Guest Post by The Zman
Imagine a world in which governments do business with one another only in gold, as in physical gold. They can issue promissory notes to one another, but it has to be backed by verified stores of gold. Governments, however, do not use gold for paying employees or contracting work with private business. In the case of employees, government pays in script, the value of which is set by the government. The vendors, on the other hand, are paid with silver, as in real silver coin or silver notes.
The first part of this thought experiment is not a big leap, as governments still hoard gold and will on occasion pay one another in gold. In our imaginary world, gold would be the exclusive currency of government, so regular people would hold very little of it, other than for novelty. This is not much different from today, as gold is not legal tender in most of the world. It is treated, in the law, as a commodity, like diamonds, barrels of oil, bales of hay, and so on. Gold is a product, not money.
The rest of the thought experiment gets a little weird, as companies do business in the tender of their home country. If they did business with one another in silver, then one of two things would happen. Either the price of silver would be pegged at the value of the legal tender or it would be pegged at the price of gold. Since government would always be willing to buy gold in silver or tender, from anyone holding gold as a store of value, the most likely result is all three would be related in value.
The result of this arrangement would be a world where the credit worthiness of governments would be pegged to their gold reserves, but also the gold reserves of their native companies and populations. A government that could quickly buy up gold from its people would have more flexibility than a government so distrusted that its own people would resist selling its gold to the state. Something similar would apply to the credit ratings of businesses, with regards to the supply of silver.
A well run country with a high trust population and a responsible government would find that the flow of gold and silver would be high, as there would be no reason to hoard them. Similarly, the value of the paper script used for retail transactions would have a steady value, relative to the currency of business and government. This would not just be an internal trust. Outsiders would see it too. In contrast, corrupt states with corrupt people would have low trust and lots of hoarding of gold and silver.
Now, this thought experiment is useful in understanding what is happening with the screaming headlines about negative bond yields. The media hypes these events as if they are the sign of the end times. Most likely, they are triggered by the word “negative” and just assume it is bad news. In reality, what the market is saying is that the German bonds are so safe, the holder is willing to pay for the privilege of holding them. Lenders are literally paying the German state for the privilege of lending to it.
Now, it is tempting for a certain sort of person (libertarians) to say it is ridiculous to compare government debt to gold, as in this analogy. They are right. Government debt is actually more secure. The reason is this. Tomorrow, the government can ban the private ownership of gold. Executive Order 6102 is a United States presidential executive order signed on April 5, 1933, by President Franklin D. Roosevelt that effectively banned the private ownership of gold in the United States.
On the other hand, no government anywhere could ban the private ownership of government debt. In fact, no government could risk the hint of not paying its outstanding debts, as that would make all debt worthless. Since, in the case of Western countries, those government bonds are the basis of the financial system, public trust in the credit worthiness of government is vital. That’s why people are literally willing to trade gold at a loss for the privilege of holding German bonds right now.
Now, that does not mean negative rates are all puppies and sunshine. Going back to our analogy, a world where everyone trusts government, but is not willing to trust companies, would result in a disequilibrium in the relationship between gold, silver and the paper script used in retail. The “price” in terms of script for silver would collapse, while the price of gold would soar. After all, why hold silver when business is bad, when you can hold gold or even cash, which has a higher value?
In our age, government debt is the gold in the analogy, but corporate debt is the equivalent of the silver. Modern business works off debt, as it is the currency of the modern age. In prior ages, government debt and corporate debt was captive to the supply of gold and silver. Today, the relationship between sovereign debt, municipal debt, corporate debt and legal tender is enabled and managed by central banks, primarily the Federal Reserve and the European Central Bank.
This is why borrowing rates across the West remain at historic lows. The whole point of this arrangement was to prevent the ups and downs, the booms and busts that plagued industrial economies since the steam engine. The trouble is, the system also allows for the easy manipulation of the economy through the money supply. Inevitably, that worked one way and we are now in a place where no one is willing to pay the price of getting things back to something close to historic norms.
This system has also been based on certain assumptions about America that are starting to unravel. One is that America would continue to operate like a giant shopping mall, willing to buy on unfavorable terms. Both Europe and China based their economic models on this assumption. Trump has abandoned that and that’s why we see problems in China and now economic uncertainty in the heart of Europe. The uncertainty of world political arrangements is now showing up in the money.
It also suggests the markets are slowly coming to terms with the fact that the Trump economic model is the new normal. The election is fourteen months away, so if his loss in 2020 was the safe bet, the markets would be responding now. Instead, the global economy seems to be slowly coming around to the fact that either Trump wins in 2020 or his polices will be carried on no matter what happens. America as problem solver for the world’s money problems may be coming to an end.
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