Marketdepth: Change We Can Believe In

Every good skier understands snow. Why should good investors not understand money? This thought occurred to me as I listened to various reactions to the US Federal Reserve’s announcement of phase two of its “quantitative easing” program.

No longer shrouded by the fog of crisis, “QE2” has laid bare the Fed’s dollar debasement strategy. The government of the United States is now funding its entire $100 billion per month budget deficit through printing money to buy its own bonds. Were it not for the necessity to ensure that Wall Street’s bonus pool stays filled, the Federal Reserve might as well cut out the New York middlemen and just dispatch trucks around the country loaded with “Benjamins.”

The investing playbook for this era of quantitative easing is fairly straightforward. Avoid anything that looks like a government bond and buy things like wheat and silver which represent relatively cheap, hoardable commodities.

Figure 1: Silver Quarters – Change We Can Believe In

But while hoarding is definitely the best investing play of 2010, it does strike me as a rather dubious long term economic strategy. Can the troubles of excess debt and inflation be addressed by bringing back the gold standard? Absolutely, I say.

Canada and the Gold Standard

Many people do not realize that this country has a long history of operating on a gold standard. Canadian dollars were exchangeable into a specified quantity (23 grains of gold or 4.7 hundredths of a troy ounce) from the 1850's through to the outset of Word War I and also for a period following that War.

Between 1933 and 1971, Canada ran on a kind of second-hand gold standard, under which the government committed to maintain the C$ value in a range relative to the US dollar (and the British pound in the early part of this period). The US dollar was in turn fixed to gold at $35 per ounce. Under the post-WWII Bretton Woods system, Canada and other countries maintained a virtual peg to the US dollar.

The beginning of the end for Canada’s gold standard came on December 23, 1966. On that day, Mitchell Sharp, Canada’s Minister of Finance announced that coins of the 10c, 25c and 50c denominations would no longer be cast according to their long-standing mix of 80% silver and 20% copper. Given that the price of silver had by then caused the coins’ metal value to pass through their face value, Sharp presented to Parliament an amendment to the Currency, Mint and Exchange Fund Act which would eliminate the use of precious metal. By 1968, the deed was done. Canada's silver coins were removed from circulation in favour of the slugs that continue to be stamped out by the Mint at the cheapest practical cost.

By 1971, America's massive borrowing to fund the Vietnam War eventually led President Nixon to abandon gold convertibility of the US dollar in 1971. Canada's implicit gold standard, already imperilled by the end of silver coinage, died simultaneously. So if you ever wondered who really decided that Canada should have completely faith-based fiat currency, the answer is Richard Nixon. Did I just hear someone say, “Only in Canada?”

Gold Standard Benefits

The benefits of a gold standard are simple, but unfortunately a significant period of time is required to demonstrate them. For this reason many countries have been forced to learn the same lesson over and over again. Fiat money leads to inflation, wealth destruction, and ultimately, chaos.

The most important feature of a gold standard is that the supply of money, and credit, can only grow in proportion to the speed at which total gold reserves can be expanded through the acquisition of mine output. Given that we already have many centuries worth of production stored above the surface, this effectively limits the growth of money at most to a few percentage points per year. With credit growth thus constrained, the emergence of debt-fuelled bubbles such as the dot-com fiasco or the various housing bubbles would have been well-nigh impossible.

The allocation of resources in a society on a gold standard involves choices made in plain view of market participants. In a fiat world, bankers and speculators can conspire to build huge asset valuations backed by easy credit. When the inevitable crack-up follows, a government must choose between a prolonged deflationary recession or a bailout. Under a bailout, all the bubble’s non-participants pay by pro-rata dilution of their monetary assets.

The hidden cost of fiat money is a long-run reduction of capital investment of any kind. Investors, burned by confiscatory inflation, become hesitant to make long-term loans at any price. The economic troubles of Latin America over the past three decades has its root causes in undisciplined fiat money regimes. And as the West’s currency and sovereign debt problems now demonstrate, there is nothing fundamentally different about fiat money north of the Rio Grande.

However, if one were trying to fix the problem, as opposed to merely profit from it, there is of course a somewhat different prescription required. Here is my best guess at how we might proceed.

Five Not So Simple Steps

The way out of the mess begins with 1) a recognition that the debts are too big. I laid out some of my homework on that topic here. The next step 2) would be to apply some kind of haircut to outstanding debts. The better places to take the haircuts would be at the levels of private and sub-national debts, so that Canada as a nation might remains a somewhat creditworthy entity. I would suggest forcing banks to take an across-the-board haircut on consumer debts and mortgages. Other sub-national governments might also be moved to haircut their debts to the extent that they are not manageable.

What cannot be achieved through debt writedowns could also be achieved through step 3) a co-ordinated, one-time emission of fiat cash. If we want to extinguish the provincial debt of Quebec, for instance, it could be bought back with a load of freshly printed fiat cash. It would be important that the emission of fiat cash be a one-time measure. Another key step in the process 4) would be in the significant reduction in unfunded entitlement programs that would put Canada on a more sustainable go-forward fiscal footing. Finally, we would reach step 5) the critical part of this process, which would be a permanent fixing of the currency of a newly solvent Canada against gold. What the exchange level might be would depend on circumstances at the time. If it were to be done today, the fix might be applied at C$2500 per gold ounce.

Harsh medicine, indeed. It would make the imposition of the Goods and Services Tax look like a walk in the park. Yet the alternative, to do nothing and twist into inevitable chaos, seems far worse. As an investor, my bets are placed squarely on the do nothing option. But as a citizen, I recognize that there is a plan that could pull this country from the chaos of a broken fiat money system. Can we really leave this purgatory of excess debts and phoney cash for “change we can believe in?” The answer is obvious. Yes we can.