold standard would elicit a one-time transfer of wealth to the US and the Eurozone
via the devaluation of public and private sector debts (in real or, more specifically, gold terms).
It might take a long time for the US to re-tool its economy to compete in a global Ricardian-style
economy. Fixing the US dollar to gold at its equilibrium price would effectively pay the US today for
what would most likely be a long period of economic digestion. The US would have to execute new
measures of fiscal and trade discipline to the betterment and fairness of all.

The writing is on the wall. The US’s largest trading partners are tiring of US dollars in their current
form (witness the seven year relative weakness in the exchange value of the US dollar, the bull
markets in commodities and gold, and the more recent de-leveraging of virtually all paper asset
markets). Rhetoric from all corners is increasing to diversify terms of payments away from dollars.
Yet, the US still retains more gold than any other economy. These holdings would allow it to continue
to import as needed while its economy restructures (and jobs come home) to develop competitive
exporting businesses and industries again.

Contrary to the belief of casual observers, the gold standard was in no way responsible for the
booms and busts in any era. The blame for this lies squarely at the feet of the credit (business) cycle
– the magnitude of which may be directly tied to the political frailties of regulators overseeing the
fractional reserve banking system. When a banking system gets overleveraged and asset collateral
prices rise to unsustainable levels, economic gravity ensures an ensuing bust. (We suspect that
global policy changes orchestrated going forward would address this concern. Basel III perhaps?)

A gold peg would not hinder a central bank’s ability to expand bank reserves. What it would do,
however, is create perfect transparency of managed bank reserve maneuverings. As Congress and
regulators that oversee banks, capital markets and consumers are right to insist on increasing global
market transparency, we believe global consumers and investors should insist on increasing central
bank transparency.

The benefits and costs of a new financial order to some economies would be mostly counterbalanced
by the benefits and costs to other economies. We think the unavoidable devaluation of the global
foreign exchange reserve pool, which would certainly be a point of contention among many emerging
economies, could be overcome easily through negotiated diplomatic and trade initiatives. Such a bold
strategy would set the stage for a new era of equitable and growing world trade. This would hopefully
cure, not just temporarily fix, the troubled foundation that has led to today’s global financial and
economic crises. We are confident our leaders can muster the necessary imagination to get the job
done.

Lee Quaintance
Paul Brodsky