Sunday, August 3, 2014

Dirty Float


SteveH asked where it all started so I told him "Jamaica Accords". In good order, Cage Rattler found a nice rundown about the entire evolution of the world monetary system. Everyone here should read all of it because it helps put into perspective much of the Historical material that we analyze.

As for an international or heads of government signed accord, the Jamaica is as close as you will ever see. Often, in politics, protocols are but forced standoffs. Just like when two armies stop shelling each other. Someone makes the wise observation that "the generals must have come to an agreement to stop fighting". Yet, a reporter, trying to make a "responsible" assessment to the public, asks "when will we see a copy of the contract?"! My friend, the observer exclaims, "the events and the actions are the agreement"! –FOA (8/2/99)


_________

Exchange rate stability has long been promoted by economists and desired by central banks. But when Freegold was officially launched for the first time on April 1, 1978 (don't worry, I'll explain in a moment), it was a shock to economists and central bankers alike that the dollar plunged 15% against other currencies and 30% against gold in just 5 short months. The USDX is at 81 today, so that would be like a plunge to 68 before the end of the year (the lowest the dollar has ever been was 70.69 in 2008). Gold is at $1,295 as I write, so that would be like gold jumping to $1,850 in December.

I realize that doesn't seem very alarming given the volatility of the last decade, but try putting yourself back in 1978. We'd recently come off the Bretton Woods system in which currencies traded for 25 years within 1% of their par values. The dollar had previously declined as much as 10% over 5 months, but this time it dropped 7.5% in a single month. Some of the European central banks knew what had changed, and they knew it wouldn't stop there, nor would its effects be limited to the United States. This realization would change the course of monetary history for the next 35 years.

What happened on April 1, 1978 was that the 2nd Amendment to the IMF Articles of Agreement went into force, officially legitimizing floating exchange rates and allowing each CB to choose its own exchange rate policy. They could choose to float their currency or tie it to any external anchor with the sole exception of gold.

In other words, gold was officially set free from its shackles to the monetary system for the first time in history. The 2nd Amendment not only set gold free, but it also effectively established the first ever fiat currency floating exchange rate regime. Together, those two things constitute Freegold, and that's why I said it was officially launched on April 1, 1978… then it was quickly aborted by the same European CBs who had lobbied for it. But I'm getting a little ahead of myself.


Smithsonian Agreement

Under the Articles of Agreement of the International Monetary Fund, the Bretton Woods system required currency exchange rate transactions to stay within ±1% of their fixed par value with the dollar. To maintain this tight range, the foreign public sector, the European central banks, had to fix their currency exchange rates each day by supplementing either supply of or demand for their own currency or the dollar. Before 1958, this meant buying dollars with gold. After 1958 it meant buying dollars with newly printed currency.

Par values could be adjusted only with prior approval from the IMF, and only if there was a "fundamental disequilibrium", a notion that was never precisely defined. But by 1971, fundamental disequilibrium was systemic, and this rigid system was under great tension. In a situation reminiscent of the last days of the London gold pool, the Bundesbank had to buy a billion dollars in a single day on May 4, 1971, in order to maintain its par value. The next morning it had to buy another billion dollars in just the first hour. At that point it made the decision to let the mark float.

In the weeks that followed May 5th, pressure on the dollar grew to extreme levels as the foreign private sector (often called "the speculators" when it goes against the status quo, but I prefer to simply call it "the market") bet on an imminent dollar devaluation. But while each CB could propose a change to its own par value against the dollar, it wasn't so simple to effect a change in the dollar itself. Under IMF rules, a uniform change in par values (which was what a dollar devaluation was by definition) required a majority of the voting members to agree to simultaneously revalue their currencies against the dollar, and many countries didn't want to do this because they thought it would negatively impact their exports to the US. Besides, they didn't mind printing to buy dollars to maintain their par values because the dollar was still technically convertible to gold at $35 per ounce, a 22% discount to the market price at that time.

Then, three months later on August 15, 1971, a Sunday, President Nixon shocked the world by announcing that the dollar was no longer convertible to gold, and that a new 10% tax on imports would remain in effect until US trading partners agreed to revalue their currencies against the dollar. That announcement brought the "Group of Ten" (Belgium, Canada, France, Italy, Japan, the Netherlands, the United Kingdom, Germany, Sweden and Switzerland) to the bargaining table at a meeting at the Smithsonian Institution in Washington, D.C. in December of 1971. The group agreed to devalue the dollar and the import tax was removed.


Snake in the Tunnel

One of the results of the Smithsonian Agreement was the idea of a 2.25% trading band. The dollar was devalued with a new set of par values for the other main currencies, and the tight band of 1% in Bretton Woods was widened to 2.25%.

Four months later, in the "Basel Agreement" on April 10, 1972, the members of the European Economic Community (EEC) conceived the idea of the snake in the tunnel. It was an easy explanation of the Smithsonian Agreement setup, but more importantly, it distinguished the snake (the European currencies) from the tunnel (the dollar), opening the possibility of the snake existing without a tunnel. It also marked even tighter European cooperation than the Smithsonian Agreement technically required.

Here is the explanation of the snake in the tunnel from Wikipedia:

"With the failure of the Bretton Woods system with the Nixon shock in 1971, the Smithsonian agreement set bands of ±2.25% for currencies to move relative to their central rate against the US dollar. This provided a tunnel in which European currencies to trade. However, it implied much larger bands in which they could move against each other: for example if currency A started at the bottom of its band it could appreciate by 4.5% against the dollar, while if currency B started at the top of its band it could depreciate by 4.5% against the dollar.

If both happened simultaneously, then currency A would appreciate by 9% against currency B. This was seen as excessive, and the Basel agreement in 1972 between the six existing EEC members and three about to join established a snake in the tunnel with bilateral margins between their currencies limited to 2.25%, implying a maximum change between any two currencies of 4.5%, and with all the currencies tending to move together against the dollar."

The snake in the tunnel marked the trailhead of the dirty float trail which is ending today, as well as the beginning of Eurocentric exchange rate cooperation that ended with a common currency in 1999. But the snake left its tunnel after barely one year.


Exchange Rate Anarchy

Lest you got the impression that Bretton Woods was a strict disciplinary system under a tyrannical master (the IMF), let me assure you that it was not. Regardless of how it was written, in practice, it was a system of voluntary cooperation (more or less) between CBs. In fact, enforcement was pretty slack. It was actually more of an honor system.

Some countries used "multiple" par values, and some never declared any par value at all, essentially floating their exchange rates without incurring any sanctions. And most par value adjustments (unilateral de- or re-valuations) were not run through the IMF as was required.

When Bretton Woods started, the IMF had 44 different member currencies. By the mid-1970s, that number was up to 127. The point of mentioning this is not that some of the members disobeyed the rules, but that most of them followed the rules voluntarily, without any serious threat of sanctions. The international monetary system yearns for a set of rules that everyone can easily follow, voluntarily. But from mid-1972 until 1978, anarchy was a good description of the international monetary system.

In June of '72, the UK decided to float the pound, followed by Italy in January of '73. In February of '73, the EEC had to buy $3.6 billion just to keep the snake in the tunnel. Then on March 1st, the EEC temporarily closed its foreign exchange markets and pulled its snake out of the dollar tunnel allowing it to float as a group against the dollar. Japan and Switzerland followed. Over the next three years, a number of international meetings were held in attempt to deal with the chaos, to somehow make sense out of the anarchy, and to try to codify it into a new set of rules that would be agreeable to the majority.

In September of '73, a new IMF "Committee of 20" (the full name was the Committee on Reform of the International Monetary System) met in Nairobi to begin constructing new IMS rules. Two basic ideas were agreed upon in Nairobi. 1. Stable but adjustable exchange rates were the goal. At the time, that seemed to mean something in between fixed parities and floating exchange rates. And 2. There should not be a single national currency with the privileged position of the dollar in that all other currency pairs must not only watch their exchange rates with each other but also their combined relation to the dollar.

A few weeks after Nairobi, the oil crisis hit, and with it came a dramatic rise in the general price level of raw materials and food. In April of 1974, the EEC met informally in the Dutch town of Zeist where they decided that their gold reserves should be mobilized (bought and sold with each other and with the free gold market) at the free gold market price in order to help the struggling European oil and raw material importing countries. Some even took the additional step of revaluing their gold reserves from the current $42.22 to the market price which, at the time of the meeting, was $174 per ounce.

Then, in June of 1974, the IMF decided to change the value of an SDR from gold to a trade-weighted basket of 16 different currencies. International monetary links to gold and the dollar were quickly disintegrating, but the monetary system continued to destabilizes. One by one, European countries severed their ties to the snake, including France in July of 1975, until it was little more than a worm with just five remaining members.


Jamaica Accord

By 1976, the Bretton Woods monetary system was little more than a distant memory, but the Articles of Agreement for the International Monetary Fund were still the rule book for the international monetary system which had grown from 44 to 127 members. The US had broken the rules in 1971, but by 1976 everyone was breaking the rules.

So what do you do when everyone is breaking the rules, when everyone is a barbarous outlaw? That's right. You rewrite the rules! And that's precisely what the Committee of 20 set out to do when it met again, this time in Jamaica, on January 7-8, 1976.

What came out of that meeting was the 2nd Amendment to the IMF Articles of Agreement. The 1st Amendment was back in 1969, creating the SDR as a supplemental reserve asset. But the primary achievements of the 2nd Amendment were sweeping; a full rewrite of Article IV—Obligations Regarding Exchange Arrangements, as well as the abolition of the official price of gold and authorization for central banks to carry out gold transactions at free gold market prices.

Regarding exchange rate policy, the new Article IV laid down the general objectives as promoting and fostering growth and stability, while avoiding "erratic disruptions" and exchange rate manipulations that prevent effective adjustment mechanisms, "or to gain an unfair competitive advantage over other members." Each member would have 30 days after the Amendment went into force to notify the IMF of its chosen exchange rate policy. The range of possible choices was unlimited except for one single restriction. The sole limitation was that no member could choose to maintain the value of its currency in terms of gold.

In addition to Article IV, the 2nd Amendment mentions gold in five more of its 31 Articles as well as in four of its 13 Schedules. Here are the highlights:

Under Article V: Operations and Transactions of the Fund, Section 12, it made provisions for the sale of IMF gold back to its members that want it back and for other purposes excluding "the management of the price, or the establishment of a fixed price, in the gold market."

Section 12. Other operations and transactions

(a) The Fund shall be guided in all its policies and decisions under this Section by the objectives set forth in Article VIII, Section 7 and by the objective of avoiding the management of the price, or the establishment of a fixed price, in the gold market.

[…]

(e) The Fund may sell gold held by it on the date of the second amendment of this Agreement to those members that were members on August 31, 1975 and that agree to buy it, in proportion to their quotas on that date.

Under Schedule B: Transitional Provisions with Respect to Repurchase, Payment of Additional Subscriptions, Gold, and Certain Operational Matters, it says that any existing obligations for a member to pay gold to the IMF will now be paid in SDRs:

2. A member shall discharge with special drawing rights any obligation to pay gold to the Fund in repurchase or as a subscription that is outstanding at the date of the second amendment of this Agreement, but the Fund may prescribe that these payments may be made in whole or in part in the currencies of other members specified by the Fund.

Under Schedule C: Par Values, in the case that adjustable par values are ever reestablished based on an 85% majority vote [bracketed notes are mine]:

1. […] The common denominator shall not be gold or a [single] currency [like the dollar in the past].

Under Schedule K: Administration of Liquidation (of the IMF)

9. The Fund shall determine the value of gold under this Schedule on the basis of prices in the market.

The 2nd Amendment was approved and adopted in April of 1976, and went into force two years later on April 1, the first day of the second quarter of 1978. It is still in force today. You can read the new Article IV here, as well as the full text of the IMF Articles of Agreement as they stand today.


Q2 1978

Q2 1978 marked the first and only major change in the official rules governing international currency exchange rate policy in the last 70 years, legitimizing floating exchange rates and allowing each CB to choose its own policy. Coincidentally (or not… probably not), it also marked the first quarter since the collapse of the Bretton Woods fixed exchange rate system that European central banks, in aggregate, stopped buying dollars.

The term "dirty float" has two components. "Float" refers to the private sector, "the market" as I like to call it, or "the speculators" as the public sector likes to call it whenever it upsets the status quo. And "dirty" refers to the public sector resisting market forces, also known as CB intervention whenever "the speculators" disturb the status quo.

Even though the snake pulled out of the tunnel and the European currencies began floating against the dollar in 1973, it was still a dirty float all through the 70s, until Q2 1978 when it suddenly went clean. To give you an idea of the abruptness of this "going cold turkey" change, during the two preceding quarters, foreign CBs in aggregate bought $16B per quarter, or about $5.3B per month, just to support the dollar exchange rate. But in Q2 they not only stopped buying dollars altogether, they actually sold $5B of their dollar reserves during that quarter. [1]

Also coincidentally (or not… probably not), May, the 2nd month of the 2nd quarter of 1978, marked the beginning of the largest and quickest decline in the dollar exchange rate that had ever occurred. A five-month, 15% waterfall-like decline in which 50% of the fall happened in October alone, the last 20% of the time period.


Overvalued

There's a very simple way to know if a currency is overvalued. If its currency zone is running a persistent trade deficit, the currency is overvalued. It's as simple as that. But the causes, cures and consequences are a little more complex, especially for the dollar.

From mid-May until October 1st, 1978, the dollar declined 8.5% on the USDX. October 1st was the date of the annual meeting of the IMF which, in 1978, was held in Washington. At that meeting, European central bankers urged then Fed Chairman G. William Miller to take tough action to stem high dollar inflation, the persistent US trade deficit and the dollar's steep decline which was already seen as disastrous for the global economy.

The dollar was the only real international currency at that time, and it was estimated that as much as 80% of all private sector international transactions outside of the US were conducted in dollars, simply for want of an international currency. This was called the Eurodollar market, and it was estimated to be $560B circulating through banks outside of the Federal Reserve System, so any abrupt decline in the dollar's exchange rate threatened both global trade flows and the entire international financial system.

But the dollar's decline only accelerated in October, plunging another 8% over the next four weeks. Here are a few excerpts from newspaper articles during that time.

Newsweek
October 2, 1978

International Finance
By Paul A. Samuelson

Lord Keynes used to say there are two opinions in economics, public opinion and inside opinion… Inside opinion is split on the state of the dollar. Poll bankers and foreign-government officials. I think you will learn their views resemble the following.

1. The decline in the dollar exchange rate relative to the German mark, the Japanese yen and the Swiss franc is a disaster.

2. President Carter, Treasury Secretary Michael Blumenthal and Under Secretary of State Richard N. Cooper must bear the blame for unwillingness to intervene to support the dollar.

[…]

By contrast, take a pool of 5,000 U.S. economists gathered at a convention. Or better, sample views of the 1,000 who specialize in international finance and macroeconomics. Three quarters would hold the following quite different opinions…

1. If the dollar floats downward (or upward, for that matter), that is a good or bad thing depending upon whether it represents a movement toward or away from equilibrium.

2. The great advantage of getting away from the shackles of pegged exchange rates, a la the old Bretton Woods regime or the limping gold standard, is that it permits each country to pursue its own economic objectives.

[…]

The annual meeting of the International Monetary Fund and World Bank, now taking place in Washington, is a forum in which the above contrasting views will be debated both publicly and in the hotel corridors. Somehow a unified insiders' consensus will have to emerge.

There are yet few signs that the U.S. trade deficit is on its way toward being permanently reversed. I must therefore warn against the tempting assumption that the dollar has already dropped so much that it can be safely assumed now to be an undervalued currency. Agnosticism is still in order. One must counsel Carter against premature agreement to peg the dollar by massive interventions and binding guarantees.

Chairman G. William Miller of the Federal Reserve Board is aware that the U.S. recovery could turn into a 1979 mini-recession. I trust that he and his Fed colleagues will not yield to Continental bankers' demands that we deliberately court a recession to fight inflation and defend existing dollar parities.

Xinhua General News Service
OCTOBER 28, 1978

U.S. Records more trade deficit in September
DATELINE: Peking

The U.S. registered another trade deficit of 1.69 billion dollars last month, the 28th in a row, the U.S. government announced yesterday…

The U.S. trade deficit has been a cause for the steep slide in the value of the dollar. Reuter reported yesterday that the U.S. dollar exchange rate fell to 1.7595 against West German mark and 178.23 in terms of Japanese yen. On October 26 last year, the dollar traded in London at 2.26 mark and 251 yen.

Newsweek
November 13, 1978

SAVING THE DOLLAR BUT RISKING A RECESSION
By LARRY MARTS with RICH THOMAS, THOMAS M. DeFRANK and ELEANOR CLIFT in Washington, PAMELA LYNN ABRAHAM in New York and bureau reports.

[…] In theory, a falling dollar makes imports more expensive and thus helps domestic manufacturers compete. But in practice over the past few years, domestic producers have seized on rising import prices as an excuse to raise their own prices, not undersell the competitions.

Perhaps for the same reasons, the falling dollar hasn't helped the U.S. balance of payments, as long promised. In theory, a falling currency discourages imports and spurs exports. There is always a lag in this benefit, known to economists as the J-curve. But for the U.S., the downward leg of the J has seemed interminable. And the nation's persistent deficit in its accounts with the rest of the world spews more dollars overseas and in turn, in a vicious circle further erodes their value.

The dollars abroad multiply not only from the U.S. deficit, but in the course of normal banking operations. By one common measurement, the Eurocurrency pool swelled from $360 billion in 1974 to $700 billion last June, and $560 billion of the total was in dollars. For a while, expanding world trade and the need to finance oil payments at quadrupled prices absorbed the increasing flow of dollars. But lately, as The Times of London put it last week, "There are more dollars around than people want." Since the U.S. inflation rate considerably exceeds those of the strong-currency nations, dollars are increasingly suspect as a store of value, and more and more investors tend to prefer assets denominated in Deutsche marks, yen or Swiss francs.

BUYING AMERICAN CHEAP

The result: the dollar's exchange value has plummeted far below its realistic purchasing power - that is, a dollar in the U.S. will buy far more goods and services than its equivalent in, say, marks will buy in Germany. And in growing numbers, foreign holders are taking advantage of this disparity by using their cheap dollars to buy vast quantities of common stock, farm land, houses and factories in the U.S.

But the most frightening potential effects of a continued dollar decline could be a catastrophic world crash. At some point, foreign holders of dollars might become so nervous that an orderly fall in prices could turn into a panicky rout, with investors and speculators frantically trying to find havens for their money. Since there is no equivalent to the dollar - all the Deutsche marks outside Germany, for instance, amount to only $84 billion-the result would be a frantic rise in the price of everything in harder currencies, a collapse of the dollar, stringent exchange barriers and a virtual halt to world trade. The only consolation, as Carter's financial aides saw it, was the bitter old adage that a whiff of panic both permits and forces a Head of State to take steps that would be unthinkable in normal times…


Solomon's Kitchen Sink

Late in the day on October 24th, President Carter was scheduled to make a speech announcing his new anti-inflation plan. But a copy of the press brief was leaked to a banker about an hour before the speech and word quickly spread that the details of the plan were weak. Front running the yet-to-be-news, a sell-off of the dollar began in Singapore which was the only dollar market open at that time, and it continued around the globe dropping the USDX another 4% over the next four days.

Treasury Under Secretary for Monetary Affairs, Anthony M. Solomon, had been working on a contingency plan ever since the IMF meeting at the beginning of October which Treasury insiders had started calling "Solomon's Kitchen Sink" because it called for throwing "everything but the kitchen sink" at the problem of the dollar's declining exchange rate. Following the Oct. 24th disaster, Solomon's plan became the plan.

This time Carter insisted on strict secrecy prior to announcing Solomon's plan. One of Carter's aides later reported that he wanted to maximize impact at the time of the announcement, saying "One of the pleasures in this is punishing the damn people who have been underselling the dollar." Carter, together with Treasury Secretary Blumenthal and Fed Chairman Miller, made the announcement a week later, on November 1st, this time right before the New York stock market opened.

Aside from one suspected leak in Switzerland, the elements of timing and surprise in Carter's bear trap bombshell worked, catching traders short and exposed, and delivering the dollar a quick 10% bounce. One trader commented, "They really clobbered the foreign traders. No one will dare make a move for several months. The losses must have been staggering." Even Jim Sinclair gave a comment to Newsweek, saying the mood was like a funeral for anyone who had recently jumped on the currency market bandwagon.

Carter's kitchen sink approach was a multi-front attack on the dollar's weakness, from buying up international dollar liquidity through "massive intervention" in the foreign exchange market and tightening domestic liquidity by raising interest rates and bank reserve requirements, to quintupling the size of the ongoing US Treasury gold auctions from 9 to 46 tonnes per month. Carter's war chest of foreign currency ammunition was declared to be $30B, $5B already held by the US at the IMF, and another $25B in foreign currency that would be borrowed, primarily through expanded swaps with foreign CBs.

The expanded swap line agreements were arranged with Germany, Switzerland and Japan the week before the announcement (thus the suspected leak in Switzerland). The plan was that the US Treasury could, at any time it wanted, exchange dollars for German marks, Swiss francs and Japanese yen and use them to buy dollars on the open market. The foreign CBs would hold the swapped dollars as reserves until the market calmed down and the Treasury was able to repurchase the foreign currency and swap it back again.

Notice that this was essentially the same mechanism as the dirty float prior to Q2 1978—the foreign CB prints new currency which gets used to buy dollars on the open market and the foreign CB ends up sitting on dollar reserves—with a few notable differences. One difference was that the US Treasury was now in control of the timing and magnitude of the manipulation rather than the foreign CB. Another was that the US Treasury couldn't do it on its own like the foreign CBs could. It needed their support and cooperation. And the last main difference is that it was done belligerently, to scare the private sector market, rather than quietly in the background.

I also want to note that it was widely believed that Carter's domestic monetary tightening, the largest interest rate increase in 45 years, a full percent from 8.5% to 9.5%, would likely induce a recession in the US economy, making it a surprisingly conservative move which concerned some of Carter's fellow Democrats. It was a bold and risky move that most people were optimistic about, even if they were split on whether it went too far or not far enough.

Here's part of a good article from November 13th to give you a feel for the mood following Carter's November 1st announcement:

Newsweek
November 13, 1978

YES...BUT
By Paul A. Samuelson

President Carter scored a smashing tactical triumph. His surprise counterattack against the speculators turned the dollar around, sending it up against the yen, mark and pound. The dollar price of gold, always a barometer of psychology about U.S. inflation and stability, plummeted.

The Carter team is beaming. Bankers and businessmen applaud, complaining only that it should have been done earlier. Main Street likes a President who is doing something-anything. Naturally it likes a medicine man who sends up its common stocks.

What do economists think? Is the battle against inflation at long last getting somewhere? Will the euphoria last? Is $30 billion a large enough fund to succeed in pegging the dollar at its new parity? What will be the price that the American economy will have to pay if the first tactical victory is to be consolidated into a lasting strategic success?

The jury of analysts cannot be expected to arrive at unanimous verdicts on every one of these crucial questions. But there should be possible a reasonable consensus on the important variables that will be decisive in determining the longer-run consequences of our new economic game plan.

First, here is the hard-boilded interpretation. Carter, knowingly or naively, has acted to create a 1979-80 recession. High interest rates, sustainable only by a tight monetary policy on the part of the Federal Reserve, will choke off housing starts, dampen investment spending, turn around inventory growth and undermine consumers' incomes and willingness to spend.

Indeed, the only effective way of bringing down inflation in the short run is to cool off the economy, increase unused plant capacity, add to the supplies of unemployed labor. This hard boiled school does not blame Carter for engineering a recession. It was inevitably coming, anyway. Now it will come earlier. Probably it can therefore be a milder and shorter recession. By Election Day 1980, candidate Carter may well be glad that he grasped the nettle 24 months ago.

SWEAT AND TEARS

These economists may be right. Political economy is not, however, so exact a science that you should put all your bets on a full-fledged recession in 1979. For one thing, the President and Congress may not in fact persist in their defense of the dollar and determination to fight inflation at all costs. After the cheering has died down, once there begin to be complaints from the electorate about layoffs, declining real income, and melting corporate earnings, Washington Democrats may begin to falsify the hopes of European bankers.

For another thing, a considerable part of the hysteria about inflation and the bottomless floating dollar was just that-hysteria based more upon the self-fulfilling fears of the market mob than upon objective evidence that U.S. inflation was escalating out of control and that our trade deficit was incapable of being cured by a finite depreciation of the dollar.

[…]

IN SUM

My own view is that pegging exchange rates is usually unwise. Usually governments defend the indefensible. Usually they present speculators with juicy heads-I-win tails-you-lose chances. I do not deem it philosophically sinful for government to intervene-only for the most part stupid.

But occasionally that rare opportunity arises when government can counterspeculate successfully. This may have been just such an opportunity.

I must still remain an agnostic on the longer-run question: has the dollar fallen enough to make our costs so competitive as to ensure curing of the basic U.S. balance-of-payments deficit?

Only time will tell. Meanwhile, I must warn against the notion that a recession is our only salvation.


Belgrade

The dollar's exuberant bounce in November was rather short-lived. In December it fell 5% and in June and July of 1979 it did it again. By September 28, 1979, the dollar was 4% below where it had been a year earlier, and back down to the same low level it was in late October, 1978. Meanwhile, the price of gold had more than doubled from its kitchen sink low in November.

In July of 1979, a desperate Jimmy Carter, facing numerous problems including a tough reelection campaign, fired five of his cabinet members including Treasury Secretary Blumenthal, reportedly calling him "inept" in a private conversation. Fed Chairman G. William Miller left the Fed to become Carter's new Treasury Secretary, and Paul Volcker, the President of the New York Fed and former Treasury Under Secretary for Monetary Affairs during the Nixon Administration, was chosen to be the new Fed Chairman.

The annual IMF meeting that year was to be held in Belgrade, Yugoslavia, from September 28th to October 5th. Volcker and Miller would both attend. You won't hear much about this meeting anywhere else, but my readers know that I have mentioned it numerous times. That's because it marks an important turning point in monetary history.

FOA: We are, today, at the very conclusion of a fiat architecture that is straining to cope with our changing world. Neither the American currency dollar, its world reserve monetary system or the native US structural economy it all currently represents will, in the near future, look anything as it presently does…

…one important, almost unthinkable question; what if current trends are moving away from using our dollar reserve system? Even further, let's ask; what if the last decade's efforts to prolong dollar use, both internally and worldwide, have inflated its worth to such an extent that it's now vastly overvalued? Asking more; what if the architects of a competing currency system and the major players that helped guide its internal construction, all took a hand in promoting the dollar's extended life, its overvaluation and its use; so as to buy time for this great transition in our money world?


In my analysis, Belgrade marks the resumption of the dirty float that abruptly ended in Q2 1978, and the beginning of foreign public sector (CB) structural (dirty float) support that carried the dollar for the next 34 years, ending just this past November (more on this in a moment).

Back in Q2 1978, a series of meetings in Europe made great strides toward monetary union and a "European Monetary System" resulting in the European Currency Unit or ECU, the predecessor to the euro, which was introduced in March of 1979.

In May of 1978, the European League for Economic Cooperation or ELEC, an influential private sector organization, unanimously approved a proposal for "A European Parallel Currency as a Shelter Against Exchange Rate Instability". The proposal, which was drafted by Robert Triffin, urged the adoption of a European currency tentatively named the Europa as "an attractive alternative to the parallel currencies widely used already in transnational contracts which cannot, obviously, be denominated simultaneously in the national currencies of each of the contracting parties. The exchange rate of an appropriately defined European parallel currency would be less volatile [than those of the Eurodollar, Euromark and other Eurocurrencies most in use today], its fluctuations remaining more moderate vis-à-vis the national currencies of member countries, as well as vis-à-vis other currencies." [2]

In June of 1978, the European Economic and Social Committee or EESC, another influential organization representing the European private sector, met in Brussels and produced an opinion paper on "Community Approach to the Present International Monetary Disorder" to be submitted to the EEC. It concluded that "the Community must not abandon the objective of complete economic and monetary union, in spite of the failures and setbacks. In the present international monetary disorder, the EEC should gradually form an "area of stability", which would help in restoring world monetary equilibrium. The ESC will continue its work in this field, examining other aspects of economic and monetary union with the aim of determining the requirements for the creation of a common currency which can help restore equilibrium to the national monetary system." [3]

Then in early July of 1978, the European Commission met in Bremen, Germany where German Chancellor Helmut Schmidt and French President Valéry Giscard d'Estaing proposed the European Monetary System (EMS) and the European Currency Unit (ECU). Both would begin eight months later in March of 1979.

According to a paper by Robert Triffin four months later, "The first reactions of the Carter Administration to the Bremen proposals were ambivalent. The Administration reiterated both long-standing U.S. support for European monetary union, and U.S. skepticism over its feasibility. High-ranking Treasury officials also reiterated U.S. support for making SDRs the principal instrument for international settlements and reserve accumulation, "but, of course, without eroding the traditional role of the dollar." This is, of course, a contradiction in terms since the dollar has been, since the war, and remains, by far the major instrument in both these respects. American officials also expressed some fears about the inflationary potential of ECU issues and accumulation — as though the use of the dollar had not proved wildly inflationary and was not one of the main arguments for an ECU alternative more controllable by the Europeans than the unlimited acceptance by their central banks of dollar overflows.

"Finally, and most bizarrely, they voiced their concern about the fact that the new system might deter the strongest currencies from appreciating sufficiently against the dollar. While it is true that such appreciation might be slowed by being more evenly spread out from the present "refuge currencies"-primarily the mark and the Swiss franc —to a broader range of currencies, Washington's major worry should be exactly the opposite: an excessive, rather than inadequate, depreciation of the dollar vis-à-vis the ECU and the European currencies anchored to it. Possible switches in international demand from a weakening dollar to a stronger ECU would indeed threaten to accelerate dollar depreciation and so to make the dollar more and more undervalued. If this were to happen, the clamor for protection against U.S. "exchange-rate dumping" might become nearly irresistible abroad, and the depreciation of the dollar might also trigger a panicky reaction here at home toward protectionism and even some forms of exchange controls and restrictions. Americans and foreigners should accept a depreciation of the dollar sufficient to restore our price and cost competitiveness in world trade, but should not be expected to tolerate the much deeper depreciation that might be —and perhaps already is being—triggered in the exchange markets by the diversification of portfolio holdings from a near-monopoly of the dollar into a broader range of "parallel currency" alternatives. The Europeans are even more anxious than we are to avoid such a danger, and to participate with us in the joint defense and readjustments of the dollar rate vis-à-vis their currencies."
[4]

Meanwhile, at the same time as serious plans for a pathway to European monetary union were taking shape, the dollar collapsed until Carter threw everything but the kitchen sink at it, most of which was borrowed from European CBs. After a one-month bounce driven more by rhetorical shock and awe than fundamentals or technical intervention, the dollar spent the next ten months returning to its pre-bounce lows even as Carter fired his Treasury Secretary who would have been in charge of exchange rate interventions, which brings us to Belgrade.

Having made the decision to proceed toward European monetary union and ultimately a common currency, and to structurally support the existing dollar reserve system until it was complete, the euro architects (the core European central banks, probably Germany, France, Italy, the Benelux countries plus Switzerland) would have faced two distinct but related challenges regarding the dollar: controlling both domestic US and international dollar liquidity.

Controlling international dollar liquidity was easy, and dirt cheap from a European central bank's perspective (although it had a steep cost to its local economy in the form of an artificially-suppressed living standard). All the foreign CB had to do was print new currency and use it to buy dollars on the open market whenever the private sector dropped the dollar ball.

There was a very real fear at the Belgrade IMF meeting that the global financial system was on the verge of collapse. A collapse in the dollar's exchange rate was one problem, but the more challenging problem was that the Fed's interest rate increases had failed to tame domestic money supply expansion—some of which spilled over into the foreign exchange purchasing new imports—and therefore failed to sufficiently reduce the US trade deficit which was still 400% higher than in 1976. This represented $25B in new dollars or dollar-denominated US assets that would have to be absorbed by someone each year, just to maintain the status quo.

$25B per year doesn't seem like much by today's US trade deficit standards, but in hindsight we can add up how much of it actually needed to be absorbed by the foreign public sector (as opposed to the profit-driven foreign private sector). Adding up the US trade deficits from 1971 through 2013, the total comes to $9.5T. Of that, 42% or $4.05T was absorbed by foreign CBs. We see that number on the Foreign Official holdings line of the TIC data put out by the US Treasury.

The biggest problem isn't "the excessive dollar overhang piled up in the past" as Triffin called it, it's that the US has become structurally dependent upon it continuing to pile up more and more each month, and that's not something the US controls. Possibly trying to head off this potential future nightmare, the core European central bankers confronted Paul Volcker in Belgrade with "strongly stated recommendations" that stern action needed to be taken immediately.

Back in the US, the Federal Reserve Board spent the past year deeply divided and indecisive. It was a perfect example of the Fed's dueling (dual) mandates. On the one hand, there was the emerging recession for which the Fed doves wanted looser monetary policy, and on the other hand was the rising inflation rate for which the hawks preferred tightening. Paul Volcker was well known as one of the hawks. As Chairman of the Fed, Miller was weak, hardly ever expressing his own opinion, always seeking a compromised consensus, and troubled by any dissent.

During his interview with President Carter for the chairman's seat, Volcker recalls, "I told him the Federal Reserve was going to have to be tighter and that it was very important that its independence be maintained." He thought this would exclude him from the seat, but Carter picked him anyway, tacitly coming down on the side of inflation being a more pressing concern than recession.

In his first meeting as Chairman in August of '79, Volcker expressed his desire to take bold action, but he also said that it should only be done during a crisis. Less than a month and a half later, his idea for bold action had taken shape a fundamental change in Fed policy from controlling interest rates to letting the market take control of interest rates and the Fed directly targeting the money supply aggregates, and his crisis had also apparently arrived just as he was leaving for Belgrade on September 29th.

Volcker flew over on the plane with Miller, now Carter's Treasury Secretary, and Charles Schultze, chairman of the Council of Economic Advisors. On the plane ride over, Volcker explained his new plan to the two Carter advisors who made it clear to him that they didn't like it and neither would the President.

After meeting with his European counterparts, Volcker unexpectedly left Belgrade, three days before the end of the conference, leaving the rest of the US contingent behind. According to a Fed paper published in 2004, "Chairman Volcker arrived in Washington on Tuesday, October 2, with his ears still resonating with strongly stated European recommendations for stern action to stem severe dollar weakness on exchange markets. His unexpectedly early return fueled market rumors that action dealing with the crisis might be imminent. This had a stabilizing effect on commodities markets, with futures markets opening lower on October 3, retracing some of their sharp increases on the previous several days." [5]

The next regular FOMC meeting was scheduled for October 16th, but as soon as he got back from Belgrade, Volcker held three secret meetings, one on Thursday the 4th, a conference call on Friday the 5th and another meeting on Saturday the 6th.

Meanwhile, back in Belgrade where the IMF meeting was still going on, Saudi Arabia took the opportunity to address the West. The American Banker reported on 10/4/79:

In another development here Wednesday, a strong warning was delivered to Western governments by Saudi Arabia, which said in effect that it could continue to pursue a responsible oil policy only if the West pursued a responsible monetary policy.

The strength of Saudi Arabia's view was underscored by the fact that its governor of the World Bank and [International Monetary] Fund was availing himself for the first time in six years of the opportunity given to all governors to address the joint meetings.

Sheikh Mohamend Abalkhail, the Saudi Arabian Minister of Finance, said, "it would be naive to pretend that a continuous erosion of our financial resources through inflation and exchange depreciation could not provoke reactions. We have undertaken to provide a larger supply of oil to promote more orderly conditions in the oil market and promote a higher level of sustained growth of the world economy. But we are finding it increasingly difficult to maintain our policies under prevailing instabilities in exchange markets coupled with high levels of inflation in industrial countries."

The American Banker also reported on rumors that Swiss and German central bankers were not exactly happy with the Treasury's direct intervention in their currency exchange rates over the previous year, and that they may have even done their own counter-intervention against US interventions earlier in the year. Even though I'm referring mainly to the USDX in this post, an index of the dollar versus a basket of currencies, US interventions were made against specific currencies, primarily the German mark and the Swiss franc, using marks and francs borrowed from their CBs.

The Belgrade meeting ended on October 5th, and back at the Fed, Paul Volcker's FOMC meeting began at 10AM on Saturday the 6th. By 1:30 they had a unanimous vote, and a press conference was scheduled for 6PM that same day. At the press conference, Volcker began his explanation of the reasons for the Fed's unscheduled actions thusly:
"I think in general you know the background of these actions; the inflation rate has been moving at an excessive rate and the fact that inflation and the anticipations of inflation have been unsettling to markets both at home and abroad. That unsettlement in itself and its reflection in some commodity markets is, I think, contrary to the basic objective of an orderly development of economic activity…"


Aftermath

The Fed's actions that day have been called the most significant change in Fed policy since 1932. The details of the change are not really relevant to this post, but basically the Fed switched from a "gradualist" policy targeting money demand to a policy directly targeting money supply. If you are interested in the details, you can read all about them in the link at footnote [5].

The relevance of Volcker's October 6 surprise is not the specific actions he took, but the timing. As I said earlier, Belgrade marks an important turning point in monetary history. It marks the resumption of the dirty float that abruptly ended in Q2 1978, and the beginning of the foreign public sector (CB) structural (dirty float) support that carried the dollar for the next 34 years. So while Vocker's stern actions ("with his ears still resonating with strongly stated European recommendations for stern action") made all the headlines, there was plenty more going on quietly in the background on the European side that made no headlines.

You might also be starting to pick up on a distinct cultural difference between the American and European sides in the way their public sectors influence the private sector (the market). The American side tends to prefer bold announcements and subtle innuendo meant to scare the private sector back into line, rather than real, sustainable action, while the European side tends to prefer quiet, behind-the-scenes action. The result is that the Americans and their bold headlines often get the credit of causality for what follows.

What followed the Belgrade meeting and Volcker's subsequent "stern actions" was that the US trade deficit dropped 21% in the first year and another 17% the next year. With fewer dollars being created and therefore fewer flowing overseas, the USDX began climbing immediately, and inflation began its decline shortly thereafter. With the market now in control of interest rates, the Fed Funds rate, the interest rate at which banks trade reserve balances at the Fed with each other to meet overnight reserve requirements, rose from around 11% to 20%. The US had two recessions, a very short one in 1980, and then another one from mid-1981 through 1982. And I think we're all familiar with what happened in the commodity futures markets, especially gold. Gold rose from $385 on October 5th to $850 3½ months later on January 21st, then quickly fell back into the $600s, ending the year 1980 at $590, up 12% for the year and up 53% since Belgrade and the stern actions.


Two Versions

First, here's the Fed's version of the story in brief:

A quarter-century after Paul Volcker’s monetary policy reform in October 1979, the profound significance of restoring price stability for the nation’s prosperity is widely recognized. Taming the inflation problem of the 1970s did set the stage for a long period of prosperity, as Volcker and many others had hoped. Over the past two decades, the nation has enjoyed greater price stability together with greater economic stability. Expansions have been uncommonly long and recessions relatively brief and shallow. [6]

And here's Another version, as told by FOA and edited by me. I'm not here to tell you which one to believe, I'm merely presenting them both so that you can make up your own mind. ;D

FOA: "For decades hard money thinkers have been looking for "price inflation" to show up at a level that accurately reflects the dollar's "printing inflation". But it never happened! Yes, we got our little 3, 4, 8 or 9% price inflation rates in nice little predictable cycles. We gasped in horror at these numbers, but these rates never came close to reflecting the total dollar expansion if at that moment it could actually be represented in total worldwide dollar debt. That creation of trillions and trillions of dollar equivalents should have, long ago, been reflected in a dollar goods "price inflation" that reached hyper status. But it didn't.

That "price inflation" never showed up because the world had to support its only money system until something could replace it. We as Americans came to think that our dollar, and its illusion of value, represented our special abilities; perhaps more pointedly our military and economic power. We conceived that this wonderful buying power, free of substantial goods price inflation, was our god given right; and the rest of the world could have this life, too, if they could only be as good as us! Oh boy,,,,,, do we have some hard financial learning to do.

[…]

Our recent American economic expansion has, all along, actually been the result of a worldly political "will" that supported dollar use and dollar credit expansion so as to buy time for Another currency block to be formed. Without that international support, this decades long dollar derivative expansion could not have taken place. Further, nor would our long term dollar currency expansion produce the incredible illusion of paper wealth that built up within our recent internal American landscape.

[…]

For another currency block to be built, over years, the current world economy had to be kept functioning. To this end the dollar reserve system had to be structurally maintained; with its IMF agenda intact, gold polices followed and foreign central bank support all being part of that structure. Truly, the recent years of dollar value was just an illusion. An illusion of currency function and value, maintaining the purpose of holding the world financial and economic system together for a definite timeline. Politically, the world does not hate America; rather they hate the free lifestyle our dollar's illusion value brought us yesterday and today.

[…]

In the past if the system began driving the dollar too high and forcing US trade deficits, the Fed would raise rates to throw us (USA) into an economic recession that broke the vicious deficit trade cycle. Knowing full well that it would be a short recession policy because "noone" would jump the dollar ship before the medicine could work. Looking around back then we see there was no other reserve currency ship to jump to. We either lose jobs and profits from an "overvalued currency" or from an induced recession. The first can lead to a financial breakdown, the last corrects things after only a short while. Naturally, we embarked on the quick fix of a fast recession.

This is why our times are so very different now. What we came to know over this 20+ year period as a strong America in a high dollar, was always something our money creators were striving to fight against. We truly have always been inflating our currency for these many years in an attempt to keep the natural effects of the IMF reserve system from spiking the currency too high up. Again, if we had a regular currency, our policies would have been reflected in sky high prices for everything. What most of us know as price inflation reflecting money supply inflation.

Ever since the Euro was seen by US policy makers as an eventual success, our treasury has tried to put its best "New York Spin" on the ongoing process. Simply stated; from the early to mid-90s we are in favor of a strong dollar policy. In reality, with the advent of the Euro and the evolving stance of the BIS, this has made our "economy killing" strong dollar unavoidable.

There is no way the Fed can create a new recession now without everyone jumping ship for another currency reserve. There is no possible way the Euro Zone will suffer as big a downfall as the US in another policy induced recession. Just looking at their closed economy and debt structure tells that story by itself. Any US slowdown means a run for the Euro, yet weakness in the Euro means the US must inflate at a torrid rate. We now stand toe to toe and wait to see who will fall first. All the while our world dollar gold markets are caught in the cross fire!

This is where we have been for the last decade. This explains why the DOW and all its paper cousins have enjoyed the effects of a massive, ongoing dollar expansion worldwide without any official policy interference. Right when we were to the point of changing policy to slow things down, the Euro was to be introduced in a year or two and risked taking away or sharing the dollar's standard.

[…]

The lesser of the two evils today (and this is the one the ECB / BIS enjoys watching) is our current frozen policy. We can no longer cut off the strong dollar / growing deficit cycle by raising rates and invoking a recession as in the past. This time we must continue to pump the reserves at all costs in a process that only floods the world with more dollars. It's called a currency hyperinflation and is one we (as US people) have never witnessed in modern times. The pressure has built up full volume now as all escape valves are being closed. We are well on the way to a derivatives exploding event that will break into the open with a cascading dollar and full force US price inflation.

[…]

But once we get to that stage, I expect that a super US economic downturn will ensue. Then the fed will go wide open and cover everything in sight to keep us going!"


"Wait… WHAT?! Is the dollar too strong or too weak? Does the Fed want it stronger or weaker, and what does Europe want? I'm confused!" Yes, I know it's confusing. It's not about too weak or too strong at this point. The dollar is simply overvalued, and has been since 1958 when the Bretton Woods gold flow reversed. In the 1960s, that overvaluation was reflected in the European accumulation of dollars and the one-way gold flow. Today it is reflected in the perpetual US trade deficit, which over 40 years has become structural and immutable within the status quo.

The foreign private sector use of dollars as the primary international currency (which still continues today) overvalues it. Back in the 60s, the Bretton Woods foreign public sector exchange rate fixing encouraged this foreign private sector use of the overvalued dollar. Ever since then, the foreign public sector (foreign CBs) simply supplemented the private sector use to keep the world economy functioning in the absence of an alternative international currency. That structural support (aka, the dirty float) apparently ended eight months ago.

Back in 1978 at the bottom of the dollar's plunge, it was still overvalued. The plunge was stopped because the public sector stepped in, but what the European CBs learned from that experience was the difference in motivations between the public and private sectors. The private sector is very simply motivated by profit, while the public sector is motivated by its desire for exchange rate stability. They learned that, without their structural support (supplementing private sector demand for an overvalued currency via the dirty float), the private sector (the market) will not support a currency if such support turns unprofitable, regardless of the fact that it would collapse the whole system.

The answer to this problem was to create an alternative international currency, with sufficient depth and liquidity to match the dollar, so that they could eventually stop supporting an overvalued national currency (which while it was dirt cheap to them personally, still cost their local economies dearly by suppressing their overall standard of living) just to prevent a collapse in the modern global economy. The answer was the euro, and it was already well in the works after the July 1978 meeting in Bremen. The last piece to the puzzle was that the dollar system obviously needed foreign public sector structural support in order to buy the time necessary to meet that goal.

The dollar didn't plunge in 1978 because the foreign private sector stopped using dollars. The dollar was still the only choice at that time. It didn't plunge because the Saudis stopped pricing their oil in dollars. They didn't. In fact, the price of oil was rising dramatically at that time and the dollar still plunged. The reason it plunged is that foreign private sector use, including oil, is simply insufficient to support such an overvalued international currency. Non profit-motivated structural support is required to hold such a system together for an extended period of time. We can know this is true by the fact that 42% of the US trade deficit over the last 43 years came from the foreign public sector in aggregate supporting foreign dollar settlement with CB storage.

Back to FOA:

"The game is to let the US economy suffer from its own bloated expansion by moving slowly away from supporting foreign dollar settlement with CB storage. This is more than enough to end the dollar's timeline as we are already stretched to the leverage limit. They know that Greenspan has but one policy to use and that will be super printing. He is doing it now, right on cue!

[…]

Remember back in the early 80s or even further back into the 70s. All we heard was how the dollar was finished and going to crash and burn. Books about hyper inflation and the need for gold / swiss francs were all over the place.

I read all of them to gain perspective and also acted on some of their advice. Made some money on it too. But even then, something just didn't completely ring true about the whole scenario. Indeed, in hindsight, gold never did return above $800, the dollar didn't hyper inflate and most of the world kept using the dollar as a reserve.

Today, we can more fully understand why so much of that early insight failed to deliver.

True, the dollar was seen as a basket case back then. It had just been pulled from its gold bond and prices were going up all around us. However, because the world had been on a semi dollar / gold standard, all nations that had previously signed onto using the US buck as their currency reserve now did so with even more resolve. More important, it seemed that using gold itself was out of the question as every country's Central Bank bought dollars as fast as we printed them. The dollar still settled most all trade accounts while dollar reserve buying made an obvious show of support for this world system. No matter how much bad press was offered, they were staying on track and they have continued to do so right up into the 90s!

But all of this flew in the face of what every economist was saying back then. The common understanding of the era was: if the US didn't stop over printing its money, we would all experience a major price inflation,,,,,, and no one could stop it! Again, "major" inflation didn't happen and to ask a further question: if the dollar system was so bad, why didn't the world just dump the reserve system and refrain from using it further? In other words, let the dollar be "the US dollar" but don't use it as a backing for your own money system.

Going against the logic of "sound money": throughout all the currency turbulence of the 70s and 80s era (including today), the US never did rein in the over printing of its currency. It continued almost non-stop money supply expansion for its local economy and in addition sent a good portion of its cash all over the world. On and on the US trade deficit continued to do its work of feeding ever more US cash into foreign economic systems. We printed paper currency by borrowing it into existence,,,,,, used it to purchase real goods overseas ,,,,,, while foreign governments actively soaked up this dollar flood by expanding their own money supply.

Like this: When you buy an item externally, a dollar is sent overseas to pay for it. Usually, through the world currency trading arena, that dollar is converted into the local currency of the nation which the goods came from. But more often than not,,,,,,, as we print that dollar out of thin air, the foreign government takes the dollar into its reserve account and prints one of their units for deposit in the local economic system. They do this because: if the foreign CB didn't save the dollar as a currency reserve ,,,,,, and sent it back into the world currency markets to "buy" an existing unit of their money supply,,,,, this action would drive up their currency value vs the dollar and make the price their goods non-competitive in world markets. In other words, a US citizen couldn't use a printed (borrowed) dollar to buy an item for $10.00 that outside the "dirty float" of exchange intervention would cost $15.00.

This is how the "dollar reserve process" inflates the money supply worldwide as we (USA) run a trade deficit for our benefit. It keeps the dollar exchange rate higher than it would naturally be thus allowing a US citizen to buy goods at a cheaper price than our expanding money supply and implied currency value would normally dictate. A process in and of itself that invites still more dollars to flow out and purchase still more external goods. Had foreign CBs not taken so many dollars, the ever expanding US money supply would have long ago impacted currency exchange rates and forced a major price inflation internally (in the US). Yes, the major inflation so many saw coming,,, back then,,,,, would have arrived,,,,, then.

So why did these other CBs do it? The standard explanation was that this created a market for their goods here in the US. Yes that's true, but it begs the question; did no one in their land want to buy goods manufactured locally,,,,,, and pay for them with the same printed money supply? Why is it the US could inflate its money supply to buy cheaper goods externally for no more than the price of printed paper? But, in the same country our paper was sent to, they couldn't print their own currency to buy their own goods? Why couldn't they raise their real standard of living somewhat using the same process like the US,,,,,, and doing so without the burden of inflation or importing foreign currencies?

Again, why would our printed, inflated money movements not create price inflation for us (USA) in goods purchased externally? What if they (foreign goods producing countries) printed an amount of their money equal to the inflow of dollars,,,, but, without holding paper dollars as reserves to back it,,,,, bought the exact same goods from themselves. Common prevalent economic theory says price inflation would result? Or would it? Or better said: why them and not us?

Again, and as above,,,,, In the 70s, it was widely held that the dollar reserve system forced other countries to inflate their local currencies, thereby importing dollar price inflation. But, as time went by,,,,, indeed a decade or two now,,,,,, the same process continued non-stop, with no change. It seemed that some "other" countries had found a "new way" to somewhat circumvent the dilemma. Or was this "new way" something sold to them in order to extend the dollar system's timeline?

Many of the lesser third world countries experienced a combination of sporadic hyper inflation and deflation as we forced the dollar reserve system down the throats of their citizens. Their people's living standard constantly fell as they worked ever harder to produce more goods in return for more of our printed dollars. But, instead of using the extra inflow of dollars (positive trade balance) to buy their own currencies in the local system,,,,, thereby keeping their currency strong,,,,, they used that dollar flow as collateral to borrow (from IMF and international banks) more dollars from the world dollar float (mostly called Eurodollars). The lure (or the hard sell) was that they could build up their infrastructure,,, increasing their production efficiencies (human productivity),,,, thereby raising the national standard of living. Further, they were sold the unneeded idea that even if they didn't completely use the dollar surplus to borrow more, they should hold those dollars in reserve (buy and hold US treasuries) and print more of their own money!

Again, it seemed they had no advocate to push for their own best interest. No one told them that their people already worked cheaply enough to more than offset the competitive loss of a stronger local currency. No one told them that with a strong local currency structure,,,, (that using the dollar surplus to buy their own currency would create),,,,,,,, would allow them to borrow in their own capital markets. A more go slow approach that builds long term benefits. This process would free them from the entanglements of making international debt payments in another money. Indeed, the costs of those involvement's later proved overwhelming!

For third world countries, their international dollar debt exposure eventually locked them into a servitude to the dollar reserve system. Despite all their natural and human resources, currency involvement had taken a lion share of any productivity increases and increased lifestyle this modern world offered.

However, it did help the cause for the dollar reserve system. By creating an ever growing international debt in dollars, eventual dollar demand to service this debt would only increase. Thereby keeping its value artificially high. In addition, any leftover floating dollars quickly took the form of US treasury debt held in these small countries treasuries. There they were used to further hyper inflate their own currency supply.

For the more developed gold owning countries of the G-7, they had a different question in mind. Again, if taking in inflated dollar reserves was the act of importing US dollar inflation into ones local economy,,,,, and in the process creating a market for your goods overseas,,,, why not just print your own currency [the euro] without taking in dollars,,,,,, and in doing so give the same buying power the US citizens have in your market,,,,,, to your own people?

If it's not price inflationary to take in part of a world "inflated dollar supply" and create jobs for your people locally,,,,,, why would it be any more inflationary to print your own currency outright? Indeed, why does one need a dollar inflow to legitimize the same money inflation process? That being currency inflation to create jobs?

Why should we (as dollar asset holders) think about this question? Because someone else is and doing something about it today!

Today,,,,,, and after all of this,,,, the dollar never did crash from price inflation. At least nothing like what was expected earlier in the last two decades.

The dollar reserve system was never going to fail then because the major world economic powers were willing to use (waste) all the productive efforts of the world's people to keep it running. Looking back we now understand the thinking behind this… There was no other currency structure strong enough or deep enough to carry the load.

[…]

So, dollar hyper inflation never arrived and gold did not make its run because world CBs bet your productive efforts on supporting the dollar reserve. In the process, the US standard of living was raised tremendously on the backs of most of the world's working poor. But this is not about to last!

Not long after the US defaulted on its gold loans,,,, dollars held as gold certificates,,,,,, major thinkers began the long process of forming another world currency. One that would not maintain the fiction of a gold standard with the somewhat fixed gold prices inherent in such a system. The creation was distorted, to say the least. Just as the River in my first post was often seen in distortion, so too was this currency issue. It began with the European Currency Unit (ECU) [agreed upon at the Bremen meeting] and has later progressed to its present state of the Euro.

After operating on a fiat system for 20+ years people are starting to realize that the only thing that backs a currency is the real productive efforts of their people. Yes, over time we always borrow more than our productive efforts can pay back and proceed to crash the money system. But what else is new? (smile)

We call this a money's "timeline" and it's as new an idea as life, death and taxes! Time and debt age any money system until it dies. The world moves on. Only this time gold is going to play a different part in the drama. We will all watch it unfold.

[…]

What changes is the recognition of what we do produce for ourselves and what we require from others to maintain our current standard of living. In the US this function will be a reverse example from these others. We will come to know just how "above" our capabilities we have been living. Receiving free support by way of an overvalued dollar that we spent without the pain of work.

[…]

We are, today, at the very conclusion of a fiat architecture that is straining to cope with our changing world… Trained from birth, as all Western thinkers are, to read everything economic in dollar system terms; we, too, are all straining to understand the seemingly unexplainable dynamics that surround us today.

[…]

Indeed, as an ongoing trade deficit in the US has become irreversibly structural to the integrity of the local economy and remained in this function for many years; the legal tender function of foreign dollar reserves comes very much into question.

[…]

The relatively small goods "price inflation" so many gold bugs looked for will be far surpassed and the "hyper price inflation" I have been saying is coming is now being "structurally" set free to run.

Why "structurally", why now?

For years now, "politically", the dollar system has had no support! Once again, for effect,
"Politically NO", "Structurally Yes"!

[…]

To this end, I have been calling for a hyper inflation that is being set free to run as a completed Euro system alters Political perceptions and support. That price inflation will be unending and all encompassing. While others call, once again, for a little bit of 5, 10, 15% price inflation, that lasts until the fed can once again get it under control,,,,,,,,, I call for a complete, currency killing, inflation process that runs until the dollar resembles some South American Peso!"



China

FOA wrote that last bit on October 3, 2001, stating unambiguously that structural support (the dirty float) had ended. So what happened? Well, China happened. This is an image I used in my 2011 Moneyness post and my 2012 Inflation or Hyperinflation? post:


On December 11, 2001, China was admitted into the World Trade Organization. I don't know if the idea was "sold" to China in order to extend the dollar's timeline, or whether they did it on their own following the lead of other third world countries, but the Chinese central bank immediately started buying dollars by the tens of billions in order to keep its exchange rate pegged to the dollar while its international trade grew in leaps and bounds. We don't know Another's take on this turn of events because, unfortunately and coincidentally, FOA stopped posting five days after China joined the WTO.

A good gauge of China's structural support for the dollar, and one that is easy to watch, is China's Treasury holdings. From 2002 through 2013, the Chinese central bank purchased US Treasury debt equal to 19% of the total US trade deficit during those years. For comparison, all of the OPEC countries combined, including both public and private sector Treasury purchases, covered only 3% of the US trade deficit during the same time frame. There's only one reason for the PBoC to purchase that many dollars, more than any other country, and that's to manipulate its currency exchange rate, i.e., to peg it to the dollar.

Yet over those last 12 years, China has been taking determined and concerted steps, year after year, toward having an internationally-convertible currency, steps which have gradually reduced its need to manipulate its exchange rate with the dollar in particular. When China joined the WTO, the yuan was not allowed outside of China. Today the yuan is traded in 12 hubs outside of China, including several in Europe and Asia, with 10 more on the way. Half of the 12 began within the past year or are still in the process of being set up. At least 18 foreign commercial banks now trade yuan.

China has also set up bilateral currency swap agreements with 25 different central banks covering 42 different countries, Switzerland being the latest just two weeks ago. The big one, the Eurosystem, 18 countries in one deal, was established on October 10, 2013.

Most remarkable, though, is that last November, one month after the ECB deal, China's US Treasury holdings peaked. That was eight months ago, and they are basically flat ever since. In fact, all Foreign Official holdings are flat for the entire last year! That is, public sector (CB) buying of Treasuries, aka the dirty float, is virtually nonexistent for more than a year now.


As I noted back in April, year-over-year monthly comparisons turned negative for the first time back in February. This means we've apparently been clean for a year and a half now. In other words, it looks like 2013 was the Year of the Window just as I suspected. ;D


Europe

Manipulating exchange rates to achieve exchange rate stability actually creates an unstable situation. It requires the perpetual overvaluation of some of the currencies, preventing adjustment mechanisms from automatically correcting imbalances. This leads to a structurally unbalanced and therefore unstable international currency system.

With built-in (structural) imbalances, currency devaluations when they happen are generally larger and more disruptive than the crisis that caused them. A better, more stable system would be clean floating exchange rates where imbalances are corrected gradually through the exchange rate. In such a system, crises would not affect the monetary plane disproportionately the way they do today due to these longstanding and structural imbalances.

The hard part is transitioning away from dependency on past valuations that were based on longstanding structural imbalances. In order for a clean float to work and deliver sustainable exchange rate stability, you need a clean starting point without any built-in imbalances. This means weathering one final devaluation storm that will shake all currencies free from their dependency on past valuations. I think you know what I'm talking about. ;D

To weather such a storm, you might first build an ark (the euro) like Noah did, and then let it float. Perhaps you foresaw the coming flood (in 1978/79) and figured out a way to hold it off long enough to build your ark. I have my ark. Do you have yours?

If you want to see whether a central bank is manipulating its exchange rate or not, just watch for significant changes in its foreign currency reserves. The assets on the asset side of a central bank's balance sheet fall into two general categories: assets related to monetary policy which means assets related to domestic liquidity operations, and assets not related to monetary policy which means assets related to international liquidity operations, including exchange rate manipulation. Items not related to monetary policy are non-borrowed CB reserves (foreign currency and gold), plus a few other items like swap lines which are short term borrowed reserves.

Unlike the "kitchen sink" swap lines in 1978, today's swap lines are used to supply short term foreign liquidity (foreign base money) to the commercial banks dealing in the exchange of foreign currency, not for exchange rate manipulation. Exchange rate manipulation (if it's happening) shows up as significant changes in non-borrowed foreign currency reserves. On the Eurosystem's balance sheet, that would be Line 2 on the asset side.

Here's the latest weekly financial statement for the Eurosystem (at my time of writing). On the left side bar, you can click on any year and see all of the weekly and quarterly statements going back to the beginning in 1999. At the top of each statement, they summarize what happened in each of the two general categories, and below that you'll find the balance sheet. I highlighted line 2 on the asset side:


What I'm looking for is evidence of whether or not the ECB is manipulating the euro's exchange rate. In other words, are they still doing the dirty float? My thesis is that they are not, but let's take a look at the data.

You'll notice a slight change on line 2 in the latest statement above, a decline in foreign currency reserves of less than one half of one percent. That is most likely not related to exchange rate manipulation. And you can disregard the tiny increase in the "net position in foreign currency" of less than one twentieth of one percent as that was due to USD swap-related liquidity operations within the European banking system.

Doing the dirty float leaves a large footprint in the foreign currency reserves of a CB. China is a good example. From the time it joined the WTO until last November, its dollar holdings in Treasury debt rose from about $50B to $1,300B, a 2,600% increase, and its total foreign currency reserves rose to $3,990B, although that's not all dollars.

If the ECB were doing the dirty float, we should see a substantial change over time on Assets Line 2. Now not all of the Eurosystem's foreign currency reserves are dollars either, but most of them are, left over from three decades of doing the dirty float from 1972 until the euro launch. So I thought I'd take a snapshot of line 2 from each year during the same week in July as the latest statement. I started with 1999.

Coincidentally, it's almost the same as 2014! Line 2 in July of 1999 was €247,105M, and in 2014 it's €248,173M, a difference of less than one half of one percent. So right on the surface, it doesn't look like they've been playing dirty. But that doesn't tell the whole story.

We can ignore small fluctuations because they can have explanations other than exchange rate manipulation, but more importantly, there are two things that automatically change line 2 over time, regardless of anything else. First, notice that they state their foreign currency reserves in euro-denominated value. Well, they revalue those reserves every three months based on changes in the euro exchange rate, so line 2 automatically changes once a quarter.

Second, seven countries joined the Eurosystem after 1999, and each time a new country joins, they add its foreign currency reserves into the consolidated statement. So each time a new member is added, line 2 rises by the euro-denominated amount of foreign currency reserves the new member was holding on the date they joined. Once they have joined the euro, they can't buy or sell CB reserves on their own anymore. They have joined a group, and all reserve operations must be coordinated through that group (the ECB).

Correcting for these two variables, the net change in foreign currency reserves from the first quarterly statement in 1999 until the most recent statement in 2014 is about +$60B. [7] Let me put this into perspective for you. $60B covers one month of the US trade deficit in 2006, or a mere 0.8% of our cumulative trade deficit from 1999 through 2013. Prior to 1999, the dollar holdings of the initial Eurosystem members were equal to 14% of the cumulative US trade deficit up until then, which compares with China's Treasury holdings which are equal to 19% of the cumulative US trade deficit since 2001.

Going from 14% over 28 years to 0.8% over the next 15 years is a big change. It's the difference between structural support or not, between the dirty float or not. But I didn't stop there. I wanted a clearer picture of the last 15 years, and here's what I found.

There's a definite period in which the ECB was increasing its foreign currency reserves at a rate resembling the dirty float. As I circled below, from July 2009 to July 2010, the Eurosystem increased its foreign currency reserves by $63B, which coincidentally works out to 14% of the US trade deficit during that time and which apparently supported the dollar while weakening the euro from $1.46 in 2009 down to $1.22 a year later.

See footnote [8] for an explanation of the data

I think that fits with Ari's 2010 email to me which I included in 2013's Year of the Window:

ARI (via email Dec. 2, 2010) - I feel that the ongoing financial crisis that began with the subprime fiasco has caused instability of such magnitude that the central bankers have been forced to delay briefly and "play it safe" -- one does not dare rock the boat (if there remains any choice in deciding the matter) when the financial waters have become so turbulent and choppy. As for the new timeframe, I'd say that the reported EU plan "to make private bond holders shoulder some of the pain from any sovereign debt restructuring after mid-2013" is as good an indication of a benchmark as any I've seen.

Other than that relatively brief time frame, they have done very little with line 2. This supports my theory that they have no intention of manipulating the euro's exchange rate on a regular basis. In other words, they want a clean float.


Just Say No

Calls for the ECB to intervene in the foreign exchange market and weaken the euro's exchange rate have been growing lately, but officials with the ECB have made it clear that they have no interest in doing the dirty float anymore.

ECB under pressure to tackle ‘crazy’ euro
Financial Times
July 7, 2014
By Michael Stothard in Paris, Andrew Parker, Peggy Hollinger and Ferdinando Giugliano in London

Pressure is mounting on the European Central Bank to take action against a persistently strong euro with a leading industrialist calling on Frankfurt to tackle the “crazy” strength of the currency.

Fabrice Brégier, chief executive of Airbus’s passenger jet business, said the ECB should intervene to push the value of the euro against the dollar down by 10 per cent from an “excessive” $1.35 to between $1.20 and $1.25.

“[Europe] cannot be the only economic zone of the world that doesn’t consider its currency as a weapon . . . as a key asset to promote its economy,” he told the Financial Times in an interview.

[…]

Benoît Coeuré, a member of the ECB’s executive board, acknowledged in an interview that the stronger the euro became, the more the bank would come under pressure to act. “A lot of the low level of inflation . . . is due to the strength of the euro so the stronger the euro the more we have to do monetary accommodation.”

However, he rejected calls to focus on the exchange rate explicitly. “It is not possible to target it because exchange rates are set on global markets, so it wouldn’t be wise or possible for us to have it as a policy target.”

He also insisted there was no pressing need for the ECB to embark on a round of QE. “I see the odds as being low,” he said. “I am very convinced that what we decided already will work and will prop up inflation.”

[…]

Any explicit attempt to weaken the euro is likely to be opposed in Germany. “We need a stable currency and we have one. The euro at $1.35 gives us a stable framework for competitiveness,” said one senior German official. “We do not need to talk the euro up or down. Currency manipulation is not a route to competitiveness, it is a soft alternative to hard explanations to the electorate.”

Airbus, which sells its aircraft in dollars but incurs costs in euros, is one of the most exposed groups in Europe to a strong single currency. Other groups such as Unilever, SAP and BMW have also faced currency headwinds.

Mr Brégier stressed he was not specifying what additional measures the ECB should take, but said: “Let’s look at what the Japanese are doing. They have devalued the Yen by 20 per cent.”

Germany urges euro zone to reform, not rely on ECB help
Reuters
Fri Jul 18, 2014
By Paul Day

…In Paris, German Finance Minister Wolfgang Schaeuble said monetary policy could give governments time to reform but could not achieve everything, urging them to focus on improving economic competitiveness rather than on the euro exchange rate.

The Germans' double-barreled warning shot for euro zone governments came against the backdrop of a debate among the bloc's policymakers about the flexibility of their fiscal rules, and calls from French officials for the ECB to weaken the euro.

"We should not overestimate the capacity of central banks to solve the crisis. It is not up to us to solve the crisis," said Weidmann, whose role as Germany's central bank chief gives him a seat on the ECB's policymaking Governing Council.

[…]

Schaeuble also pushed back at French policymakers and businesses who have complained about the strength of the euro and asked for the EU and the ECB to do more to weaken it. Germany has insisted on the independence of the ECB.

A strong euro has its advantages, Schaeuble said, adding: "We have to concentrate on whether the European economy is competitive and then we will have an appropriate exchange rate." […]


The Value of Reserves

Just like savings are extremely valuable to the individual come illness or old age, public sector monetary reserves have a similar value to the commonwealth in the case of unforeseen crises. No one knew this better than Europe, having used its gold reserves following WWII and again during the oil crisis in 1974. But the dollar's near-collapse in 1978 revealed a fundamental problem with the new dollar standard. The very act of accumulating foreign currency reserves overvalued that currency creating an unstable situation that itself could cause the crisis that would devalue the reserves just when you needed them most. The only way to avoid the crisis was to keep buying more, even as their ultimate uselessness was revealed. Gold was obviously different.

Thoughts like this have undergone an evolution of sorts since 1944, especially among central bankers. It is good to have sufficient reserves in case of emergency, but not all reserves are created equal. And not all reserves serve the same purpose. And yes, a CB can accumulate too many reserves, which is wasteful and unnecessary.

Fixed exchange rates like we had in Bretton Woods require the accumulation of CB reserves to maintain the fix. On the surface, such transfers of CB reserves seem to be settlement, or the adjustment mechanism for correcting imbalances. But in practice they are quite the opposite. They are not settlement, they do not correct the imbalance—they perpetuate it—and they neutralize natural adjustment mechanisms by blocking signals of strength and weakness from reaching the private sector.

With floating exchange rates, the transfer of CB reserves is simply not necessary. The exchange rate responds gradually to changes in relative strength. Imbalances are "settled" on a daily basis through changes in the exchange rate, eliminating the need for the faux-settlement that is reflected in changes to the reserves portion of a CB's balance sheet. Said another way, if the reserves on the CBs' balance sheets sat there untouched and unchanged, lying still, simply being there in case of a crisis or emergency, the automatic result would be a clean floating exchange rate system.

This evolution of thought that moved the goal from fixed to floating exchange rates is nearly complete and universal. It went from fixed, to fixed but adjustable, to floating. The dirty float of the last 40 years or so was never a goal or solution. It was always an awkward intermediate step.

Back in the Bretton Woods system, the IMF was like a pool of foreign reserves which could be drawn upon by any member with insufficient reserves of its own. In a way, it was kind of like an insurance policy for CBs. They paid into it with their subscription and then, when needed, they could draw out foreign reserves to be used for the specific purpose of fixing (manipulating) their exchange rate.

Today the IMF still works similarly, as a kind of foreign reserve insurance policy, but the big difference is that if you find yourself in position of needing to draw reserves from the IMF, it is now an explicit condition that you not use those reserves for directly manipulating your exchange rate. Today it is often countries that used up their own reserves trying to do the dirty float the expensive way that find themselves needing IMF help, and the prerequisite is that they stop manipulating their exchange rate and let their currency float. That's what I mean by nearly complete and universal.

Ukraine is a good example. Ever since the collapse of the Soviet Union and the hyperinflation that followed, Ukraine has been fixing and pegging (manipulating) its own currency to the dollar, periodically suffering devaluations every time a new crisis hits. Following the Asian crisis in '98 it devalued, then in the 2008 global financial crisis it devalued again, and then early this year it devalued for a third time.

During Bretton Woods, the IMF would have provided Ukraine with the foreign currency needed to maintain its fixed exchange rate, perhaps after officially devaluing it. But today the IMF simply provides a loan of foreign currency to help them meet international payment obligations on the condition that they now let their currency float.

IMF Says Ukraine Qualifies for Second Tranche of Loan
Bloomberg
Jul 18, 2014

An International Monetary Fund mission will recommend that the lender’s board approve the second installment of a $17 billion bailout to Ukraine.

The Washington-based board will meet to approve the disbursement of $1.4 billion, the mission said today in an e-mailed statement from Kiev. The eastern European country met conditions including allowing its currency, the hryvnia, to float freely, said the mission, which has been visiting the Ukrainian capital since June 24…

Think about how this policy reflects the evolution of thought that has transpired, especially among central bankers. The 2nd Amendment to the IMF Articles of Agreement, which is still in force today, gave each member the freedom to choose its own exchange rate policy, from fixed to floating, with the sole exception of fixing to gold. And today they insist on a clean float, among other conditions, if you need their help.

Reserves are so valuable in the case of a crisis or emergency. Whether you're an individual or a sovereign nation, don't you think that having sufficient non-borrowed reserves in a crisis would be preferable to relying on help from someone else, or relying on an "insurance policy" that may not be around when you need it, and even if it is, comes with a long list of conditions? And you also need to consider the quality of those reserves. Are they such that they might go poof just when you need them the most?

This is where gold fits into the picture! It is prudent to have a sufficient amount of reserves, and it is possible to figure out roughly what that amount is, though it varies by individual or CB. But it is wasteful to have more than a sufficient amount. It is wasteful because excess amounts will most likely never be needed and the cost of acquiring them is an unnecessary reduction in standard of living, both for the individual and the currency zone.

Imagine an obsessive hoarder who lives like a pauper just to die with millions in savings and no one to leave it to. Unspent, unused, and wastefully acquired at the cost of an unnecessary reduction in lifestyle. It's the same for a currency zone whose CB accumulates more reserves than it could ever reasonably expect to need. The point is, the prudent course of action is to accumulate reserves up to a reasonable amount, and then let them lie still, untouched, unchanged, for years on end, until that unforeseen crisis or emergency arrives.

This is the value of reserves. Accumulation up to a reasonable level is prudent and good. And dishoarding reserves in a crisis situation is exactly what they are for. Beyond that, significant changes in the reserves portion of a CB's balance sheet are simply exchange rate manipulations. Small amounts of foreign currency are useful for short term liquidity management in your commercial banks that trade foreign currency, but even today we see CB swaps (bilateral borrowing) taking care of that function, essentially bypassing the need to buy foreign currency from the foreign exchange markets for that purpose.


The Freegold Model

If we look at the reserves portion of the Eurosystem's balance sheet, including both gold and foreign currency reserves, it is clear that the ECB has been doing just that, leaving its reserves virtually unchanged for the last three years at least. The Eurosystem's gold reserves have been virtually untouched even longer, but combined, for the past three years, changes in the Eurosystem's reserves have averaged about 1.5% per year, in alternating directions. [9]

This, quite simply, is the model for Freegold. I won't make specific predictions of what the ECB will and won't do pre-transition, because as long as the $IMFS rules, they could potentially take any action, even due to political pressure. But what I expect to see is these reserves, both gold and foreign currency, remain relatively unchanged, from now through the transition, and then until Europe faces its next major post-transition crisis or emergency.

Again, I say this not to predict what the ECB will do, but to explain the Freegold model. I think it is clear that the ECB is, and has been since its inception, comfortable that the Eurosystem has a sufficient amount of gold reserves, and they should know. That's why we haven't seen them buy any more gold since inception. They even sold some 15% of their gold over the years, so they obviously felt they had more than enough from the beginning. But even that selling has now ended, and their gold reserves have gone virtually untouched for the past five years.

As for their foreign currency reserves, those have gone virtually untouched for the last three years. The fluctuations have been in alternating directions and small enough that they are obviously incidental and not related to exchange rate manipulation. Furthermore, they are now actively resisting calls for exchange rate manipulation. For these reasons and more, I expect to see most of the ECB's actions fall under the category of "Items related to monetary policy operations", which includes things like lending facilities, refinancing facilities, deposit facilities, LTROs, securities market programs, and so on. This is where the ECB is active, and this is the model for Freegold. As for "Items not related to monetary policy operations", I expect to see almost no activity aside from quarterly revaluations and minor movements in alternating directions.

Call it what you want—I'm calling it the Freegold model—but I think the ECB understands this stuff better than your average central bank, let alone the clueless private sector and financial media. And I think the ECB is doing these things and others, not only because they are the right things to do and the best course of action for the Eurosystem (different actions would be more popular and not very damaging), but because they want to lead by example, especially heading into and through such a major transition. It's much easier to simply lead by example than to try and explain all this stuff at once. Trust me, I know! ;D


Right Before Our Very Eyes

People often email me, "FOFOA, the markets are so calm right now. What do you make of it?" My answer is that it's happening right now, right before our very eyes, if you just know where to look. And then I usually say I'll have a new post up soon trying to explain what I mean.

FOA really nailed it. Maybe not for 2001, but he did nail it, and it's happening in 2014. And anyway, he clearly disavowed timing. We're right back in October 2001. Or actually, we're right back in Q2 1978, only this time the European CBs are prepared and there are no more massive underdeveloped countries with a non-convertible currency and 1.3 billion people ready to join world trade.

Structural support has clearly ended, and as FOA said, "this is more than enough to end the dollar's timeline." Europe is obvious, China is no longer dependent upon its exchange rate with the dollar, and total foreign official holdings of Treasury debt (the gold standard of structural support for decades) are flat for the last year and a half, not to mention that China itself is flat for the last year. The foreign public sector in aggregate has let go, and now it's all up to the foreign private sector.

The problem is, we're still putting out about $40B in new dollars that need to be bought up by someone in the foreign sector each month. The foreign private sector loves dollars, but not that much. We know this because the status quo of the last few decades included the foreign public sector supplementing the foreign private sector's demand for dollars by a significant percent.

How long do you think the foreign private sector can continue absorbing $40B new dollars a month? Remember, the private sector is driven only by profit, and without the supplemental public sector maintaining the status quo of dollar profitability, demand could turn on a dime. All I can say is hold on to your hat next time there's any kind of a shakeout in the dollar markets, and thank goodness there are no major geopolitical crises at the moment that could potentially precipitate a financial crisis. Enjoy the calm while it lasts, because Freegold is unfolding right before our very eyes, if you just know where to look!

FOA 8/2/99: "When a currency dominates the world, it usually isn't forced into that position. It evolves there from forces governments cannot stop! Did you think the entire world wanted the dollar to be on top from long ago? A quick history read will show that other governments tried to prevent it, but couldn't. Just as the British Pound fell from dominance, they didn't want it to happen either, but couldn't stop it.

Understand, the dollar isn't being forced out of position because it's getting better. It's building so much debt that it's destroying the current world economy. If you think it's been doing a good job, then please read the history of Foreign Exchange (in the link I provided earlier). My friend, battle after battle has been fought to save the dollar, not destroy it! Did you think Nixon took it off the gold standard to "kill it"? No, they were trying to patch it back into some useful form, as nothing else was available."

FOA 09/13/99: "Today, the ECB has largely withdrawn from this supporting function. See the chart of total foreign net US debt purchases I offered earlier(if you have one?). It has now fallen back to 1980 levels. Without the private foreign citizen purchases, it could be considered that a run on the dollar has started.

This is leaving mostly the hedge fund community to use their 100 to 1 leverage to further accumulating US debt in the carry trade. Yet, these private international funds are not CBs and their trading can benefit the dollar debt only so much. If the market reacts against them they (unlike CBs) must close out or seek support. From this viewpoint we understand why the Fed is now buying so much debt in open market operations."

FOA 2/15/01: "We, America, promote the value of our dollar in and of itself. Mostly pointing to our goods, services and assets that dollars can buy. Of course, if you have followed this for long, you know the dollar and near dollar supply has shot to the nearest star and will never actually convert into these products in total. At least not at current exchange rates or internal price levels in the US.

So,,, we promote the dollar using a different format, by saying that foreigners can invest here, not buy, and find the best returns. This works as long as foreign CBs support our dollar as a reserve by saving it themselves. Making for a stable exchange rate and benign price inflation (in the US). Many thinkers have said, over the last 30 years, that those foreign CBs would never continue to do this. Well, confounding everyone, they did! Their real reasons have been our topic for years now. […]

Eventually, as the dollar works it's way toward becoming just a regular money, it's exchange rate will tumble. Vastly aggravated by our world class trade deficit. A deficit, I might add, that has become structural to the function of our economy in a non price inflation manner. […]

The one thing that was negotiated into the EMU was gold's place in the world. Indeed, this is where the ECB and BIS knew their oil neighbors well. By signaling gold to be an asset, not a currency, it could be promoted to rise outside its commodity range without competing with the new currency. With the history of the dollar's use of gold, America's war on gold and its locked in political stance on gold, Old World Europe played a Master Stroke. This could not help but solidify an evolution into Euro use by practically every country outside the dollar world. […]

In ANOTHER master stroke, the BIS knew that the entire bullion house structure was endorsed and supported politically, to frame gold in a dollar price band. Outside that band, up or down, these paper markets cannot function. Especially if the driving force becomes a physical demand that drains all settlement credibility from contract gold. There will be no squeeze in these markets now, as they will be allowed to kill themselves by trying to save themselves. Inflating the supply is that process. The loss of such credibility will eventually come as trading just stops, virtually closing the dollar contract markets as we know them. Opening the door to an ECB sponsored physical market.

If I had to guess, we will see Shanghai, Johannesburg and Dubai all joining with major internal Euroland financial centers to form the EBES (Euro Bullion Exchange System). By this time, the ECB quarterly reports will be seen as a scorecard of Dollar vs Euro values. We shall see!

I think you can take the microphone from here, sir. I've said enough on this. (smile))"

FOA 10/3/01: "Physical gold will be the very best holding as all of this comes into play. Virtually all government gold policy will gravitate towards sponsoring citizen gold ownership. Essentially because Europe will have removed the entanglement of modern fiat competition from said gold markets. […]

Timing?

We, and I, as physical gold advocates, don't need timing for this position! Timing is for poor, paper traders. We are neither, and our solid, long term, one call over several years to hold physical gold will confirm our reasoning. There is no stress for me to own this ancient asset as it is in a good proportion to all my other wealth. There is no trading an economic system whose currency is ending its timeline.

Thank you
TrailGuide"
[10]

This post is the second in a continuing series that began with Fiat 33.

Sincerely,
FOFOA

[1] Robert Triffin (Nov. 1978) The International Role and Fate of the Dollar Foreign Affairs p. 13/281
[2] Ibid., p. 11/279
[3] Economic and Social Committee of the European Communities (June 1978) Monetary Disorder p. 98
[4] Ibid. [1], pp. 11/279-12/280
[5] David E. Lindsey, Athanasios Orphanides, and Robert H. Rasche (2004) The Reform of October 1979: How It Happened and Why Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C. p. 21
[6] Ibid., p. 1
[7] Comparing the April 6, 1999 quarterly statement with the July 22, 2014 weekly statement converting line 2 to dollars using the exchange rate the ECB was using on those statements and adjusting for new members (see footnote 8 for more).
[8] Data is Assets Line 2 for the same week in late July each year going back to 1999, converted into dollars using the exchange rate the ECB used on each statement, then adjusted for the dollar-denominated amount each new member brought in upon joining the Eurosystem using the exchange rate the ECB was using on the date they joined, adjusted by subtracting the amounts added when new members joined, from the year they joined onward. This gives us a good approximation of what the ECB has done that could constitute a dirty float (i.e., dollar structural support) since its inception. The smaller movements outside of my yellow circle are probably not related to exchange rate manipulation.
[9] Foreign currency reserves adjusted as in [8] and changes in gold reserves by the tonne, with gold changes weighted slightly more than foreign currency changes, consistent with their relative MTM values.
[10] All of the FOA quotes in this post can be found in these two pdfs: AFTER (THOUGHTS!) Part 1, AFTER (THOUGHTS!) Part 2