Will COVID-19 lead to a gold standard?
By Alasdair Macleod
Goldmoney Insights February 20, 2020
Even before the coronavirus sprang upon an unprepared China the credit cycle was
tipping the world into recession. The coronavirus makes an existing situation
immeasurably worse, shutting down China and disrupting global supply chains to the
point where large swathes of global production simply cease.
The crisis is likely to be a wake-up call for complacent investors, who are content to buy
benchmark bonds issued by bankrupt governments at wildly excessive prices. A
recession turned by the coronavirus into a fathomless slump will lead to a synchronised
explosion of debt issuance for which there are no genuine buyers and can only be
monetised.
The adjustment to reality will be catastrophic for government finances, and their
currencies. This article explains why the collapse in overpriced financial assets and fiat
currencies is likely to be rapid, perhaps giving ordinary people in some jurisdictions an
early prospect of a return to gold and silver as circulating money.
Introduction
My last article suggested that both financial assets and currencies would collapse together. the
basis of this supposition is twofold: first, central bank policies are binding together the rise in
financial assets with the maintenance of value in fiat currencies. Therefore, if one falls, they
both fall. And secondly there is historical precedence for this when one examines The
Mississippi bubble 300 years ago.
The timing for such a collapse appears to be imminent. Every day, more and more data
confirm that the global economy is sliding into recession. So far, people have been ignoring
this important development, but now that it is becoming hard to ignore, no doubt the
coronavirus will be blamed. This is a mistake because the factors leading to a slump,
principally the end of the expansionary credit cycle combining with trade protectionism
against Chinese imports by President Trump, echo developments leading up to the Wall Street
crash in October 1929. If that point is accepted, then clearly the world could be on the edge of
a very deep slump exacerbated but not caused by the virus.
The coronavirus has all but closed down China's economy. It threatens to become a pandemic
with serious consequences for all other national economies and their fiat currencies.
The central issue flowing from the upcoming monetary crisis centres on the rating of
government debt. Almost all welfare-driven states are in debt traps. They think price inflation
is under control, because their colleagues in the statistics departments tell them so, allowing
them to continue to run increasing budget deficits with apparent impunity. Central banks do
not realise that very soon they will be the only buyers of their governments’ debt which they
will pay for with newly minted money. The irony of repeating the mistakes of Germany’s
Reichsbank in 1918-23 will be completely lost to them and the path of escalating failure will
only encourage the pace of printing to be accelerated.
The latest bombshell, coronavirus, is a trigger perhaps for the markets to regain control from
the statist price riggers. This has to be the first step to fixing broken economies. The
Panglossians in the ranks of the banking and investment communities will be rudely
awakened to find themselves staring down the barrel of economic reality. Only then is there a
chance that neo-Keynesian lies will be discarded by one and all, and a retreat towards sound
money commence.
There is unlikely to be much time. Even without the downhill kick of coronavirus a bear
market in bonds could be a devastating event on its own in a period of less than a year.
Inflation of fiat currencies and interest rate suppression have been the principal agents for
ramping bond prices, which tells us that their collapse will undermine currencies as well,
giving complacent investors a double hit. But what are we to measure a decline of fiat
currencies against? Sound money of course, gold and silver, with other stores of value, such
as bitcoin, favoured by tech-savvy millennials, who will be quick to observe and understand
the debauchment of fiat money. And the sooner we throw out fiat currencies, the sooner we
can revert to sound money, which is gold.
Changing values for government bonds
We shall take as our primary example the US bond market, because fiat currency fans believe
that other than individual time-values it is the risk-free investment yardstick. The ten-year US
Treasury bond yields less than 1.6%, but its future pricing raises some serious issues.
Before addressing risk, we should note that time preference theory tells us that possession of
cash is always worth more than its non-possession. The discount of that future value is not
significant if you part with it to buy a ten-year UST with a view to trading it out in the next
few days. But if you buy it with a view to holding it as an investment, then its discounted
future value does become relevant. We cannot know what this time preference is, because it
can only be realised in an unfettered market, not a market manipulated by the Fed’s actions.
But with history as our guide an annualised discounted value of about two per cent for a 10year bond can be used as a rough guide.
Figure 1, which is a long-term chart of the yield on this bond, appears to indicate there is a
solid floor in the region of 1.4% represented by the horizontal line joining points at July 2012,
July 2016 and August 2019. This floor is about half a per cent less than our estimated time
preference value.
With its yield currently 1.56%, there appears to be very little upside in the price, and we can
understand why. And if we accept government estimates of CPI-U all items index rising at
2.5% (year to January) the yield should be closer to 4% and must therefore be heavily
suppressed at current levels.
That is not all. While the general level of prices is an economic concept, it is not measurable;
a fact which allows the Bureau of Labour Statistics, along with all other nations who use
“standardised” CPIs to effectively goal-seek an official figure for its rate of change. Two
independent analysts, Chapwood Index and Shadowstats confirm each other that a more
realistic rate for monetary depreciation of the US dollar is not 2%, but about 10% annually.
But for the moment, investors believe the price inflation lie because they want to. When they
begin to realise the official rate is pure fiction, then one would expect government bonds to
reflect a far higher redemption yield. In other words, any upside in bond prices is strictly
limited while the downside is substantial. As an illustration, a 10-year bond at the current
yield would have to fall from par to $47.40 to yield a more realistic gross 10% to redemption.
Clearly, the US Treasury market is badly mispriced. To estimate the likelihood of the Fed
losing control of bond pricing, we should also take into account the state of the US
Government’s finances, because we have not yet incorporated future currency debasement
risks in our calculations. With a starting budget deficit in the current fiscal year estimated by
the Congressional Budget Office at $1,027bn, a recession, let alone a slump, will make
government finances considerably worse. For the years 2020-2022 the CBO expects real GDP
to grow at an average 2% per annum. In the very near future, due to the coronavirus alone that
is likely to be revised sharply downwards, if not by the CBO, but by market participants as
further evidence of a looming slump becomes too hard to ignore.
All we need to know for now is the revision of economic prospects will be significant, based
on recent evidence of recessionary trends and the potential impact of the coronavirus. The
current stage of the credit cycle indicates the banks are in the process of withdrawing
circulating credit, hitting SMEs particularly hard. Unemployment will rise, along with
bankruptcies. And this assumes little or nothing for the effect of coronavirus.
But even if coronavirus is contained to China and East Asia, US corporations’ supply chains
will cease to function, requiring both time and bank credit to relocate. Neither are available in
the short term and in the current credit climate. And this is an election year, when any
president’s financial and economic prudence are at their lowest ebb and his administration is
most inclined to throw money at any and all economic problems.
Without a recession, other things being equal the CBO’s forecasting assumptions and the
effect on government debt outstanding might be taken to be credible by gullible investors. But
expressed in the economist’s jargon, not all else is equal and we can already see why these
forecasts are going horribly wrong. The question then is what the effect on markets will be
when these errors are realised and prices for financial assets are adjusted for reality.
The adjustment will follow the current period of complacency. US Treasury bond prices have
recently risen, partly on a safe-haven basis, but certainly with an enduring belief in the state’s
economic management. Equities are at or close to all-time highs on a relative value to bond
yields argument, and an expectation that any recession will be shallow. Further monetary
easing is expected to support the economy and maintaining the long-term prospect of a
resumption to decent economic growth. Further monetary easing is seen to be bullish.
Concerns about the dollar are broadly absent. There is embedded in investor psychology Part
One of Triffin’s dilemma, that concludes otherwise irresponsible fiscal policies will allow the
provider of the world’s reserve currency to run deficits to increase its supply to foreigners,
always hungry for scarce dollars, which they reinvest in US Treasuries. And if there is a
recession, the argument goes, then there will always be a further flight to the safety of dollars
and US Treasuries.
Part Two of Triffin’s dilemma ends in crisis, which broadly is what we now face. Investors
are yet to take note.
Putting the effects of the coronavirus to one side for the moment, in their private capacity
businessmen and their bankers are usually the first to see that economic optimism is
misplaced. Businessmen are battling in deteriorating trading conditions, and bankers with
their internal market intelligence and its impact on risk assessment. The authorities,
particularly the Fed, who have made the mistake of believing in their own statistics, and of
falling hook, line and sinker for Keynesian stimulation theories, will be next.
One can envisage the setup: having seen from its own internal information the economy is not
performing as hoped, the Fed decides to call in the management of the G-SIB banks to hear
their concerns, gather intelligence and reassure them they are on the case. Afterwards, we can
imagine the following conversation:
Banker A. “Well, what did you make of that?”
Banker B. “The Fed must be worried to feel the need to reassure us. Things must be worse
than we thought.”
Bankers A & B. (Thinking) I’ll report back to my Board that the Fed is very worried, and we
must urgently reduce our loan book before our competitors do.
It has happened before. None of this would occur in an economy which is based on sound
money and free markets, only susceptible to one-off disasters, such as war and the
coronavirus. Instead, the US economy is managed on the basis of maintaining the crumbling
confidence of consumers and the uninterrupted provision to them of credit. After many years
of being bailed out, economic actors have become fully dependent on confidence being
maintained and have no alternative plan in the case of its failure. But failure is now becoming
evident.
The central question therefore devolves upon the future credit rating of the US Government.
Assuming the Fed is losing control of the overall monetary situation and pricing returns to
being set by markets, how do you rate a very large borrower with the following credit profile:
•
No surplus of income over expenses since 2001. Current trend is for further
deterioration with no end in sight.
•
Net present value of future liabilities mandated by law is independently estimated
(Kotlikoff) to be over $200 trillion. Current income (taxes etc.) of $3.6 trillion
gives a ratio of income to future expense of well over 50 times. Tax income will
almost certainly decline raising this ratio further.
•
Net interest cost at unrealistically low interest rates is 38% of last year’s deficit. A
more realistic interest rate could have an immediate and catastrophic effect on
finances.
•
Management seems unjustifiably optimistic that future revenue will pick up.
In the absence of a management that agrees to radically alter course, there can only be one
answer: do not lend it any money and eliminate all existing exposure. When they wake up,
this should, and therefore will be, the reality facing not just the banks but all holders of US
Treasuries, including foreigners without sound reasons to be invested in them.
Consequently, the switch from the current state of suppressive control to realistic pricing of
government debt will be both vicious and rapid. The only foreigners likely to delay selling
existing US Government debt are some governments, either under the US Government’s cosh,
or not wishing to exacerbate the situation. With cross-border trade collapsing, others have no
good reason to hold dollars and dollar-denominated debt, let alone extend their exposure.
Furthermore, in recent years large hedge funds have made hay out of being short euros and
yen and long dollars and US Treasury debt through fx swaps. Those trillion-dollar positions
need to be unwound as well, which will put additional pressure on the dollar and the bond
markets.
At anything close to these yields, the only buyer will be the Fed, which, as well as new
issuance will have to absorb foreign sales and those of distressed hedge funds. For these
reasons the monetisation of debt will almost certainly have to be on a far larger scale than
following the Lehman crisis. There is no price for government debt in these circumstances,
because the higher the interest rate, the worse the numbers become. Nor will there be any
value in the currency used to buy it, because if the government is effectively bust its unbacked
currency will also be worthless.
Other governments with substantial future welfare commitments are in a similar position.
High debt to GDP ratios will become a debt trap on a combination of recession-fuelled budget
deficits and realistic funding costs. In the EU and Japan, government funding costs have even
further to travel from under the zero bound.
Meanwhile, there is an air of complacency with a general assumption that the next crisis will
lead to yet lower rates, as has been the case with every credit crisis for the last forty years. But
as Figure 1, the chart of the ten-year US Treasury above clearly showed, after a long decline
in yields the world’s reserve currency benchmark yield is now struggling to go any lower.
Zero or even negative dollar rates imposed by the Fed cannot alter that fact.
This is important, because central banks have tried everything that they can think of to restore
economic growth and have run out of ideas. Led by the Bank for International Settlements,
they are now pleading with their governments to borrow more while rates are cheap in the
hope that greater budget deficits will stop the world from sliding into recession.
Other central banks are in the same boat
The debt devil tempts, and the weak follow, and debtor hell is the highest reward he can offer.
The response by all G20 members to a sliding global economy will obviously be a BIS
sanctioned coordinated burst of deficit spending leading to a synchronised expansion of
government bond supply and fiat money to pay for it. It is proving impossible, even for a free
trader like Boris Johnson, to resist the political imperative to build new hospitals, train
thousands of new nurses and policemen and throw money at a new, wildly over-budget
railway connecting the North of England to London. Which, incidentally, will probably empty
the North of northerners seeking their fortunes in London, instead of spreading London’s
wealth northwards. Most of this spending is classified as investment, but the fact is that
without a commensurate increase in personal savings it is inflationary spending.
Perhaps the dollar will not be the first to slide, given the shutting down of China’s economy
by the coronavirus. The yuan, surely, will be the first to suffer in the foreign exchanges, a
process that appears to be starting. But this might galvanise the People’s Bank into positive
action to stabilise the currency, which it can do by tying it to gold. In doing so, it would do
humanity a favour by leading the way early towards a sound money solution to the unfolding
financial and economic crisis, which with the coronavirus threatens to be potentially much
worse than anything recorded in modern times.
The reason the dollar is likely to be next to slide is the exposure foreigners have to it, the
equivalent of more than one year’s GDP. It is comprised of about $4 trillion in bank deposits,
and $19.4 trillion of US securities, according to the last available TIC figures.[i]
For the short-term, perhaps China’s imploding economy, taking Germany’s and others with it,
encourages the investor’s myth that the dollar is a safe haven. The trade-weighted index has
strengthened in recent weeks on the back of both the yuan and euro weakening, and US
Treasury yields have declined as well. It is a situation unlikely to survive deteriorating
economic conditions for much longer.
In addition to foreign sellers, speculative positions of perhaps several trillion dollars in
currency swaps held by large hedge funds will have to be reversed if and when the dollar is
undermined by foreign selling. That would lead to temporary buying of euros and yen. When
that short-term effect is over, presumably these currencies will then suffer the combination of
collapsing values for government bonds and stockmarket values at the same time as the
currencies themselves fall measured against gold, silver and bitcoin.
Sound money alternatives signal the fiat crisis
An unfolding crisis from the combined effects of the turn of the credit cycle and the
coronavirus can be expected to hit individual fiat currencies both sequentially and generally.
This article has made some suggestions over a likely sequence: yuan, dollar, euro and yen.
But how things actually unfold is for the moment a matter of speculation. From the turmoil
ahead of us, the clear winners are likely to be gold and silver, and supply-constrained hedges
such as bitcoin.
In real terms, gold is still under-priced relative to the dollar, based on their relative quantities.
This is illustrated in Figure 2, which is of gold adjusted by the increase in the fiat money
quantity.
This chart should contradict any thoughts that the recent increase in the price of gold might be
overdone. The truth is that the devastating bear market in the gold price following the spike in
1980 has almost eliminated gold from investment portfolios in favour of inflation
beneficiaries. If that long period is coming to an end, investors will attempt to switch their
allocations from inflation beneficiaries and bonds with rising yields in favour of inflation
protection. For this reason, the rise in the dollar gold price could be very dramatic,
particularly when a further acceleration of global monetary debasement is taken into account.
And this is before we see official CPI measures move much above their 2% goal-sought
targets.
For both gold and silver, we can expect initial moves reflecting their eventual replacement of
failing fiat as the trusted money in circulation. In the case of silver, it is worth mentioning that
its original price relationship under bimetallic standards only become discarded when silver
was generally dropped as money in favour of gold alone in the 1870s. When fiat fails, it is
likely that silver will regain a secondary monetary role, and its remonetisation will have a
substantial impact on its purchasing power. From a current gold/silver ratio of 87 times, a
move towards the old ratio of approximately 15 times means that for speculators buying into
the sound money argument, silver is likely to be the catch-up form of sound money.
Bitcoin
During previous currency hiatuses, the problem of failing fiat money has always been
evidenced in the rising prices of precious metals. Since the last financial crisis, there has
arisen a new category of store of value in thousands of different cryptocurrencies. While most
of them appear to be akin to quack monetary remedies, the first cryptocurrency to be devised
with its innovative blockchain technology is sufficiently understood by a growing band of
followers to be firmly established as a form of money.
Bitcoin is currently not ideally suited as a means of settling transactions, or for making value
comparisons between one good against another. Settlements are severely restricted relative to
the superior scalability offered by credit and debit cards. Where bitcoin scores is as a store of
value.
In learning about bitcoin and why it works, a new generation of tech-savvy millennials have
become aware of the way their governments debauch their currencies as a means of secretly
transferring wealth from them as individuals to the state, the banks, and their favoured
borrowers. Bitcoin supporters are an intelligent, educated mob angry at their governments’
abuse of their fiat currencies.
In all populations, there is therefore a marginally greater recognition of the fragility of state
currencies, and therefore the abandonment of them by the general public is likely to develop
over a shorter time period than experience of previous instances would suggest.
Conclusion
The straws in the wind listed in this article point to a more rapid collapse of financial asset
values and currencies than generally thought by sound money theorists who have long
anticipated this outcome. Doubts about the timing have been settled to a degree by the sudden
development of the coronavirus, which has already imploded China’s economy, disrupting
global supply chains and the provision of consumer goods.
To the extent the coronavirus has had a hand in the forthcoming destruction of fiat currencies
and Keynesian mythology, we can take some comfort that it will have brought forward the
eventual reintroduction of gold and gold standards. The path is not straightforward. There will
be destruction of financial asset values and the economic consequences for ordinary people
will be dire. We can expect widespread civil unrest and political instability.
Western governments and their advisers are not familiar with the arguments in favour of gold,
having spent half a century dismissing it. This fact favours the new economies which have not
discarded gold, which include Russia, China, and many other Asian nations. Some
governments, such as India, might attempt to confiscate their citizens’ gold, but in general the
collapse of western economic fallacies could lead to Asia’s economic superiority.
It will be a rough ride for the rest of us.