The Triffin Dilemma & Gold
David R. Kotok
September 30, 2012
“This tension – the Triffin dilemma – was linked to the specific modalities of the gold-exchange standard in 1960, when his Gold and the dollar crisis was first published. Today we are in a much more flexible system, where the demand for global liquidity can be more easily accommodated. But even if the mechanics have changed, the dilemma is still valid if we capture its essence and formulate it in broader terms, as I will do in the first part of my comments today. In second place, I will briefly recall how the dilemma came into being and was addressed in Triffin’s times. This will allow me to better identify the main differences and similarities compared with our times, which will lead me to conclude that it is indeed correct to talk about a ‘Triffin dilemma revisited’. Finally, I will look ahead and ask whether and how it is possible to escape the dilemma today.”
Source: Speech by Lorenzo Bini Smaghi, Member of the Executive Board of the ECB, at the Conference on the International Monetary System: sustainability and reform proposals, marking the 100th anniversary of Robert Triffin (1911-1993), at the Triffin International Foundation, Brussels, 3 October 2011. See: http://www.ecb.int/press/key/date/2011/html/sp111003.en.html . The link does not always open; so, you may have to go to the ECB website and separately pull up the Bini Smaghi speech.
Robert Triffin saw the inherently destabilizing effects that originate from global reserve currency status. He perceived the tensions between short-term and long-term effects, in terms of trade deficits. He never imagined that the tension would be exacerbated by extraordinary monetary policy of the type we see implemented by central banks today.
Triffin’s observations were made in the 1960s. He saw how gold rose to trade at $40 per ounce after the official $35 price gave way to the incipient anti-dollar pressure of the ’60s. By the 1970s, the Bretton Woods fixed currency exchange regime had collapsed. The gold exchange standard ceased when President Nixon revalued the dollar to $42 per ounce of gold and then closed the “gold window” by stopping the exchange of gold for dollars. In its official accounting, the US Treasury still values its gold hoard in Fort Knox at $42 per ounce. The Federal Reserve’s gold certificates are similarly valued.
Until his death in 1993, Triffin watched the trade deficit grow and the reserve currency status of the US dollar slowly erode. His warnings about the Triffin dilemma were unheeded by policy makers. The speculation around Triffin’s work was about how the US dollar’s world reserve currency status would evolve (unwind) and what the catalyst would be for its demise. Second-derivative questions were about whether the unwinding would be orderly or violent. Lastly, there was speculation about what would replace the dollar. Many proposals about a global central bank and a global reserve were offered. None have materialized in any serious way.
Fast forward to today.
The dollar maintains its reserve currency status because it is the least worst of the major four currencies – the US dollar, the British pound, the Japanese yen, and the euro. All four of these currencies are now suffering the effects of a stimulative, expansive, and QE-oriented monetary policy.
We must now add the Swiss franc as a major currency, since Switzerland and its central bank are embarked on a policy course of fixing the exchange rate between the franc and the euro at 1.2 to 1. Hence the Swiss National Bank becomes an extension of the European Central Bank, and therefore its monetary policy is necessarily linked to that of the eurozone. For the balance sheets of the five central banks associated with these currencies, see www.cumber.com.
When you add up these currencies and the others that are linked to them, you conclude that about 80% of the world’s capital markets are tied to one of them. All of the major four are in QE of one sort or another. All four are maintaining a shorter-term interest rate near zero, which explains the reduction of volatility in the shorter-term rate structure. If all currencies yield about the same and are likely to continue doing so for a while, it becomes hard to distinguish a relative value among them; hence, volatility falls.
The other currencies of the world may have value-adding characteristics. We see that in places like Canada, Sweden, and New Zealand. But the capital-market size of those currencies, or even of a basket of them, is not sufficient to replace the dollar as the major reserve currency. Thus the dollar wins as the least worst of the big guys.
Fear of dollar debasement is, however, well-founded. The United States continues to run federal budget deficits at high percentages of GDP. The US central bank has a policy of QE and has committed itself to an extension of the period during which it will preserve this expansive policy. That timeframe is now estimated to be at least three years. The central bank has specifically said it wants more inflation. The real interest rates in US-dollar-denominated Treasury debt are negative. This is a recipe for a weaker dollar. The only reason that the dollar is not much weaker is that the other major central banks are engaged in similar policies.
Gold is not money when it comes to functioning as a medium of exchange. We live in a fiat currency world where money is printed (electronically) by central banks. We pay each other in currency, not gold. The US dollar and euro are the two giants when it comes to payments.
We do not use gold as a unit of account. We measure prices in dollars, not ounces of gold. True, other countries measure their prices and settle their payments in currency like yuan, krona, or rand. But the world’s transactions are still largely executed in dollars, priced in dollars, and paid in dollars. Modern currency hedging allows this practice to continue without much risk to the specific agent making or receiving the payment.
Gold comes into play when we focus on the store of value characteristic of money. The world’s distrust of fiat currencies is rising. Given the policies in place, one would expect that to be the case. One investor, or one agent, at a time decides to reallocate a portion of wealth to gold. That agent also looks at the central banks of the world and sees them buying gold to add to their reserves. He doesn’t see much institutional selling of gold. Individual investors now have vehicles like the exchange-traded products (ETFs and ETNs), which allow them to participate in this reallocation process.
When an investor buys a gold ETF, like GLD or IAU, he may be thinking only of a speculative trade. But given the size of the total gold holdings in ETFs and their turnover, it appears that a growing number of investors are adding to a personal hoard of gold ETFs as a way to store value in other than a domestic currency. Physically backed gold ETPs now exceed 2500 tonnes (source: Barclays) and are steadily growing. That makes the ETF universe one of the largest gold hoards in the world. Very few countries hold more than 2500 tonnes of gold.
Cumberland recognizes this trend and believes it may persist as long as the central banks continue their present policies. Our internal modeling of changes in velocity (GDP divided by M2) suggests that the gold price will move much higher, when measured in the various currencies engaged in QE. Remember, gold is a long-duration asset, and the central banks are buying long duration from the market. A “deep-pockets,” persistent buyer is likely to drive the price higher.
Cumberland’s Global Multi-Asset Class portfolios hold gold and are routinely rebalanced to maintain the internally determined weight. Relative to the size of gold in a global allocation, we consider these gold positions to be overweight.
Triffin’s paradox did not focus on QE and its effects on reserve reallocation. Triffin did not have to consider a central bank policy of buying long duration from the market. Triffin’s writings disparaged gold as a reserve and also opposed floating exchange rates. Professor Triffin did not foresee the present-day construction.
Today, we have floating exchange rates, gold as reserves, and central banks using QE to buy long duration. One can only speculate what Triffin would write today. Meanwhile, gold prices seem to be headed higher.
David R. Kotok, Chairman and Chief Investment Officer