The Death of Money

■ The Meaning of Money

What is a dollar? This question has no easy answer. Most people respond that a dollar is money, something they make, spend, or save. That raises another question: What is money? Experts recite the three-part definition of money as a medium of exchange, a store of value, and a unit of account. The unit of account part of the definition is useful but almost trivial. Bottle caps can be a unit of account; so can knots on a string. A unit of account is merely a way of adding or subtracting perceived value. Medium of exchange also refers indirectly to value, since each party to an exchange must perceive value in the unit being exchanged for goods or services. Two of the three parts of the definition implicitly reference value. The entire standard definition can thus be collapsed into the one remaining part, the store of value.

If, then, money is value, what is value? At this point, the analysis becomes philosophical and moral. Values can be held by individuals yet shared within a culture or community. Values can be subjective (as is the case with ethics) or absolute (as is the case with religion). Values can come into conflict when competing or contiguous groups have widely varied values.

Despite this breadth in the meaning of value, two facets stand out. The first is the idea of a metric: that there is a way of measuring the presence, absence, or degree of value. The second is the idea of trust: that when one ascribes values to an individual or group, one trusts that the individual or group will act consistently with those values. Trust embodies consistent behavior in the form of reciprocal or altruistic acts.

At heart, a dollar is money, money is value, and value is trust consistently honored. When one buys a bottle of Coca-Cola anywhere in the world, one trusts that the original formula is being used, and that the contents are not adulterated; in this respect, Coca-Cola does not disappoint. This is trust consistently honored, meaning that a bottle of Coke has value.

When a customer buys a bottle of Coke, he hands the seller a dollar. This is not mere barter, but rather a value exchange. What is the source of the dollar’s value? How does it hold up as an example of trust consistently honored?

To answer that question, one needs to dig deeper. The dollar itself, whether in paper or digital form, is a representational object. What does the dollar represent? To whom is the trust directed? When trust is required, Ronald Reagan’s dictum applies: Trust, but verify. The Federal Reserve System, owned by private banks, is the issuer of the dollar. The Fed asks for our trust, but how can one verify if the trust is being honored?

In a rule-of-law society, a customary way of verifying trust is the written contract. A first-year law student in contracts class immediately learns to “get it in writing.” The beliefs and expectations of the parties to a contract are written down and read by both parties. Assuming both parties agree, the contract is signed, and from then forward, the contract embodies the trust. At times, disputes arise about the meaning of words in the contract or the performance of its terms. Countries have courts to resolve those disputes. This system of contracts, courts, and decisions guided by a constitution is what is meant by a rule-of-law society.

How does the Federal Reserve fit into this system? On one level, the Fed follows the written contract model. One can begin by reading the fine print on a dollar bill. That is where one finds the written money contract. The parties to this contract are specified as “The Federal Reserve” and “The United States of America” on behalf of the people.

One-dollar contracts are entered into by each of the Fed’s twelve regional reserve banks. Some of these written contracts are entered by the Dallas Fed, some by the Philadelphia Fed, and so on. Larger denominations such as twenty-dollar contracts are entered into by the “System.” These contracts are all signed by an agent, the U.S. secretary of the Treasury, on behalf of the people.

The most important clause in the written dollar contract appears on the front at the top of each bill. It is the phrase “Federal Reserve Note.” A note is an obligation, a form of debt. Indeed, this is how the Fed reports money issued on its balance sheet. Balance sheets show assets on the left-hand side, liabilities on the right-hand side, and capital, which is assets minus liabilities, at the bottom. Notes issued by the Fed are reported on the right-hand side of the balance sheet, as a liability, exactly where one would place debt.

Fed notes are an unusual form of debt because they bear no interest and have no maturity. Another way to describe a dollar, using the contract theory, is that it is a perpetual, non-interest-bearing note issued by the Fed. Any borrower will attest that perpetual, non-interest-bearing debt is the best kind of debt because one never pays it back, and it costs nothing in the meantime. Still, it is a debt.

So the dollar is money, money is value, value is trust, trust is a contract, and the contract is debt. By application of the transitive law of arithmetic, the dollar is debt owed by the Fed to the people in contractual form. This view may be called the contract theory of money, or contractism. As applied to the dollar, one way to understand the theory is to substitute the word debt every time one sees the word money. Then the world looks like a different place; it is a world in debt.

This approach to money through the lens of contract is one of many monetary theories. The most influential of these is the quantity theory of money, or monetarism, advocated in the twentieth century by Irving Fisher and Milton Friedman. Monetarism is one of the Fed’s chosen guides to money creation, although the original formulation advocated by Friedman is no longer in vogue.

Another approach is the state theory of money, which posits that unbacked paper money has value since the state may demand such money as tax payments. The state may use coercion unto death to collect taxes; therefore citizens work for and value money because it can satisfy the state. This relationship of money and state means paper money has extrinsic value in excess of its intrinsic value due to the medium of state power. This type of money is known as chartal money, and chartalism is another name for the state theory of money. In the 1920s John Maynard Keynes adopted chartalism in his calls for the abolition of gold standards. More recent acolytes of the theory of money as an arm of state power are Paul McCulley, former executive at bond giant PIMCO, and Stephanie Kelton, economist at the University of Missouri, who marches under the banner of modern monetary theory.

A new entrant in the money theory sweepstakes is the quantity theory of credit. This theory, advanced by Richard Duncan, is a variant of the quantity theory of money. Duncan proposes that credit creation has become so prolific and pervasive that the idea of money is now subsumed in the idea of credit, and that credit creation is the proper focus of monetary study and policy. Duncan brings impressive statistical and forensic analyses of government data to the study of credit expansion. His work could properly be called creditism, although it is really a twenty-first-century version of a nineteenth-century view of money called the British Banking School.

Monetarism, chartalism, and creditism all have one idea in common: a belief in fiat money. The word fiat has a Latin origin that means “let it be done.” As applied to money, fiat refers to the case where the state orders that a particular form of money serve as currency and be treated as legal tender. All three theories agree that money does not have to have intrinsic value as long as it possesses extrinsic value supplied by the state. When fiat money opponents say money “is not backed by anything,” these theorists answer, “So what?” In their view, money has value because the state dictates it be so, and nothing else is required to give money its value.

A theory is useful only to the extent it accords with real-world phenomena and helps observers to understand and anticipate events in that world. Theories of money that rely on state power are a thin reed on which to lean because the application of state power is changeable. In that sense, these competing theories of money may be said to be contingent.

Returning to where we started, the contract theory of money focuses on money’s intrinsic value. The money may be paper, but the paper has writing, and the writing is a legal contract. A citizen may deem the contract valuable for her own reasons independent of state dictates. The citizen may value contract performance rather than fiat. This theory is useful for understanding not only the dollar but also whether the dollar contract is being honored, both now and in the future.

Although the dollar as debt bears no interest and has no maturity, the dollar still involves duties of performance on the parts of both the Fed and the Treasury, the two named parties on the contract. This performance is made manifest in the economy. If the economy is doing well, the dollar is useful, and contract performance is satisfactory or valuable. If the economy is dysfunctional, performance may be thought poor to the point of default under the contract.

A gold standard is a way to enforce the money contract. Advocates for gold insist that all paper money has no intrinsic value, which can be supplied only by tangible precious metal in the form of gold, or perhaps silver. This view misapprehends the role of gold in a gold standard, but for the few who insist that coins or bullion be the sole medium of exchange—a highly impractical state of affairs. All gold standards involve a relationship between physical gold and paper representations of gold, whether these representations are called notes, shares, or receipts. Once this relationship is accepted, one is quickly back to the world of contract.

On this view, gold is the collateral or bond posted to ensure satisfactory performance of the money contract. If the state prints too much money, the citizen is then free to declare the money contract in default and redeem her paper money for gold at the market exchange rate. In effect, the citizen takes her collateral.

Gold advocates suggest that the exchange rate between paper money and gold should be fixed and maintained. There is merit to this idea, but a fixed exchange rate is not essential to gold’s role in a contract money system. It is necessary only that the citizen be free to buy or sell gold at any time. Any citizen can go on a personal gold standard by buying gold with paper dollars, while anyone who does not buy gold is expressing comfort with the paper-money contract for the time being.

The money price of gold is therefore a measure of contractual performance by the Fed and Treasury. If performance is satisfactory, gold’s price should be stable, as citizens rest easy with the paper-money deal. If performance is poor, the gold price will spike, as citizens terminate the money-debt contract and claim their collateral through gold purchases on the open market. Like any debtor, the Fed prefers that the citizen-creditors be unaware of their right to claim collateral. The Fed is betting that citizens will not claim the gold collateral en masse. This bet depends on a high degree of complacency among citizens about the nature of the money contract, the nature of gold, and their right to take collateral for nonperformance.

This is one reason the Fed and fiat money economists use phrases like “barbarous relic” and “tradition” to describe gold and insist that gold has no role in a modern monetary system. The Fed’s view is absurd, akin to saying land and buildings have no role in a mortgage. Money is a paper debt with gold as its collateral. The collateral can be claimed by the straightforward purchase of gold.

The Fed prefers that investors not make this connection, but one investor who did was Warren Buffett. In his case, he moved not into gold but into hard assets, and his story is revealing.

In November 2009, not long after the depths of the market selloff resulting from the Panic of 2008, Buffett announced his acquisition of 100 percent of the Burlington Northern Santa Fe Railway. Buffett described this purchase as a “bet on the country.”

Maybe. A railroad is the ultimate hard asset. Railroads consist of a basket of hard assets, such as rights of way, adjacent mining rights, tracks, switches, signals, yards, and rolling stock. Railroads make money by transporting other hard assets, such as wheat, steel, ore, and cattle. Railroads are hard assets that move hard assets.

By acquiring 100 percent of the stock, Buffett effectively turned the railroad from an exchange-traded public equity into private equity. This means that if stock exchanges were closed in a financial panic, there would be no impact on Buffett’s holdings because he is not seeking liquidity. While others might be shocked by the sudden illiquidity of their holdings, Buffett would just sit tight.

Buffett’s acquisition is best understood as getting out of paper money and into hard assets, while immunizing those assets from a stock exchange closure. It may be a “bet on the country”—but it is also a hedge against inflation and financial panic. The small investor who cannot acquire an entire railroad can make the same bet by buying gold. Buffett has been known to disparage gold, but he is the king of hard asset investing, and when it comes to the megarich, it is better to focus on their actions than on their words. Paper money is a contract collateralized by gold, the latter a hard asset nonpareil.

■ Debt, Deficits, and Sustainability

The Federal Reserve is not the only government-linked debtor in the U.S. money system; in fact, it is far from the largest. The U.S. Treasury has issued over $17 trillion of debt in the form of bills, notes, and bonds, compared to about $4 trillion of debt-as-money notes issued by the Fed.

Unlike Federal Reserve notes, Treasury notes are not thought of as money, although the most liquid instruments are often called “cash equivalents” on corporate balance sheets. Another difference between Federal Reserve notes and Treasury notes is that Treasury notes have maturity dates and pay interest. Fed notes can be issued in indefinite quantities and remain outstanding indefinitely, but Treasury notes are more subject to the discipline of bond markets, where investors trade over $500 billion in Treasury securities every day.

Market discipline includes continual evaluation by investors as to whether the Treasury’s debt burden is sustainable. This evaluation asks whether the Treasury can pay its outstanding debts as agreed. If the answer is yes, the market will gladly accept more Treasury debt at reasonable interest rates. If the answer is no, the market will dump Treasury debt, and interest rates will skyrocket. In cases of extreme uncertainty due to lack of funds or lack of willingness to pay, government debt can become nearly worthless, as happened in the United States after the Revolutionary War and in other countries many times before and since.

Analysis of government debt is most challenging when the answer is neither yes nor no but maybe. It is at these tipping points (which complexity theorists call phase transitions) that the bond market stands poised between confidence and panic, and debt default seems like a real possibility. European sovereign bond markets approached this point in late 2011 and remained poised on the brink until September 2012, when the European Central Bank head, Mario Draghi, offered his famous “whatever it takes” pronouncement. He meant that the ECB would substitute its money debt for sovereign debt in the quantities needed to reassure the sovereign debt holders. This reassurance worked, and European sovereign debt markets pulled back from the brink.

In recent years, purchases of government securities with money printed by the Federal Reserve account for a high percentage of net new debt issued by the Treasury. The Fed insists that its purchases are a policy tool to ease monetary conditions and are not intended to monetize the national debt. The Treasury, at the same time, insists that it is the world’s best debtor and has no difficulty satisfying the funding requirements for the U.S. government. Still, the casual observer could be forgiven for believing that the Fed is monetizing the debt by debasing money—historically a step on the road to collapse for economic and political systems, from ancient Rome to present-day Argentina. The Fed’s great confidence game is to swap its non-interest-bearing notes for the Treasury’s interest-bearing notes, then rebate the interest earned back to the Treasury. The challenge for bond markets, and investors generally, is to decide how much Treasury note issuance is sustainable and how much substitution of Fed notes for Treasury notes is acceptable before the phase transition emerges and a collapse begins.

The dynamics of government debt and deficits are more complicated than the conventional argument admits. Too often the debate over debt and deficits degenerates into binary choices: Is debt good or bad for an economy? Is the U.S. deficit too high, or is it affordable? Tea Party conservatives take the view that deficit spending is intrinsically bad, that a balanced budget is desirable in and of itself, and that the United States is well down the path to becoming Greece. Krugman-style liberals take the view that debt is necessary to fund certain desirable programs, and that the United States has been here before in terms of its debt-to-GDP ratio. After World War II, the U.S. debt-to-GDP ratio was 100 percent—about where it is today. The United States gradually reduced it during the 1950s and 1960s, and liberals say America can do it again with slightly more taxation.

There are valid points in both positions, but there are also strong rebuttals to both. The policy problem is that a debate framed in this way creates false dichotomies that facilitate not resolution but rhetoric. Debt is inherently neither positive nor negative. Debt’s utility is determined by what the borrower does with the money. Debt levels are not automatically too high or too low; what matters to creditors is their trend toward sustainability.

Debt can be ruinous if it is used to finance deficits, and with no plan for paying the debt other than through additional debt. Debt can be productive if it funds projects that produce more than they cost and that pay for themselves over time. Debt-to-GDP ratios can be relatively low, but still troubling, if they are getting higher. Debt-to-GDP ratios can be relatively high and not be a cause for concern if they are getting lower.

■ The Debt Debate

Framing the debt and deficit debates in these terms raises further questions. What are the proper guidelines for determining whether debt is being used for a desirable purpose and whether debt-to-GDP trends are moving in the right direction? Fortunately, both questions can be answered in a rigorous, nonideological way, without retreating to the rhetoric of conservatives or liberals.

Debt used to finance government spending is acceptable when three conditions are met: the benefits of the spending must be greater than the costs, the government spending must be directed at projects the private sector cannot do on its own, and the overall debt level must be sustainable. These tests must be applied independently, and all must be satisfied. Even if government spending can be shown to produce net benefits, it cannot be justified if private activity can do the job better. When government spending produces net costs, it destroys the stock of wealth in society and can never be justified except in an existential crisis such as war.

Difficulties arise when costs and benefits are not well defined and when ideology substitutes for analysis in the decision-making process. Two cases illustrate these problems—the Internet and the 2009 Obama stimulus.

Government-spending advocates point out that the government financed the early development of the Internet. In fact, the government sponsored ARPANET, a robust message traffic system among large-scale university computers designed to facilitate research collaboration during the Cold War. However, ARPANET’s development into today’s Internet was advanced by the private sector through the creation of the World Wide Web, the Web browser, and many other innovations. This history shows that certain government spending can be highly beneficial when it jump-starts private-sector innovation. ARPANET had fairly modest ambitions by today’s standards, and it was a success. The government did not freeze ARPANET for all time; instead, it made the protocols available to private developers and got out of the way. The Internet is an example of government leaving the job to the private sector.

An example of destructive government spending is the 2009 Obama stimulus plan. The expected benefits were based on erroneous assumptions about so-called Keynesian multipliers. In fact, the Obama stimulus was directed largely at supplementing state and local payrolls for union jobs in government and school administration, many of which are redundant, nonproductive, and wealth-destroying. Much of the rest went to inefficient, nonscalable technologies such as solar panels, wind turbines, and electric cars. Not only did this spending not produce the mythical multiplier, it did not even produce nominal growth equal to nominal spending. The Obama stimulus is an example of government spending that does not pass the cost-benefit test.

An example of a government initiative that meets all tests for acceptable spending is the interstate highway system. In 1956 President Eisenhower championed and Congress authorized the interstate highway system, which cost about $450 billion in today’s dollars. The benefits of that system vastly exceeded $450 billion and continue to accrue to this day. It is difficult to argue that the private sector could have produced anything like this matrix of highways; at best, we would have a hodgepodge of toll roads with many areas left unserved. Only government could have completed the project on a nationwide scale, and debt-to-GDP ratios were stable at the time. Thus the interstate highway system passes the three-pronged test of efficient government spending that justifies debt.

Today long-term interest rates are near all-time lows, and the United States could easily borrow $150 billion for seven years at 2.5 percent interest. With that money, the government could, for example, construct a new natural gas pipeline adjacent to the interstate highway system and place natural gas fueling stations at existing facilities. This interstate pipeline could be connected to large natural gas trunk pipelines at key nodes, and the government could then require a ten-year conversion of all interstate trucking from diesel to natural gas.

With this pipeline and fueling station network in place, private companies like Chevron, ExxonMobil, and Ford would then take over the innovation and expansion of natural-gas-powered transportation, a public-to-private handoff as happened after ARPANET. The shift to natural-gas-powered trucks would facilitate the growth of natural-gas-powered automobiles. The demand for natural gas would then boost exploration and production along with related technologies in which the United States excels.

As with the interstate highway system, the results of an interstate natural-gas-fueling system would be transformative. The boost to the economy would come immediately—not from mythical multipliers but from straightforward productive spending. Hundreds of thousands of jobs would be created in the actual pipeline construction, and more jobs would come from the conversion of vehicles from gasoline to natural gas. Dependence on foreign oil would end, and the U.S. trade deficit would evaporate, boosting growth. The environmental benefits are obvious since natural gas burns cleaner than diesel or gasoline.

Will this happen? It is doubtful. Republicans are more focused on debt reduction than on growth, and Democrats are ideologically opposed to all carbon-based energy, including natural gas. The political stars seem aligned against this kind of out-of-the-box solution. However, it remains the case that government debt to finance spending can be acceptable if it passes the three-pronged test of positive returns, no displacement of private-sector efforts, and sustainable debt levels. The third prong is the most problematic today.

■ Sustainable Debt

Another essential question must be asked: Are debt levels sustainable? That, in turn, leads to other questions: How can policy makers know if they are pushing the debt-to-GDP trend in the desired direction? What role does the Fed play in making deficits sustainable and debt affordable?

The relation of Federal Reserve monetary policy to national debt and deficits is fraught with grave risks for the debt-as-money contract. At a primitive level, the Fed actually can monetize any amount of debt the Treasury issues, up to the point of a collapse of confidence in the dollar. The policy issue is one of rules or limitations imposed on the Fed’s money-printing ability. What are the guidelines for discretionary monetary policy?

Historically, a gold standard was one way to limit discretion and reveal when monetary policy was off track. Under the classic gold standard, gold outflows to trading partners showed that monetary policy was too easy and tightening was required. The tightening would have a recessionary effect, lower unit labor costs, improve export competitiveness, and once again start the inward flow of physical gold. This process was as self-regulating as an automatic thermostat. The classic gold standard had its problems, but it was better than the next-best system.

In more recent decades, the Taylor Rule—named after its creator, the economist John B. Taylor—was a practical guide for Fed monetary policy. It had the virtue of recursive functions so that data from recent events would feed back into the next policy decision, to produce what network scientists call a path-dependent outcome. The Taylor Rule was one tool in the broader sweep of the sound-dollar standard created by Paul Volcker and Ronald Reagan in the early 1980s. The sound-dollar policy was carried forward through the late 1980s and 1990s in Republican and Democratic administrations by Treasury secretaries as diverse as James Baker and Robert Rubin. If the dollar was not quite as good as gold, at least it maintained its purchasing power as measured by price indexes, and at least it served as an anchor for other countries looking for a monetary reference point.

Today every reference point is gone. There is no gold standard, no dollar standard, and no Taylor Rule. All that remains is what financial writer James Grant calls the “Ph.D. Standard”: the conduct of policy by neo-Keynesian, neo-monetarist academics with Ph.D.’s granted by a small number of elite schools.

Rules used by academic policy makers to define sustainable deficits are argued among elite economists and revealed in speeches, papers, and public comments of various kinds. In an environment of deficit spending, one of the most important tools is the primary deficit sustainability (PDS) framework. This analytic framework, which can be expressed as an equation or identity, measures whether national debt and deficits are sustainable, or conversely when the trend in deficits could cause a loss of confidence and rapidly increasing borrowing costs. PDS is a way to tell if America is becoming Greece.

This framework has been used for decades, but its use was crystallized in the current context by economist John Makin, one of the most astute analysts of monetary policy. In 2012 Makin wrestled with the relationship of U.S. debt and deficits to gross domestic product (GDP), using the PDS framework as a guide.

The key factors in PDS are borrowing costs (B), real output (R), inflation (I), taxes (T), and spending (S); together, the BRITS. Real output plus inflation (R + I) is the total value of goods and services produced in the U.S. economy, also called nominal gross domestic product (NGDP). Taxes minus spending (T – S) is called the primary deficit. The primary deficit is the excess of what a country spends over what it collects in taxes. In calculating the primary deficit, spending does not include interest on the national debt. This is not because interest expense does not matter; it matters a lot. In fact, the whole purpose of the PDS framework is to illuminate the extent to which the United States can afford the interest and ultimately the debt. Interest is excluded from the primary deficit calculation in order to see if the other factors combine in such a way that the interest is affordable. Interest on the debt is taken into account in the formula as B, or borrowing costs.

In plain English, U.S. deficits are sustainable if economic output minus interest expense is greater than the primary deficit. This means the U.S. economy is paying interest and producing a little “extra” to pay down debt. But if economic output minus interest expense is less than the primary deficit, then over time the deficits will overwhelm the economy, and the United States will be headed for a debt crisis, even financial collapse.

To a point, what matters is not the debt and deficit level but the trend as a percentage of GDP. If the levels are trending down, the situation is manageable, and debt markets will provide time to remain on that path. Sustainability does not mean that deficits must go away; in fact, deficits can grow larger. What matters is that total debt as a percentage of GDP becomes smaller, because nominal GDP grows faster than deficits plus interest.

Think of nominal GDP as one’s personal income and the primary deficit as what gets charged on a credit card. Borrowing costs are interest on the credit card. If personal income increases fast enough to pay the interest on the credit card, with money left over to pay down the balance, this is a manageable situation. However, if one’s income is not going up, and new debt is piled on after paying the old interest, then bankruptcy is just a matter of time.

The PDS framework is an economist’s formal expression of the credit card example. If national income can pay the interest on the debt, with enough left over to reduce total debt as a percentage of GDP, then the situation should remain stable. This does not mean that deficits are beneficial, merely that they are affordable. But if there is not enough national income left over after the interest to reduce the debt as a percentage of GDP, and if this condition persists, then the United States will eventually go broke.

Expressed in the form of an equation, sustainability looks like this:

then U.S. deficits are sustainable. Conversely,

then U.S. deficits are not sustainable.

The PDS/BRITS framework and the credit card example encapsulate the recent drama, posturing, and rhetoric of the great economic debates in the United States. When Democrats and Republicans fight over taxes, spending, deficits, debt ceilings, and the elusive grand bargain, these politicians are really arguing over the relative sizes of the BRITS.

PDS by itself does not explain which actions to take or what ideal policy should be. What it does is allow one to understand the consequences of specific choices. PDS is a device for conducting thought experiments on different policy combinations, and it acts as the bridge connecting fiscal and monetary solutions. The BRITS are a Rosetta stone for understanding how all of these policy choices interact.

For example, one way to improve debt sustainability is to increase taxes. If taxes are larger, the primary deficit is smaller, so a given amount of GDP will bring the United States closer to the sustainability condition. Alternatively, if taxes are held steady but spending is cut, then the primary deficit also shrinks, producing a move toward sustainability. A blend of spending cuts and tax increases produces the same beneficial results. Another way to move toward sustainability is to increase real growth. An increase in real growth means more funds are available, after interest expense, to reduce debt as a percentage of GDP.

There are also ways for the Federal Reserve to affect the PDS factors. The Fed can use financial repression to keep a lid on borrowing costs. Lower borrowing costs have the same impact as higher real growth in terms of increasing the amount of GDP remaining after interest expense. Importantly, the Fed can cause inflation, which increases nominal growth, even in the absence of real growth. Nominal growth minus borrowing costs is the left side of the PDS equation. Inflation increases the funds that are left over after interest expense, which also helps to reduce the debt as a percentage of GDP.

These potential policy choices in the PDS framework each involve a change in one BRITS component and assume the other components are unchanged, but the real world is more complex. Changes in one BRITS component can cause changes in another, which can then amplify or negate the desired effect of the original change. Democrats and Republicans disagree not only about higher taxes and less spending but also about the impact of these policy choices on the other BRITS. Democrats believe that taxes can be increased without hurting growth, while Republicans believe the opposite. Democrats believe that inflation can be helpful in a depression, while Republicans believe that inflation will lead to higher borrowing costs that will worsen the situation.

The result of these disagreements is political stalemate and policy dysfunction. The political stalemate has played out in a long series of debates and quick fixes, beginning with the August 2011 debt ceiling debacle, continuing through the January 2013 fiscal cliff drama, and then the spending sequester and debt ceiling showdowns in late 2013 and early 2014.

The PDS can be used to quantify trends, but it cannot forecast the exact level at which a trend becomes unsustainable; that is the job of bond markets. The bond markets are driven by investors who risk money every day betting on the future path of interest rates, inflation, and deficits. These markets may be tolerant of political stalemate for long periods of time and give policy makers the benefit of a doubt. But at the end of the day, the bond markets can render a harsh judgment. If the United States is on an unsustainable path as revealed by PDS, and that downward path is accelerating with no end in sight, then the markets may suddenly and unexpectedly cause interest rates to spike. The interest-rate spike makes PDS less sustainable, which makes interest rates higher still. A feedback loop is created between progressively worsening PDS results and progressively higher rates. Eventually the system can collapse into outright default or hyperinflation.

■ Fed Policy and the Money Contract

Today the Federal Reserve confronts a daunting mixture of unforgiving math, anxious markets, and dysfunctional politics. The U.S. economy is like a sick patient, with politicians as the concerned relatives at the patient’s bedside arguing over what to do next. The PDS framework is the thermometer that reveals whether the patient’s condition is deteriorating, and bond markets are the undertaker, waiting to carry the patient to her grave. Into this melodramatic mise-en-scène walks Dr. Fed. The doctor may not have the medicine needed to provide a cure, but newly printed money is like morphine for the economy. It can ease the pain, as long as it does not kill the patient.

As the proprietor of the debt-as-money contract with the American people and creditors around the world, the Fed must not be seen to dishonor the trust placed in it by holders of Fed notes. From the perspective of the international monetary system, the only scenario worse than a collapse of confidence in Treasury bonds is a collapse of confidence in the dollar itself. Debt, deficits, and the dollar are three strands in a knot that secures the world financial system. By issuing unlimited dollars to prop up Treasury debt, the Fed risks unraveling the knot and undoing the dollar confidence game. The difference between success and failure for the Fed is a fine line.

In strict terms, government finance can be thought of as two large circles in a classic Venn diagram. One circle is the world of monetary policy controlled by the Federal Reserve. The other circle is fiscal policy, consisting of taxes and spending, controlled by Congress and the White House. As in a Venn diagram, the two circles have an area of intersection. That area is inflation. If the Fed can create enough inflation, the real value of debt will melt away, and spending can continue without tax increases. The trick is to increase inflation without increasing borrowing costs, since higher borrowing costs increase debt. The PDS framework shows how this can be done.

To understand this, it is useful to consider conditions revealed by PDS using model inputs. An ideal situation for the Fed consists of 4 percent real growth, 1 percent inflation, 2 percent borrowing costs (measured as a percentage of GDP), and a 2 percent primary deficit (also measured as a percentage of GDP). Plugging these numbers into the PDS framework results in:

In other words, real growth plus inflation, minus interest expense, is greater than the primary deficit, which means that debt as a percentage of GDP is declining. This is the condition of debt sustainability with high real growth and low inflation.

Unfortunately the example above is not what the Fed is confronting in markets today. Borrowing costs are low, at 1.5 percent of GDP, which helps the equation relative to the first example; but some other terms are worse for sustainability. Real growth is closer to 2.5 percent, and the primary deficit is about 4 percent (inflation is the same at about 1 percent). Plugging these actual numbers into the PDS framework results in:

In this example, real growth plus inflation minus interest expense is less than the primary deficit, which means that debt as a percentage of GDP is increasing. This is the unsustainable condition. Again, what matters in this model is not the level but the trend, as played out in the dynamics of the BRITS and their interactions. Contrary to the oft-cited Carmen Reinhart and Kenneth Rogoff thesis, the absolute level of debt to GDP is not what triggers a crisis; it is the trend toward unsustainability.

One beauty of PDS is that the math is simple. Starting with the identity as 2 < 4 means that to achieve sustainability, either the 2 must go up, the 4 must go down, or both. Real growth in the United States today is stuck at 2.5 percent, partly due to policy uncertainty. The U.S. primary deficit may decrease to 3 percent because of the 2013 tax increases and spending sequester, but otherwise the tax and spending stalemate seems set to continue. The math is basic but rigid: if real growth is 2.5 percent, the primary deficit is 3 percent, and borrowing costs won’t go lower, then the only path to sustainability is for the Fed to raise inflation above borrowing costs. Of course, inflation tends to increase borrowing costs, a good example of feedback loops within the BRITS.

For example, the Fed could cap borrowing costs at 2 percent and raise inflation to 3 percent. With all of these new inputs, the PDS framework results in:

This result satisfies the condition for sustainability, and bond markets should not panic but show patience and give the United States more time to increase real growth, reduce the primary deficit, or both.

Through PDS and BRITS, it becomes possible to unravel the acrimony, political dysfunction, and televised shouting matches. The policy solution is unavoidable. In the absence of higher real growth, either politicians must reduce deficits, or the Fed must produce inflation. There is no other way to avoid a debt crisis.

Political success in reducing deficits so far has been modest and insufficient, and increases in real growth continue to disappoint expectations. Therefore, the burden of avoiding a debt crisis falls on the Fed in the form of higher inflation through monetary policy. Inflation is a prominent solution in the PDS framework despite the unfairness this imposes on small savers.

Savers may have few alternatives, but bond buyers have many. The issue is whether bond buyers will tolerate the capital erosion that comes from inflation. This condition in which inflation is higher than the nominal interest rate produces negative real rates. For example, a nominal 2 percent interest rate with 3 percent inflation produces a real interest rate of negative 1 percent. In normal markets, bond buyers would demand higher interest rates to offset inflation, but these are not normal markets. The bond market may want higher nominal rates, but the Fed won’t permit it. The Fed enforces negative real rates through financial repression.

The theory of financial repression was explained incisively by Carmen Reinhart and M. Belen Sbrancia in their 2011 paper “The Liquidation of Government Debt.” The key to financial repression is the use of law and policy to prevent interest rates from exceeding the rate of inflation. This strategy can be carried out in many different ways. In the 1950s and 1960s it was done through bank regulation that made it illegal for banks to pay more than a stated amount on savings deposits. Meanwhile the Fed engineered a mild form of inflation, slightly higher than the bank deposit rate, which eroded those savings. It was executed with such subtlety that savers barely noticed. Besides, savers had few alternatives, as this was a time before money-market accounts and 401(k)s. The 1929 stock market crash was still a living memory for many, and most investors considered equities too speculative. Money in the bank was a primary form of wealth preservation. As long as the Fed did not steal the money too quickly or too overtly, the system remained stable.

This condition of modest negative real rates for a sustained period of time also worked its wonders on the debt-to-GDP ratio. During this golden age of financial repression, national debt declined from over 100 percent of GDP in 1945 to less than 30 percent by the early 1970s.

By the late 1960s, the game of financial repression was over, and inflation became too prevalent to ignore. The theft of wealth from traditional savers had become painful. Merrill Lynch responded in the 1970s with the creation of higher-yielding money-market funds, and others quickly followed. Mutual fund families like Fidelity made stock ownership easy. Investors broke free of financial repression, left the banks behind, and headed for the new frontier of risky assets.

The problem confronting the Fed today is how to use financial repression to cap interest rates without the benefit of 1950s-style regulated bank deposit rates and captive savers. The Fed’s goal is the same as in the 1950s—higher inflation and a cap on rates, but tactics have evolved. Inflation comes from money printing, and rate caps come from bond buying. Conveniently for the Fed, money printing and bond buying are two sides of the same coin, because the Fed buys bonds with printed money.

The name for this type of operation is quantitative easing (QE). The first of several QE programs commenced in 2008, and over $2 trillion of new money was printed by the end of 2012. By early 2014, printing was proceeding at the rate of over $1 trillion of new money per year.

Money that sits in banks as excess reserves does not produce inflation. Price inflation emerges only if consumers or businesses borrow and spend the printed money. From the Fed’s perspective, the manipulation of consumer behavior to encourage borrowing and spending is a critical policy component. The Fed has chosen to manipulate consumers with both carrots and sticks. The stick is an inflation shock, intended to scare consumers into spending before prices go up. The carrot is the negative real interest rate, designed to encourage borrowing money to buy risky assets such as stocks and housing. The Fed will ensure negative real rates by using its own bond buying power, and that of the commercial banks if necessary, to suppress nominal interest rates.

In order to make the carrots and sticks effective, at least 3 percent inflation is needed. At that level, real interest rates will be negative, and consumers should be sufficiently worried to start spending. These powerful inducements to lend and spend are designed to grow nominal GDP at a rate closer to historical trends. Over time the Fed hopes this growth becomes self-sustaining, so it can then reverse policy and let nominal GDP turn into real GDP through an accelerating real growth process. The Fed is using policies of zero interest rates and quantitative easing to reach its goals of higher inflation and negative real rates.

Banks can make significant profits by borrowing at the zero short-term rates offered by the Fed and lending for longer terms at higher rates. But this type of lending can produce losses if short-term rates rise quickly while the banks are stuck with the long-term assets, such as mortgages and corporate debt. The Fed’s solution to this problem is forward guidance. In effect, the Fed tells the banks not to worry about short-term rates rising until well into the future.

In March 2009 the Fed issued an announcement that short-term rates would remain at zero for “an extended period.” In August 2011 the “extended period” phrase was dropped and a specific date of “mid-2013” was announced as the earliest on which rates would increase. By January 2012 this date had been pushed back to “late 2014.” Finally, in September 2012 the Fed announced that the earliest that rates would increase was “mid-2015.”

Even this assurance was not enough for all banks and investors. There was concern that the Fed might bring the rate hike date forward just as easily as it had pushed it back. The criteria on which the Fed might change its mind were unclear, and so the impact of forward guidance was muted. A debate raged within the Fed about whether forward guidance should be converted from an ever-changing series of dates to a set of hard numeric goals that were more easily observed.

This debate was captured in historic and analytic detail in a paper presented by Michael Woodford of Columbia University at the Fed’s Jackson Hole Symposium at the end of August 2012. While Woodford’s argument is nuanced, it boils down to one word—commitment. His point was that forward guidance is far more effective in changing behavior today if that guidance is clear and framed in such a way that the central bank will not repudiate the guidance in the future:

The impact of Woodford’s tour de force on Fed thinking was immediate. On December 12, 2012, just three months after the Jackson Hole Symposium, the Fed scrapped its practice of using target dates for forward guidance and substituted strict numeric goals. In customary Fed-speak, the new goals were described as follows:

The Fed is now publicly wedded to a set of numeric goals and committed to zero rates until those goals are achieved and perhaps even longer.

Three aspects of the Fed’s commitment stand out. The first is that the numeric targets of 6.5 percent unemployment and 2.5 percent inflation are thresholds, not triggers. The Fed did not say that it would raise rates when those levels were hit; it said it would not raise rates before those levels were hit. This leaves ample room to continue easy money even if unemployment falls to 6 percent or inflation rises to 3 percent. Second, the Fed said both targets would have to be satisfied before it raised rates, not just one or the other. This means that if unemployment is 7 percent, the Fed can continue its easy-money policy even if inflation rises to 3 percent or higher. Finally, the Fed’s inflation target is based on projected inflation, not actual inflation. This means that if actual inflation is 4 percent, it can continue with easy money so long as its subjective inflation projection is 2.5 percent or less.

This new policy is a brilliant finesse by the Fed. Superficially it pays lip service to Woodford’s recommendation for commitment to unambiguous goals; but in reality the goals are slippery and ill defined. No one knows if the Fed will slam on the brakes at 3 percent inflation, if unemployment is still 7 percent. No one knows how much time will elapse between the end of money printing and a rate increase. Yet the Fed’s new policy is consistent with its hidden 3 percent inflation goal under the carrots-and-sticks approach. The Fed can justify higher inflation if its employment goal is unmet. It can justify higher inflation if projected inflation is lower. It can justify higher inflation in all events because the numeric targets are thresholds and not triggers. The new policy puts no real constraints on higher inflation.

The PDS and BRITS framework and the Fed’s new policies converge around the specter of inflation, which lurks behind the academic theories and public pronouncements. Low borrowing costs and higher inflation are the only ways the Fed can improve deficit sustainability. Financial repression lowers borrowing costs, and quantitative easing can create higher inflation if the markets believe it will continue. The Fed’s December 2012 policy is a muddled version of Woodford’s recommendations. The Fed is pretending to have numeric goals while preserving the degrees of freedom it needs to reach any inflation target it finds necessary, but that involves a certain sleight of hand.

The Fed’s form of theft from savers has a name: it’s called money illusion by economists. The idea is that money printing on its own cannot create real growth but can create the illusion of growth by increasing nominal prices and nominal GDP. Eventually the illusion will be shattered, as it was in the late 1970s, but it can persist for a decade or more before inflation emerges with a lag and steals the perceived gains.

While the Fed’s goals of higher inflation and rising nominal GDP are clear, there is good reason to believe the Fed will fail to achieve these goals and may even produce disastrous consequences for the United States by trying. The Fed’s own staff have expressed reservations about whether forward guidance works at all in the time horizons the Fed is using. Prominent economist Charles Goodhart has said that nominal GDP targeting is “a thinly disguised way of aiming for higher inflation” and that “no one has yet designed a way to make it workable.”

Perhaps the most compelling critique of the flaws in nominal GDP targeting and the inflation embedded within it comes from inside the Fed board of governors itself. In February 2013 Fed governor Jeremy Stein offered a highly detailed critique of the Fed’s easy-money policy and obliquely pointed to its greatest flaw: that increased turnover is not the only channel money creation can find, and that other channels include asset bubbles and financial engineering.

Stein’s thesis is that a low-interest-rate environment will induce a search for higher yields, which can take many forms. The most obvious form is a bidding up of the price of risky assets such as stocks and housing. This can be observed directly. Less obvious are asset-liability mismatches, where financial institutions borrow short and lend long on a leveraged basis to capture a spread. Even more opaque are collateral swaps, where a financial institution such as Citibank pledges junk bonds to a counterparty in exchange for Treasury securities on an overnight basis, then uses those Treasury securities as collateral on a higher-yielding off-balance-sheet derivative. Such transactions set the stage for a run on Citibank or others if the short-term asset providers suddenly want their securities back and Citibank must dump other assets at fire-sale prices to pay up. The invisible web of counterparty risk increases systemic risk—and moves the system closer to a replay of the Panic of 2008 on a larger scale.

The scenarios sketched by Stein would rapidly undo the Fed’s efforts if such events came to pass. A market panic stemming from excessive leverage and risk taking occurring so soon after the Panic of 2008 would destroy the Fed’s efforts to lure consumers back into the lending and spending game of the early 2000s.

Stein’s paper has been taken to say that Fed must end QE sooner rather than later to avoid the buildup of hidden risk in financial institutions. But there is another interpretation. Stein himself warns that if banks do not take the hint and curtail risky financial engineering, the Fed might force them to do so with increased regulation. The Federal Reserve has life-and-death powers over banks in areas such as loss reserves, dividend policies, stress tests, acquisitions, capital adequacy, and more. Bank managers would be foolhardy to defy the Fed in the areas Stein highlights. Stein’s paper suggests a partial return to an older kind of financial repression through regulation.

The Fed’s manipulations have left it in the position of a tightrope walker with no net, one who must exert all his energy in a concentrated effort just to keep moving forward, even as the slightest slip or unexpected gust could cause a catastrophic end to the enterprise. The Fed must promote inflation (while not acknowledging it) and must inflate asset prices (without causing bubbles to burst). It must exude confidence while having no idea whether its policies will work or when they might end.

In short, the Fed is caught between its roles as proprietor of the debt-as-money contract and as the singular savior of sovereign debt. It is unlikely to succeed in only one of these roles; it shall succeed, or fail, at both.

■ One World

To meet Dr. Min Zhu is to see the future of global finance. He stands out in a crowd, his six-foot-four-inch frame reminding financiers of the late twentieth century’s most powerful bankers, Paul Volcker and Walter Wriston, who dominated a room not just with intellect but with physical presence. Min Zhu belongs not to the twentieth century but to the twenty-first, and it is difficult to name anyone who better personifies the conflicting forces—east versus west, gold versus paper, state versus markets—coursing through the world today.

Min Zhu is the IMF’s deputy managing director, among the most senior positions in the IMF, reporting directly to the managing director, Christine Lagarde. The IMF is one of the key institutions established at the 1944 Bretton Woods Conference, which created the framework for the international monetary system in the aftermath of the Great Depression as the Second World War drew to a close. Since its founding, the IMF has been the great enigma of global finance.

The IMF is quite public about its operations and objectives. At the same time, it is little understood even by experts, in part because of the unique role it performs and the highly technical jargon it uses in doing so. Specialized university training at institutions like the School of Advanced International Studies in Washington, D.C., is a typical admission ticket to a position at the IMF. This combination of openness and opaqueness is disarming; the IMF is transparently nontransparent.

The IMF’s mission has repeatedly morphed over the decades since Bretton Woods. In the 1950s and 1960s, it was the caretaker of the fixed-exchange-rate gold standard and a swing lender to countries experiencing balance-of-payments difficulties. In the 1970s, it was a forum for the transition from the gold standard to floating exchange rates, engaging in massive sales of gold at U.S. insistence to help suppress the price. In the 1980s and 1990s, the IMF was like a doctor who made house calls, dispensing bad medicine in the form of incompetent advice to emerging economies. This role ended abruptly with blood in the streets of Jakarta and Seoul and scores killed as a result of the IMF’s mishandling of the 1997–98 global financial crisis. The early 2000s were a period of drift, during which the IMF’s mandate was unclear and experts suggested that the institution had outlived its usefulness. The IMF reemerged in 2008 as the de facto secretariat and operating arm of the G20, coordinating policy responses to the financial panic that year. Today the IMF has capitalized on its newfound role as global lender of last resort: it has become the central bank of the world.

Min Zhu holds the highest-ranking position ever held by a Chinese citizen at the IMF, the World Bank, or the Bank for International Settlements, the international monetary system’s three multilateral pillars. His career personifies China’s financial rise in nuce. He graduated in 1982 from Fudan University in Shanghai, among the most prestigious schools in China. He obtained a Ph.D. in economics in the United States, before moving through various jobs at the World Bank and the international division of the Bank of China. In 2009 he became China’s central bank deputy governor. In May 2010 he was handpicked by Dominique Strauss-Kahn, then IMF chief, to be his special adviser. Finally in 2011 Strauss-Kahn’s successor, Christine Lagarde, selected him to be the IMF’s deputy managing director.

Zhu has a relaxed demeanor and good sense of humor, but when pressed hard on a policy he feels strongly about, he can suddenly turn strident, as if he were lecturing students rather than engaging in debate. His slightly accented English is excellent, but his soft-spoken style is difficult to hear at times. His background is unique: he has operated at the highest levels at a central bank under Chinese Communist Party control and at the highest levels of the IMF, an institution ostensibly committed to free markets and open capital accounts.

Zhu travels continually on official IMF business, for university lectures, and to attend prestigious international conferences such as the Davos World Economic Forum. Private bankers and government officials eagerly seek his advice at the IMF’s Washington, D.C., headquarters and on the sidelines of G20 summits, while Communist Party Central Politburo members do the same on his periodic trips to Beijing. From East to West, from communism to capitalism, Min Zhu straddles the contending forces in world finance today, with a foot in both camps.

No one, including central bank governors and Madame Lagarde herself, is more aware than Zhu of the international monetary system’s hidden truths, which makes his global economic and financial views especially significant. He is an adamant globalist, reflecting his position between the worlds of state capitalism and free markets. He does not think of the world in traditional categories of north-south or east-west but rather as country clusters based on economic factors, supply-chain linkages, and historical bonds. These clusters intersect and overlap. For example, Austria belongs to a European manufacturing cluster that includes Germany and Italy, but it is also part of a central European clutch of former Austro-Hungarian Empire nations, including Hungary and Slovenia. As that group’s leader, Austria is a “gatekeeper” that gives the Austro-Hungarian group access to the European manufacturing cluster through a nexus of subcontracting, supply chains, and bank lending. These linkages might, for example, facilitate sales by a Slovenian auto parts manufacturer to Fiat in Italy. The Slovenian-Italian link runs through gatekeeper Austria.

This paradigm of clusters, overlaps, and gatekeepers results in unexpected alignments. Zhu places South America in a China–western hemisphere supply-chain cluster, a point also made by Riordan Roett, a leading scholar of Latin American economics. Zhu’s view is that U.S. economic hegemony stops at the Panama Canal, while most of South America is now properly regarded as a Chinese sphere of influence.

Zhu’s cluster paradigm is of more than academic interest because it is beginning to have a direct impact on IMF policy as it relates to surveillance of its 188 member countries. The paradigm provides a basis for the study of national policy “spillover” effects as labeled by the IMF. The IMF treats spillovers in the same way that bank risk managers talk about contagion—the rapid uncontrolled transmission of collapse from one market to another through a dense web of counterparty obligations and collateral pledges, in a blind stampede for liquidity in a financial panic. Spillovers happen within clusters when national economies are tightly linked, and between clusters when gatekeepers are in distress. Min Zhu is helping the IMF to develop a working risk-management model based on complexity, one that is far more advanced than those used by individual central banks or private financial institutions.

■ Updating Keynes

Zhu is showing traditional Keynesians how their model of policy action, in conjunction with an individual or corporate response, is obsolete. This two-part action-response model must be modified to place financial intermediation between the policy maker and the economic agent. This distinction is illustrated as follows:

Classic Keynesian Model

New IMF Model

While financial institutions in earlier decades had been predictable and passive players in policy transmission to individual economic actors, today’s financial intermediaries are more active and materially mute or amplify policy makers’ wishes. Private banks may use securitization, derivatives, and other forms of leverage to greatly increase the impact of policy easing, and they can tighten lending standards or migrate to safe assets like U.S. Treasury notes to diminish the impact. Banks are also the main transmission channels for spillover effects. Zhu makes the point that Keynesian analysis fails in part because it has not fully incorporated the role of banks into its functions.

Clustering, spillover, and financial transmission are the three theoretical legs supporting the platform from which the IMF surveys the international monetary system. New concepts of this kind can percolate in university economics departments for decades before they have practical effect. Despite a preponderance of Ph.D.’s in its ranks, the IMF is not a university. It is a powerful institution with the ability either to preserve or condemn regimes through its policy decisions on lending and the conditionality attached. Zhu’s paradigm offers a glimpse of the IMF’s plans: clustering implies that economic linkages are more important than sovereignty. Spillover effects mean top-down control is needed to contain risk. Financial transmission suggests that banks are the key nodes in the exercise of control. In a nutshell, the IMF seeks to control finance, to contain risk, and to condition economic development on a global basis.

This one-world mission requires assistance from the most talented and politically powerful players available. The IMF executive suite is an exquisitely balanced microcosm of the global economy. In addition to Min Zhu and managing director Christine Lagarde, the IMF top management includes David Lipton from the United States, Naoyuki Shinohara from Japan, and Nemat Shafik from Egypt. Group diversity is more than an exercise in multinationalism. Lagarde represents the European interest, Min Zhu the Chinese, Lipton the American, Shinohara the Japanese, and Shafik the developing economies. The top five managers at the IMF, seated around a conference table, effectively speak for the world.

David Lipton’s is the single most powerful voice, more powerful than Christine Lagarde’s, because the United States has a veto over all important actions by the IMF. This doesn’t mean Lipton doesn’t play for the team; on many issues the United States and the IMF see eye to eye—including the dollar’s eventual replacement as the global reserve currency. Lipton’s veto power means that changes will take place at a tempo dictated by any quid pro quo that the United States demands.

Lipton is one of numerous Robert Rubin protégés, who include Timothy Geithner, Jack Lew, Michael Froman, Larry Summers, and Gary Gensler. These men have for years controlled U.S. economic strategy in the international arena. Robert Rubin was Treasury secretary from 1995 to 1999, after having worked several years in the Clinton White House as National Economic Council director. Before joining the U.S. government, Rubin was Goldman Sachs co-chairman; he worked at Citigroup in the chairman’s office from 1999 to 2009, and he briefly served as Citigroup chairman at the start of the financial markets collapse in 2007. Lipton, Froman, Geithner, Summers, and Gensler all worked for Rubin at the U.S. Treasury in the late 1990s, Lew at the White House. Lipton, Lew, and Froman later followed Rubin to Citigroup, while Summers later worked as a Citigroup consultant.

After being vetted and groomed in midlevel positions in the 1990s, this bland bureaucratic team was carefully placed and promoted within the White House, Treasury, IMF, and elsewhere in the 2000s, to ensure Rubin’s web of influence and role as the de facto godfather of global finance. Geithner is the former Treasury secretary and former president of the Federal Reserve Bank of New York. Lew currently holds the Treasury secretary position. Froman was a powerful behind-the-scenes figure in the White House National Economic Council and National Security Council from 2009 through 2013 and then the U.S. trade representative. Larry Summers is a former Treasury secretary and chaired President Obama’s National Economic Council. During his White House years, Froman was the U.S. “sherpa” at G20 meetings, sometimes seen whispering in the president’s ear just as a key policy dispute was about to be ironed out with Chinese president Hu Jintao or another world leader. From 2009 through 2013, Gensler was chairman of the Commodity Futures Trading Commission, the agency that regulates Treasury bond and gold futures trading.

The members of the Rubin clique are extraordinary in the incompetence they displayed during their years in public and private service, and in the financial devastation they left in their wake. Rubin and his subordinate and successor, Larry Summers, promoted the two most financially destructive legislative changes in the past century: Glass-Steagall repeal in 1999, which allowed banks to operate like hedge funds; and derivatives regulation repeal in 2000, which opened the door to massive hidden leverage by banks. Geithner, while at the New York Fed from 2003 to 2008, was oblivious to the unsafe and unsound banking practices under his direct supervision, which led to the subprime mortgage collapse in 2007 and the Panic of 2008. Froman, Lipton, and Lew were all at Citigroup along with Rubin and contributed to catastrophic failures in risk management that led to the once-proud bank’s collapse and its takeover by the U.S. government in 2008, with over fifty thousand jobs lost at Citigroup alone. Gensler was instrumental in the 2002 passage of Sarbanes-Oxley legislation, which has done much to stifle capital formation and job creation in the years since. He was also on watch at the Commodity Futures Trading Commission in 2012 during the catastrophic collapse of MF Global, a bond and gold broker. Recently Gensler has shown better sense, calling for tougher derivatives regulation.

The lost wealth and personal hardship resulting from the Rubin clique’s policies are incalculable, yet their economic influence continues unabated. Today Rubin still minds the global store from his seat as co-chairman of the nonprofit Council on Foreign Relations. David Lipton, the Rubin protégé par excellence, with the lowest public profile of the group, is now powerfully placed in the IMF executive suite, at a critical juncture in the international financial system’s evolution.

The Rubin web of influence is not a conspiracy. True conspiracies rarely involve more than a few individuals because they continually run the risk of betrayal, disclosure, or blunders. A large group like the Rubin clique actually welcomes conspiracy claims because they are easy to rebut, allowing the insiders to get back to work in the quiet, quasi-anonymous way they prefer. The Rubin web is more a fuzzy network of like-minded individuals with a shared belief in the superiority of elite thought and with faith in their coterie’s capacity to act in the world’s best interests. They exercise global control not in the blunt, violent manner of Hitler, Stalin, or Mao but in the penumbra of institutions like the IMF, behind a veneer of bland names and benign mission statements. In fact, the IMF’s ability to topple a regime by withholding finance in a crisis is no less real than the power of Stalin’s KGB or Mao’s Red Guards.

The executive team at the IMF holds the view, more gimlet-eyed than any central bank’s, that the international monetary system is severely impaired. Because of massive money printing since 2008, a new collapse could emerge at any time, playing out not just with failures of financial institutions or sovereigns but with a loss of confidence in the U.S. dollar itself. Institutional memory reaches back to the dollar crash of October 1978, reversed only with Fed chairman Paul Volcker’s strong-dollar policies beginning in August 1979 and IMF issuance of its world money, the special drawing right or SDR, in stages from 1979 to 1981. The dollar gained strength in the decades that followed, but the IMF learned how fragile confidence in the dollar could be when U.S. policy was negligently managed.

Min Zhu sees these risks as well, even though he was a college student during the last dollar collapse. He knows that if the dollar collapses again, China has by far the most to lose, given its role as the world’s largest external holder of U.S.-dollar-denominated debt. Zhu believes the world is in a true depression, the worst since the 1930s. He is characteristically blunt about the reasons for it; he says the problems in developed economies are not cyclical—they are structural.

Economists publicly disagree about whether the current economic malaise is cyclical or structural. A cyclical downturn is viewed as temporary, a phase that can be remedied with stimulus spending of the classic Keynesian kind. A structural downturn, by contrast, is embedded and lasts indefinitely unless adjustments in key factors—such as labor costs, labor mobility, taxes, regulatory burdens, and other public policies—are made. In the United States, the Federal Reserve and Congress have acted as if the U.S. output gap, the difference between potential and actual growth, is temporary and cyclical. This reasoning suits most policy makers and politicians because it avoids the need to make hard decisions about public policy.

Zhu cuts through this myopia. “Central bankers like to say the problem is mostly cyclical and partly structural,” he recently said. “I say to them it’s mostly structural and partly cyclical. But actually, it’s structural.” The implication is that a structural problem requires structural, not monetary, solutions.

The IMF is currently confronted with a full plate of contradictions. IMF economists such as José Viñals have warned repeatedly about excessive risk taking by banks, but the IMF has no regulatory authority over banks in its member countries. Anemic global growth gives rise to calls for stimulus-style policies, but stimulus will not work in the face of structural impediments to growth. Any stimulus effort requires more government spending, but spending involves more debt at a time when sovereign debt crises are acute. Christine Lagarde calls for short-term stimulus combined with long-term fiscal consolidation. But markets do not trust politicians’ long-term commitments. There is scant appetite for benefit cuts, even by countries on the brink of collapse like Greece. Proposed solutions are all either politically infeasible or economically dubious.

Min Zhu’s new paradigm points the way out of this bind. His clustering and gatekeeper analysis suggests that policies should be global, not national, and his spillover analysis suggests that more direct global bank regulation is needed to contain crises. The specter of the sovereign debt crisis suggests the urgency for new liquidity sources, bigger than those that central banks can provide, the next time a liquidity crisis strikes. The logic leads quickly from one world, to one bank, to one currency for the planet. The combination of Christine Lagarde’s charismatic leadership, Min Zhu’s new paradigm, and David Lipton’s opaque power have positioned the IMF for its greatest role yet.

■ One Bank

The Federal Reserve’s status as a central bank has long been obvious, but in its origins, from 1909 to 1913, following the Panic of 1907, supporters went to great lengths to disguise the fact that the proposed institution was a central bank. The most conspicuous part of this exercise is the name itself, the Federal Reserve. It is not called the Bank of the United States of America, as the Bank of England and the Bank of Japan proclaim themselves. Nor does the name contain the key phrase “central bank” in the style of the European Central Bank.

The obfuscation was much by design. The American people had rejected central banks twice before. The original central bank, the Bank of the United States chartered by Congress in 1791, was closed in 1811 after its twenty-year charter expired. A Second Bank of the United States, also a central bank, existed from 1817 to 1836, but its charter was also allowed to expire in the midst of acrimonious debate between supporters and opponents. From 1836 to 1913, a period of great prosperity and invention, the United States had no central bank. Well aware of this history and the American people’s deep suspicion of central banks, the Federal Reserve’s architects, principally Senator Nelson Aldrich of Rhode Island, were careful to disguise their intentions by adopting an anodyne name.

Likewise, the IMF is best understood as a de facto central bank of the world, despite the fact that the phrase “central bank” does not appear in its name. The test of central bank status is not the name but the purpose. A central bank has three primary roles: it employs leverage, it makes loans, and it creates money. Its ability to perform these functions allows it to act as a lender of last resort in a crisis. Since 2008, the IMF has been doing all three in a rapidly expanding way.

A key difference between a central bank and ordinary banks is that a central bank performs these three functions for other banks, rather than for public customers such as individuals and corporations. Buried in the IMF’s Articles of Agreement, its 123-page governing document, is a provision that states, “Each member shall deal with the Fund only through its… central bank… or other similar fiscal agency, and the Fund shall deal only with or through the same agencies.” According to its charter, then, the IMF is to function as the world’s central bank, a fact carefully disguised by nomenclature and by the pose of IMF officials as mere international bureaucrats dispensing dispassionate technical assistance to nations in need.

The IMF’s central-bank-style lending role is the easiest to discern of its functions. It has been the IMF’s mission from its beginnings in the late 1940s and is one still trumpeted today. This function grew at a time when most major currencies had fixed exchange rates to the dollar and when countries had closed capital accounts. When trade deficits or capital flight arose, causing balance-of-payments problems, countries could not resort to a devaluation quick fix unless they could show the IMF that the problems were structural and persistent. In those cases, the IMF might approve devaluation. More typically, the IMF acted as a swing lender, providing liquidity to the deficit country for a time, typically three to five years, in order for that country to make policy changes necessary to improve its export competitiveness. The IMF functioned for national economies the way a credit card works for an individual who temporarily needs to borrow for expenses but plans to repay from a future paycheck.

Structural changes required by the IMF in exchange for the loan might include labor market reforms, fiscal discipline to reduce inflation, or lower unit labor costs, all aimed at making the country more competitive in world markets. Once the adjustments took hold, the deficits would then turn to surpluses, and the IMF loans would be repaid. However, that theory seldom worked smoothly in practice, and as trade deficits, budget deficits, and inflation persisted in certain member nations, devaluations were permitted. While devaluation can improve competitiveness, it can also impose large losses on investors in local markets, who relied on attractive exchange rates to the dollar to make their initial investments. On the other hand, if it so chooses, the IMF can make loans to help countries avoid devaluation and thereby protect investors such as JPMorgan Chase, Goldman Sachs, and their favored clients.

Today the IMF website touts loans to countries such as Yemen, Kosovo, and Jamaica as examples of its positive role in economic development. But such loans are window dressing, and the amounts are trivial compared to the IMF’s primary lending operation, which is to prop up the euro. As of May 2013, 45 percent of all IMF loans and commitments were extended to just four countries—Ireland, Portugal, Greece, and Cyprus—as part of the euro bailout. Another 46 percent of loans and commitments were extended to just two other countries: Mexico, whose stability is essential to the United States, and Poland, whose stability is essential to both NATO and the EU. Less than 10 percent of all IMF lending was to the neediest economies in Asia, Africa, or South America. Casual visitors to the IMF’s website should not be deceived by images of smiling dark-skinned women wearing native dress. The IMF functions as a rich nations’ club, lending to support those nations’ economic interests.

If the IMF’s central-bank-lending function is transparent, its deposit-taking function is more opaque. The IMF does not function like a retail commercial bank with teller windows, where individuals can walk up and make a deposit to a checking or savings account. Instead, it runs a highly sophisticated asset-liability management program, in which lending facilities are financed through a combination of “quotas” and “borrowing arrangements.” The quotas are similar to bank capital, and the borrowing arrangements are similar to the bonds and deposits that a normal bank uses to fund its lending. The IMF’s financial activities are mostly conducted off balance sheet as contingent lending and borrowing facilities. In this way, the IMF resembles a modern commercial bank such as JPMorgan Chase whose off-balance-sheet contingent liabilities dwarf those shown on the balance sheet.

To see the IMF’s true financial position, one must look beyond the balance sheet to the footnotes and other sources. IMF financial reports are stated in its own currency, the SDR, which is easily converted into dollars. The IMF computes and publishes the SDR-to-dollar exchange rate daily. In May 2013 the IMF had almost $600 billion of unused borrowing capacity, which, when combined with existing resources, gave the IMF $750 billion in lending capacity. If this borrowing and lending capacity were fully utilized, the IMF’s leverage ratio would only be about 3 to 1, if quotas were considered to be equity. This is extremely conservative compared to most major banks, whose leverage ratios are closer to 20 to 1 and are higher still when hidden off-balance-sheet items are considered.

The interesting aspect of IMF leverage is not that it is high today but that it exists at all. The IMF operated for decades with almost no leverage; advances were made from members’ quotas. The idea was that members would contribute their quotas to a pool, and individual members could draw from the pool for temporary relief as needed. As long as total borrowings did not exceed the total quota pool, the system was stable and did not need leverage. This is no longer the case. As corporations and individuals deleveraged after the Panic of 2008, sovereign governments, central banks, and the IMF have employed leverage to keep the global monetary system afloat. In effect, public debt has replaced private debt.

The overall debt burden has not been reduced—it has increased, as the global debt problem has been moved upstairs. The IMF is the penthouse, where the problem can be passed no higher. So far the IMF has been able to facilitate the official leveraging process as an offset to private deleveraging. Public leverage has mostly occurred at the level of national central banks such as the Federal Reserve and the Bank of Japan. But as those central banks reach practical and political limits on their leverage, the IMF will emerge as the last lender of last resort. In the next global liquidity crisis, the IMF will have the only clean balance sheet in the world because national central bank balance sheets are overleveraged with long-duration assets.

The biggest single boost to the IMF’s borrowing and leverage capacity came on April 2, 2009, very near the depths of the stock market crashes that began in 2008, a time of pervasive fear in financial markets. The occasion was the G20 Leaders’ Summit in London, hosted by the U.K. prime minister Gordon Brown and attended by U.S. president Obama, French president Sarkozy, German chancellor Merkel, China’s Hu Jintao, and other world leaders. The summit pledged to expand the IMF’s lending capacity to $750 billion. For every dollar the IMF lends, it must first obtain a dollar from its members; so expanded lending capacity implied expanded borrowing and greater leverage. It took the IMF over a year to obtain most of the needed commitments, although for a panoply of political reasons, the full amount has not yet been subscribed.

The largest IMF commitments came from the European Union and Japan, each committing $100 billion, and China, which committed another $50 billion. Other large commitments of $10 billion each came from the other BRIC nations, Russia, India, and Brazil, and from the developed nations of Canada, Switzerland, and Korea.

The most contentious commitment to the IMF’s new borrowing facility involved the United States. On April 16, 2009, just days after the G20 summit, President Obama sent letters to the congressional leadership requesting its support for a $100 billion commitment to the new IMF borrowings. The president, guided by Rubin protégé Mike Froman, had made a verbal pledge of the $100 billion at the summit, but he needed legislation to deliver on the actual funding. The letters to Congress stated that the new funding was a package deal intended to increase IMF votes for China and to force gold sales by the IMF. President Obama’s letters also called for “a special one-time allocation of Special Drawing Rights, reserve assets created by the IMF… that will increase global liquidity.” The president’s letters were refreshingly candid on the IMF’s ability to print world money.

China wanted additional votes at the IMF, and it wanted more gold dumped on the market to avoid a run-up in the price at a time when it was acquiring gold covertly. The United States wanted the IMF to print more world money. The IMF wanted hard currency from the United States and China to conduct bailouts. The deal, which had something for everyone, had been carefully structured by Mike Froman and other sherpas at the summit and signed on by Geithner, Obama, and the G20 leaders.

Looking a bit deeper, the Obama letter to Congress contained another twist. The new commitments to the IMF came not as quotas but as loans, consistent with the IMF’s growing role as a leveraged bank. The president sought to reassure Congress that the loan to the IMF was not an expenditure and therefore would have no impact on the U.S. budget deficit. The president’s letter said, “That is because when the United States transfers dollars to the IMF… the United States receives in exchange… a liquid, interest-bearing claim on the IMF, which is backed by the IMF’s strong financial position, including… gold.” This statement is entirely true. The IMF does have a strong financial position, and it has the third-largest gold hoard in the world after the United States and Germany. It was curious that just as Federal Reserve officials were publicly disparaging gold’s role in the monetary system, the president felt the need to mention gold to the Congress as a confidence booster. Despite disparagement of gold by academics and central bankers, gold has never fully lost its place as the bedrock of global finance.

Drilling still further down, we find a curious feature of the IMF loan proposal. If the United States gave the IMF $100 billion in cash, it would receive an interest-bearing note from the IMF in exchange. However, the note would be denominated not in dollars but in SDRs. Since the SDR is a nondollar world currency, its value fluctuates against the U.S. dollar. The SDR exchange value is calculated partly by reference to the dollar, but also by reference to a currency basket that includes the Japanese yen, the euro, and the U.K. pound sterling. This means that when the IMF note matures, the United States will receive back not the original $100 billion but a different amount depending on the fluctuation of the dollar against the SDR. If the dollar were to grow stronger against the other currencies in the SDR basket, the United States would receive less than the original $100 billion loan in repayment, because the nondollar basket components would be worth less. But if the dollar were to grow weaker against the other currencies in the SDR basket, the United States would receive more than the original $100 billion loan in repayment, because the nondollar basket components would be worth more. In making the loan, the U.S. Treasury was betting against the dollar since only a decline in the dollar would enable the United States to get its money back. This $100 billion bet against the dollar was not mentioned in the president’s letter and went largely unrecognized by Congress at the time. As it happens, it proved a political time bomb that came back to haunt the United States and the IMF ahead of the 2012 presidential election.

The president’s letters also misled Congress about the loan commitment’s purpose. They state in several places that the loan proceeds would be used by the IMF for assistance “primarily to developing and emerging market countries.” In fact, the IMF’s new borrowing capacity was used primarily to bail out the Eurozone members Ireland, Portugal, Greece, and Cyprus. Little of the cash was used for emerging markets lending. The misleading language was intended to dodge criticism from Congress that U.S. taxpayer money would be used to bail out Greek bureaucrats who retired at age fifty with lifetime pensions, while Americans were working past seventy to make ends meet.

These deceptions and the Treasury’s bet against the dollar went unnoticed in the frenzy of auto company bailouts and stimulus packages. Under the leadership of House Democrat Barney Frank and Senate Republican Richard Lugar, the U.S. commitment to the IMF borrowings was buried in a war spending bill and was passed by Congress on June 16, 2009. The IMF issued a press release with remarks by then managing director Dominique Strauss-Kahn touting the legislation and describing it as a “significant step forward.”

While the legislation provided for the $100 billion U.S. commitment, the IMF did not actually borrow the funds right away. The commitment was like a credit line on a MasterCard that the cardholder has not yet used. The IMF could swipe the MasterCard at any time and get the $100 billion from the United States simply by issuing a borrowing notice.

In November 2010 the Obama plan to finance IMF bailouts had the rug pulled out from under it by the midterm elections and the Republican takeover of the House of Representatives. Republican success was fueled by Tea Party resentment at earlier bailouts for Wall Street banks Goldman Sachs and JPMorgan Chase. Barney Frank lost his House Financial Services Committee chairmanship, and the new Republican leadership began examining the implications of the U.S. commitment to the IMF.

By early 2011, the European sovereign debt crisis had reached a critical state, and it was impossible to disguise the fact that U.S. funds, if drawn by the IMF, would be used to bail out retired Greek and Portuguese bureaucrats. Conservative publications featured headlines like “Why Is the U.S. Bankrolling IMF’s Bailouts in Europe?” On November 28, 2011, Barney Frank announced his retirement. Also in 2011 Senator Jim DeMint (R-S.C.) introduced legislation to rescind the U.S. commitment to the IMF. The DeMint bill was defeated in the Senate on a 55–45 vote. That defeat needed votes from Republicans, which were provided by Richard Lugar (R-Ind.) and a few others. On May 8, 2012, the Tea Party struck back by supporting Richard Mourdock, who went on to defeat Lugar in a primary election, forcing Lugar’s retirement after thirty-six years as a senator. One by one the IMF’s friends in the U.S. Congress were stepping aside or being forced out. With regard to the Frank and Lugar departures from Congress, the IMF’s Lagarde gave a Gallic shrug and said, “We will miss them.”

By late 2013, the sparring match between the White House and Congress over funding for the IMF had grown more intense. After the London G20 Summit, the IMF had taken further steps to increase its borrowing power beyond the original commitments, shifting some of the U.S. lending commitment away from debt toward a quota increase—in effect, it moved part of the U.S. money from temporary lending to permanent capital. These 2010 changes, which also followed through on the London Summit commitments to increase the voting power of China, required congressional approval beyond that contained in the 2009 Barney Frank legislation. Hundreds of eminent international economists, and prominent former officials such as Treasury secretary Hank Paulson, who had engineered the Goldman Sachs bailout in 2008, publicly called on Congress to approve the legislation. However, President Obama did not include the new requests in his 2012 or 2013 budgets, in order to avoid making a campaign issue out of U.S. taxpayer support for European bailouts.

At this point Christine Lagarde’s impatience with the process began to boil over. During the World Economic Forum in Davos on January 28, 2012, she hoisted her Louis Vuitton handbag in the air and said, “I am here with my little bag, to actually collect a bit of money.” In an interview with The Washington Post published on June 29, 2013, she was more pointed and said, “We have been able to significantly increase our resources… notwithstanding the fact that the U.S. did not contribute or support that move…. I think everybody would like to complete the process. Let’s face it. It has been around a long time.”

Fortunately for the IMF, the controversial U.S. funds commitment was not needed in the short run. By late 2012, the European sovereign debt crisis had stabilized, as growth continued in the United States and China, albeit at a slower rate than hoped for by the IMF. But after the history of debt crises in Dubai, Greece, Cyprus, and elsewhere from 2009 to 2013, it appeared to be just a matter of time before the situation somewhere destabilized and the U.S. commitment would be needed to finance another rescue package.

The IMF’s role as a leveraged lender, in effect a bank, is now institutionalized. The IMF has evolved from a quota-based swing lender to a leveraged lender of last resort like the Federal Reserve. Its borrowing and lending capabilities are well understood by economic experts, if not by the public at large. But even experts are largely unfamiliar with or confused by the IMF’s greatest power—the ability to create money. Indeed, the name of the IMF’s world money, the special drawing right, seems designed more to confuse than to enlighten. The IMF’s printing press is standing by, ready for use when needed in the next global liquidity crisis. It will be a key tool in engineering the dollar’s demise.

■ One Currency

John Maynard Keynes once mused that not one man in a million was able to understand the process by which inflation destroys wealth. It is as likely that not one woman or man in ten million understands special drawing rights, or SDRs. Still, the SDR is poised to be an inflationary precursor par excellence. The SDR’s mix of opacity and unaccountability permits global monetary elites to solve sovereign debt problems using an inflationary medium, which in turn allows individual governments to deny political responsibility.

The SDR’s stealth qualities begin with its name. Like Federal Reserve and International Monetary Fund, the name was chosen to hide its true purpose. Just as the Federal Reserve and IMF are central banks with disguised names, so the SDR is world money in disguise.

Some monetary scholars, notably Barry Eichengreen of the University of California at Berkeley, object to the use of the term money as applied to SDRs, viewing the units as a mere accounting device used to shift reserves among members. But the IMF’s own financial reports refute this view. Its annual report contains the following disclosures:

As money is classically defined as having three essential qualities—store of value, unit of account, and medium of exchange—this disclosure clinches the case for the SDR as money. The IMF itself says the SDR has value, is a unit of account, and can be used as a medium of exchange in transactions among designated holders. The three-part money definition is satisfied in full.

The amount of SDRs in circulation is minuscule compared to national and regional currencies such as the dollar and euro. The SDR’s use is limited to IMF members and certain other official institutions and is controlled by the IMF Special Drawing Rights Department. Further, SDRs will perhaps never be issued in banknote form and may never be used on an everyday basis by citizens around the world. But even such limited usage does not alter the fact that the SDR is world money controlled by elites. In fact, it enhances that role by making the SDR invisible to citizens.

The SDR can be issued in abundance to IMF members and can also be used in the future for a select list of the most important transactions in the world, including balance-of-payments settlements, oil pricing, and the financial accounts of the world’s largest corporations such as ExxonMobil, Toyota, and Royal Dutch Shell. Any inflation caused by massive SDR issuance would not immediately be apparent to citizens. The inflation would show up eventually in dollars, yen, and euros at the gas pump or the grocery, but national central banks could deny responsibility with ease and point a finger at the IMF. Since the IMF is not accountable to any electoral process and is a self-perpetuating supranational organization, the buck would stop nowhere.

The SDR’s history is as colorful as its expected future. It was not part of the original Bretton Woods monetary architecture agreed to in 1944. It was an emergency response to a dollar crisis that began in 1969 and continued in stages through 1981.

During the Bretton Woods system’s early decades, from 1945 to 1965, international monetary experts worried about a so-called dollar shortage. At that time the dollar was the dominant global reserve currency, essential to international trade. Europe’s and Japan’s industrial bases had been devastated during the Second World War. Both Europe and Japan had human capital, but neither possessed the dollars or gold needed to pay for the machinery and raw materials that could revive their manufacturing. The dollar shortage was partly alleviated by Marshall Plan aid and Korean War spending, but the greatest boost came from the U.S. consumer’s newfound appetite for high-quality, inexpensive imported goods. American baby boomers, as teenagers in the 1960s, may recall driving to the beach in a Volkswagen Beetle with a Toshiba transistor radio in hand. By 1965, competitive export nations such as Germany and Japan were rapidly acquiring the two principal reserve assets at the time, dollars and gold. The United States understood that it needed to run substantial trade deficits to supply dollars to the rest of the world and facilitate world trade.

The international monetary system soon fell victim to its own success. The dollar shortage was replaced with a dollar glut, and trading partners became uneasy with persistent U.S. trade deficits and potential inflation. This situation was an illustration of Triffin’s dilemma, named after Belgian economist Robert Triffin, who first described it in the early 1960s. Triffin pointed out that when one nation issues the global reserve currency, it must run persistent trade deficits to supply that currency to its trading partners; but if the deficits persist too long, confidence in the currency will eventually be lost.

Paradoxically, both a dollar shortage and a dollar glut give rise to consideration of alternative reserve assets. In the case of a dollar shortage, a new asset is sought to provide liquidity. In the case of a dollar glut, a new asset is sought to provide substitutes for investing reserves and to restore confidence. Either way, the IMF has long been involved in the contemplation of alternatives to the dollar.

By the late 1960s, confidence in the dollar was collapsing due to a combination of U.S. trade deficits, budget deficits, and inflation brought on by President Lyndon Johnson’s “guns and butter” policies. U.S trading partners, notably France and Switzerland, began dumping dollars for gold. A full-scale run on Fort Knox commenced, and the U.S. gold hoard was dwindling at an alarming rate, leading to President Nixon’s decision to end the dollar’s gold convertibility, on August 15, 1971.

As caretaker of the international monetary system, the IMF confronted collapsing confidence in the dollar and a perceived gold shortage. The U.K. pound sterling had already devalued in 1967 and was suffering its own crisis of confidence. German marks were considered attractive, but German capital markets were far too small to provide global reserve assets in sufficient quantities. The dollar was weak, gold was scarce, and no alternative assets were available. The IMF feared that global liquidity could evaporate, triggering a collapse of world trade and a depression, as had happened in the 1930s. In this strained environment, the IMF decided in 1969 to create a new global reserve asset, the SDR, from thin air.

From the start, the SDR was world fiat money. Kenneth W. Dam, a leading monetary scholar and former senior U.S. government official who served in the Treasury, the White House, and Department of Defense, explains in his definitive history of the IMF:

Initially the SDR was valued as equivalent to 0.888671 grams of fine gold, but this IMF gold standard was abandoned in 1973 not long after the United States itself abandoned the gold standard with respect to the dollar. Since 1973, the SDR’s value has been computed with reference to a reserve-currency basket. This does not mean that the SDR is backed by hard currencies, as Dam points out, merely that its value in transactions and accounting is calculated in that manner. Today the basket consists of dollars, euros, yen, and pounds sterling in specified weights.

SDRs have been issued to IMF members on four occasions since their creation. The first issue was for 9.3 billion SDRs, handed out in stages from 1970 to 1972. The second issue was for 12.1 billion SDRs, also done in stages from 1979 to 1981. There was no SDR issuance for almost thirty years, from 1981 to 2009. This was the King Dollar era engineered by Paul Volcker and Ronald Reagan, which continued through the Republican and Democratic administrations of George Bush, Bill Clinton, and George W. Bush. Then in 2009, in the wake of the financial crisis and in the depths of a new depression, the IMF issued 161.2 billion SDRs on August 28 and 21.5 billion SDRs on September 9. The cumulative SDR issuance since their creation is 204.1 billion, worth over $300 billion at the current dollar-SDR exchange rate.

The history makes it clear that there is a close correspondence between periods of SDR issuance and periods of collapsing confidence in the dollar. The best index of dollar strength or weakness is the Price-adjusted Broad Dollar Index, calculated and published by the Federal Reserve. The Fed’s dollar index series begins in January 1973 and is based on a par value expressed as 100.00 on the index. The first SDRs issued in 1970 to 1972 predate this index but were linked to the dollar’s 20 percent collapse against gold at the time.

The second SDR issuance, from 1979 to 1981, immediately followed a dollar breakdown from a Fed index level of 94.2780 in March 1977 to 84.1326 in October 1978—an 11 percent decline in nineteen months. After the issuance, the dollar recovered its standing, and the index hit 103.2159 in March 1982. This was the beginning of the King Dollar period.

The third and fourth SDR issuances began in August 2009, not long after the dollar crashed to an index level of 84.1730 in April 2008, near its level in the crisis of 1978. The lags of approximately a year between index lows and SDR issuance are a reflection of the time it takes the IMF to obtain board approval to proceed with new issuance.

Unlike the issuance in the 1980s King Dollar period, the massive 2009 issuance did not result in the dollar regaining its strength. In fact, the dollar index reached an all-time low of 80.5178 in July 2011, just before gold hit an all-time high of $1,895.00 on September 5. The difference in 2011 compared to 1982 was that the Fed and Treasury were pursuing a weak-dollar policy, in contrast to Paul Volcker’s strong-dollar policy. Nevertheless, the 2009 SDR issuance served its purpose, reliquefying global financial markets after the Panic of 2008. Markets regained their footing by late 2012 with the stabilization of the European sovereign debt crisis after Mario Draghi’s “whatever it takes” pledge on the ECB’s behalf. By 2012, global liquidity was restored, and SDRs were once again placed on the shelf, awaiting the next global liquidity crisis.

Although the SDR is a useful tool for emergency liquidity creation, thus far the dollar retains its status as the world’s leading reserve currency. Performing a reserve-currency role requires more than just being money; it requires a pool of investable assets, primarily a deep, liquid bond market. Any currency can be used in international trade if the trading partners are willing to accept it as a medium of exchange. But a problem arises after one trading partner has acquired large trade currency balances. That party needs to invest the balances in liquid assets that pay market returns and preserve value. When the balances are large—for example, China’s $3 trillion in reserves—the investable asset pool must be correspondingly large. Today U.S.-dollar-denominated government bond markets are the only markets in the world large and diversified enough to absorb the investment flows coming from surplus nations such as China, Korea, and Taiwan. The SDR market is microscopic in comparison.

Still, the IMF makes no secret of its ambitions to transform the SDR into a reserve currency that could replace the dollar. This was revealed in an IMF study released in January 2011, consisting of a multiyear, multistep plan to position the SDR as the leading global reserve asset. The study recommends increasing the SDR supply to make them liquid and more attractive to potential private-sector market participants such as Goldman Sachs and Citigroup. Importantly, the study recognizes the need for natural sellers of SDR-denominated bonds such as Volkswagen and IBM. Sovereign wealth funds are recommended as the most likely SDR bond buyers for currency diversification reasons. The IMF study recommends that the SDR bond market replicate the infrastructure of the U.S. Treasury market, with hedging, financing, settlement, and clearance mechanisms substantially similar to those used to support trading in Treasury securities today.

Beyond the SDR bond market creation, the IMF blueprint goes on to suggest that the IMF could change the SDR basket composition to reduce the weight given to the U.S. dollar and increase the weights of other currencies such as the Chinese yuan. This is a stealth mechanism to enhance the yuan’s role as a reserve currency long before China itself has created a yuan bond market or opened its capital account. If the SDR market becomes liquid, and the yuan is included in the SDR, bank dealers will discover ways to arbitrage one currency against the other and thereby increase the yuan’s use and attractiveness. With regard to a future SDR bond market, the IMF study candidly concludes, “If there were political willingness to do so, these securities could constitute an embryo of global currency.” This conclusion is highly significant because it is the first time the IMF has publicly moved beyond the idea of the SDR as a liquidity supplement and presented it as a leading form of world money.

Indeed, the IMF’s distribution of SDRs is not limited to IMF members. Article XVII of the IMF’s governing Articles of Agreement permits SDR issuance to “non-members… and other official entities,” including the United Nations and the Bank for International Settlements (BIS), in Basel, Switzerland. The BIS is notorious for facilitating Nazi gold swaps while being run by an American, Thomas McKittrick, during the Second World War, and is commonly known as the central bank for central banks. The IMF can issue SDRs to the BIS today to finance its ongoing gold market manipulations. Under Article XVII authority, the IMF could also issue SDRs to the United Nations, which could put them to use for population control or climate change regimes.

An expanded role for SDRs awaits further developments that may take years to evolve. While the SDR is not ready to replace the dollar as the leading reserve currency, it is moving slowly in that direction. Still, the SDR’s rapid-response role as a liquidity source in a financial panic is well practiced. The 2009 SDR issuance can be viewed as “test drive” prior to a much larger issuance in a future liquidity crisis.

SDRs granted to an IMF member are not always immediately useful, because that member may need to pay debts in dollars or euros. However, SDRs can be swapped for dollars with other members who do not mind receiving them. The IMF has an internal SDR Department that facilitates these swaps. For example, if Austria has obligations in Swiss francs and receives an SDR allocation, Austria can arrange to swap SDRs for dollars with China. Austria then sells the dollars for Swiss francs and uses the francs to meet its obligations. China will gladly take SDRs for dollars as a way to diversify its reserves out of dollars. In actual swaps, China had acquired the equivalent of $1.24 billion in SDRs above its formal allocations by April 30, 2012. IMF deputy managing director Min Zhu cryptically summarized the SDR’s liquidity role when he stated, “They are fake money, but they are a kind of fake money that can be real money.”

The IMF is transparent when it comes to the purpose of SDR issuance. The entire Bretton Woods architecture, which gave rise to the IMF, was a reaction to the 1930s Depression and deflation. The IMF Articles of Agreement address this issue explicitly:

Deflation is every central bank’s nemesis because it is difficult to reverse, impossible to tax, and makes sovereign debt unpayable by increasing the real value of debt. By explicitly acknowledging its mission to prevent deflation, the IMF’s actions are consistent with the aims of other central banks.

With its diverse leadership, leveraged balance sheet, and the SDR, the IMF is poised to realize its one-world, one-bank, one-currency vision and exercise its intended role as Central Bank of the World. The next global liquidity crisis will shake the stability of the international monetary system to its core; it may also be the catalyst for the realization of the IMF’s vision. The SDR is the preferred pretender to the dollar’s throne.

■ Gold Realities, Gold Myths

Thoughtful discussion of gold is as rare as the metal itself. The topic seems too infused with emotion to admit of much rational discourse. On the one hand, opponents of a role for gold in the international monetary system are as likely to resort to ad hominem attacks as to economic analysis in their efforts to ridicule and marginalize the topic. A 2013 column by a well-known economist used the words paranoid, fear-based, far-right fringe, and fanatics to describe gold investors, while flitting through a shopworn list of supposed objections that do not hold up to serious scrutiny.

On the other hand, many so-called gold bugs are no more nuanced, with their charges that the vaults in Fort Knox are empty, the gold having been long ago shipped to bullion banks like JPMorgan Chase and replaced with tungsten-filled look-alikes. This fraud is alleged to be part of a massive, multidecade price suppression scheme to deprive gold investors of the profits of their prescience and to deny gold its proper place in the monetary cosmos.

Legitimate concerns about gold’s use in conjunction with discretionary monetary policy do exist, of course, and there’s evidence of government intervention in gold markets. Both argue for an examination of the issue that sorts fact from fantasy. Understanding gold’s real role in the monetary system requires reliance on history, not histrionics; analysis should be based on demonstrable data and reasonable inference rather than accusation and speculation. When a refined view is taken on the subject of gold, the truth turns out to be more interesting than either the gold haters or the gold bugs might lead one to believe.

Lord Nathan Rothschild, bullion broker to the Bank of England and head of the legendary London bank N. M. Rothschild & Sons, is said to have remarked, “I only know of two men who really understand the value of gold—an obscure clerk in the basement vault of the Banque de Paris and one of the directors of the Bank of England. Unfortunately, they disagree.” This comment captures the paucity of well-founded views and the opacity that infuses discussion of gold.

At the most basic level, gold is an element, atomic number 79, found in ore, sometimes nuggets, in scarce quantities, in or on the earth’s crust. The fact that gold is an element is important because that means pure gold is of uniform grade and quality at all times and in all places. Many commodities such as oil, corn, or wheat come in various grades with greater or lesser impurities, which are reflected in the price. Leaving aside alloys and unrefined products, pure gold is the same everywhere.

Because of its purity, uniformity, scarcity, and malleability, gold is money nonpareil. Gold has been money for at least four thousand years, perhaps much longer. Genesis describes the Patriarch Abraham as “very rich in livestock, gold and silver.” King Croesus minted the first gold coins in Lydia, modern-day Turkey, in the sixth century B.C. The 1792 U.S. Coinage Act, passed just three years after the U.S. Constitution went into effect, authorized the newly established Mint to produce pure gold coins called eagles, half eagles, and quarter eagles. Gold’s long history does not mean that it must be used as money today. It does mean that anyone who rejects gold as money must feel possessed of greater wisdom than the Bible, antiquity, and the Founding Fathers combined.

To understand gold, it is useful to know what gold is not.

Gold is not a derivative. A gold exchange-traded fund listed on the New York Stock Exchange is not gold. A gold futures contract traded on the CME Group’s COMEX is not gold. A forward contract offered by a London Bullion Market Association bank is not gold. These financial instruments, and many others, are contracts that offer price exposure to gold and are part of a system that has physical gold associated with it, but they are contracts, not gold.

Contracts based on gold have many risks that are not intrinsic to gold itself, starting with the possibility that counterparties may default on their obligations. Exchanges where the gold contracts are listed may be closed as a result of panics, wars, acts of terror, storms, and other acts of God. Hurricane Sandy in 2012 and the 9/11 attack on the World Trade Center are two recent cases in which the New York Stock Exchange closed. Exchange rules may also be abruptly changed, as happened on the COMEX in 1980 during the Hunt brothers’ attempted silver market corner. Banks may claim force majeure to terminate contacts and settle in cash rather than bullion. In addition, governments may use executive orders to abrogate outstanding contracts. Power outages and Internet backbone collapses may result in an inability to close out or settle exchange-traded contracts. Changes in exchange-margin requirements may prompt forced liquidations that cascade into panic selling. None of these occurrences affects the physical gold bullion holder.

Outright physical gold ownership, without pledges or liens, stored outside the banking system, is the only form of gold that is true money, since every other form is a mere conditional claim on gold.

Gold is not a commodity. The reason is that it is not consumed or converted to anything else; it is just gold. It is traded on commodity exchanges and is thought of as a commodity by many market participants, but it is distinct. Economists as diverse as Adam Smith and Karl Marx defined commodities generally as undifferentiated goods produced to satisfy various needs or wants. Oil, wheat, corn, aluminum, copper, and countless other true commodities satisfy this definition. Commodities are consumed as food or energy, or else they serve as inputs to other goods that are demanded for consumption. In contrast, gold has almost no industrial uses and is not food or energy in any form. It is true that gold is desired by almost all of mankind, but it is desired as money in its store-of-value role, not for any other purpose. Even jewelry is not a consumption item, although it is accounted as such, because gold jewelry is ornamental wealth, a form of money that can be worn.

Gold is not an investment. An investment involves converting money into an instrument that entails both risk and return. True money, such as gold, has no return because it has no risk. The easiest way to understand this idea is to remove a dollar bill from a wallet or purse and look at it. The dollar bill has no return. In order to get a return, one must convert the money to an investment and take a risk. An investor who takes her dollar bills to the bank and deposits them can earn a return, but it is not a return on money; it is a return on a bank deposit. Bank deposit risks may be quite low, but they are not zero. There is maturity risk if the deposit is for a fixed term. There is credit risk if the bank fails. Bank deposit insurance may mitigate bank failure risk, but there is a chance the insurance fund will become insolvent. Those who believe that bank deposit risk is a thing of the past should consider the case of Cyprus in March 2013, when certain bank deposits were forcibly converted into bank stock after an earlier scheme to confiscate the deposits by taxation was rejected. This conversion of deposits to equity in order to bail out insolvent banks was looked upon favorably in Europe and the United States as a template for future bank crisis management.

There are innumerable ways to earn a return by taking risk. Stocks, bonds, real estate, hedge funds, and many other types of pooled vehicles are all investments that include both risk and return. An entire branch of economic science, particularly options pricing theory, was based on the flawed assumption that a short-term Treasury bill is a “risk-free” investment. In fact, recent U.S. credit downgrades below the AAA level, a rising U.S. debt-to-GDP ratio, and continuing congressional dysfunction about debt-ceiling legislation have all shown the “risk-free” label to be a myth.

Gold involves none of the risks inherent in these investments. It has no maturity risk since there is no future date when gold will mature into gold; it is gold in the first place. Gold has no counterparty risk because it is an asset to the holder, but it is not anyone else’s liability. No one “issues” gold the way a note is issued; it is just gold. Once gold is in your possession, it has no risks related to clearance or settlement. Banks may fail, exchanges may close, and the peace may be lost, but these events have no impact on the intrinsic value of gold. This is why gold is the true risk-free asset.

Confusion about the role of gold arises because it usually treated as an investment and is reported as such in financial media. Not a day goes by without a financial reporter informing her audience that gold is “up” or “down” on the day, and in terms of gold’s dollar price per ounce, this is literally true. But is gold fluctuating, or is it the dollar? On a day that gold is reported to be “up” 3.3 percent, from $1,500 per ounce to $1,550 per ounce, it would be just as accurate to treat gold as a constant and report that the dollar is “down” from 1/1,500th of an ounce of gold to 1/1,550th of an ounce. In other words, one dollar buys you less gold, so the dollar is down. This highlights the role of the numeraire, or the unit of account, which is part of the standard definition of money. If gold is the numeraire, then it is more accurate to think of dollars or other currencies as the fluctuating assets, not gold.

This numeraire question can also be illustrated by the following example involving currencies. Assume that on a given trading day, gold’s dollar price moves from $1,500 per ounce to $1,495 per ounce, a 0.3 percent decline, and on the same day the yen exchange rate to one dollar moves from 100 yen to 101 yen. Converting dollars to yen, it is seen that gold’s price in yen moved from ¥150,000 ($1,500 X 100) to ¥150,995 ($1,495 X 101), a 0.6 percent increase. On the same trading day, gold was down 0.3 percent in dollars but up 0.6 percent in yen. Did gold go up or down? If one views the dollar as the only form of money in the world, then gold declined, but if one views gold as the numeraire, or monetary standard, then it is more accurate to say that gold was constant, that the dollar rose against gold and the yen fell against gold. This unified statement resolves the contradiction of whether gold went up or down. It did neither; instead, the currencies fluctuated. This also illustrates the fact that gold’s value is intrinsic and not a mere function of global currency values. It is the currencies that are volatile and that lack intrinsic value.

If gold is not a derivative, a commodity, or an investment, then what is it? Legendary banker J. P. Morgan said it best: “Money is gold, and nothing else.”

While money was gold for J. P. Morgan—and everybody else—for four thousand years, money suddenly ceased to be gold in 1974, at least according to the IMF. President Nixon ended U.S. dollar convertibility into gold by foreign central banks in 1971, but it was not until 1974 that an IMF special reform committee, at the insistence of the United States, officially recommended gold’s demonetization and the SDR’s elevation in the workings of the international monetary system. From 1975 to 1980, the United States worked strenuously to diminish gold’s monetary role, conducting massive gold auctions from official U.S. stocks. As late as 1979, the United States dumped 412 tonnes of gold on the market in an effort to suppress the price and deemphasize gold’s importance. These efforts ultimately failed. Gold’s market price briefly spiked to $800 per ounce in January 1980. There have been no significant official U.S. gold sales since then.

The demotion of gold as a monetary asset by the United States and the IMF in the late 1970s means that the economics curricula of leading universities have not seriously studied gold for almost two generations. Gold might be taught in certain history classes, and there are many gold experts who are self-taught, but any economist born since 1952 almost certainly has no formal training in the monetary uses of gold. The result has been an accretion of myths about gold in place of serious analysis.

The first myth is that gold cannot form the basis of a modern monetary system because there’s not enough gold to support the requirements of world trade and finance. This myth is transparently false, but it is cited so often that its falsity merits rebuttal.

The total gold supply in the world today, exclusive of reserves in the ground, is approximately 163,000 tonnes. The portion of that gold held by official institutions, such as central banks, national treasuries, and the IMF, is 31,868.8 tonnes. Using a $1,500-per-ounce price, the official gold in the world has a $1.7 trillion market value. This value is far smaller than the total money supply of the major trading and financial powers in the world. For example, U.S. money supply alone, using the M1 measure provided by the U.S. Federal Reserve, was $2.5 trillion at the end of June 2013. The broader Fed M2 money supply was $10.6 trillion at the same period. Combining this with money supplies of the ECB, the Bank of Japan, and the People’s Bank of China pushes global money supply for the big four economic zones to $20 trillion for M1 and $48 trillion for M2. If global money supply were limited to $1.7 trillion of gold instead of $48 trillion of M2 paper money, the result would be disastrously deflationary and lead to a severe depression.

The problem in this scenario is not the amount of gold but the price. There is ample gold at the right price. If gold were $17,500 per ounce, the official gold supply would roughly equal the M1 money supply of the Eurozone, Japan, China, and the United States combined. The point is not to predict the price of gold or to anticipate a gold standard but merely to illustrate that the quantity of gold is never an impediment to a gold standard as long as the price is appropriate to the targeted money supply.

The second myth is that gold cannot be used in a monetary system because gold caused the Great Depression of the 1930s and contributed to its length and severity. This myth is half true, but in that half-truth lies much confusion. The Great Depression, conventionally dated from 1929 to 1940, was preceded by the adoption of the “gold exchange standard,” which emerged in stages from 1922 to 1925 and functioned with great difficulty until 1939. The gold exchange standard was agreed in principle at the Genoa Conference in 1922, but the precise steps toward implementation were left to the participating countries to work out in the years that followed.

As the name implies, the gold exchange standard was not a pure gold standard of the type that had existed from 1870 to 1914. It was a hybrid in which both gold and foreign exchange—principally U.S. dollars, U.K. pounds sterling, and French francs—could serve as reserves and be used for settlement of any balance of payments. After the First World War, citizens in most major economies no longer carried gold coins, as had been common prior to 1914.

In theory, a country’s foreign exchange reserves were redeemable into gold when a holder presented them to the issuing country. Citizens were also free to own gold. But international redemptions were meant to be infrequent, and physical gold possession by citizens was limited to large bars, which are generally unsuitable for day-to-day transactions. The idea was to create a gold standard but have as little gold in circulation as possible. The gold that was available was to remain principally in vaults at the Federal Reserve Bank of New York, the Bank of England, and the Banque de France, while citizens grew accustomed to using paper notes instead of gold coins, and central bankers learned to accept their trading partners’ notes instead of demanding bullion. The gold exchange standard was, at best, a pale imitation of a true gold standard and, at worst, a massive fraud.

Most important, nations had to choose a conversion rate between their currencies and gold, then stick to that rate as the new system evolved. In view of the vast paper money supply increases that had occurred during the First World War, from 1914 to 1918, most participating nations chose a value for their currencies that was far below the prewar rates. In effect, they devalued their currencies against gold and returned to a gold standard at the new, lower exchange rate. France, Belgium, Italy, and other members of what later became known as the Gold Bloc pursued this policy. The United States had entered the war later than the European powers, and its economy was less affected by the war. The United States also received large gold inflows during the war, and as a result, it had no difficulty maintaining gold’s prewar $20.67-per-ounce exchange rate. After the Gold Bloc devaluations, and with the United States not in distress, the future success of the gold exchange standard now hinged on the determination of a conversion rate for U.K. pounds sterling.

The U.K., under the guidance of chancellor of the exchequer Winston Churchill, chose to return sterling to gold at the prewar rate equivalent to £4.86 per ounce. He did this both because he felt duty bound to honor Bank of England notes at their original value, but also for pragmatic reasons having to do with maintaining London’s position as the reliable sound money center of world finance. Given the large amount of money printed by the Bank of England to finance the war, this exchange rate greatly overvalued the pound and forced a drastic decrease in the money supply in order to return to the old parity. An exchange rate equivalent to £7.50 per ounce would have been a more realistic peg and would have put the U.K. in a competitive trading position. Instead, the overvaluation of pounds sterling hurt U.K. trade and forced deflationary wage cuts on U.K. labor in order to adjust the terms of trade; the process was similar to the structural adjustments Greece and Spain are experiencing today. As a result, the U.K. economy was in a depression by 1926, years before the conventional starting date of 1929 associated with the Great Depression and the U.S. stock market crash.

With an overvalued pound and disadvantageous terms of trade, the U.K.’s gold began flowing to the United States and France. The proper U.S. response should have been to ease monetary policy, controlled by the Federal Reserve, and allow higher inflation in the United States, which would have moved the terms of trade in the U.K.’s favor and given the U.K. economy a boost. Instead, the Fed ran a tight money policy, which contributed to the 1929 market crash and helped to precipitate the Great Depression. By 1931, pressure on the overvalued pound became so severe that the U.K. abandoned the 1925 parity and devalued sterling. This left the dollar as the most overvalued major currency in the world, a situation rectified in 1933, when the United States also devalued from $20.67 per ounce to $35.00 per ounce, cheapening the dollar to offset the effect of the sterling devaluation two years earlier.

The sequence of events from 1922 to 1933 shows that the Great Depression was caused not by gold but rather by central bank discretionary policies. The gold exchange standard was fatally flawed because it did not take gold’s free-market price into account. The Bank of England overvalued sterling in 1925. The Federal Reserve ran an unduly tight money policy in 1927. These problems have to do not with gold per se but with the price of gold as manipulated and distorted by central banks. The gold exchange standard did contribute to the Great Depression because it was not a true gold standard. It was a poorly designed hybrid, manipulated and mismanaged by discretionary monetary policy conducted by central banks, particularly in the U.K. and the United States. The Great Depression is not an argument against gold; it is a cautionary tale of central bank incompetence and the dangers of ignoring markets.

The third myth is that gold caused market panics and that modern economies are more stable when gold is avoided and central banks use monetary tools to smooth out periodic panics. This myth is one of economist Paul Krugman’s favorites, and he recites it ad nauseam in his antigold, pro-inflationary writings.

In fact, panics do happen on a gold standard, and panics also happen in the absence of a gold standard. Krugman likes to recite a list of panics that arose during the classical gold standard and the gold exchange standard; it includes market panics or crashes in 1873, 1884, 1890, 1893, 1907, and the Great Depression. Fair enough. But panics also occurred in the absence of a gold standard. Examples include the 1987 stock market crash, when the Dow Jones Industrial Index fell over 22 percent in a single day, the 1994 Mexican peso collapse, the 1997–98 Asia-Russia-Long-Term Capital market panic, the 2000 tech stock collapse, the 2007 housing market collapse, and the Lehman-AIG financial panic of 2008.

Panics are neither prevented nor caused by gold. Panics are caused by credit overexpansion and overconfidence, followed by a sudden loss of confidence and a mad scramble for liquidity. Panics are characterized by rapid declines in asset values, margin calls by creditors, dumping of assets to obtain cash, and a positive feedback loop in which more asset sales cause further valuation declines, which are followed by more and more margin calls and asset sales. This process eventually exhausts itself through bankruptcy, a rescue by solvent parties, government intervention, or a convergence of all three. Panics are a product of human nature, and the pendulum swings between fear and greed and back to fear. Panics will not disappear. The point is that panics have little or nothing to do with gold.

In practice, gold standards worked well in the past and remain entirely feasible today. Still, daunting design questions arise in the creation of any gold standard. Designing a gold standard is challenging in the same way that designing a digital processor can be challenging; there is good design and bad design. There are technical issues that deserve serious consideration, and spurious issues that do not. There is enough gold in the world—it is just a matter of price. Gold did not cause the Great Depression, but central bank policy blunders did. Panics are not the result of gold; they are the result of human nature and easy credit. Puncturing these myths is the way forward to an authentic debate of gold’s pros and cons.

■ The Scramble for Gold

While academics and pundits debate gold’s virtues as a monetary standard, central banks are past the debate stage. For central banks, the debate is over—gold is money. Today central banks are acquiring gold as a reserve asset at a pace not seen since the early 1970s, and this scramble for gold has profound implications for the future role of every currency, especially the U.S. dollar.

The facts speak for themselves and require little elaboration. Central banks and other official institutions such as the IMF were net sellers of gold every year from 2002 through 2009, although sales dropped sharply during that time from over 500 tonnes in 2002 to less than 50 tonnes in 2009. Beginning in 2010, central banks became net buyers, with purchases rising sharply from less than 100 tonnes in 2010 to over 500 tonnes in 2012. In the ten-year span from 2002 to 2012, the shift from net sales to net purchases was over 1,000 tonnes per year, an amount greater than one-third of annual global mining output. Increasingly, gold is moving directly from mines to central bank vaults.

Table 1 shows increases in gold reserves for selected countries from the first quarter of 2004 to the first quarter of 2013, measured in tonnes:

All these large central bank acquirers are in Asia, Latin America, and eastern Europe. Over this same period, from 2004 to 2013, Western central banks were net sellers of gold, although such sales stopped abruptly in 2009. Since then emerging economies have had to acquire gold from mine production, scrap gold recycling, or open-market sales, including sales of over 400 tonnes by the IMF in late 2009 and early 2010. Taking into account all national central banks, exclusive of the IMF, official gold reserves increased 1,481 tonnes from the fourth quarter of 2009 through the first quarter of 2013—a 5.4 percent increase. Central banks have become significant gold buyers, and the movement of gold is from west to east.

These statistics all need to be qualified by the curious case of China. China reported a gold reserve position of 395 tonnes for over twenty years from 1980 through the end of 2001. Then the reported position suddenly leaped to 500 tonnes, where it remained for a year; then it leaped again to 600 tonnes at the end of 2002, where it remained for over six years. Finally, the reported position was increased to 1,054 tonnes in April 2009, where it has remained for almost five years through early 2014.

Officially, China has reported a series of sudden spikes in its gold holdings of 105 tonnes in 2001, 100 tonnes in 2002, and 454 tonnes in 2009. Increases of this size are extremely difficult to conduct in a single transaction except by prearrangement between two central banks or the IMF. No such prearranged central bank or IMF sales to China have been reported, and no reported central bank or IMF holdings show the necessary sudden drops at the appropriate times that would correspond to such increases by China. The conclusion is inescapable that China is actually accumulating gold in smaller quantities over long periods of time, and reporting the changes in a lump sum on an irregular basis.

This covert, piecemeal gold-acquisition program makes perfect sense. Physical gold is marketable in the sense that it can be readily purchased or sold, but it is also thinly traded, and the price is volatile. Large buyers in any thinly traded market try to disguise their intentions to avoid market impact, in which bank dealers move the price adversely to the buyer in anticipation of large, inelastic buy orders.

China minimizes the market impact of its buying program through the use of secret agents and direct purchases from mines. The agents are principally located in the HSBC headquarters building on Queen’s Road Central in Hong Kong and in the Shanghai branch of ANZ Bank, although the network of buying agents is worldwide. These agents place purchase orders for commercial-size gold lots of several tonnes each with brokers and London-based bullion banks. The buyer’s true identity is not disclosed. The gold is paid for by one of China’s sovereign wealth funds, the State Administration for Foreign Exchange, which is managed by former PIMCO bond trader Zhu Changhong. Once purchased, the gold is shipped by air transport to secure vaults in Shanghai. The agents are highly disciplined and patient in their buying activity and typically “buy the dips” in market price, as indicated on the New York–based COMEX exchange. In a masterpiece of market savvy, China bought 600 tonnes of gold directly from Australia’s Perth Mint and other sellers near the interim low price of $1,200 per ounce reached in the April to July 2013 price dip. Partly as a result of these large-scale covert operations, in addition to more customary commercial purchases, China is estimated to have imported approximately 1,000 tonnes of gold per year in 2012 and 2013.

China’s direct gold ore purchases are principally from gold mines located in China, but they have expanded rapidly to include newly acquired mines in southern Africa and western Australia. As recently as 2001, China produced less than 200 tonnes per year from its own mines. Output increased steadily from 2001 to 2005 and then surged in 2006, so that by 2007 China surpassed South Africa as the world’s largest gold producer, a position it has maintained since. By 2013, China was producing over 400 tonnes per year—about 14 percent of worldwide mine production. Gold ore produced in Chinese-controlled mines, whether inside China or elsewhere, is sent to refineries in China, Australia, South Africa, and Switzerland, where it is refined to pure gold, cast into one-kilo gold bars, and shipped to vaults in Shanghai. Through these channels, Chinese gold bypasses the London market, minimizing the market impact and keeping the exact size of China’s gold hoard a state secret.

The combination of internal gold mining output and imports from abroad means that China has increased its domestic gold holdings, both public and private, by approximately 4,500 tonnes since the last official update of its central bank gold reserves in 2009. It is impossible for observers outside the Chinese government to gauge exactly how much of that increase is waiting to be added to official reserves at the next announcement, and how much was devoted to Chinese domestic demand from consumers for jewelry, bars, and coins. It is well known that Chinese citizens are avid gold consumers, both for reasons of wealth preservation and as a convenient medium for flight capital. Gold is sold in various forms in thousands of bank branches and boutiques throughout China.

In the absence of better data, a first approximation is that half the increase in China’s gold since 2009 went to domestic consumption and half, or 2,250 tonnes, has secretly been added to official reserves. If this approximation is correct, then China’s official gold reserves as of early 2014 are not the reported 1,054 tonnes but instead are closer to 3,300 tonnes. At the current pace of mine output and imports, and assuming half the available gold goes to official reserves, China will add another 700 tonnes to its reserves-in-waiting throughout 2014, which would put total Chinese gold reserves at 4,000 tonnes by early 2015. China waited over six years, from late 2002 to early 2009, before publicly announcing its last increase in official reserves. If China repeats that tempo, the next update to the gold reserve figures can be expected in 2015.

Even these estimates based on known mining output and known imports must be qualified by the fact that certain gold imports to China are completely unreported. A senior manager of G4S, one of the world’s leading secure logistics firms, recently revealed to a gold industry executive that he had personally transported gold into China by land through central Asian mountain passes at the head of a column of People’s Liberation Army tanks and armored transport vehicles. This gold was in the form of the 400-ounce “good delivery” bars favored by central banks rather than the smaller one-kilo bars imported through regular channels and favored by retail investors. What is clear from such disclosures is that any estimates of China’s official gold reserves are more likely to be too low than too high.

An announcement by China in 2015 that it holds 4,000 tonnes of gold in its official reserves will discredit the view of Western pundits and economists that gold is not a monetary asset. With 4,000 tonnes, China will surpass France, Italy, Germany, and the IMF in the ranks of the world’s largest gold holders, and it will be second only to the United States. This would be in keeping with China’s status as the world’s second-largest economy.

China’s covert gold acquisition is in sharp contrast to Russia’s far more transparent efforts to increase its own gold reserves. In the nine years from early 2004 to late 2013, Russian gold reserves increased over 250 percent, from approximately 390 tonnes to over 1,000 tonnes. Unlike China’s, this increase was achieved almost entirely through domestic mine production and did not rely on imports. Russia is the world’s fourth-largest gold producer, with output of approximately 200 tonnes per year. The Russian reserve increase was also done in steady increments of about 5 tonnes per month, announced regularly on the website of the Central Bank of Russia. Since the central bank does not rely on imports or the London bullion market to increase its gold holdings, Russia can afford to be more transparent than China because it is less vulnerable to price manipulation and front-running by the London bullion banks. Russia’s acquisition program is ongoing, and its official gold holdings should surpass 1,100 tonnes in 2014. Reserves of 1,100 tonnes are over one-eighth the size of U.S. gold reserves, but the Russian economy is also about one-eighth the size of the U.S. economy. Measured in proportion to the size of their respective economies, Russian gold reserves have pulled ahead of those of the United States.

Many analysts have been baffled by the paradox of strong demand for physical gold around the world and the simultaneous weakness in the price of gold futures traded on the COMEX exchange since the August 2011 peak in gold prices. Physical buying is coming not only from central banks but also from individuals, as reflected in the demand for one-kilo bars versus the 400-ounce “good delivery” bars favored by central banks. Swiss refineries have been working overtime to convert large bars to smaller ones to meet this demand. This seeming paradox is easily explained. If the price of any good, whether gold or bread, is held below its intrinsic value by intervention in any form, the behavioral response is always to strip the shelves bare.

The scramble for gold, epitomized in the central bank gold-acquisition programs of China and Russia, also manifests itself in the urgency with which central banks are attempting to repatriate gold from foreign depositories to vaults on their home soil.

Apart from the U.S. hoard, almost half the official gold in the world is not stored in the home country of the holder but in vaults at the Federal Reserve Bank of New York and at the Bank of England in London. The Federal Reserve vaults hold approximately 6,400 tonnes of gold, and the Bank of England vaults approximately 4,500 tonnes. Almost none of the gold in the New York Federal Reserve vaults belongs to the United States, and less than 300 tonnes of the gold in the Bank of England belongs to the U.K. U.S. gold is mostly kept in two U.S. Army facilities at Fort Knox, Kentucky, and West Point, New York, with a small amount held at the U.S. Mint in Denver, Colorado. The Federal Reserve and the Bank of England together have about 10,600 tonnes of official gold belonging to Germany, Japan, the Netherlands, the IMF, and other large holders, as well as many smaller holders around the world. Third-party gold held at the Fed and the Bank of England constitutes 33 percent of the official gold in the world.

This concentration of official gold in New York and London is mostly a legacy of the various gold standards that existed on and off from 1870 to 1971. When gold was used to settle balance of payments between countries, it was easier to keep the gold in financial centers such as New York and London, then reassign legal title as needed, rather than ship the gold around the world. Today balance of payments are settled mostly in dollars or euros, not gold, so the money center rationale for gold no longer applies.

Centralized gold holdings are also a legacy of the Cold War (1946–91), when it was considered safer for Germany to keep its gold in New York than to risk confiscation by the Soviet armored divisions that surrounded Berlin. Now the risks to Germany of gold confiscation by the United States in the event of a financial meltdown are considerably higher than the risks of confiscation by Russian invasion. Countries such as Germany no longer have a compelling reason to keep their gold in New York or London, and there are significant risks in doing so. If the United States or the U.K. suddenly deemed it necessary to confiscate foreign gold to defend its paper currency in a crisis, that gold would be conveyed from the original owners to the possession of the United States or the U.K.

As a result of these changed circumstances and emerging risks, gold-owning nations have begun a movement to repatriate their gold. The first prominent repatriation was initiated by Venezuela, which ordered the Bank of England to return 99 tonnes from London to Caracas in August 2011. The first gold shipments took place in November 2011, and upon their arrival, President Hugo Chávez paraded the gold-filled armored cars through Caracas streets, to the cheers of everyday Venezuelans.

A larger and more significant gold-repatriation program was launched by Germany in 2013. Germany holds 3,391 tonnes of official gold and is currently the world’s second-largest holder after the United States. At the end of 2012, German gold was located as follows: 1,051 tonnes in Frankfurt; 1,526 tonnes in New York; 441 tonnes in London; and 374 tonnes in Paris. On January 16, 2013, the Deutsche Bundesbank, the central bank of Germany, announced an eight-year plan to repatriate all the gold in Paris and 300 tonnes of the gold in New York back to Frankfurt. The gold in London would be left in place, and at the end of the repatriation plan in December 2020, German gold would be 50 percent in Frankfurt, 37 percent in New York, and 13 percent in London.

Commentators quickly fell upon the fact that the 300-tonne transfer from New York to Frankfurt would take eight years to complete as prima facie evidence that the New York Fed did not have the German gold in its vaults or was otherwise financially embarrassed by the request. But the Deutsche Bundesbank does not want the gold returned quickly. It prefers to have it in New York, where it can more efficiently be used for market manipulation. The Deutsche Bundesbank did not want to request the transfer at all but was pressured to do so by political supporters of Angela Merkel, who was facing reelection in September 2013. The physical security of Germany’s gold had become a political issue in the Bundestag, the German parliament. The Deutsche Bundesbank’s announced plan was merely a way to defuse the political issue while still leaving most of Germany’s gold in New York. Even after full implementation of the plan in 2020, Germany will still have 1,226 tonnes in New York, an amount greater than the total reserves of all but three other countries in the world. It is more convenient for the Deutsche Bundesbank to have its gold in New York, where it can be utilized in gold swaps and gold leases, as part of central bank efforts to manipulate gold markets. Still, a significant amount of gold is on its way to Frankfurt—part of a global movement to repatriate national gold.

The same populist political pressures that forced the German central bank to repatriate part of its gold have also swelled up in Switzerland. While the central banks of China, Russia, and other nations were avidly purchasing gold, Switzerland was one of the largest sellers. At the beginning of 2000, Switzerland’s gold reserves were over 2,590 tonnes. That amount dropped steadily, as the gold price was rising sharply, and by late 2008, Switzerland held only 1,040 tonnes, down 60 percent from the amount eight years earlier. Swiss gold reserves have remained at this level since, while gold’s price rose significantly from its 2008 level.

There was sharp reaction in the Swiss parliament to these massive sales despite rising prices. On September 20, 2011, four Swiss parliament members, led by Luzi Stamm of the Swiss People’s Party, introduced an initiative that requires all Swiss gold to be stored in Switzerland and that strips the Swiss National Bank of its ability to sell Switzerland’s gold. The initiative also requires the Swiss National Bank to hold at least 20 percent of its total assets in gold. The last provision might actually require Switzerland to acquire even more bullion, since gold was only 8.9 percent of total Swiss reserves as of July 2013. On March 20, 2013, the initiative sponsors announced they had obtained the one hundred thousand signatures required to place the initiative on a ballot to be voted on by Swiss citizens—a key feature of Swiss democracy. The exact date of the Swiss gold referendum is not known but is expected by 2015.

In 2003 Kaspar Villiger, then the Swiss minister of finance, when asked in parliament about the location of Swiss gold, infamously replied, “I don’t know… don’t have to know, and don’t want to know.” Such arrogance, typical of global financial elites, is increasingly unacceptable to citizens, who see their gold reserves being dissipated by bureaucrats operating behind closed doors in central banks and enclaves like the IMF and BIS. The actions of Swiss officials cost their citizens over $35 billion in lost wealth, compared to the value of their reserves had Switzerland kept its gold.

The Venezuelans, Germans, and Swiss may be the most prominent exemplars of the gold-repatriation movement, but they are not alone in raising the issue. In 2013 the sovereign wealth fund of Azerbaijan, a major energy exporter, ordered its gold reserves moved from JPMorgan Chase in London to the Central Bank of Azerbaijan in Baku. The gold-repatriation issue was also raised publicly in 2013 in Mexico. In the Netherlands, members of the center-right Christian Democratic Appeal Party and the leftist Socialist Party have petitioned De Nederlandsche Bank, the Dutch central bank, to repatriate its 612 tonnes of gold. Only 11 percent of the Dutch gold, or 67 tonnes, is actually in the Netherlands. The remainder is divided with about 312 tonnes in New York, 122 tonnes in Canada, and 110 tonnes in London. When asked in 2012 about the possibility of Dutch gold stored in New York being confiscated by the United States, Klaas Knot, then president of De Nederlandsche Bank, replied, “We are regularly confronted with the extra-territorial functioning of laws from the United States and usually these are not cheerfully received in Europe.” A small movement in Poland under the name “Give Our Gold Back,” launched in August 2013, focused on the repatriation of Poland’s 100 tonnes of gold held by the Bank of England. Of course, many countries, such as Russia, China, and Iran, already store their gold at home and are free of confiscation risk.

The issues of gold acquisition and gold repatriation by central banks are closely related. They are two facets of the larger picture of gold resuming its former role as the crux of the international monetary system. Major gold holders do not want to acknowledge it because they prefer the paper money system as it is. Smaller gold holders do not want to acknowledge it because they want to obtain gold at attractive prices and avoid the price spike that will result when the scramble for gold becomes disorderly. There is a convergence of interests, between those who disparage gold and those who embrace it, to keep the issue of gold as money off the table for the time being. This will not last, because the world is witnessing the inexorable remonetization of gold.

■ Gold Redux

There are few more tendentious comments on gold than the a priori statement that a gold standard cannot work today. In fact, a well-designed gold standard could work smoothly if the political will existed to enact it and to adhere to its noninflationary disciplines. A gold standard is the ideal monetary system for those who create wealth through ingenuity, entrepreneurship, and hard work. Gold standards are disfavored by those who do not create wealth but instead seek to extract wealth from others through inflation, inside information, and market manipulation. The debate over gold versus fiat money is really a debate between entrepreneurs and rentiers.

A new gold standard has many possible designs and would be effective, depending on the design chosen and the conditions under which it was launched. The classical gold standard, from 1870 to 1914, was hugely successful and was associated with a period of price stability, high real growth, and great invention. In contrast, the gold exchange standard, from 1922 to 1939, was a failure and a contributing factor in the Great Depression. The dollar gold standard, from 1944 to 1971, was a middling success for two decades before it came undone due to a lack of commitment by its principal sponsor, the United States. These three episodes from the past 150 years make the point that gold standards come in many forms and that their success or failure is determined not by gold per se but by the system design and the willingness of participants to abide by the rules of the game.

Consideration of a new gold standard begins with the understanding that the old gold standard was never completely left behind. When the Bretton Woods system broke down in August 1971, with President Nixon’s abandonment of gold convertibility by foreign central banks, the gold standard was not immediately deserted. Instead, in December 1971 the dollar was devalued 7.89 percent so that gold’s official price increased from $35 per ounce to $38 per ounce. The dollar was devalued again on February 12, 1973, by an additional 10 percent so that gold’s new official price was $42.22 per ounce; this is still gold’s official price today for certain central banks, for the U.S. Treasury, and for IMF accounting purposes, although it bears no relationship to the much higher market price. During this period, 1971–73, the international monetary system moved haltingly toward a floating-exchange-rate regime, which still prevails today.

In 1972 the IMF convened the Committee of Twenty, C-20, consisting of the twenty member countries represented on its executive board, to consider the reform of the international monetary system. The C-20 issued a report in June 1974, the “Outline of Reform, that provided guidelines for the new floating-rate system and recommended that the SDR be converted from a gold-backed reserve asset to one referencing a basket of paper currencies. The C-20 recommendations were hotly debated inside the IMF during 1975 but were not adopted at the time. At a meeting in Jamaica in January 1976, the IMF did initiate substantial reforms along the lines of the C-20 report, which were incorporated in the Second Amendment to the IMF Articles of Agreement. They became effective on April 1, 1978.

The international monetary debate, from the C-20 project in 1972 to the Second Amendment in 1978, was dominated by the disposition of IMF gold. The United States wanted to abandon any role for gold in international finance. The U.S. Treasury dumped 300 tonnes of gold on the market during the Carter administration to depress the price and demonstrate U.S. lack of interest. Meanwhile, France and South Africa were insisting on a continued role for gold as an international reserve asset. The Jamaica compromise was a muddle, in which 710 tonnes of IMF gold was returned to members, another 710 tonnes was sold on the market, and the remainder of approximately 2,800 tonnes was retained by the IMF. The IMF changed its unit of account to the SDR, and the pricing of SDRs was changed from gold to a basket of paper currencies. The United States was satisfied that gold’s role had been demoted; France was satisfied that gold remained a reserve asset; and the IMF continued to own a substantial amount of gold. The essence of this U.S.-Franco compromise remains to this day.

With the coming of the Reagan administration in 1981, the United States went through a profound shift in its attitude toward gold. It sold less than 1 percent of its remaining gold from 1981 to 2006, and it has sold no gold at all since 2006. The retention of gold by the United States and the IMF since 1981, as well as the continuation of large gold hoards by Germany, Italy, France, Switzerland, and others, have left the world with a shadow gold standard.

Gold’s continued role as a global monetary asset was brought home in a stunningly candid address given by Mario Draghi, head of the European Central Bank, at the Kennedy School of Government on October 9, 2013. In reply to a question from a reporter, Tekoa Da Silva, about central bank attitudes toward gold, Draghi remarked:

France’s insistence at Jamaica in 1976 that gold continue as a reserve asset has returned to the IMF’s monetary banquet like Banquo’s ghost. Just as Banquo was promised in Macbeth that he would beget a line of kings, so gold may persevere as the once and future money.

■ A New Gold Standard

How would a twenty-first-century gold standard be structured? It would certainly have to be global, involving at least the United States, the Eurozone, Japan, China, the U.K., and other leading economies. The United States is capable of launching a gold-backed dollar on its own, given its massive gold reserves, but if it were to do so, other currencies in the world would be unattractive to investors relative to a new gold-backed dollar. The result would be deflationary, with a diminution of transactions in those other currencies and reduced liquidity. Only a global gold standard could avoid the deflation that would accompany an effort by the United States to go it alone.

The first step would be a global monetary conference, similar to Bretton Woods, where participants would agree to establish a new global monetary unit. Since the SDR already exists, it is a perfectly suitable candidate for the new global money. But this new SDR would be gold backed and freely convertible into gold or the local currency of any participant in the system. It would not be the paper SDR that exists today.

The system would also have to be two-tiered. The top tier would be the SDR, which would be defined as equal to a specified weight in gold. The second tier would consist of the individual currencies of the participating nations, such as the dollar, euro, yen, or pound sterling. Each local currency unit would be defined as a specified quantity of SDRs. Since local currency is defined in SDRs, and SDRs are defined in gold, by extension every local currency would be worth a specified weight in gold. Finally, since every local currency is in a fixed relationship to SDRs and gold, each currency would also be in a fixed relationship to one another. As an example, if SDR1.00 = €1.00, and SDR1.00 = $1.50, then €1.00 = $1.50, and so on.

In order to participate in the new gold SDR system, a member nation would have to have an open capital account, meaning that its currency would have to be freely convertible into SDRs, gold, or currencies of the other participating members. This should not be a burden for the United States, Japan, the Eurozone, or others who already maintain open capital accounts, but it could be an impediment for China, which does not. However, China may find the attractions of a nondollar, gold-backed currency such as the new SDR sufficiently enticing that it would open its capital account in order to join and allow the new system to succeed.

Participants would be encouraged to adopt the new gold SDR as a unit of account as broadly as possible. Global markets in oil and other natural resources would now be priced in SDRs rather than dollars. The financial records of the largest global corporations, such as IBM and Exxon, would be maintained in SDRs, and various economic metrics, such as global output and balance-of-payments accounts, would be computed and reported in SDRs. Finally, an SDR bond market would develop, with issuance by sovereign nations, global corporations, and regional development banks, and with purchases by sovereign wealth funds and large pension funds. It might be intermediated by the largest global banks, such as Goldman Sachs, under IMF supervision.

One of the more daunting technical issues in this potential global gold SDR system is the determination of the proper fixed rates at which currencies can convert to one another. For example, should €1.00 be equivalent to $1.30, $1.40, $1.50, or another amount? This is essentially the same issue that the founders of the euro faced after the Maastricht Treaty was signed in 1992, which committed the parties to create a single currency from diverse currencies such as the Italian lira, the German mark, and the French franc. In the euro’s case, years of technical study and economic theory developed by specialized institutions were applied to the task. Technical consideration is warranted today, too, but the best approach would be to use market signals to solve the problem. The parties in the new system could announce that the fixed rate would be determined in four years based on the weighted average of bank foreign currency transactions during the last twelve months prior to the fixing date. The four-year period would give markets sufficient time to adjust and consider the implications of the new system, and the twelve-month averaging period would smooth out short-term anomalies or market manipulation.

The most challenging issue involves the SDR’s value measured in a weight of gold, and the fractional gold reserve required to make the system viable. The problem can be reduced to a single issue: the implied, nondeflationary price of gold in a global gold-backed monetary system. Once that issue was resolved with respect to one numeraire, conversion to other units of account using fixed exchange rates would be trivial.

Initially, the new system would operate without an expansion of the global money supply. Any nation that wanted SDRs could buy them from banks or dealers, earn them in trade, or acquire them from the IMF in exchange for its own currency. Local currency delivered to the IMF in exchange for SDRs would be sterilized so the global money supply did not expand. Discretionary monetary policy would be reserved to national central banks such as the Fed and ECB, subject to the need to maintain fixed rates to gold, SDRs, and other currencies. The IMF would resort to discretionary monetary policy through the unsterilized creation of new SDRs only in extraordinary circumstances and with approval of a supermajority of IMF members participating in the new system.

Given these constraints on the creation of new SDRs, the system would launch with the SDR as an anchor and unit of account but a relatively small amount of SDRs in existence. The combined base money supplies of the participants would constitute the global money supply, as it does today, and that money supply would be the reference point for determining the appropriate price for gold.

Another key issue would be determining the amount of gold backing needed to support the global money supply. Austrian School economists insist on 100 percent backing, but this is not strictly required. In practice, the system requires only enough gold to supply anyone with a preference for physical gold over gold-backed paper money, and adequate assurance that the fixed gold price will not be changed once established. These two goals are related; the stronger the assurance of consistency, the less gold is required to maintain confidence. Historically, gold standards have operated successfully with between 20 percent and 40 percent backing relative to money supply. Given the abandonment of gold in 1914, 1931, and 1971, a high figure will be required to engender confidence by justifiably cynical citizens. For illustrative purposes, take 50 percent of money supply as the target backing; the United States, the Eurozone, China, and Japan as the participating economies; global official gold holdings as the gold supply; and M1 as the money supply. Dividing the money supply by the gold supply gives an implied, nondeflationary price for gold, under a gold-backed SDR standard, of approximately $9,000 per ounce.

The inputs in this calculation are debatable, but $9,000 per ounce is a good first approximation of the nondeflationary price of gold in a global gold-backed SDR standard. Of course, nothing moves in isolation. The world of $9,000-per-ounce gold is also the world of $600-per-barrel oil, $120-per-ounce silver, and million-dollar starter homes in mid-America. This new gold standard would not cause inflation, but it would be a candid recognition of the inflation that has already occurred in paper money since 1971. This one-time price jump would be society’s reckoning with the distortions caused by the abuse of fiat currencies in the past forty years. Participating nations would need legislation to nominally adjust fixed-income payments to the neediest in forms such as pensions, annuities, social welfare, and savings accounts up to the insured level. Nominal values of debt would be left unchanged, instantaneously solving the global-sovereign-debt-and-deleveraging conundrum. Banks and rentiers would be ruined—a healthy step toward future growth. Theft by inflation would be a thing of the past, for as long as the system was maintained. Wealth extraction would be replaced with wealth creation, and the triumph of ingenuity could commence.

Discretionary monetary policy conducted by national central banks would be preserved in this new system. Indeed, the percentage of physical gold backing the currency issues could even be increased or decreased from time to time if needed. However, central banks participating in the system would be required to maintain the fixed gold price in their currency by acting as buyers and sellers in physical gold. Any central bank perceived as too easy for too long would find citizens lined up at its doors and would be quickly stripped of its gold. IMF gold-swap lines backed by other central banks would be made available to deal with temporary adjustment requirements—an echo of the old Bretton Woods system. These gold market operations would be conducted transparently to instill confidence in the process.

Importantly, the IMF would have emergency powers to increase the SDR supply with the approval of a supermajority of its members to deal with a global liquidity crisis, but SDRs and national currencies would remain freely convertible to gold at all times. If citizens had confidence in the emergency actions, the system would remain stable. If citizens perceived that money creation was occurring to rescue elites and rentiers, a run on gold would commence. These market signals would act as a brake on abuse by the IMF and the central banks. In effect, a democratic voice, mediated by market mechanisms, would be injected into global monetary affairs for the first time since the First World War.

Austrian School supporters of a traditional gold standard are unlikely to endorse this new gold standard because it has fractional, even variable gold backing. The conspiracy-minded are also unlikely to support it because it is global and has the look and feel of a new world order. Even the milder critics will point out that this system depends completely on promises by governments, and such promises have consistently been broken in the past. Yet it has the virtue of practicality; it could actually get done. It forthrightly addresses the problems of deflation that would occur if the United States took a go-it-alone approach, and it mitigates the hyperinflationary shock that would result if fractional backing were not used. The new gold standard comes close to Mundell’s prescription that the optimal currency zone is the world, and it revives a version of Keynes’s vision at Bretton Woods before the United States insisted on dollar hegemony.

Most profoundly, a new gold standard would address the three most important economic problems in the world today: the dollar’s decline, the debt overhang, and the scramble for gold. The U.S. Treasury and Federal Reserve have decided that a weak-dollar policy is the remedy for the lack of world growth. Their plan is to generate inflation, increase nominal aggregate demand, and rely on the United States to pull the global economy out of the ditch like a John Deere tractor hitched to a harvester up to its axles in mud. The problem is that the U.S. solution is designed for cyclical problems, not for the structural problems that the world currently faces. The solution to structural problems involves new structures, starting with the international monetary system.

There is no paper currency that will come close to replacing the dollar as the leading reserve currency in less than ten years. Even now the dollar is being discarded and gold remonetized at an increasing tempo—both perfectly sensible reactions to U.S. weak-dollar policies. The United States and the IMF should lead the world to the gold-backed SDR, which would satisfy Chinese and Russian interests while leaving the United States and Europe with the leading reserve positions. The world cannot wait ten years for the paper SDR, the yuan, and the euro to converge into Barry Eichengreen’s “Kumbaya” world of multiple reserve currencies. The consequences of misguided monetary leadership will be on display in far fewer than ten years.

■ The Inflation-Deflation Paradox

Federal Reserve policy is at a crossroads facing unpleasant paths in all directions. Monetary policy around the world has reached the point where the contradictions embedded in years of market manipulation have left no choices that do not involve either contraction or catastrophic risk. Further monetary easing may precipitate a loss of confidence in money; policy tightening will restart the collapse in asset values that began in 2007. Only structural change in the U.S. economy, something outside the Fed’s purview, can break this stalemate.

This much was clear by 2013, as weary economists and policy makers waited for the robust recovery they had eagerly anticipated since the stock market rally started in 2009. Annual GDP growth in the United States touched 4 percent in the fourth quarter of 2009, prompting talk of “green shoots” amid signs that the economy was bouncing back from the worst recession since the Great Depression. Even when growth fell to a 2.2 percent annual rate by the second quarter of 2010, the optimistic spin continued, with happy talk by Treasury secretary Timothy Geithner of a “recovery summer” in 2010. Reality slowly sank in. Annual growth was an anemic 1.8 percent in 2011 and was only slightly better at 2.2 percent in 2012. Then, despite predictions from the Fed and private analysts that 2013 would be a turnaround year, growth fell again to 1.1 percent in the first quarter of 2013, although it revived to 4.1 percent in the third quarter.

The economy was in a phase not seen in eighty years. It was neither a recession as technically defined, nor a robust recovery as widely expected. It was a depression, exactly as Keynes had defined it, “a chronic condition of sub-normal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse.” There was no cyclical recovery because the problems in the economy were not cyclical; they were structural. This depression should be expected to continue indefinitely in the absence of structural changes.

Fed forecasters and most private analysts use models based on credit and business cycles from the seventy-odd years since the end of the Second World War. Those baselines do not include any depressions. One must reach back eighty years, to the 1933–36 period, a recovery within a depression, to find a comparable phase. The Great Depression ended in 1940 with structural changes: the economy was put on a war footing. In early 2014 no war was imminent, and no structural changes were being contemplated. Instead, depressionary low growth and high unemployment have become normal in the U.S. economy.

The American Enterprise Institute’s John Makin, who has an uncanny record of accurately predicting economic cycles, pointed out that based on historical patterns, the United States might actually be headed for a recession in 2014—the second recession within a depression since 2007, an eerie replay of the Great Depression. Makin pointed out that despite below-trend growth since 2009, the expansion has lasted over four years and is approaching the average longevity for modern economic expansions in the United States. Based on duration if not strength, U.S. real growth should be expected to turn negative in the near future.

Even if the United States does not enter a technical recession in 2014, the depression will continue, the strongest evidence coming from depression-level employment data. Despite cheerleading in late 2013 about the creation of two hundred thousand new jobs per month and a declining unemployment rate, the reality behind the headline data is grim. As analyst Dan Alpert points out, almost 60 percent of jobs created in the first half of 2013 were in the lowest-wage sectors of the U.S. economy. These sectors normally account for one-third of total jobs, meaning that new job creation was disproportionately low wage by a factor of almost two to one. Low-wage jobs are positions such as the order taker at McDonald’s, the bartender at Applebee’s, and the checkout clerk at Walmart. All work has dignity, but not all work has pay that can ignite a self-sustaining economic recovery.

About 50 percent of the jobs created during the first half of 2013 were part-time, defined as jobs with thirty-five hours of work per week or less. Some part-time jobs offer as little as one hour per week. If the unemployment rate were calculated by counting those working part-time who want full-time work, and those who want a job but have given up looking, the unemployment rate in mid-2013 would be 14.3 percent instead of the officially reported 7.1 percent. The 14.3 percent figure is comparable to levels reached during the Great Depression, a level consistent with an economic depression.

New hiring since 2009 has been roughly equal to the number of new entrants into the workforce in that time period, which means that it did nothing to reduce the total number of those who became unemployed during the acute phase of the panic and downturn in 2008 and 2009. Alpert also shows that even the supposed “good news” of a declining unemployment rate is misleading because the declining rate reflects those workers dropping out of the workforce entirely rather than new job creation in an expanding labor pool. The percentage of Americans counted in the labor force had dropped from a high of 66.1 percent before the new depression to 63.5 percent by mid-2013. Even with the reduced labor force, real wage gains adjusted for inflation were not being realized, and in fact real wages have been falling for the past fifteen years.

Added to this dismal employment picture is the striking increase in dependency on government programs. By late 2013, the United States had over 50 million citizens on food stamps; over 26 million citizens unemployed, underemployed, or discouraged from looking for work; and over 11 million citizens on permanent disability, many of those because their unemployment benefits had run out. These numbers are a national disgrace. Combined with feeble growth, borderline recession conditions, and over five years of zero interest rates, these figures made talk of an economic recovery seem misplaced.

Though overall conditions suggest a new depression, one element was missing from the portrait—namely, deflation, defined as a generalized drop in consumer prices and asset values. During the darkest stage of the Great Depression, from 1930 to 1933, cumulative deflation in the United States was 26 percent, part of a broader, worldwide deflationary collapse. The United States experienced slight deflation in 2009 compared to 2008, but nothing at all comparable to the Great Depression; in fact, mild inflation has persisted in the new depression, and the official consumer price index shows a 10.6 percent increase from the beginning of 2008 to mid-2013. The contrast between the extreme deflation of the Great Depression and the mild inflation of the new depression is the most obvious difference between the two episodes and is also the source of the greatest challenge now facing the Federal Reserve. It raises the vexing question of when and how to reduce and eventually reverse money printing.

A depression’s natural state is deflation. Businesses faced with declining revenue and individuals faced with unemployment will rapidly sell assets to reduce debt, a process known as deleveraging. As asset sales continue and as spending declines, prices decline further, which is deflation’s immediate cause. Those price declines then add further economic stress, leading to additional asset sales, more unemployment, and so on in a feedback loop. In deflation, the real value of cash increases, so individuals and businesses hoard cash instead of spending it or investing in new land, plant, and equipment.

This entire process of asset sales, hoarding, and price declines is called a liquidity trap, famously described by Irving Fisher in his 1933 work The Debt-Deflation Theory of Great Depressions and by John Maynard Keynes in his most influential work, The General Theory of Employment, Interest and Money. In a liquidity trap, the response to money printing is generally weak, and from a Keynesian perspective, fiscal policy is the preferred medicine.

While the response to money printing may be weak, it is not nil. Working against potential deflation has been a massive money-printing operation by the Federal Reserve. In the six years from 2008 to 2014, the Federal Reserve has increased base money from about $800 billion to over $4 trillion, a more than 400 percent increase. While the turnover or velocity of money has been in sharp decline, the quantity of money has skyrocketed, helping to offset the slower pace of spending. The combination of massive money printing and zero interest rates has also propped up asset prices, leading to a stock market rally and a strong recovery in housing prices since 2009. But asset values are being inflated from other sources too.

■ Tuition Tally

Another reason deflation has not prevailed over inflation, despite faint economic growth, is that the U.S. Treasury has promoted a new cash injection into the economy, larger than subprime housing finance in the 2002–7 period. This injection is in the form of student loans.

Student loans are the new subprime mortgages: another government-subsidized bubble about to burst. Students have a high propensity to spend, whether on tuition itself or on books, apartments, furniture, and beer. If you give students money, they will spend it; there is little danger that they will buy gold or otherwise hoard the money as savings. Tuition payments financed by student loans are a mere conduit since the payments are passed along as union faculty salaries or university overhead. Loan proceeds remaining after tuition are spent directly by the students.

Annual borrowing in all undergraduate and graduate student loan programs surged to over $100 billion per year in 2012, up from about $65 billion per year at the start of the 2007 depression. By August 2013, total student loans backed by the U.S. government exceeded $1 trillion, an amount that has doubled since 2009. A provision contained in the 2010 Obamacare legislation provided the U.S. Treasury with a near monopoly on student loan origination and sidelined most private lenders who formerly participated in this market. This meant that the Treasury could relax lending standards to continue the flow of easy money.

The student loan market is politically untouchable because higher education historically produces citizens with added skills who repay the loans and earn higher incomes over time. No member of Congress wants to support legislation that would crimp Johnnie or Susie’s ability to afford college. But the program has morphed into direct government pump priming, in the same manner that historically productive home lending programs morphed into a housing bubble between 1994 and 2007. In the mortgage market, Fannie Mae and Freddie Mac used government subsidies to push home ownership beyond levels that buyers could afford, giving rise to subprime mortgages without documentation or down payments. The mortgage market crashed in 2007, marking the start of the depression.

Student loans now pose a similar dynamic. Most of the loans are sound and will be repaid as agreed. But many borrowers will default because the students did not acquire needed skills and cannot find jobs in a listless economy. Those defaults will make federal budget deficits worse, a development not fully reflected in official budget projections. In effect, student loans are being pumped out by the U.S. Treasury and directed to borrowers with a high propensity to spend and limited ability to repay.

These monies have helped prop up the U.S. economy, but the flow of tuition dollars isn’t sustainable. It is economically no different than the Chinese building ghost cities with borrowed money that cannot be repaid. Chinese ghost cities and U.S. diplomas are real, but productivity increases and the ability to repay the borrowings are not.

While student loans may provide a short-term lift to discretionary spending, the long-term effects of excessive debt combined with the absence of jobs are another encumbrance on the economy. A record 21 million young adults between ages eighteen and thirty-one are living with their parents. Many of these stay-at-homes are recent graduates who cannot pay rent or afford down payments on homes because of student loans. For now, student loan cash flows and spending have helped to defer the deflation threat, but the student loan bubble will burst in the years ahead, making the debt and deficit crises worse.

■ The Inflation Conundrum

Former Fed chairman Bernanke once said that the Federal Reserve could combat deflation by throwing money from helicopters. His metaphor assumed that people would gladly pick up the money and spend it. In the real world, however, picking up the money means going into debt in the form of business loans, mortgages, or credit cards. Businesses and individuals are unwilling to go into debt because of policy uncertainty and the threat of even more deflation.

Going back to 2009, Bernanke’s critics have claimed that quantitative easing would lead to unacceptably high inflation, even imminent hyperinflation. These critics focused exclusively on money printing, failing to perceive that inflation is only partially a function of money supply. The other key factor is behavior in the form of lending and spending. Underlying weakness in the economy, and extreme uncertainty about policies on taxes, health care, environmental regulation, and other business cost determinants, resulted in stagnation both in consumer spending and in business investment, two main drivers of economic growth.

A standoff in the battle between deflation and inflation does not mean that price stability prevails. The opposing forces may have neutralized each other for the time being, but neither has gone away. Collapsing growth in China and a reemergence of the sovereign debt crisis in Europe could give deflation the upper hand. Conversely, a war in the Middle East followed by a commodity price shock, surging oil prices, and panicked gold buying could cause dollar dumping and an inflationary groundswell that the Fed would be unable to contain. Either extreme is possible.

This dilemma is reflected in a difference of opinion at the Federal Open Market Committee (FOMC), the Fed’s policy-making arm, between those who favor reduced money printing and those who favor a continuation or even expansion of the money supply through Fed asset purchases. The group that favors reduced money printing, so-called tapering, led by Fed governor Jeremy Stein, contends that continued money printing is having only limited positive effects and may create asset bubbles and systemic risk. Since money is practically free because of zero-rate policy, and since leverage magnifies returns to investors, the inducement to borrow money and take a chance on rising asset prices is hard to resist. Leverage is available to stock traders in the form of margin loans and to home buyers in the form of cheap mortgages. Since rising stock and home prices are based on cheap money rather than economic fundamentals, both markets are forming new bubbles, which will eventually burst and damage confidence again.

Under certain scenarios, the outcome could be worse than a bursting bubble and might include systemic risk and outright panic. The stock market is poised for a crash worse than 2000 or 2008. Business television anchors and sell-side analysts are only too happy to announce each new “high” in the stock market indexes. In fact, these highs are mostly nominal—they are not entirely real. When the reported index levels are adjusted for inflation, a different picture emerges. The 2008 peak was actually below the 2000 peak in real terms. The nominal peak in 1973 was followed in 1974 by one of the worst stock market crashes in U.S. history. Past is not necessarily prelude; still, the combination of extreme leverage, economic weakness, and a looming recession all put the stock market at risk of a historic crash. Any such crash would result in a blow to confidence that no amount of Fed money printing could assuage. It would trigger an extreme version of Fisher’s debt-deflation cycle. In this scenario, deflation would finally gain the upper hand over inflation, and the economic dynamics of the early 1930s would return with a vengeance.

Another factor that could contribute to a worst-case result is the hidden leverage on bank balance sheets in the form of derivatives and asset swaps. The concern here relates not to a stock market crash but to a counterparty failure that triggers a liquidity crisis in financial markets and precipitates a panic.

The pro-tapering group around Fed governor Stein understands that reduced money printing may hurt growth, but they fear that a stock market crash or a financial panic could hurt growth much more by destroying confidence. In their view, reduced money printing now is a way to let a little air out of the bubbles without deflating them entirely.

In opposition to this view are FOMC members like Fed chairwoman Janet Yellen, who see no immediate inflation risk due to excess capacity in labor markets and manufacturing, and who favor continued large asset purchases and money printing as the only hope for continued growth, especially in light of the recent tightening in fiscal policy. For Yellen, the money printing should continue until persistent inflation above 2.5 percent actually emerges and until unemployment is 6.5 percent or less. Yellen favors continued money printing even if inflation rises to 3 percent or more so long as unemployment is above 6.5 percent. She regards the risks of financial panic as remote and is confident that inflation can be controlled in due course with available tools if inflation does rise too far.

Yellen’s confidence in the remoteness of inflation and in the Fed’s ability to control inflation, if it does emerge, is based on her application of conventional general equilibrium models that do not include the most advanced theoretical work on complexity theory, interconnectedness, and the sudden emergence of systemic risk. On the other hand, her understanding that inflation was not imminent due to slack in labor and industrial capacity made her economic forecasts consistently more accurate than those of her colleagues and the Fed staff from 2011 to 2013. These forecasting successes added to her credibility inside the Federal Reserve and were important in her selection as the new Fed chairwoman. As a result, her views on the need for continued money printing carry great weight with the Fed staff and the FOMC.

It is not surprising that the FOMC members are deeply divided between the contrasting views espoused by Stein and Yellen. Stein is no doubt correct that systemic risk is building up unseen in the banking system through off-balance-sheet transactions and that new bubbles are emerging. Yellen is undoubtedly right that the economy is fundamentally weak and needs all the policy support it can get to avoid outright recession and deflation. The fact that both sides in the debate are correct means both sides are also incorrect to the extent that they fail to incorporate their opponents’ valid points in their own views. The resulting policy incoherence is the inevitable outcome of the Fed’s market manipulation. Valid price signals are suppressed or distorted, which induces banks to take risky positions that serve no business purpose except to eke out profits in a zero-rate environment. At the same time, asset values are inflated, which means that capital is not devoted to its most productive uses but instead chases evanescent mark-to-market gains in stocks and housing. Both continued money printing and the reduction of money printing pose risks, albeit different kinds.

The result is a standoff between natural deflation and policy-induced inflation. The economy is like a high-altitude climber proceeding slowly, methodically on a ridgeline at twenty-eight thousand feet without oxygen. On one side of the ridge is a vertical face that goes straight down for a mile. On the other side is a steep glacier that offers no way to secure a grip. A fall to either side means certain death. Yet moving ahead gets more difficult with every step and makes a fall more likely. Turning back is an option, but that means finally facing the pain that the economy avoided in 2009, when the money-printing journey began.

The great American novelist F. Scott Fitzgerald wrote in 1936 that “the test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function.” By 2014, the Federal Reserve board members were being put to Fitzgerald’s test. Inflation and deflation are opposed ideas, as are tapering and nontapering. No doubt, the Fed board members start with first-rate intelligence; they are now confronted with opposing ideas. The question is whether, as Fitzgerald phrased it, they can “still retain the ability to function.”

■ Confidence

Former Federal Reserve chairman Paul Volcker joined the Fed as a staff economist in 1952 and has witnessed or led every significant monetary and financial development since. As the Treasury undersecretary, he was at President Nixon’s side when the dollar’s convertibility into gold was ended in 1971. Appointed Fed chairman by President Carter in 1979, he raised interest rates to 19 percent in 1981 to break the back of the borderline hyperinflation that gripped America from 1977 onward. In 2009 President Obama selected him to head the Economic Recovery Advisory Board, to formulate responses to the worst economic slump since the Great Depression. From this platform, he advanced the Volcker Rule, an attempt to restore sound banking practices that were abandoned with the repeal of Glass-Steagall in 1999. The Volcker Rule finally got past the big bank lobbyists in 2013. Volcker correctly perceived the riskiest facet of the banking system and deserves much credit for working to fix it. No banker or policy maker knows more about money, and how it works, than Volcker.

When pressed about the dollar’s role in the international monetary system today, Volcker acknowledges the challenges facing the U.S. economy, and the dollar in particular, with a kind of been-there-done-that attitude. He points out that circumstances are not as dire as they were in 1971, when there was a run on Fort Knox, or in 1978, when, because international creditors had begun to reject the U.S. dollar as a store of value, the U.S. Treasury issued the infamous Carter Bonds, denominated in Swiss francs.

When pressed harder, Volcker is candid about China’s rise and acknowledges talk of the dollar being knocked off its pedestal as the world’s leading reserve currency. But he just as quickly points out that despite the talk, no currency comes close to the dollar in terms of the deep, liquid pools of investable assets needed for true reserve-currency status. Volcker is no fan of the gold standard and believes a return to gold is neither feasible nor desirable.

Finally, when presented with issues such as bonded debt, massive entitlements, continuing deficits, and legislative dysfunction that suggests the dollar dénouement has already begun, Volcker narrows his gaze, hardens his demeanor, and utters one word: “Confidence.”

He believes that, if people have confidence in it, the dollar can weather any storm. If people lose confidence in the dollar, no army of Ph.D.s can save it. On this point, Volcker is certainly right, yet no one can say whether confidence in the dollar has passed the point of no return due to Fed blunders, debt-ceiling debacles, and the precautions of the Russians and Chinese.

Unfortunately, there are growing signs that confidence in the dollar is evaporating. In October 2013 the Fed’s Price-adjusted Broad Dollar Index, the best gauge of the dollar’s standing in foreign exchange markets, stood at 84.05, an improvement on the all-time low of 80.52 of July 2011 but approximately equal to prior lows in October 1978, July 1995, and April 2008. Demand for physical gold bullion, a measure of lost confidence in the dollar, began rising sharply in mid-to-late 2013, another sign of a weaker dollar. The foreign currency composition of global reserves shows a continuing decline in the dollar’s use as a reserve currency from about 70 percent in 2000 to about 60 percent today. No one of these readings indicates an immediate crisis, but all three show declining confidence.

Other indications are anecdotal and difficult to quantify but are no less telling. Among them are the rise of alternative currencies and of virtual or digital currencies such as bitcoin. Digital currencies exist within private peer-to-peer computer networks and are not issued by or supported by any government or central bank. The bitcoin phenomenon began in 2008 with the pseudonymous publication of a paper (by Satoshi Nakamoto) describing the protocols for the creation of a new electronic digital currency. In January 2009 the first bitcoins were created by Nakamoto’s software. He continued making technical contributions to the bitcoin project until 2010, at which point he withdrew from active participation. However, by that time a large community of developers, libertarians, and entrepreneurs had taken up the project. By late 2013, over 11.5 million bitcoins were in circulation, with the number growing steadily. The value of each bitcoin fluctuates based on supply and demand, but it had exceeded $700 per bitcoin in November 2013. Bitcoin’s long-term viability as a virtual currency remains to be seen, but its rapid and widespread adoption can already be taken as a sign that communities around the world are seeking alternatives to the dollar and traditional fiat currencies.

Beyond the world of alternative currencies lies the world of transactions without currencies at all: the electronic barter market. Barter is one of the most misunderstood of economic concepts. A large economic literature is devoted to the inefficiencies of barter, which requires the simultaneous coincidence of wants between the two bartering parties. If one party wanted to trade wheat for nails, and the counterparty wanted wheat but had only rope to trade, the first party might accept the rope and go in search of someone with nails who wanted rope. In this telling, money was an efficient medium of exchange that solved the simultaneity problem because one could sell her wheat for money and then use the money to buy nails without having to barter the rope. But as author David Graeber points out, the history of barter is mostly a myth.

Economists since Adam Smith have assumed that barter was the historical predecessor of money, but there is no empirical, archaeological, or other evidence for the existence of a widespread premoney barter economy. In fact, it appears that premoney economies were based largely on credit—the promise to return value in the future in exchange for value delivered today. The ancient credit system allowed intertemporal exchanges, as it does today, and solved the problem of the simultaneous coincidence of wants. Historical barter is one more example of economists developing theories with scant attachment to reality.

Mythical history notwithstanding, barter is a rapidly growing form of economic exchange today, because networked computers solve the simultaneity problem. One recent example involved the China Railway Corporation, General Electric, and Tyson Foods. China Railway had a customer, a poultry processor, that filed for bankruptcy, resulting in the railroad taking possession of frozen turkeys pledged as collateral. General Electric was selling gas turbine-electric locomotives to the railroad, and China Railway inquired if it could pay for the locomotives with the frozen turkeys. GE, which has an eighteen-person e-barter trading desk, quickly ascertained that Tyson Foods China would take delivery of the turkeys for cash. China Railway delivered the turkeys to Tyson Foods, which paid cash to GE, and then GE delivered the locomotives to China Railway. The transaction between GE and China Railway was effectively the barter of turkeys for turbines, with no money changing hands. Cashless barter may not have been part of the past, but it will increasingly be part of the future.

The bitcoin and barter examples both illustrate that the dollar grows less essential every day. This is also seen in the rise of regional trade currency blocs, such as Northeast Asia and the China–South America connection. Three-way trade among China, Japan, and Korea, and the bilateral trade between China and its respective trading partners in South America, are among the largest and fastest-growing trading relationships in the world. None of the currencies involved—yuan, yen, won, real, or peso—are close to becoming reserve currencies. But all serve perfectly well as trade currencies for transactions that would previously have been invoiced in dollars. Trade currencies are used as a temporary way to keep score in the balance of trade, while reserve currencies come with deep pools of investable assets used to store wealth. Even if these local currencies are used for trade and not as reserves, each transaction represents a diminution in the role of the dollar.

To paraphrase Hemingway, confidence in the dollar is lost slowly at first, then quickly. Virtual currencies, new trade currencies, and the absence of currency (in the case of barter) are all symptoms of the slow, gradual loss of confidence in the dollar. They are the symptoms but not the cause. The causes of declining confidence in the dollar are the dual specter of inflation and deflation, the perception on the part of many that the dollar is no longer a store of value but a lottery ticket, potentially worth far more, or far less, than face value for reasons beyond the holder’s control. Panic gold buying, and the emergency issuance of SDRs to restore liquidity when it comes, will signal the stage of a rapid loss of confidence.

Volcker was right in his assertion that confidence is indispensable to the stability of any fiat currency system. Unfortunately, the academics who are now responsible for monetary policy focus exclusively on equilibrium models and take confidence too much for granted.

■ Failure of Imagination

Following the 9/11 attacks in New York and Washington, D.C., the U.S. intelligence community was reproached for its failure to detect and prevent the hijacking plots. These criticisms reached a crescendo when it was revealed that the CIA and the FBI had specific intelligence linking terrorists and flying lessons but failed to share the information or connect the dots.

New York Times columnist Tom Friedman offered the best description of what went wrong: “Sept. 11 was not a failure of intelligence or coordination. It was a failure of imagination.” Friedman’s point was that even if all the facts had been known and shared by the various intelligence agencies, they still would have missed the plot because it was too unusual and too evil to fit analysts’ preconceived notions of terrorist capabilities.

A similar challenge confronts U.S. economic policy makers today. Data on economic performance, unemployment, and the buildup of derivatives inside megabanks are readily available. Conventional economic models abound, and the analysts applying those models are among the best and brightest in their field. There is no lack of information and no shortage of intelligence; the missing piece is imagination. Fed and Wall Street analysts, tied to the use of models based on past business cycles, seem incapable of imagining the dangers actually confronting the U.S. economy. The 9/11 attacks demonstrated that the failure to imagine the worst often results in a failure to prevent it.

The worst economic danger confronting the United States is deceptively simple. It looks like this:

In this equation, the first term represents nominal growth, the second term represents inflation or deflation, and the right side of the equation equals real growth. A more familiar presentation of this equation is:

In this familiar form, the equation says that we begin with 5 percent nominal growth, then subtract 2 percent inflation, in order to reach 3 percent real growth. Nominal growth is the gross value of goods and services produced in the economy, and inflation is a change in the price level that does not represent real growth. To arrive at real growth, one subtracts inflation from the nominal value. This same inflation adjustment can be applied to asset values, interest rates, and many other data points. One must subtract inflation from the stated or nominal value in order to get the real value.

When inflation turns to deflation, the price adjustment becomes a negative value rather than a positive one, because prices decline in a deflationary environment. The expression (-1) – (-3) = 2 describes nominal growth of negative 1 percent, minus a price change of negative 3 percent, producing positive 2 percent real growth. In effect, the impact of declining prices more than offsets declining nominal growth and therefore produces real growth. This condition has almost never been seen in the United States since the late nineteenth century. But it is neither rare elsewhere nor impossible in the United States; in fact, it has been Japan’s condition for parts of the past twenty-five years.

The first thing to notice about this equation is that there is real growth of 2 percent, which is weak by historic standards but roughly equal to U.S. growth since 2009. As an alternative scenario, using the formula above, assume annual deflation of 4 percent, as actually occurred from 1931 to 1933. Now the expression is (-1) – (-4) = 3. In this case, real growth would be 3 percent, much closer to trend and arguably not at depressionary levels. However, a condition of high deflation, zero interest rates, and continuing high unemployment closely resembles a depression. This is an example of the through-the-looking-glass quality of economic analysis in a world of deflation.

Despite possible real growth, the U.S. Treasury and the Federal Reserve fear deflation more than any other economic outcome. Deflation means a persistent decline in price levels for goods and services. Lower prices allow for a higher living standard even when wages are constant, because consumer goods cost less. This would seem to be a desirable outcome, based on advances in technology and productivity that result in certain products dropping in price over time, such as computers and mobile phones. Why is the Federal Reserve so fearful of deflation that it resorts to extraordinary policy measures designed to cause inflation? There are four reasons for this fear.

The first is deflation’s impact on government debt repayment. Debt’s real value may fluctuate based on inflation or deflation, but the nominal value of a debt is fixed by contract. If one borrows $1 million, then one must repay $1 million plus interest, regardless of whether the real value of $1 million is greater or less due to deflation or inflation. U.S. debt is at a point where no feasible combination of real growth and taxes will finance repayment of the amount owed. But if the Fed can cause inflation—slowly at first to create money illusion, and then more rapidly—the debt will be manageable because it will be repaid in less valuable nominal dollars. In deflation, the opposite occurs, and the real value of the debt increases, making repayment more difficult.

The second problem with deflation is its impact on the debt-to-GDP ratio. This ratio is the debt amount divided by the GDP amount, both expressed in nominal terms. Debt is continually increasing in nominal terms because of continuing budget deficits that require new financing, and interest payments that are financed with new debt. However, as shown in the previous example, real growth can be positive even if nominal GDP is shrinking, provided deflation exceeds nominal growth. In the debt-to-GDP ratio, when the debt numerator expands and the GDP denominator shrinks, the ratio increases. Even without calculating entitlements, the U.S. debt-to-GDP ratio is already at its highest level since the Second World War; including entitlements makes the situation far worse. Over time, the impact of deflation could drive the U.S. debt-to-GDP ratio above the level of Greece, closer to that of Japan. Indeed, this deflationary dynamic is one reason the Japanese debt-to-GDP ratio currently exceeds 220 percent, by far the highest of any developed economy. One impact of such sky-high debt-to-GDP ratios on foreign creditors is ultimately a loss of confidence, higher interest rates, worse deficits because of the higher interest rates, and finally an outright default on the debt.

The third deflation concern has to do with the health of the banking system and systemic risk. Deflation increases money’s real value and therefore increases the real value of lenders’ claims on debtors. This would seem to favor lenders over debtors, and initially it does. But as deflation progresses, the real weight of the debt becomes too great, and debtor defaults surge. This puts the losses back on the bank lenders and causes bank insolvencies. Thus the government prefers inflation, since it props up the banking system by keeping banks and debtors solvent.

The fourth and final problem with deflation is its impact on tax collection. This problem is illustrated by comparing a worker making $100,000 per year in two different scenarios. In the first scenario, prices are constant and the worker receives a $5,000 raise. In the second scenario, prices drop 5 percent and the worker receives no raise. On a pre-tax basis, the worker has the same 5 percent increase in her standard of living in both scenarios. In the first scenario, the improvement comes from a higher wage, and in the second it comes from lower prices, but the economic result is the same. Yet on an after-tax basis, these scenarios produce entirely different outcomes. The government taxes the raise, say, at a 40 percent rate, but the government cannot tax the declining prices. In the first scenario, the worker keeps only 60 percent of the raise after taxes. But in the second scenario, she keeps 100 percent of the benefit of lower prices. If one assumes inflation in the first example, the worker may be even worse off because the part of the raise remaining after taxes is diminished by inflation, and the government is better off because it collects more taxes, and the real value of government debt declines. Since inflation favors the government and deflation favors the worker, governments always favor inflation.

In summary, the Federal Reserve prefers inflation because it erases government debt, reduces the debt-to-GDP ratio, props up the banks, and can be taxed. Deflation may help consumers and workers, but it hurts the Treasury and the banks and is firmly opposed by the Fed. This explains Alan Greenspan’s extraordinary low-interest-rate policies in 2002 and Ben Bernanke’s zero-rate policy beginning in 2008. From the Fed’s perspective, aiding the economy and reducing unemployment are incidental by-products of the drive to inflate. The consequence of these deflationary dynamics is that the government must have inflation, and the Fed must cause it.

The dynamics amount to a historic collision between the natural forces of deflation and government’s need for inflation. So long as price index data show that deflation is a threat, the Fed will continue with its zero-rate policy, money printing, and efforts to cheapen the dollar in foreign exchange markets in order to import inflation through higher import prices. When the data show a trend toward inflation, the Fed will allow the trend to continue in the hope that nominal growth will become self-sustaining. This will cause inflation to take on a life of its own through behavioral feedback loops not included in Fed models.

Japan is a large canary in a coal mine in this regard. The Asian nation has undergone persistent core deflation since 1999 but also saw positive real growth from 2003 to 2007 and negative nominal growth in 2001 and 2002. Japan has not experienced the precise combination of negative nominal growth, deflation, and positive real growth on a persistent basis, but it has flirted with all those elements throughout the past fifteen years. To break out of this coil, Japan’s new prime minister, Shinzo Abe, elected in December 2012, declared his policy of the “three arrows”: money printing to cause inflation, deficit spending, and structural reforms. A corollary to this policy was to weaken the exchange value of the yen to import inflation, mostly through higher prices for energy imports.

The initial response to “Abenomics” was highly favorable. In the five months following Abe’s election, the yen, measured against dollars, dropped 17 percent, from 85 to 1 to 102 to 1, while the Japanese Nikkei stock index rose 50 percent. The combination of a cheaper yen, the wealth effect from rising stock prices, and the promise of more money printing and deficit spending seemed like a page from a central banker’s playbook on how to break out of a deflationary spiral.

Despite the burst of market enthusiasm for Abenomics, a cautionary note was raised in a speech on May 31, 2013, in Seoul, South Korea, by one of the most senior figures in Japanese finance, Eisuke Sakakibara, a former deputy finance minister, nicknamed “Mr. Yen.” Sakakibara emphasized the importance of real growth even in the absence of nominal growth and pointed out that the Japanese people are wealthy and have prospered personally despite decades of low nominal growth. He made the often-overlooked point that because of Japan’s declining population, real GDP per capita will grow faster than real aggregate GDP. Far from a disaster story, a Japan that has deflation, depopulation, and declining nominal GDP can nevertheless produce robust real per capita GDP growth for its citizens. Combined with the accumulated wealth of the Japanese people, this condition can result in well-to-do society even in the face of nominal growth that would cause most central bankers to flood the economy with money.

Sakakibara is not unaware of the impact of deflation on the real value of debt. The Japanese debt-to-GDP ratio is mitigated by zero interest rates, which prevent the debt from compounding rapidly. Most Japanese government debt is owned by the Japanese themselves, so a foreign financing crisis of the kind that struck Thailand in 1997 and Argentina in 2000 is unlikely. Sakakibara’s most telling point is that Japan’s growth problems are structural, not cyclical, and therefore cyclical remedies such as money printing will not work; he sees no chance of Japanese inflation hitting the 2 percent target rate.

Sakakibara’s insights, that monetary remedies will not solve structural problems, and that real growth is more important than nominal growth, are being ignored by central banks in both the United States and Japan. The Federal Reserve and the Bank of Japan will pursue the money-printing pseudoremedy as far as possible until investors finally lose confidence in their currencies, their bonds, or both. Japan, the canary, will likely suffer this crisis first.

The Federal Reserve’s supporters ask defensively, What else could the Fed have done? If the Fed had not resorted to extraordinary money creation in 2008 and the years since, it does seem likely that asset prices would have plunged further, unemployment would have been significantly higher, and GDP growth significantly worse. A sharp contraction with rising bankruptcies and crashing industrial output, akin to the depression of 1920, might have resulted. In short, the Fed defenders argue, there really was no choice except to create money on an unprecedented scale.

In this view, the problems of executing an exit strategy from monetary expansion are more manageable than the problems of economic depression. Defenders assert that the Fed took the right path in 2008 and persevered with great skill. This is the mainstream view that has resulted in the contemporary lore of Bernanke-as-hero, a halo that has now been transferred to Janet Yellen.

The history of depressions in the United States from 1837 onward supports another perspective on the Fed’s actions. Under this view, the Fed should have provided only enough liquidity to mitigate the worst phase of the financial panic in late 2008. Thereafter the Fed should have capped the amount of excess reserves and normalized interest rates in a range of 1 to 2 percent. Most of the large banks—including Citibank, Morgan Stanley, and Goldman Sachs—should have been temporarily nationalized, their stockholders wiped out, and their bondholders subject to principal reductions as needed to restore capital. Nonperforming assets could have been stripped from these banks in receivership, then placed in a long-term government trust, to be liquidated for the taxpayers’ benefit as circumstances permitted. Management of the banks should have been fired, while enforcement actions and criminal prosecutions were pursued against them as the facts warranted. Finally asset prices, particularly housing and stocks, should have been allowed to fall to much lower levels than were seen in 2009.

In this scenario, bankruptcies and unemployment in 2009–10 would have been much higher and asset values much lower than what actually occurred. The year 2009 would have resembled 1920 in the severity of its depression, with skyrocketing unemployment, collapsing industrial production, and widespread business failure. But an inflection point would have been reached. The government-owned banks could have been taken public with clean balance sheets and would have exhibited a new willingness to lend. Private equity funds would have found productive assets at bargain prices and begun investing. Abundant labor, with lower unit labor costs, could have been mobilized to expand productivity, and a robust recovery, rather than a lifeless one, would have commenced. The depression would have been over by 2010, and real growth would have been 4 to 5 percent in 2011 and 2012.

The benefit of a severe depression in 2009 is not severity for its own sake. No one wishes to play out a morality tale involving greedy bankers getting their just deserts. The point of a severe depression in 2009 is that it would have prompted the structural adjustments that are needed in the U.S. economy. It would also have diverted assets from parasitic pursuits in banking toward productive uses in technology and manufacturing. It would have moved unit labor costs to a new, lower level that would have been globally competitive when higher U.S. productivity was taken into account. Normalized interest rates would have rewarded savers and helped strengthen the dollar, making the United States a magnet for capital flows from around the world. The economy would have been driven by investment and exports rather than relying on the lending-and-spending consumption paradigm. Growth composition would have more nearly resembled the 1950s, when consumption was about 60 percent of GDP, instead of recent decades, when consumption was closer to 70 percent. These types of healthy, long-term structural adjustments would have been forced on the U.S. economy by a one-time liquidation of the excesses of debt and leverage and the grotesque overexpansion of finance.

It is not correct to say the Federal Reserve had no choice in its handling of the economy at the start of the Depression. It is correct to say, in Tom Friedman’s phrase, that there was a failure of imagination to see that the economy’s problems were structural, not cyclical. The Fed applied obsolete general equilibrium models and took a blinkered view of the structural challenge. Policy makers at the Fed and the Treasury avoided a sharp depression in 2009 but created a milder depression that continues today and will continue indefinitely. Federal Reserve and U.S. Treasury officials and staff said repeatedly in 2009 that they wanted to avoid Japan’s mistakes in the 1990s. Instead, they have repeated every one of Japan’s mistakes in their failure to pursue needed structural changes in labor markets, eliminate zombie banks, cut taxes, and reduce regulation on the nonfinancial sector. The United States is Japan on a larger scale, with the same high taxes, low interest rates that penalize savers, labor market rigidities, and too-big-to-fail banks.

Abenomics and Federal Reserve money printing share a frenzied focus on avoiding deflation, but the underlying deflation in both Japan and the United States is not anomalous. It is a valid price signal that the system had too much debt and too much wasted investment prior to the crash. Japan was overinvested in infrastructure, just as the United States was overinvested in housing. In both cases, the misallocated capital reached the point where it had to be written off in order to free up bank balance sheets to make new, more productive loans. But that isn’t what happened.

Instead, as a result of political corruption and cronyism, regulators in both countries preserved the ailing balance sheets in amber along with banker job security. The deflationary price signals were muted with money printing, the same way pain in athletes is masked with steroids. But the deflation did not go away, and it will never go away until the structural adjustments are made.

The United States may find false courage in Japan’s apparent success, using its model as ammunition for evaluating its own QE policies. But the signs in Japan are misleading, consisting of more money illusion and new asset bubbles. Japan reached the crossroads first; it opted for Abenomics. The Fed needs to look more critically at Japan’s putative escape from depression. If it follows the Japanese path, both nations will be headed for an acute debt crisis. The only difference may be that Japan gets there first.

■ The Snowflake and the Avalanche

An avalanche is an apt metaphor of financial collapse. Indeed, it is more than a metaphor, because the systems analysis of an avalanche is identical to the analysis of how one bank collapse cascades into another.

An avalanche starts with a snowflake that perturbs other snowflakes, which, as momentum builds, tumble out of control. The snowflake is like a single bank failure, followed by sequential panic, ending in fired financiers forced to vacate the premises of ruined Wall Street firms carrying their framed photos and coffee mugs. Both the avalanche and the bank panic are examples of complex systems undergoing what physicists call a phase transition: a rapid, unforeseen transformation from a steady state to disintegration, finally coming to rest in a new state completely unlike the starting place. The dynamics are the same, as are the recursive mathematical functions used in modeling the processes. Importantly, the relationship between the frequency and severity of events as a function of systemic scale, called degree distribution, is also the same.

In assessing the risk of financial collapse, one should not only envision an avalanche but study it as well. Complexity theory, first advanced in the early 1960s, is new as the history of science goes, but it offers striking insights into how complex systems behave.

Many analysts use the words complex and complicated interchangeably, but that is inexact. A complicated mechanism, like the clockworks on St. Mark’s Square in Venice, may have many moving parts, but it can be assembled and disassembled in straightforward ways. The parts do not adapt to one another, and the clock cannot suddenly turn into a sparrow and fly away. In contrast, complex systems sometimes do morph and fly away, or slide down mountains, or ruin nations. Complex systems include moving parts, called autonomous agents, but they do more than move. The agents are diverse, connected, interactive, and adaptive. Their diversity and connectivity can be modeled to a limited extent, but interaction and adaptation quickly branch into a seeming infinity of outcomes that can be modeled in theory but not in practice. To put it another way, one can know that bad things might happen yet never know exactly why.

Clocks, watches, and motors are examples of constrained systems that are complicated but not complex. Contrast these with ubiquitous complex systems, including earthquakes, hurricanes, tornadoes—and capital markets. A single human being is a complex system. One billion human beings engaged in trading stocks, bonds, and derivatives constitute an immensely complex system that defies comprehension, let alone computation. This computational challenge does not mean policy makers and risk managers should throw up their hands or use make-believe models like “value at risk.” Risk management is possible with the right combination of complexity tools and another essential: humility about what is knowable.

Consider the avalanche. The climbers and skiers at risk can never know when an avalanche will start or which snowflake will cause it. But they do know that certain conditions are more dangerous than others and that precautions are possible. Snow’s wetness or dryness is carefully observed, as is air temperature and wind speed. Most important, alpinists observe the snowpack size, or what physicists call systemic scale. Those in danger know that a large snowpack can unleash not just a large avalanche but an exponentially larger one. Sensible adaptations include locating villages away from chutes, skiing outside the slide paths, and climbing ridgelines above the snow. Alpinists can also descale the snowpack system with dynamite. One cannot predict avalanches, but one can try to stay safe.

In capital markets, regulators too often do not stay safe; rather, they increase the danger. Permitting banks to build up derivatives books is like ignoring snow accumulation. Allowing JPMorgan Chase to grow larger is like building a village directly in the avalanche path. Using value at risk to measure market danger is like building a ski lift to the unsteady snowpack with free lift tickets for all. Current financial regulatory policy is misguided because the risk-management models are unsound. More unsettling still is the fact that Wall Street executives know the models are unsound but use them anyway because the models permit higher leverage, bigger profits, and larger bonuses. The regulators suspect as much but play along, often in the hope of landing a job with the banks they regulate. Metaphorically speaking, the bankers’ mansions are high on a ridgeline far from the village, while the villagers, everyday Americans and citizens around the world, are in the path of the avalanche.

Financial avalanches are goaded by greed, but greed is not a complete explanation. Bankers’ parasitic behavior, the result of a cultural phase transition, is entirely characteristic of a society nearing collapse. Wealth is no longer created; it is taken from others. Parasitic behavior is not confined to bankers; it also infects high government officials, corporate executives, and the elite societal stratum.

The key to wealth preservation is to understand the complex processes and to seek shelter from the cascade. Investors are not helpless in the face of elite decadence.

■ Risk, Uncertainty, and Criticality

The prototypical explication of financial risk comes from Frank H. Knight’s seminal 1921 work Risk, Uncertainty and Profit. Knight distinguished between risk, by which he meant an unknown outcome that can nevertheless be modeled with a degree of expectation or probability, and uncertainty, an unknown outcome that cannot be modeled at all. The poker game Texas hold’em is an example of risk as Knight used the term. When a card is about to be turned up, a player does not know in advance what it will be, but he does know with certainty that it will be one among fifty-two unique possibilities in one of four suits. As more cards are turned up, the certainty increases because some outcomes have been eliminated by prior play. The gambler takes risks but is not dealing with complete uncertainty.

Now imagine the same game with a player who insists on using “wild cards.” In a wild card game, any card can be deemed to be any other card by any player to help her make a high hand like a full house or a straight flush. Technically, this is not complete Knightian uncertainty, but it comes close. Even the best poker players with superb computational skills cannot compute the odds of making a hand with wild cards. This is why professional poker players detest wild card games and amateurs enjoy them. The wild card is also a good proxy for complexity. Turning the two of clubs into an ace of spades on a whim is like a phase transition—unpredictable, instantaneous, and potentially catastrophic if one is on the losing side of the bet.

Knight’s work came forty years before complexity theory emerged, before the advent of the computer made possible advanced research into randomness and stochastic systems. His division of the financial landscape into the black-and-white worlds of risk and uncertainty was useful at the time, but today there are more shades of gray.

Random numbers are those that cannot be predicted but can be assigned values based on a probability of occurrence over time or in a long series. Coin tosses and playing cards are familiar examples. It is impossible to know if the next coin toss will be heads or tails, and you cannot know if the next card in the deck is the ace of spades, but you can compute the odds. Stochastic models are those that describe systems based on random number inputs. Such systems are not deterministic but probabilistic, and when applied to financial markets, they allow prices and values to be assigned based on the probabilities. This was Knight’s definition of risk. Stochastic systems may include nonlinear functions, or exponents, that cause small input changes to produce massive changes in results.

Stochastic models are supplemented by integral calculus, which measures quantity, and differential calculus, which measures change. Regressions, which are backward-looking associations of one variable to another, allow researchers to correlate certain events. This taxonomy of random numbers, stochastic systems, nonlinear functions, calculus, and regression comprises modern finance’s toolkit. The application of this toolkit to derivatives pricing, value at risk, monetary policy, and economic forecasting takes practitioners to the cutting edge of economic theory.

Beyond the cutting edge is complexity theory. Complexity has not been warmly embraced by mainstream economics, in part because it reveals that much economic research for the past half-century is irrelevant or deeply flawed. Complexity is a quintessential example of new science overturning old scientific paradigms. Economists’ failure to embrace the new science of complexity goes some way toward explaining why the market collapses in 1987, 1998, 2000, and 2008 were both unexpected and more severe than experts believed possible.

Complexity offers a way to understand the dynamics of feedback loops through recursive functions. These have so many instantaneous iterations that explosive results may emerge from minute causes too small even to be observed. An example is the atomic bomb. Physicists know that when highly enriched uranium is engineered into a critical state and a neutron generator is applied, a catastrophic explosion will result that can level a city; but they do not know precisely which subatomic particle will start the chain reaction. Modern economists spend their time looking for the subatomic particle while ignoring the critical state of the system. They are looking for snowflakes and ignoring the avalanche.

Another formal property of complex systems is that the size of the worst event that can happen is an exponential function of the system scale. This means that when a complex system’s size is doubled, the systemic risk does not double; it may increase by a factor of ten or more. This is why each financial collapse comes as a “surprise” to bankers and regulators. As systemic scale is increased by derivatives, systemic risk grows exponentially.

Criticality in a system means that it is on the knife-edge of collapse. Not every complex system is in a critical state, as some may be stable or subcritical. One challenge for economists is that complex systems not in the critical state often behave like noncomplex systems, and their stochastic properties can appear stable and predictable right up to the instant of criticality, at which point emergent properties manifest and a catastrophe unfolds, too late to stop. Again, enriched uranium serves as an illustration. A thirty-five-pound block of uranium shaped as a cube poses no risk. It is a complex system—the subatomic particles do interact, adapt, and decay—but no catastrophe is imminent. But when the uranium block is precision engineered in two parts, one the size of a grapefruit and one like a baseball bat, and the parts are forced together by high explosives, an atomic explosion results. The system goes from subcritical to critical by engineering.

Complex systems can also go from subcritical to critical spontaneously. They morph in the same way a caterpillar turns into a butterfly, a process physicists call “self-organized criticality.” Social systems including capital markets are characterized by such self-organized criticality. One day the stock market behaves well, and the next day it unexpectedly collapses. The 22.6 percent one-day stock market crash on Black Monday, October 19, 1987, and the 7 percent fifteen-minute “flash crash” on May 6, 2010, are both examples of the financial system self-organizing into the critical state; at that point, it takes one snowflake or one sell order to start the collapse. Of course, it is possible to go back after the fact and find a particular sell order that, supposedly, started the market crash (an example of hunting for snowflakes). But the sell order is irrelevant. What matters is the system state.

■ Gold Games

Central bank gold market manipulation is an example of action in a complex system that can cause the system to reach the critical state.

That central banks intervene in gold markets is neither new nor surprising. To the extent that gold is money, and central banks control money, then central banks must control gold. Prior to gold’s partial demonetization in the mid-1970s, central bank involvement in gold markets was arguably not manipulative but a matter of policy, although the policy was conducted nontransparently.

In the post–Bretton Woods era, there have been numerous well-documented central bank gold market manipulations. In 1975 Federal Reserve chairman Arthur Burns wrote a secret memorandum to President Gerald Ford that stated:

Just three days after the Burns memorandum was written, President Ford sent a letter to German chancellor Helmut Schmidt incorporating the substance of Burns’s advice:

Central bank gold market manipulation wasn’t unique to the 1970s but continued in the decades that followed. A Freedom of Information Act (FOIA) lawsuit against the Federal Reserve System filed by an advocacy group uncovered meeting notes of the secret Gold and Foreign Exchange Committee of G-10 central bank governors held at the Bank for International Settlements on April 7, 1997. That committee is the successor to the notorious 1960s London Gold Pool price-fixing scheme. The notes, prepared by Dino Kos of the Federal Reserve Bank of New York, include the following:

More recently, on September 17, 2009, former Federal Reserve Board governor Kevin Warsh sent a letter to a Virginia law firm denying an FOIA request for documentation of Fed gold swaps on the grounds that the Fed had an exemption for “information relating to swap arrangements with foreign banks on behalf of the Federal Reserve System.” While the FOIA request was denied, Warsh’s letter at least acknowledged that central bank swaps exist.

On May 31, 2013, Eisuke Sakakibara, former vice minister of the Japanese Ministry of Finance, cheerfully recalled how Japan’s government had secretly acquired 300 tonnes of gold in the mid-1980s. This gold acquisition does not appear in the Bank of Japan’s reserve position reported by the World Gold Council, because it was executed by the Finance Ministry rather than by the central bank:

The gold was transported to Japan by Brinks in the upper deck of two Boeing 747s configured for cargo use. Two shipments were used not because of weight but to spread the risk. Brinks had two couriers on each flight so that the gold could be watched at all times even as one courier slept.

The foregoing documentary record is just the tip of the iceberg in terms of official gold market manipulation by central banks, finance ministries, and their respective bank agents. Still, it establishes beyond dispute that governments use a combination of gold purchases, sales, leases, swaps, futures, and political pressure to manipulate gold prices in order to achieve policy objectives, and they have done so for decades, since the end of Bretton Woods. Official gold sales that depressed gold prices were practiced extensively by Western central banks from 1975 to 2009 but came to an abrupt end in 2010, as gold prices skyrocketed and citizens questioned the wisdom of selling such a valuable asset.

The most notorious and heavily criticized case involved the sale of 395 tonnes of U.K. gold by chancellor of the exchequer Gordon Brown in a series of auctions from July 1999 to March 2002. The average price received by the U.K. was about $275 per ounce. Using $1,500 per ounce as a reference price, losses to U.K. citizens from Brown’s blunder exceed $17 billion. More damaging than the lost wealth was the U.K.’s diminished standing among the ranks of global gold powers. Recently, outright gold sales by central banks as a form of price manipulation have lost their appeal as gold reserves have been depleted, prices have surged, and the United States has conspicuously refused to sell any gold of its own.

The more powerful price manipulation techniques by central banks and their private bank agents involve swaps, forwards, and futures or leases. These “paper gold” transactions permit massive leverage and exert downward pressure on gold prices, while the physical gold seldom leaves the central bank vaults.

A gold swap is typically conducted between two central banks as an exchange of gold for currency, with a promise to reverse the transaction in the future. In the meantime, the party receiving the currency can invest it for a return over the life of the swap.

Gold forward and gold futures transactions are conducted either between private banks and counterparties or on exchanges. These are contracts that promise gold delivery at a future date; the difference between a forward and a future is that the forward is traded over the counter with a known counterparty, while a future is traded anonymously on an exchange. Parties earn a profit or incur a loss depending on whether the gold price rises or falls between the contract date and the future delivery date.

In a lease arrangement, one central bank leases its gold to a private bank that sells it on a forward basis. The central bank collects a fee for the lease, like rent. When a central bank leases gold, it gives the private banks the title needed to conduct forward sales. The forward sales market is then amplified by the practice of selling unallocated gold. When a bank sells unallocated gold to a customer, the customer does not own specific gold bars. This allows the banks to sell multiple contracts to multiple parties using the same gold. In allocated transactions, the client has direct title to specific numbered bars in the vault.

These arrangements have one thing in common, which is that physical gold is rarely moved, and the same gold can be pledged many times to support multiple contracts. If the Federal Reserve Bank of New York leases 100 tonnes to JPMorgan in London, JPMorgan then takes legal possession under the lease, but the gold remains in the Fed’s New York vault. With legal title in hand, JPMorgan can then sell the same gold ten times to different customers on an unallocated basis.

Similarly, a bank like HSBC can enter the futures market and sell 100 tonnes of gold to a buyer for delivery in three months but needs no physical gold to do so. The seller needs only to meet margin requirements in cash, which are a small fraction of the gold’s value. These leveraged paper gold transactions are far more effective in manipulating market prices than outright sales, because the gold does not have to leave the central bank vaults; therefore the amount of selling power is many times greater than the gold on hand.

The easiest way for central banks to disguise their actions in the gold markets is to use bank intermediaries such as JPMorgan. The granddaddy of all bank intermediaries is the Bank for International Settlements, based in Basel, Switzerland. That the BIS acts for the central bank clients in the gold markets is not surprising; in fact, it was one reason the BIS was created in 1930. The BIS denominates its financial books and records in SDRs, as does the IMF. The BIS website states plainly, “Around 90% of customer placements are denominated in currencies, with the remainder in gold…. Gold deposits amounted to SDR 17.6 billion [about $27 billion] at 31 March 2013…. The Bank owned 115 tonnes of fine gold at 31 March 2013.”

The BIS’s eighty-third annual report, for the period ending March 31, 2013, states:

Sight accounts in gold are unallocated, and earmarked accounts in gold are allocated. In finance, sight is an old legal term meaning “payable on demand or presentment,” although there is no requirement to have the gold on hand until such demand is actually made. The BIS achieves the same leverage employed by its private bank peers using leasing, forwards, and futures.

Notably, footnote 15 of the accounting policies in the 2010 BIS annual report stated, “Gold loans comprise fixed-term gold loans to commercial banks.” In the 2013 report, the same footnote stated, “Gold loans comprise fixed-term gold loans.” Apparently by 2013 the BIS considered it wise to hide the fact that the BIS deals with private commercial banks. This deletion makes sense because the BIS is one of the main transmission channels for gold market manipulation. Central banks deposit gold with the BIS, which then leases the gold to commercial banks. Those commercial banks sell the gold on an unallocated basis, which allows ten dollars of sales or more for every one dollar of gold deposited at the BIS. Massive downward pressure is exerted on the gold market, but no physical gold ever changes hands. It is a well-honed system for gold price suppression.

While the presence of central banks in gold markets is undoubted, the exact times and places of their manipulation are not disclosed. But intriguing inferences can be made. For example, on September 18, 2009, the IMF authorized the sale of 403.3 tonnes of gold. Of that amount, 212 tonnes were sold, during October and November 2009, to the central banks of India, Mauritius, and Sri Lanka. An additional 10 tonnes were sold to the Central Bank of Bangladesh in September 2010. These sales were done by prearrangement to avoid disrupting the market. Sales of the remaining 181.3 tonnes commenced on February 17, 2010, but the buyers have never been disclosed. The IMF claimed the other sales were “on market” but also said that “initiation of on-market sales did not preclude further off-market gold sales directly to interested central banks or other official holders.” In other words, the 181.3 tonnes could easily have gone to China or the BIS.

At the same time as the IMF gold sales were announced and conducted, the BIS reported a sharp spike in its own gold holdings. BIS gold increased from 154 tonnes at the end of 2009 to over 500 tonnes at the end of 2010. It is possible that the IMF transferred part of the unaccounted-for 181.3 tonnes to the BIS, and that the BIS Banking Department, controlled at the time by Günter Pleines, a former central banker from Germany, sold the gold to China. It is also possible that the large gold influx was attributable to gold swaps from desperate European banks trying to raise cash to meet obligations as their asset values imploded during the sovereign debt crisis. The answer is undisclosed, but either way the BIS stood ready to facilitate such nontransparent gold market activity as it had done for the Nazis and others since 1930.

Some of the most compelling evidence for manipulation in gold markets comes from a study conducted by the research department of one of the largest global-macro hedge funds in the world. This study involved two hypothetical investment programs over a ten-year period, from 2003 to 2013. One program would buy gold futures at the New York COMEX opening price every day and sell at the close. The other program would buy gold at the beginning of after-hours trading and sell just before the COMEX open the following day. In effect, one program would own New York hours and the other program would own the after-hours. In a nonmanipulated market, these two programs should produce nearly identical results over time, albeit with daily variations. In fact, the New York program revealed catastrophic losses, while the after-hours program showed spectacular gains well in excess of the market gold price over the same period. The inescapable inference is that manipulators slam the New York close, which creates excess profit opportunities for the after-hours trader. Since the New York close is the most widely reported “price” of gold, the motivation is equally clear.

The motivation for central bank gold market manipulation is as subtle as the methods used. Central banks want inflation to reduce the real value of government debt and to transfer wealth from savers to banks. But central banks also work to suppress the price of gold. These twin goals seem difficult to reconcile. If central banks want inflation, and if a rising gold price is inflationary, why would central banks suppress the gold price?

The answer is that central banks, principally the Federal Reserve, do want inflation, but they want it to be orderly rather than disorderly. They want the inflation to come in small doses so that it goes unnoticed. Gold is highly volatile, and when it spikes up sharply, it raises inflationary expectations. The Federal Reserve and the BIS suppress gold prices not to keep them down forever, but rather to keep the increases orderly so that savers do not notice inflation. Central banks act like a nine-year-old-boy who sees fifty dollars in his mom’s wallet and steals one dollar thinking she won’t notice. The boy knows that if he takes twenty, Mom will notice, and he will be punished. Inflation of 3 percent per year is barely noticed, but if it persists for twenty years, it cuts the value of the national debt almost in half. This kind of slow, steady inflation is the central banks’ goal. Managing inflation expectations by manipulating gold prices downward was the rationale given by Fed chairman Arthur Burns to President Gerald Ford in the secret 1975 memo. That hasn’t changed.

Since then, however, an even more ominous motive for central bank gold price manipulation has emerged. The gold price must be kept low until gold holdings are rebalanced among the major economic powers, and the rebalancing must be completed before the collapse of the international monetary system. When the world returns to a gold standard, either by choice to create inflation, or of necessity to restore confidence, it will be crucial to have support from all the world’s major economic centers. A major economy that does not have sufficient gold will either be relegated to the periphery of any new Bretton Woods–style conference, or refuse to participate because it cannot benefit from gold’s revaluation. As in a poker game, the United States possessed all the chips at Bretton Woods and used them aggressively to dictate the outcome. Were Bretton Woods to happen again, nations such as Russia and China would not permit the United States to impose its will; they would prefer to go their own way rather than be subordinate to U.S. financial hegemony. A more equal starting place would be required to engender a cooperative process for reforming the system.

Is there a preferred metric for rebalancing reserves? Many analysts look at the statistics for gold as a percentage of reserves. The United States has 73.3 percent of its reserves in gold; the comparable figure for China is 1.3 percent. But this metric is misleading. Most countries have reserves consisting of a combination of gold and hard currencies. But since the United States can print dollars, it has no need for large foreign currency reserves, and as a result, the U.S. reserve position is dominated by gold. China, on the other hand, has little gold but approximately $3 trillion of hard-currency reserves. Those reserves are valuable in the short run even if they are vulnerable to inflation in the future. For these reasons, the 73 percent U.S. ratio overstates U.S. strength, and the 1.3 percent ratio overstates China’s weakness.

A better measure of gold’s role as a monetary reserve is to divide gold’s nominal market value by nominal GDP (gold-to-GDP ratio). Nominal GDP is the total value of goods and services that an economy produces. Gold is the true monetary base, the implicit reserve asset behind the Fed’s base money called M-Zero (M0). Gold is M-Subzero. The gold-to-GDP ratio reveals the true money available to support the economy and presages the relative power of a nation if a gold standard resumes. Here are recent data for a select group of economies that together comprise over 75 percent of global GDP:

The global gold-to-GDP ratio of 2.2 percent reveals that the global economy is leveraged to real money at a 45-to-1 ratio but with a significant skew in favor of the United States, the Eurozone, and Russia. Those three economies have ratios above the global average; the Eurozone’s ratio at 4.6 percent is more than double the global average. The United States and Russia are in strategic gold parity, the result of Russia’s 65 percent increase in its gold reserves since 2009. This dynamic is an eerie echo of the early 1960s “missile gap,” from a time when Russia and the United States competed for supremacy in nuclear weapons. That competition was deemed unstable and resulted in strategic arms limitations agreements in the 1970s, which have maintained nuclear stability in the forty years since. Russia has now closed the “gold gap” and stands on a par with the United States.

The conspicuous weak links are China, the U.K., and Japan, each with a 0.7 percent ratio, less than one-third the U.S.-Russia ratio and far smaller than that of the Eurozone. Other major economies, such as Brazil and Australia, stand even lower, while Canada’s gold hoard is trivial compared to the size of its economy.

If gold is not money, these ratios are unimportant. If, however, there were a collapse of confidence in fiat money and a return to gold-backed money, either by design or on an emergency basis, these ratios would determine who would have the most influence in IMF or G20 negotiations to reform the international monetary system. On current form, Russia, Germany, and the United States would dominate those discussions.

■ China’s Gold Deception

Once again we find ourselves looking at China. It seems absurd to posit that the international monetary system could be reformed without major participation by China, the world’s second-largest economy (third if the Eurozone is viewed as a single entity). It is known, but not publicly disclosed, that China has far greater gold reserves than it states officially. If Table 2 is restated to show China with an estimated—but more accurate—4,200 tonnes of gold, then the change in ratios is dramatic.

In this revised alignment, the global ratio increases slightly from 2.2 percent to 2.5 percent, putting global gold leverage at 40 to 1. More important, China would now join the “gold club” with a 2.7 percent ratio, equivalent to Russia and the United States and comfortably above the global average.

Although it is rarely discussed publicly by monetary elites, the increase of China’s gold ratio from 0.7 percent toward 2.7 percent, as shown in the comparison of Table 2 and Table 3, has actually been occurring in recent years. When this gold rebalancing is complete, the international monetary system could move to a new equilibrium gold price without China being left behind with only paper money. The increase in China’s gold reserves is designed to give China gold parity with Russia, the United States, and the Eurozone and to rebalance global gold reserves.

This rebalancing paves the way for either global inflation or gold’s emergency use as a reserve currency, but the path has been complicated for China. When Europe and Japan emerged from the ashes of the Second World War, they were able to acquire gold by redeeming their dollar trade surpluses, since the dollar was freely convertible at a fixed price. U.S. gold reserves declined by 11,000 tonnes from 1950 to 1970 as Europe and Japan redeemed dollars for gold. Thirty years later China was the dominant trading nation, earning large dollar surpluses. But the gold window had been closed since 1971, and China could not swap dollars for U.S. gold at a fixed price. As a result, China was forced to acquire its gold reserves on the open market and through its domestic mines.

This market-based gold acquisition posed three dangers for China and the world. The first was that the market impact of such huge purchases meant that gold’s price might skyrocket before China could complete the rebalancing. The second was that China’s economy was growing so quickly that the amount of gold needed to reach strategic parity was a moving target. The third was that China could not dump its dollar reserves to buy gold because it would burden the United States with higher interest rates, which would hurt China’s economy if U.S. consumers stopped buying Chinese goods in response.

The greatest risk to China in the near future is that inflation will emerge in the United States before China obtains all the gold it needs. In that case, the combination of China’s faster growth and higher gold prices will make it costly to maintain its gold-to-GDP ratio. However, once China does acquire sufficient bullion, it will have a hedged position because whatever is lost to inflation will be gained in higher gold prices. At that point, China can give a green light to U.S. inflation. This move toward evenly distributed gold reserves also explains central bank efforts at price manipulation, as the United States and China have a shared interest in keeping the gold price low until China acquires its gold. The solution is for the United States and China to coordinate gold price suppression through swaps, leases, and futures. Once the rebalancing is complete, probably in 2015, there will be less reason to suppress gold’s price because China will not be disadvantaged in the event of a price spike.

Evidence that the United States is accommodating China’s gold reserve acquisition is not difficult to find. The most intriguing comment comes from Min Zhu, the IMF’s deputy managing director. In response to a recent question concerning China’s gold acquisition, he replied, “China’s acquisition of gold makes sense because most global reserves have some credit element to them; they’re paper money. It’s a good idea to have part of your reserves in something real.” The use of the term credit to describe reserves is consistent with the reality that all paper money is a central bank liability and therefore a form of debt. Treasury bonds purchased with paper money are likewise a form of debt. Min Zhu’s distinction between credit reserves and real reserves highlights precisely the role of gold as true base money, or M-Subzero.

The reaction within the U.S. national security community to China’s gold rebalancing is nonchalance. When asked about Chinese gold acquisitions, one of the highest-ranking U.S. intelligence officials shrugged and said, “Somebody’s got to own it,” as if gold reserves were part of a global garage sale. A senior official in the office of the secretary of defense expressed concern about the strategic implications of China’s gold rebalancing but then went on to say, “The Treasury really doesn’t like it when we talk about the dollar.”

The Pentagon and CIA routinely defer to the Fed and the U.S. Treasury when the subject turns to gold and dollars, while Congress is mostly in the dark on this subject. Congressman James Himes, one of only four members of either party with a seat on both the House Financial Services Committee and the House Permanent Select Committee on Intelligence, said, “I never hear any discussion of gold reserve acquisition.” With the military, intelligence agencies, and Congress all unconcerned or uninformed about China’s acquisition of gold, the Treasury and Fed have a free hand to help the Chinese until the rebalancing is a fait accompli.

Despite the discreet and delicate handling of the global gold rebalancing, there are increasing signs that the international monetary system may collapse before a transition to gold or SDRs is complete. In the argot of chaos theorists, the system is going wobbly. Almost every “paper gold” contract has the capacity to be turned into a physical delivery through a notice and conversion provision. The vast majority of all futures contracts are rolled over into more distant settlement periods, or are closed out through an offsetting contract. But buyers of gold futures contracts have the right to request physical delivery of metal by providing notice and arranging to take delivery from designated warehouses. A gold lease can be terminated by the lessor at the end of its term. So-called unallocated gold can be turned into allocated bars, typically by paying additional fees, and the allocated gold can then be delivered to the owner on demand. Certain large gold exchange-traded fund (ETF) holders can convert to physical gold by redeeming the shares and taking gold from the ETF warehouse.

The potentially destabilizing factor is that the amount of gold subject to paper contracts is one hundred times the amount of physical gold backing those contracts. As long as holders remain in paper contracts, the system is in equilibrium. If holders in large numbers were to demand physical delivery, they could be snowflakes on an unstable mountain of paper gold. When other holders realize that the physical gold will run out before they can redeem their contracts for bullion, the slide can cascade into an avalanche, a de facto bank run, except the banks in this case are the gold warehouses that support the exchanges and ETFs. This is what happened in 1969 as European trading partners of the United States began cashing in dollars for physical gold. President Nixon shut the window on these redemptions in August 1971. If he had not done so, the U.S. gold vaults at Fort Knox would have been stripped bare by the late 1970s.

A similar dynamic commenced on October 4, 2012, when spot gold prices hit an interim peak of $1,790 per ounce. From there, gold fell over 12 percent in the next six months. Then gold crashed an additional 23.5 percent, falling to $1,200 per ounce by late June. Far from scaring off buyers, the gold crash made gold look cheap to millions of individual buyers around the world. They lined up at banks and boutiques, quickly stripping supplies. Buyers of standard 400-ounce and 1-kilo bars found there were no sellers; they had to wait almost thirty days for new bars to be produced by the refineries. The Swiss refineries Argor-Heraeus and Pamp moved to around-the-clock shifts to keep up with gold demand. Massive redemptions took place in gold ETFs, not because all investors were bearish on gold but because some wanted to obtain bullion from the ETF warehouses. COMEX warehouses holding gold for futures contract settlements saw inventories drawn down to levels last seen in the Panic of 2008. Gold futures contracts went into backwardation, a highly unusual condition in which gold for spot delivery is more expensive than gold for forward delivery; the opposite usually prevails because the forward seller has to pay for storage and insurance. This was another sign of acute physical shortages and high demand for immediate access to physical gold.

If a gold-buying panic were to break out today, there is no single gold window for the president to close. Instead, a multitude of contractual clauses, in fine print rarely studied by gold buyers, would be called into play. Gold futures exchanges have the ability to convert contracts to cash liquidation only and to shut off the physical delivery channels. Gold bullion banks can also settle gold forward contracts for cash and deny buyers the ability to convert to allocated gold. The “early termination” and force majeure clauses buried in contracts could be used by banks that sold more gold than they had on hand. The result would be that investors would receive a cash settlement up to the contract termination date, but not more. Investors would get some cash but no bullion and would miss the price surge sure to follow.

While physical gold was in short supply and high demand by early 2014, this did not necessarily mean that a superspike in gold prices was imminent. Not every snowslide turns into an avalanche; at times the avalanche awaits different initial conditions. Central banks still have enormous resources, including potential physical sales with which to suppress gold prices in the short run. Still, an alarm has gone off. The central banks’ ability to keep a lid on gold prices has been challenged, and a new willingness of paper gold buyers to demand physical gold has emerged. As China’s gold-buying operations continue apace, the entire international monetary system is tottering on the knife-edge of China’s aspirations and the global demand for physical gold.

While the gold price oscillates between the forces of physical demand and central bank manipulation, another greater catastrophe is looming: the Federal Reserve is on the brink of insolvency, if not already over the brink. This conclusion comes not from a Fed critic but from Frederic S. Mishkin, one of the most eminent monetary economists in the world and mentor to Ben Bernanke and other Fed governors and economists. In his February 2013 paper “Crunch Time: Fiscal Crises and the Role of Monetary Policy,” written with several colleagues, Mishkin warns that the Fed is dangerously close to the point where its independence is fatally compromised and its sole remaining purpose is to monetize deficit spending by causing inflation.

Mishkin and his coauthors make better use of complexity theory and recursive functions in their analysis than any of their peers. They point out the feedback loop in sovereign finance among larger deficits, followed by higher borrowing costs, which cause even larger deficits and still higher borrowing costs, and so on, until a death spiral begins. At that point, countries are faced with the unpalatable choice of either reducing deficits through so-called austerity measures or defaulting on the debts. Mishkin argues that austerity can hurt nominal growth, worsening the debt-to-GDP ratio, and possibly causing a debt default in the course of trying to stop one.

The alternative, in Mishkin’s view, is for a central bank to keep interest rates under control by engaging in monetary ease, while politicians enact long-term deficit solutions. In the meantime, short-term deficits can be tolerated to avoid the austerity curse. Short-term monetary and fiscal ease work in tandem to keep an economy growing, while long-term fiscal reform reverses the death spiral.

Mishkin says this approach works fine in theory, but he brings us back to the real world of dysfunctional political systems that have come to rely on monetary ease to avoid hard choices on the fiscal side. Mishkin calls this condition “fiscal dominance.” His paper describes the resulting crisis:

Mishkin and his coauthors point to another collapse in the making, independent of debt monetization and inflation. As the Fed buys longer-term debt with newly printed money, its balance sheet incurs large mark-to-market losses as interest rates rise. The Fed does not disclose these losses until it actually sells the bonds as part of an exit strategy, although independent analysts can estimate the size of the losses from information that is publicly available.

Monetization of debt leaves the Fed with a Hobson’s choice. If the United States tips into deflation, the debt-to-GDP ratio will worsen because there is insufficient nominal growth. If the United States tips into inflation, the debt-to-GDP ratio will worsen due to higher interest rates on U.S. debt. If the Fed fights inflation by selling assets, it will recognize losses on the bond sales, and its insolvency will become apparent. This insolvency can erode confidence and cause higher interest rates on its own. Fed bond losses will also worsen the debt-to-GDP ratio since the Fed can no longer remit profits to the Treasury, which increases the deficit. There appears to be no way out of a sovereign debt crisis for the United States; the paths are all blocked. The Fed avoided a measure of pain in 2009 with its monetary exertions and market manipulations, but the pain was stored up for another day. That day is here.

Global monetary elites and the Fed, the IMF, and the BIS are playing for time. They need time for the United States to achieve long-term fiscal reform. They need time to create the global SDR market. They need time to facilitate China’s acquisition of gold. The problem is that no time remains. A run on gold has begun before China has what it needs. The collapse of confidence in the dollar has begun before the SDR is ready to take its place. The Fed’s insolvency is looming. As the dollar’s 9/11 moment approaches, the system is blinking red.