The Great Recession? Crisis? How About Relearning?

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Despite a high level of drama in nearly every corner of the economic globe, we have yet to settle on a catchy description for this particular period in history. We have had the Great Financial Crisis, or the Great Recession, following closely behind, and directly related to, the Great Moderation (itself only a slight change from the Great Inflation). While the Great Financial Crisis continues to roll on, particularly in Europe, there are stains and elements still evident elsewhere. Looking at the bigger picture, however, all of these "Greats" could easily fall within the Great Relearning.

In the December 1987 issue of The American Spectator, Tom Wolfe penned an essay describing this very Progressive trend that had begun in the last half of the 1960's.

"In 1968, in San Francisco, I came across a curious footnote to the psychedelic movement. At the Haight Ashbury Free Clinic there were doctors who were treating diseases no living doctor had ever encountered before, diseases that had disappeared so long ago they had never even picked up Latin names, diseases such as the mange, the grunge, the itch, the twitch, the thrush, the scroff, the rot. And how was it that they had now returned? It had to do with the fact that thousands of young men and women had migrated to San Francisco to live communally in what I think history will record as one of the most extraordinary religious experiments of all time."

In their rush to move beyond traditional American or Western society and social arrangements, the "hippies" Wolfe described had discarded centuries and millennia of common knowledge about the wisdom of not sharing toothbrushes, drinking glasses and dirty bed sheets. Their interests were largely centered on their own notions of equality, "fairly" leaving behind even the smallest vestiges of traditional customs and legalisms that had favored private property. Conventional and traditional wisdom, gleaned from countless generations of bland observations distilled into accepted mores and norms, had no place there. These people were out to remake the world into a shiny and shining utopia.

Around the same time as Mr. Wolfe noticed this particular contour of the modern, humanist urge to move "forward", another parallel trend was reaching its crescendo. Ever since William Jennings Bryan stood before the Democratic Convention in 1896 to decry the "cross of gold", the controlling and Progressive urge to change the economic order had taken a mainstream place. Bryan's critique was likewise an appeal to equality and fairness; bank panics and depression were regressive in aiming monetary adjustments squarely upon the working class.

From the installation of the Federal Reserve in 1913 to its post-WWI monetary framework that saw an increasing power to engage economic "management", the die had been cast for new means to change the mechanism for clearing monetary imbalance. In the post-WWII world, European countries in particular had sewn this impulse into codified and statutory practice. Economic adjustment would not fall disproportionately upon the workers; trade unions and national income and employment policies would be reprioritized in economic and monetary affairs.

The primary problem, from this perspective, was the global monetary system, even under the Bretton Woods gold exchange standard. The system still featured gold as the sole count of actual money, with US dollar and UK sterling currency as reserves. Every other nation would hold these "reserves" as convertible into real money (gold) at the official price. In Bryan's terminology, the cross was still a burden upon the working people, if only a step removed.

The tendency of the UK economic and monetary policy to favor employment and national income, determined with close "cooperation" with national trade unions, meant that the country could never quite close its persistent merchandise trade deficit. The nation's imports would always exceed exports because British exports were increasingly uncompetitive in the global marketplace. As one of the two reserve "pillars" of the Bretton Woods system, however, the British merchandise and fiscal deficits were of outsized significance. By 1967, three straight years of large fiscal deficits and no discernible change in the export situation led to a growing sterling crisis.

In 1963, external holdings of sterling as reserves exceeded £4.2 billion, an amount far greater than the Bank of England's own foreign reserve position. As investors grew wary of these trade and fiscal imbalances, the Bank of England simply did not have enough of its own reserves to support the pound's value pegged to the dollar (and thus real money, gold). Outside investors, perceiving an inflationary imbalance, demanded convertibility, and thus thrust the cross of gold upon the British workers. In the traditional notion of monetary mechanics, a run on the pound would dramatically reduce the internal supply of money, producing widespread recession and depression.

As much as the 1971 Nixon administration move to "close the gold window" is cited as the inflection and evolution into a world of fiat money, the growing sterling crisis between 1963 and 1967 actually ended the gold standard in nearly every practical manner. Eager to move beyond centuries and millennia of accepted monetary tradition, the new economists and planners of the age felt technologically and philosophically advanced enough to institute a world without money. The gold standard would be traded for a swap standard from that point forward.

Convertibility would still be promised and honored, but the Federal Reserve Bank of New York (FRBNY) and the IMF opened swap lines with the Bank of England to help manage the flow of currency reserves - all so that the trade and fiscal imbalances could be maintained without internal economic adjustment. By September 1964, the Bank of England had access to a top secret $2 billion swap line, which was increased to $3.3 billion in September 1965, further to $4.4 billion in 1966. The Bank for International Settlements also provided a secret gold swap line.

This first run at the swap standard ended in failure on November 16, 1967, as the UK devalued the pound from $2.80 to $2.40. The government and global financial authorities had tried desperately to save both the investor preference for money and the national commitment to employment and national income. No doubt current monetarists would determine that the swap lines were simply not big enough.

The sterling devaluation in 1967, however, unsettled investors and their traditional monetary views. The US dollar had already been subject to pressures of convertibility, favoring real money over currency (Triffin's Dilemma), leading to the creation of the London Gold Pool in 1961. However, this pooling of gold resources among nations to defend the US official gold price of $35 an ounce had depleted gold reserves. In December 1967, only a month after the UK pound devaluation, gold volumes in the London gold exchange averaged 20 times normal.

In just a few weeks' time, the pool had seen 1,000 tons of gold moved into investor hands. Eventually the French government would withdraw from the pool and began demanding the recycling of export currency into claims on US gold. By March 15, 1968, gold demand on the exchange had been as high as 225 tons in one day (normal daily turnover was only 5 - 10 tons). The Queen of England shut the exchange that day by declaring a bank holiday "upon the request of the United States".

From that day forward, the US no longer allowed effective convertibility of the dollar. The US Treasury would honor the official $35 price only at the request of foreign central banks. The price of the US dollar would now float in terms of gold, but this two-tiered system did not last long, as reserve holders sought to essentially arbitrage this tiered pricing structure. Primarily French and Swiss banks (acting largely on behalf of oil sheiks) were still claiming US gold at the official price. The drain on US gold finally ended the official dollar peg in 1971.

The question at that point had become one of exchange and trade imbalance. Without any real money to convert between national systems, how would imbalances get resolved?

These discrepancies would be managed by economists and PhD's, backed by the cutting edge of academic understanding. The US, as much as the UK, had been freely creating ledger money since 1965, inflating the US dollar in the pursuit of creating its own permanent fiscal deficit - governments simply wanted to be free from the shackles of real money limitations. While the UK focused on workers and trade unions, the US was into Vietnam and redistribution through the Great Society.

Where gold had stood through time as a bulwark against hubris and politics of the printing press, now would stand central banks and multi-national credit conduits.

According to the FDIC, at the end of 1970 Latin American (including Mexico) external debt totaled about $29 billion. By 1978 external debt had grown to $159 billion (a compound rate of about 24% per year), 80% of which was sovereign. Mexico and Brazil together accounted for $89 billion. Nearly all the debt featured floating rates tied to LIBOR, thus eurodollars.

These debts were incurred under similar circumstances of trade imbalances as the UK experienced in the 1960's. Latin American countries were heavy importers without the developed economies to rebalance through some trigger in exports. The imbalances in Latin, though, had been self-limiting to the availability of real money under the gold exchange standard. If a particular country wished to "self-finance" import imbalances through the printing press, eventually exporting nations and companies would incite a run on the local currency into gold (usually ending with a devastating devaluation and losses that would lock the country out of international finance markets).

In an international world devoid of money, however, imbalances could become semi-permanent through the use of eurodollar markets. US (and eventually European) commercial banks would become the new center of global trade, conducted in US dollars without a gold bar anywhere. The primary import imbalance to Latin America was petroleum. OPEC would now sell oil to Latin America and receive payment from US banks in dollars. The US banks opened credit lines or created and purchased sovereign debt securities on behalf of their Latin clients. There was no real need to settle trade imbalances since the banks provided the oil producers with newly created ledger dollars (bank balance sheet expansion) underpinned by the Fed's implicit (swaps) and explicit (lender of last resort) liquidity pledges. Credit risk remained with the banks and, given the financial support absent real money constraints, they were very eager to expand credit in massive amounts.

This eurodollar arrangement essentially centralized the "self-finance" risk. Latin countries could be as irresponsible as they wished; repercussions were now more or less remote in the US banking system. As long as eurodollar banks were willing to lend dollars through balance sheet expansion, Latin countries were willing to borrow as much as needed. With a swap standard in place, a "run on the dollar" without convertibility was not something contemplated, and global trade could continue without as much limitation. Economies could operate, it seemed, without having to bear the cross of gold, and utopia arrived especially in Lower Manhattan.

Instead, as we know, making money an outcast from the financial system ended up exactly as tradition warned. The PhD's were not able or technologically advanced enough to manage permanent imbalances. Inflation was everywhere. By 1976, the UK government was near collapse, as was the economy. Despite the promise of a more progressive arrangement for economic imbalances, the end of the gold era did not herald an end to mass unemployment, only the addition of inflation.

In the new floating fiat world of international exchange, the imbalances in Britain had led the pound below $2.00 in March 1976; to $1.65 by October 1976. Under the terms of the new monetary standard, the Bank of England was fortified by swap arrangements from the usual suspects, especially FRBNY and the US Treasury, to allow it to intervene in floating currency markets in an attempt to arrest unintentional devaluation.

Ironically, the 1976 swaps (about $2 billion from US sources, and an additional $3.2 billion from the Group of Ten, minus Italy, plus Switzerland and the BIS) were given under terms that largely acted like the gold standard. From the US, the swaps were only for three months, renewable for an additional three before terminating. The time limitation was intended for the UK government to get its act together, cutting its fiscal spending and monetary expansion to defend sterling on its own.

To underscore just how bad imbalances were at the time, declassified documents from UK cabinet meetings show just how far away from real credibility the government had ventured. Without any sort of self-restraint or gold restraint, underpinned by swaps and floating fiat, internal discussions sounded like this:

"The document pointed to the need to get the rate of price inflation down to at least 15 per cent. This target called for a major effort to get average wage increase below 20 per cent early in the next wage round. The document suggested a number of options for achieving this. The Chancellor of the Exchequer had however suggested that the Government's target for reducing the rate of inflation should be a halving of the current rate of inflation by the third quarter of 1976. This would imply a wage norm of 10 per cent for the next round of pay negotiations; the TUC were extremely unlikely to be willing to accept a figure at this level and even if they accepted it would find it almost impossible to ensure compliance from individual unions. He therefore suggested that a more reasonable target would be a wage norm of 15 per cent."

In only a few months' time the UK would draw upon the short-term swaps, and, with no real ability to repay them, was forced into a shameful bailout by the IMF in late 1976. The terms of the £2.3 billion IMF provision were to cut back government expenditures, which, in an economy where the government owns all the businesses, meant exactly the same as the cross of gold adjustments they were seeking to avoid. The IMF terms led to widespread unrest in Britain, and eventually the "winter of discontent" in 1978-79.

For the borrowers of Latin America, the swap standard was proving to be no better. By 1978, Brazil was using 60% of its export earnings just to service its debt. The FDIC notes that from 1979-82, almost all of the new bank loans and sovereign debt incurred to Latin America was used to fund interest payments and consumption of imports - very little "money" was being used for productive investment to address the merchandise imbalance and improve the quality of the local economic system. It was a debt prison.

Eventually there would be a run on the dollar, in 1978 and 1979. Without a gold solution, however, the US was left with swaps and discount rate tools. The discount rate was driven up a full percent on November 1, 1978, to a record high 9.5%. Some $30 billion in swap lines were opened the same day with the Bundesbank, trying to intervene against the strengthening D-mark, the Bank of Japan and Switzerland. The US Treasury even sold IMF SDR's to Germany, and restarted gold auctions to the public (first gold auctions were in 1975).

Yet none of these measures "worked", and instead the US experienced a sharp recession in 1980 followed by another in 1981-82, largely brought about by record high interest rates. So the US, like the UK, eventually burdened the working class with monetary imbalances - unemployment in the US reached levels not seen since the Great Depression.

The interest rate differential picture in the floating fiat world played hell with the Latin American borrowers. The US dollar "run" was arrested, but in doing so made Latin American debt positions untenable. With nearly all the eurodollar debt denominated in dollars, the cost to service and rollover existing positions was enormous. Rising interest rates for floating rate borrowing is a death trap, and the US use of higher interest rates to "defend the dollar" destroyed any capacity for Latin borrowers to sustain these elevated debt levels. As a direct result, the Latin American countries were eventually gripped with capital flight as investors rightly guessed that devaluations were the inevitable result. By 1982, even the Latin countries could not escape the same fate as they would have suffered under gold constraints.

Rather than adhering again to historic and traditional notions of imbalances in crisis, bank regulators in the US suspended mark-to-market for US commercial banks and intervened with rescue packages. Losses were not to be taken at the banking level. According to analysis cited by the FDIC, banks such as Bank of America, Manufacturers Hannover and Citigroup would have been insolvent. By 1986, loan loss reserves provisioned at commercial banks with large Latin crisis exposure only amounted to 13% of total exposure. It wasn't until 1987 that a bank, Citigroup, finally recognized a loss. That May the bank wrote off $3.3 billion, or 30%, of its Latin American exposure.

For the Latin borrowers, the IMF and the World Bank offered buybacks, exit bonds and, yes, swaps. Of course there were strict conditions that called for internal "reforms", but by 1994 about a third of the $191 billion in debt run up in the 1970's swap standard period was "forgiven" in one form or another. The Latin borrowers got the worst of all worlds - the mass unemployment, inflation and currency runs, leading eventually to the first modern "lost decade" (particularly Mexico).

So while each of these individual actors (nations) sought to remove themselves of the burdens of the cross of gold, they found themselves ending up in exactly those conditions. Except this was not a neutral proposition. Economic and monetary managers sought to avoid deflation by disregarding what they believed were outdated traditional warnings of intentionally appealing to self-financing, but in so doing followed the hippies into unintended bouts of malady.

Under gold standard terms, the "deflation" (recession, depression, unemployment) would have happened while imbalances were still largely manageable. Yes, economic adjustment would have been regressive, with lower income workers bearing the worst, but it would have been temporary; painful but relatively short-term.

Under the swap standard, not only did each economic system eventually succumb to recession and mass unemployment, it did so accompanied by years of insipid inflation. In this inflationary circumstance all savers bear the burden of adjustment in addition to workers (often one and the same). Inflation robs and steals hard earned savings, transferring stored "wealth" from the weakest economic actors to the banks that forego losses in the forgiveness of suspending mark-to-market. The banking system enlarges and "wins" in any inflationary scenario, and gets to keep those ill-gotten gains in the swap/bailout paradigm that accompanies the progressive monetary standard (the Great Inflation was a rehearsal for the Great Financial Crisis).

Between the 1970's and 2000's, imbalances simply headed East and grew without pause. The Great Moderation seems moderate in comparison because that modern narrative ignores currency volatility (see, Japan) and asset inflation. Today, there are still semi-permanent imbalances financed by a banking system dependent on a swap standard of floating fiat. Despite utopian appeals otherwise, the Spanish unemployment rate, for example, hit a new high of 27.5%, while workers fall out of the labor force in the US, the UK and Japan (for two decades running). The cross of gold is still acting upon the international system, except gold isn't money in this modern schematic. That suggests, maybe even proves, that the cross and burden of adjustment was never gold to begin with. We could use a Great Relearning lest we continue to suffer monetary scroff and grunge.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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