The Key to Managing Currencies

Managing currencies is as easy as understanding the principle of supply and demand, according to Nathan Lewis. He also asserts that at some point in the not too distant future, people may begin to clamor for a solution to the world’s monetary problems.

Managing currencies is simple if you understand the fundamental principle: supply and demand.

I told you it was simple.

The "supply" comes from the currency manager. Today, that’s the central bank and Treasury Department or Ministry of Finance. They produce base money, which is actually the only money in existence. Base money is mostly coins and bills, and a little electronic bank reserves. Every other sort of "money" is actually credit, not money.

The "demand" comes from everyone else, who is holding the currency, or, as is sometimes the case with the U.S. dollar today, choosing not to hold the currency.

I bring this up because, at some point in the not too distant future, people may begin to clamor for a solution to the world’s worsening monetary problems. Perhaps, as inflation worsens, there will even be interest in a gold standard system. At that point, there will have to be someone who can actually solve the monetary problems. That person will have to understand the fundamental principle of currency management – supply and demand – because, if they don’t, their system will eventually collapse as well. Probably sooner rather than later.

People have long believed that a currency "backed by gold" will remain stable, but there is no such guarantee. If you take a mammoth amount of gold, and lock it in a vault, it does not emit magical energy waves that automatically manages the value of otherwise worthless paper currencies. There are many methods of keeping a currency pegged to gold. Some of them involve large hoards of gold, or even making coins of gold, and some do not. However, all of them, if they are to be successful, have at their core the fundamental principle.

Which, as I mentioned, is supply and demand.

Indeed, if you understand this fundamental principle, you can peg a currency to gold even if there are no gold reserves at all.

Everyone knows that a central bank, or other currency manager, can "print money," either electronically or physically. It is not as well recognized that a currency manager can "unprint money," or remove base money from circulation. The currency manager does this by selling something, typically a government bond, and making the money received in payment disappear. This happens nearly every day in the course of the Fed’s regular operations.

For example, the Fed has been rather vigorously lending money to banks. The Fed "prints money" and lends it to the banks. However, the overall supply of base money, according to the Fed’s statistics, hasn’t changed much. This is because the Fed is "unprinting money" elsewhere to compensate for its direct lending.

Central banks don’t really control interest rates. What they do is to print money and unprint money in a fashion that influences interest rates. Or, a central bank could adopt a different operating mechanism. During the early 1980s, the Fed printed money and unprinted money – in other words, altered the supply of money – in an effort to influence various credit statistics such as M1 or M2.

A currency board system prints money and unprints money in an automatic fashion that keeps the currency pegged to another currency. Typically, a currency board has a "reserve" of foreign currency, but this reserve is not necessary if supply is being properly managed. If supply is not being properly managed, then the foreign exchange reserve is typically depleted in short order, and a crisis results.

A gold standard is essentially a currency board linked to gold. Doesn’t it make more sense to peg to gold, the ultimate currency of mankind, rather than some government’s paper plaything? This used to be very obvious.

It seems that every gold standard advocate has their own special system, involving some idiosyncratic policy of reserve holdings or coin issuance. They will work, if they are based on the fundamental principle. If not, they would soon collapse.

My own idiosyncratic system is the gold standard that involves no gold at all. There are no gold coins, and no government gold reserves. Gold bullion is freely traded on the open market, just as it is today.

In my system, the currency manager (governments today) would adjust the supply of currency on a daily basis to maintain its value at the gold peg. When the value is a little low, you unprint money. When the value is a little high, you print money. In effect, it is a currency board linked to gold.

The idea of a gold standard with no gold usually drives the traditional "gold bug" insane. They are very attached to their piles of ingots and eagles. I use it mainly as a teaching device. When a person fully understands the fundamental principle – supply and demand – they say: "Yes, of course that would work." If they are still attached to the idea of locking gold in a vault, they think it’s ridiculous, because there’s no vault.

Because many gold standard advocates do not understand the fundamental principle, they fall back on another, more primitive principle, which is to use gold coins exclusively. This system is best suited for a more primitive world. Yes, gold or silver coins are better than a wheelbarrow of paper money when you’re trying to buy bread in a hyperinflation. But consider: Warren Buffett just took part in a buyout by Mars Inc. of Wm. Wrigley Jr. Co. for $23 billion. What if they had to make payment in gold? Would they put $23 billion of bullion in an armored car? In the ninth century, this is how businessmen in China made large commercial transactions. The process of loading ships and wagons with silver coins was so cumbersome that they invented paper money, pegged to silver.

In 1910, the gold standard centered on the British pound and the Bank of England encompassed the world. At the time, the Bank of England held only 7.2 million ounces of gold. This was only 4% of all the gold held by governments and central banks in 1910, and only about 1.2% of all the gold in the world. The Bank of England didn’t have much gold, because they didn’t need it. They understood the principle of supply and demand.

When the U.S. left the gold standard in 1971, the government held 291 million ounces of gold. This had been depleted from 630 million ounces in 1942. Unfortunately, the Fed did not understand the principle of supply and demand. They were printing money aggressively to pump up the economy, with the result that everyone (especially the Bank of England and the Bank of France) wanted to dump the excess paper back on the Fed and get the gold in return. The system failed, even though the U.S. held forty times more gold than the Bank of England did in 1910.

In a fairly short time, as central bankers’ embarrassment becomes total, people may again search for someone who can manage a currency like the Bank of England did in 1910. Prepare now, or we will have to bear further decades of monetary chaos and ignorance, instead of the Golden Age we deserve.

Regards,

Nathan Lewis
for The Daily Reckoning
May 6, 2008

You can also look to currencies to protect your portfolio from the falling U.S. dollar. Our friends at EverBank offer a way to do that – with their World Currency Access Deposit Account.

Like FDIC protection against bank insolvency, access to your funds and the potential for capital appreciation – if the selected foreign currency increases against the U.S. dollar. Attractive to many – given the fall of the dollar – loss of principal can occur if the selected currency loses value versus the dollar.

Nathan Lewis is the author of Gold: the Once and Future Money, published by Agora Publishing and J. Wiley in 2007.

It is the best of times…it is the worst of times.

This morning, oil is over $120…and the price of gold is pushing back up to $875.

That’s good news, say the headlines. Oil is up because people think the United States will avoid a recession. "Oil tops $120 a barrel as U.S. optimism rises," says a headline in the Financial Times. And many think the Hillary/McCain summer gas tax holiday concept may be implemented – which would encourage people to use more gasoline!

John…Hillary…good thinking. Get people out on the road…using more fuel. Great idea. Even Thomas L. Friedman can see what vote-pandering imbeciles you are (more below…). Need we say more?

But say more we will…because, on page 1 of the Financial Times is a photo of a mob in Africa… What has stirred them to riot? The latest election result? Someone dissing their religion? No, high food prices!

It is the worst of times for people with big appetites and little money. Many of them will go hungry. And an empty belly is a dangerous thing. First, people develop a "lean and hungry look." Then, they stab you in back.

Ah yes…predictably…inevitably…the world’s intellectuals, economists, yahoos, and pandering politicians are having trouble following the trail. They ought to look down at their feet. They would see the breadcrumbs…from the door of the Fed’s headquarters in New York…through the deep woods of subprime and leveraged derivatives…and right up the hill of soaring commodity and gold prices. That’s right…the Fed is trying to keep the money and credit moving. But it is going where it wasn’t supposed to go – into commodities, food, oil and gold. Still, the experts can’t see it. Instead, they read the polls, watch the TV, and come to the wrong conclusion. What is the cause of the rise in food prices, they ask? Speculators!

Another lead story today: "India targets food futures." India imagines that food prices are being driven up by greedy hedge fund managers. It is considering a "blanket ban on food futures trading," says the FT.

Why not? Nothing is too absurd or too counterproductive to escape the notice of the world improvers. Just look at John McCain’s big idea – a "league of democracies." More about that coming up soon too… For now, let’s stick with the financial news…

The big story seems to be the idea that, as our chief financial researcher in London, Theo Casey, put it: "doom and gloom has been overplayed."

Since the drama of Bear Stearns, no other major financial firm has failed. Quick action by the Fed and other central banks seems to have saved the world.

"Has the worst of the financial crisis passed?" asked Le Monde yesterday.

"Yes," said the world’s richest man over the weekend. Warren Buffett told his shareholders that the "worst of the credit crisis on Wall Street is over."

Maybe he’s right. But let’s look at the numbers. In 2006, alone, nearly $7 trillion of new debt was issued worldwide. Maybe double that amount in the entire five-year period – 2002-2007. So far, says Bloomberg, since the beginning of 2007, less than $200 billion has been written off. You can do the math yourself, but Fred Y. Jones guesses that total losses so far probably don’t exceed 1% of the debt sold in the last 5 years.

So far, so good, in other words. This is the best of times. The Fed has cut rates 7 times. And it now takes on its balance sheet – as collateral for loans – the very credits that are likely to go bad…credit card debt, student debt, and even car loans. It has only 200 basis points left, before it gets to zero, and there are approximately $10 trillion (just guessing) worth of credits that still could go bad. If just 5% of them went bust…the loss would be $500 billion. Maybe the doom and gloom is underplayed. Moving bad debt from the people who deserve it to the Bank of All the Americans – the Fed – doesn’t turn the bad credits into good ones. It merely allows everyone to keep doing what they’ve been doing…that is, to keep pretending that everything is all right.

But everything isn’t all right. Far from it. And budding out in our brain is a little idea about why the situation can’t be fixed…and why a major breakdown may be on its way…more to come…about how democracy and modern, state-guided capitalism really work.

Interestingly, Buffett is famously pro-America. You bet against American business and you will go broke, he says. But over the last 10 years, betting against American business was the best thing you could do. The dollar sank…and foreign markets – particularly emerging markets – soared.

Buffett hasn’t missed the point. He paid $4 billion for an Israel-based metalworking company in 2006. And now he’s coming to Europe to scout for opportunities. He’ll no doubt want to stop by The Daily Reckoning headquarters in London for our advice.

Warren, look for the building with the golden balls. We’re waiting for you.

*** "He must have hired a new ghost-writer because this is actually good," writes colleague Byron King. "On energy, Friedman is nailing it exactly."

Thomas L. Friedman…writing in the New York Times:

"…If you are going to use tax policy to shape energy strategy then you want to raise taxes on the things you want to discourage – gasoline consumption and gas-guzzling cars – and you want to lower taxes on the things you want to encourage – new, renewable energy technologies. We are doing just the opposite.

"The McCain-Clinton gas holiday proposal is a perfect example of what energy expert Peter Schwartz of Global Business Network describes as the true American energy policy today: ‘Maximize demand, minimize supply and buy the rest from the people who hate us the most.’

"This is not an energy policy. This is money laundering: we borrow money from China and ship it to Saudi Arabia and take a little cut for ourselves as it goes through our gas tanks."

*** Boris Johnson is the new mayor of London. He’s also the former editor of the British magazine, The Spectator, for which we occasionally contribute an article.

Our old friend, Sue Easton, writing in Human Events has this to say about Boris:

"He is somewhat of an odd duck. Alexander Boris de Pfeffel Johnson (born in New York City in 1964) is the grandson of a liberal Turkish Muslim journalist who was welcomed into Britain as a political refugee during World War 1. Boris made his mark as the editor of the conservative magazine, The Spectator, and has been a regular guest on British telly. Often portrayed as a buffoon by the media, Johnson was elected as the Member of Parliament for Henley. The town is famous for its yuppie population, gentrified residents, their piles (as aging mansions are known in England) and for rowing races on the river that runs through it. The Thames.

"When the prospect of becoming Mayor of London surfaced, by all accounts, Johnson decided on a course of self-discipline. He found himself a stern group of advisers and put his Oxford education to work for him. Of late, he’s taken to referring to his classical hero, Pericles, in campaign appearances. Pericles had quite lofty ideals about civil life and responsibilities in ancient Greece."

The nice thing about Boris Johnson is that he has a sense of humor. Sue continues: "He says that if he does well, [as mayor] he might like to run for President of the United States someday. He is (technically) Constitutionally eligible to do just that as he was born in New York City. Of course, he’d have to reapply to renew his recently relinquished American citizenship."

*** "I don’t think I’m going to like it," said Elizabeth yesterday. She was referring to the next stage of her life – the empty nest stage. It is the best of times and the worst of times at home too. We have had children in the house for the last 25 years. But, suddenly, the house may become strangely quiet.

Henry has heard from the colleges to which he applied and made his decision. He might have stayed on with us in Paris and gone to medical school here (where it would be free!). Instead, he’s going to the University of Virginia next year.

Meanwhile, after a year in London, our actress daughter, Maria, is headed for Hollywood. We also have an older son in South America…and another daughter in London.

"Jules will be in Boston…Henry will be in Charlottesville. Maria in California," Elizabeth lamented. "And now Edward is talking about going to boarding school. If he goes, I’ll be an empty nester sooner than I planned. I don’t know if I can stand it.

"Now I think of all those times I just wanted a little peace and quiet…I wished for some time to myself…some time when I didn’t have to listen to children…didn’t have to find their clothes or help them with their homework. Now, I’ll have all the time I want…all the time to myself. I’ll come home and there won’t be any children waiting to ask me questions…or waiting for me to fix dinner. I’ll be all by myself. It sounds dreadfully lonely."

"Don’t worry," was our reply. "Edward doesn’t really want to leave us. He’s just trying out the idea to see how it sounds…and to see how we react to it. If we seem to like the idea, he won’t do it."

"Yes, but I don’t like the idea. I hate the idea."

"Well, just try not to show it."

Until tomorrow,

Bill Bonner
The Daily Reckoning