Guest Post: Gold And Triffin's Dilemma
Submitted by Joe Yasinksi and Dan Flynn of GBI,
Have you seen Robert Triffin?
"It was the outcome of an unbelievable collective mistake, which, when people become aware of it, will be viewed by history as an object of astonishment and scandal"
-Jaques Reuff 1972
The obscure Belgian economist Robert Triffin is not only very dead he also isn't exactly a household name, yet. Triffin, who died in 1993 studied at Harvard, taught at Yale, worked at the Federal Reserve, the IMF, and was a key contributor to the formation of the European monetary system. Triffin exposed serious flaws in the Bretton Woods monetary system and perfectly predicted it's inevitable demise yet his work remains largely ignored and unstudied by today's mainstream economists. This "flaw" became known as the Triffin dilemma, and many believe Triffin's dilemma has as serious implications today as it did 50 years ago. In short, Triffin proposed that when one nations currency also becomes the worlds reserve asset, eventually domestic and international monetary objectives diverge. Have you ever wondered how it's possible that the USA has run a trade deficit for 37 consecutive years? Have you ever considered the consequences on the value of your Dollar denominated assets if it eventually becomes an unacceptable form of payment to our trading partners? Thankfully for those of us trying to navigate the current financial morass, Robert Triffin did.
Prior to the 1944 Bretton Woods agreement, central banks used gold as the asset to back their currencies. By the end of World War II, the United States had established itself as the world's creditor and largest holders of gold. Under the 1944 Bretton Woods agreement, the US Dollar was fully backed by gold at a fixed value of 1/35th an ounce per dollar, and foreign Central Banks could use US Dollar assets as reserves backing their currency, in lieu of gold. This agreement avoided the inevitable deflationary pressure a return to pre-war gold/currency ratios would have forced just as Europe was beginning to rebuild, and allowed US debt held abroad to be used as an asset by central banks against their local currencies.
In the 1960's Triffin observed that there existed an excess of dollars offshore relative to the gold available to tender at the set $35 price. He hypothesized that given foreign central bank demand for dollars as reserves, the trend of a growing and continuing glut of dollars was going to continue unabated. It would continue until the excess reserves would so clearly be many multiples of the gold available to satisfy them that enough countries would start tendering dollars for gold and eventually the entire scheme would collapse. Triffin went as far as congress in 1960 to testify that the system as currently devised could not possibly maintain both liquidity and a stable value in the dollar and eventually, the agreement would prove unsustainable. As Triffin predicted, on August 15, 1971 the United States closed the gold window as Richard Nixon came on national television and defaulted on US gold obligations while national gold reserves drained from over 20,000 tons to 8,133 tons. Up until Nixons actions, foreign sovereigns tendered their dollars for gold at an increasing pace. On that day, nations that were holding US dollars because they were "as good as gold" were left with paper promises and nothing more.
At that time, the world was at a crossroads. Would foreign governments and trade partners continue to accept fully fiat US Dollars? The alternative was a deflationary return to a hard (pre-Bretton Woods) gold standard. It can be argued that structural support was granted to the dollar given the fact that with cheap oil, the US economy was expanding at a pace far more rapid than the growth in US government debt. They rationalized that US dollar was still a claim on future growth and production and the rest of the world was lifting it's standard of living as well. Going backwards to the last failed monetary regime was politically unappealing.
And so the US dollar hegemony continues to this day. The dollar is fully entrenched as the settlement currency for international trade. As of today if any nation wants to buy oil, the lifeblood of the global economy, they pay in dollars. This alone, along with demand for foreign reserves create an unnatural demand for US assets, specifically treasury debt. Robert Triffin opined that the collapse of Bretton woods did not solve his dilemma because the country that supplies the world with it's reserve asset in the form of their currency and debt will still be forced to supply an excess of this reserve to satisfy world demand and thus, run a trade deficit in perpetuity. Such a dynamic can not exist under the natural laws of economics, it can only survive only with active and unanimous political support and intervention.
The issue facing the modern United States is that since the rest of the world uses the US dollar as a reserve behind their own currencies, that demand has allowed the United States to run a deficit in perpetuity and the mechanics of this trade has allowed the US to export price inflation abroad. Quite simply, the US imports real goods in excess of the real goods it exports. The deficit balance minus service exports is made up with printed US dollars. Our trade partners ship/recycle the same dollars back to the United States in exchange for US Treasury Debt. The US Treasuries are held as reserves on the balance sheet of their central bank, and local currency printed against those new reserves. This process, although inflationary for our trade partner, allows them to keep their currency weak vs the US Dollar and prices cheap for US consumers.
Every nation on earth other than the United States has a limit to their potential trade deficit confined by their existing reserves plus their borrowing capacity. Not only does the US have the capacity to run a perpetual and growing trade deficit but the rest of the world actually demands us to run a balance of payment deficit or else their reserves will have to shrink, along with their credit, currency and economy. Good deal for us, no? This situation means that for 40 years our trade partners have not only tolerated, but dysfunctionally enabled our perpetual deficits. The United States has had the "exorbitant privilege" of being the issuer of the worlds' reserve currency. We've all enjoyed the benefits, now comes the pain.
Sure enough as Triffin foretold the US trade surplus began shrinking immediately after the collapse of Bretton Woods and transitioned to a permanent trade deficit by 1975, never to return to a surplus to date, 37 years later. The previously stable national debt (with a permanent ceiling of $400 billion dollars) has ballooned to over $16 trillion dollars, a multiple of 40 times what it was during the previous monetary regime. Given this 4-decade perpetual trade deficit with the rest of the world and "hyperinflation" of US dollar credits and claims, many have wondered how the US has avoided massive price inflation at home.
Triffin's dilemma continues to play an important role in the ongoing financial crisis the world has found itself in since 2008. The governor of the Peoples Bank of China specifically referenced Triffin's Dilemma as the root cause of the current financial disorder and suggested an immediate effort to transition away from the US dollar to avoid more catastrophic consequences.
The US Council on Foreign Relations aptly describes why Triffin's dilemma becomes unsustainable:
"To supply the world's risk-free asset, the center country must run a current account deficit and in doing so become ever more indebted to foreigners, until the risk-free asset that it issues ceases to be risk free. Precisely because the world is happy to have a dependable asset to hold as a store of value, it will buy so much of that asset that its issuer will become unsustainably burdened."
Have we reached the day when the United States has become unsustainably burdened? Can US debt honestly be considered to still be risk free? S&P certainly doesn't think so, neither does our second largest creditor, China (after our own Federal Reserve) who has been a net seller of US government debt for some time now. And where will the world go to find another dependable asset to hold as a store of value?
Triffin's endgame is simple. A rapid diversification of reserves out of the dollar by foreign central banks. This diversification out of the dollar is only possible given a viable alternative. More and more nations are agreeing to unilateral trade agreements settled in their individual currencies. With each new agreement, global demand for the dollar wanes. It is no coincidence that QE1 coincided with China and the rest of the world backing off demand for US treasury debt. The amounts of QE2 and QE3 match perfectly (or close enough for government work) with US trade deficits from 2009 to today. Given the US Government's seemingly permanent addiction to "free" foreign goods, the trade deficit appears to be irreversible. The extreme danger for those of us in the United States, holding assets denominated in US dollars, is that the Fed is actively creating base money to feed the addiction. As the monetary base grows, the value of existing US dollar denominated assets and credit is devalued. One way to protect against this debasement of your savings is to do as the central banks do – acquire and hold physical gold bullion.
The blueprint for this alternative has been in plain sight since the late 1990's, and if you watch what central banks do – not what they say – you can benefit.
For the first time in FOUR DECADES, global central banks have become net buyers of gold. This central bank demand has been driven by countries that previously had an insatiable appetite for US treasury debt – most notably China. After 40 years, the political and structural support for US dollar holdings abroad is slipping away. Foreign central banks know that the only way to protect their reserves (and defend the value of their home currency), is by holding gold. Their preparations are well under way.
Just as central banks are increasing their gold purchases, private citizens also are exercising their right to diversify their own private reserves. But given the still infinitesimal rates of gold ownership (1% tops most estimates) there is a long way to go. Why shouldn't the average person do what the big boys are doing? Diversifying out of the dollar, out of paper currencies and making sure their assets aren't someone else's liability seem prudent for everyone in times like there. Here at GBI, we see ourselves as a way for every investor to have the choice on how to save their stored labor. We want to make it as easy to buy and sell gold as it is to move money from your savings account to your checking account. We can all walk in the footsteps of the giants, as a Friend and mentor is apt to say.
As a bonus, if gold was to become the worlds foremost reserve asset, would that not finally solve good old Triffins dilemma? Wouldn't gold serving as the preferred global saving vehicle and fiat continuing to serve as the worlds spending vehicle finally break the natural tension Triffin has so aptly illuminated for us? Perhaps, but given golds stable supply and other unique features (see our next essay titled "Forget Supply and Demand, it's all Stock to Flow."), it would by necessity be at a much higher price to function in that reserve role. Some estimates put that potential price into the many tens of thousands of dollars, and given a monetary and fiscal path that seems to be following Triffin's fateful trajectory, how could any price be ruled out?
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